Beware not allocating the GSTT exemption on a gift tax return - a trap for the unwary.

The AICPA Tax Division's Trust, Estate and Gift Tax Committee has focused on a number of problems and concerns with the current generation-skipping transfer tax (GSTT) exemption that may not have caught the attention of many practitioners. While numerous practitioners prepare gift tax returns for clients, neither practitioners nor taxpayers may realize the importance of considering the impact of using die $1 million GSTT exemption at die time of filing, even for relatively small gifts. Since the result for GSTT purposes varies significantly (depending on whether an allocation is timely or late), there are serious traps in which practitioners may be caught if they do not consider the GSTT exemption at the time of filing the gift tax return. The potential future tax liability that may be avoided by the timely and judicious use of the GSTT exemption could be significant. Preparers and advisers are increasingly being blamed for unexpected results that were not fully explained at the time of the gift (which may have occurred many years prior to the actual generation-skipping transfer (GST) that results in the imposition of the (GSTT).

The IRS is currently examining the GSTT and the exemption allocation much more closely. Therefore, practitioners need to understand the full ramifications of allocating or not allocating the GSTT exemption when a gift tax return is filed.

Background

The GSTT is imposed at die maximum gift and estate tax rate (55%) on outright transfers or transfers in trust to beneficiaries more than one generation below the transferor's generation. To determine the rate applicable to a particular transfer, the 550% rate is multiplied by the inclusion ratio (a fraction based on the amount of exemption allocated to the GST. The GSTT is imposed on every GST (Sec. 2601), which includes taxable terminations, taxable distributions and direct skips. The tax does not apply to lifetime transfers (except for certain transfers in trust) exempt from gift tax because of the annual exclusion or because of the exclusion for certain tuition and medical expense payments (Sec. 2642(c)(3)).

Every individual is allowed a $1 million GSTT exemption, which may be allocated to any property transferred (Sec. 2631). Married couples may treat transfers as made one-half by each spouse, in effect giving them a combined $2 million exemption (Sec. 2652(a)(2)).

If the exemption is allocated on a timely filed gift tax return, it generally is based on the value of the property at the time of the transfer. However, if the allocation is not made on a timely filed gift tax return (i.e., not until death), the GSTT consequences are based on the value of the property at the time of the allocation (generally, a significantly higher value).

Examples of Potential Traps

Example 1: A parent transfers $1,000,000 of stock to a trust, with the child to receive income for life and the grandchild to receive the remainder. If the full $1,000,000 GSTT exemption is allocated to this transfer on a timely filed gift tax return and the value of the stock is $5,000,000 when the property passes to the grandchild, no GSTT results. However, if the GSTT exemption is not allocated until the property passes to the grandchild, a GSTT of $2,200,000 would result.

Example 2: Assume the same facts as in Example 1, except that the trust provides income to the child for the parent's life and, on the parent's death, the remainder goes to the child outright; if the child is not alive at that time, die remainder goes to the child's heirs. If no exemption is allocated on a timely filed gift tax return and the child predeceases the parent, a GSTT of $2,200,000 would occur as a result of the parent's death. Note that the "predeceased parent exception" under Sec. 2612(c)(2) does not apply because this is not a direct skip.

Example 3: A parent establishes a trust for the benefit of children and grandchildren. Gifts are made to the trust on an annual basis using a "Crummey power" (temporary right of beneficiaries to withdraw that creates a present interest) that qualify for the $10,000 annual exclusion. Assume that over the years $500,000 was transferred to the trust, and that it is worth $5,000,000 when a taxable termination occurs in favor of the grandchildren. No GSTT exemption allocations were made on the timely filed gift tax returns. Since the transfers do not qualify for the GSTT annual exclusion (Sec. 2642(c)), the taxable termination will result in a GSTT of $2,200, 000. If exemptions were allocated on timely filed gift tax returns, only $500,000 of the $1,000,000 exemption would be used, and no GSTT would result.

In Example 1, the trust is clearly designed as a generation-skipping trust, and the issue of allocating the GSTT exemption would likely be addressed when the gift tax return is filed for the gift. However, in Examples 2 and 3, the trusts are not clearly trusts that could result in a GSTT. Consequently, the issue of allocating the GSTT exemption to the transfers may not be raised when the gift tax return is filed. If an unexpected death occurs (Example 2) or gift tax annual exclusion transfers are used to create an inheritance for grandchildren (Example 3) and no timely allocations of the GSTT exemption are made, the results can be disastrous.

Checklist Item

As the Tax Division has noted in its annual Tax Practice Guides and Checklists, in the sections covering Forms 706 and 709, practitioners should consider allocating the GSTT exemption and review prior returns after 1985 for use of the GSTT exemption.

AICPA Suggested Legislative Change

The Trust, Estate and Gift Tax Committee has considered these situations and developed a legislative recommendation. This proposed legislation is only a first step; the Committee would be amenable to changes that would deal with prior missed allocations with future modifications to allocations in certain circumstances. However, it was felt that this proposal would be a simple solution to the problem, and would likely gain the support of Treasury, the IRS and Congress. The recommendation has been approved by the AICPA Tax Executive Committee and, on May 9, 1997, was sent to the chairs of the tax-writing committees in Congress. The recommendation is to change the allocation rules to provide an automatic allocation of the GSTT exemption for all lifetime transfers, with an option for the transferor to elect out of die automatic allocation at the time of the transfer.

Specifically, Sec. 2632(b) should be amended to read as follows (note: new text is underlined; deleted text is struck out):

(b) DEEMED ALLOCATION TO CERTAIN LIFETIME TRANSFERS -

(1) IN GENERAL. - If any individual makes a direct skip transfer during his lifetime that is a direct skip or could result in a taxable distribution or taxable termination, any unused portion of such individual's GST exemption shall be allocated to the property transferred to the extent necessary to make the inclusion ratio for such property zero. If the. amount of the direct skip transfer exceeds such unused portion, the entire unused portion shall be allocated to the property transferred.

(2) UNUSED PORTION. - For purposes of paragraph (1), the unused portion of an individual's GST exemption is that portion of such exemption which has not previously been allocated by such individual treated as allocated under paragraph (1) with respect to a prior direct skip).

(3) SUBSECTION NOT TO APPLY IN CERTAIN CASES. - An individual may elect to have this subsection not apply to a transfer.

Rationale for the Suggested Legislative Change

This issue is one of fairness and equity. The proposal is designed to eliminate a significant potential trap for both taxpayers and practitioners related to missed GSTT exemption allocations. Practitioners filing gift tax returns face potential significant liability in connection with preparing gift tax returns with respect to possible GSTT transfers. Taxpayers who make the GSTT exemption allocation on a timely filed gift tax return can save substantial amounts of GSTT. As can be seen from Examples 2 and 3, taxpayers may not even be aware of the possible generation-skipping consequences of certain transfers. Making the allocation automatic, which taxpayers can then elect not to apply, will force the issue to be addressed at the time of the transfer or the time of filing the gift tax return. The current climate allowing a missed allocation to create a potential GSTT liability that could grow continually over the years has resulted in a situation in which the preparation of gift tax returns may be too risky for practitioners to pursue. As a result, taxpayers may be deprived of needed professional advice in an extremely complicated area of the tax law.

Committee Plans

The Trust, Estate and Gift Tax Committee hopes Congress will give this proposal favorable consideration, and plans to meet with members of Congress and their staff, including the Joint Tax Committee, to further discuss these matters. The Tax Division has this as one of its priority issues.

In addition, in June 1997, the Trust, Estate and Gift Tax Committee met with representatives from Treasury, die IRS and the American Bar Association (ABA) on this issue and the specific proposal. The government officials and ABA representative were sympathetic to the problem and agreed that something should be done. They are willing to work with the AICPA on a solution. Some other possible recommendation include allowing a missed allocation to be reversible under a procedure similar to Sec. 9100 relief (Regs. Sec. 301.9100-1), expansions of the predeceased parent exception, and allowing taxpayers to pay the tax when discovered and stop the GSTT consequences going forward from that date.

Related Pending Legislation

The proposed Revenue Reconciliation Act of 1997 contains a provision that would provide limited relief. The provision would modify the GSTT exception for transfers to individuals with deceased parents. Under the current "predeceased parent exception," a direct skip transfer to a transferor's grandchild is not subject to the GSTT, if the child of the transferor (the grandchild's parent) is deceased at the time of the transfer (Sec. 2612(c)(2)). Currently, this predeceased parent exception is not applicable to transfers to collateral heirs (e.g., grandnieces or grandnephews), taxable terminations or taxable distributions. The proposed provision would, effective for transfers after 1997, expand the predeceased parent exception" to transfers to collateral heirs, provided that the decedent has no having lineal descendants at the time of the transfer. In addition, it would extend the predeceased parent exception (as modified by the preceding sentence) to certain taxable terminations and taxable distributions.

If a trust with an inclusion ratio of greater than zero is severed into two separate trusts, another GSTT provision in the House version of the budget get bill would allow the trustee to elect to treat one of the separate trusts as having an inclusion ratio of zero and die other separate trust as having an inclusion ratio of one. To qualify for this treatment, the separate trust with the inclusion ratio of one would have to receive an interest in each property held by die single trust (prior to severance) equal to the single trust's inclusion ratio, except to the extent otherwise provided by regulation. The remaining interests in each property would be transferred to the separate trust with the inclusion ratio of zero. The election would be required to be made at a time and in a manner prescribed by the Treasury Department. This provision would be effective for severances of trusts occurring after the date of enactment. (Note: At the time this column was written, the final budget get bill was going to a Congressional Conference Committee to reconcile the differences in the House and Senate versions of the bill, and was not yet in final form.)

Additionally, the budget bill would index annually for inflation the $1 million GSTT exemption, effective for gifts made after 1998.

Conclusion

Taxpayers and practitioners should consider whether to make the GSTT exemption at the time of filing the gift tax return. The Tax Division is working on this problem; however, at this point, the consequences of not making a timely GSTT exemption allocation may be significant. Whether to use the GSTT exemption currently, wait for another time or save it for another gift is a question that should be answered by an informed client.

Editor's note: Ms. Sherr is the technical manager of the AICPA Tax Division's Trust, Estate and Gift Tax Committee. This department is written by the AICPA Tax Division's professional staff. It is designed to heighten awareness of the Division's work and keep readers apprised of Tax Division activities involving tax policy, technical issues and other practice support matters.

If you would like additional information about this article, contact Ms. Sherr at [phone] or [e-mail].