Finality of inclusion ratio under final sec. 2642 regulations.

The generation-skipping transfer (GST) tax is computed by multiplying the taxable amount of any GST by the applicable rate. The key component of the applicable rate is the inclusion ratio or percentage of the GST subject to tax. The inclusion ratio generally is calculated based on a fraction, the numerator of which is the amount of GST exemption allocated to the transfer and the denominator is the property's fair market value (FMV) on the date it was transferred. Changes to the property's value after the date of transfer typically do not change the inclusion ratio; the notable exception is when property used to fund a GST remains subject to valuation adjustment by the IRS. The potential change to an inclusion ratio creates a measure of uncertainty for estate planners that the final regulations address in a somewhat roundabout way.

Prop. Regs. Sec. 26.2642-5(b) provided for a "later of" rule for determining when the inclusion ratio of a trust (other than a direct skip trust) becomes final. Under this approach, the inclusion ratio becomes final on the later of (1) the expiration of the period for assessment on the first GST tax computed using that inclusion ratio or (2) the termination of the period for assessment of Federal estate tax on the transferor's estate.

With respect to the first part of the "later of" rule, it was unclear how a nontaxable GST would be treated; a literal interpretation would necessitate the paying of a GST tax to trigger its operation. Given this interpretation, a trust's inclusion ratio might never become final when the purported inclusion ratio is zero. The final regulations clarified this by changing the first part to refer to "the first GST tax return filed using that inclusion ratio." This change is consistent with public comments on the proposed regulations, but falls short of being a windfall.

The shortcomings of the "later of" rule are somewhat mitigated by a change made to determining the value of property used to calculate the inclusion ratio. The change made by the final regulations applies to certain transfers made during life to which a timely allocation of GST exemption is made pursuant to Regs. Sec. 26.2632-1 (b) (2) (ii). Regs. Sec. 26.2642-2(a) (1) provides that the value of the denominator of the applicable fraction for these transfers is the property's FMV as finally determined for gift tax purposes. In this instance, the inclusion ratio will effectively become final after the gift tax statute of limitations runs.

Uncertainty as to the finality of a trust's inclusion ratio creates a host of planning problems, especially when difficult-to-value property is transferred. When GST exemption is allocated by formula to lifetime transfers (permissible under Regs. Sec. 26.2632-1 (b) (2) (i), the determination of the remaining GST exemption remains uncertain. This can make difficult additional lifetime GST planning or testamentary GST planning conditioned on "available GST exemption" (typically a reverse qualified terminable interest property (QTIP) trust created by formula).

Public comments urged changing the "later of" rule to an "earlier of" rule, arguing that there was no need to keep the inclusion ratio open to protect the government's right to a judicial determination of the value of property transferred to the trust. This conclusion was reached despite language in the preamble to the proposed regulations asserting the "later of" rule is necessary, because there may not be a justiciable issue with respect to a claimed inclusion ratio until a tax deficiency can be asserted. The public comments substantiated this conclusion by finding that there was, at least with respect to the initial transfer in trust, a justiciable issue under the estate and gift tax provisions and no reason to extend the period of assessment beyond the period for assessing tax to the applicable transfer. These same comments urged accelerating finality of the inclusion ratio so that gift tax values would become final for inclusion ratio purposes as adjusted in the transferor's estate.

Based on the change made in the final regulations, it appears there is an opportunity to accelerate the finality of inclusion ratios for some lifetime transfers, provided a timely allocation of GST exemption is made. For other lifetime transfers to trusts, the only certainty that can be provided depends on whether distributions can be made to skip persons. By filing a GST tax return that uses a purported inclusion ratio on Form 706GS(D), Generation-Skipping Transfer Tax Return for Distributions, and Form 706GS(D-1), Notification of Distribution From a Generation-Skipping Trust, the inclusion ratio would become final no later than the assessment period with respect to the transferor's estate. This would be true regardless of whether there was any GST tax paid (because of a zero inclusion ratio). However, this would be of little benefit for testamentary planning, because of the "later of" rule. To illustrate the differences, consider the following example.

Example: T transfers $500,000 of closely held business stock to a trust, which provides that income and principal may be distributed to T's child, C, and T's grandchild, G, during C's life. At C's death, the remaining principal is distributed to G. T allocates by formula so much of her GST exemption as is necessary to produce a zero inclusion ratio. The trustee makes a distribution to G during 1996. T dies in 2001, having made no other additions and allocating no additional GST exemption to the trust. C dies in 2010, and the remaining trust principal is distributed to G.

Under the proposed regulations, there was no reference to the gift tax statute of limitations when describing the value of property transferred to the trust. The trust's inclusion ratio never would become final because there would be no tax computed using the trust's inclusion ratio with respect to the taxable distribution in 1996 or the taxable termination in 2010. Under the final regulations, the inclusion ratio becomes final at the end of the gift tax assessment period, provided a timely allocation of GST exemption was made. Absent a timely allocation, the inclusion ratio becomes final at the end of the assessment period for T's estate.

Under the final regulations, the executor of T's estate now has the ability to determine what portion of T's GST exemption remains available for allocation to testamentary bequests, provided a timely allocation was made. If not, the executor remains in the dark and the trustee eventually gets some guidance as to the potential for GST tax as the trust's inclusion ratio becomes final after the estate tax assessment period for T's estate.

The example highlights the planning difficulty associated with the "later of" rule and the premium associated with making a timely allocation of GST exemption to a lifetime transfer. The change in the final regulations to the "later of" rule offers some benefit, but there would still be a significant amount of uncertainty, absent mitigation provided by the change to Prop. Regs. Sec. 26.2642-2(a) (1). One type of lifetime transfer that will benefit from the changes is a gift made to a life insurance trust, especially when premiums are funded via a split-dollar arrangement.