GST trap for the unwary.

Practitioners must exercise extreme care when preparing gift tax returns for clients making gifts in trust.

Example: Husband H and wife W make a gift to a newly created trust. The trust indenture provides that the trustee may make discretionary distributions of income and principal to the donors' child and grandchild, the only two trust beneficiaries. Each trust beneficiary is given a right of withdrawal or Crummey power, so that the gift in trust is eligible for the annual gift tax exclusion. The gifted amount totals $100,000 (before gift-splitting) and H and W wish to split gifts.

As a practitioner preparing Form 709, U.S. Gift and Generation-Skipping Transfer Tax Return, for H and W, it is critical to properly report the gift for both gift tax and generation-skipping transfer (GST) tax purposes.

Reporting the transaction for gift tax purposes is fairly straightforward and understood by most practitioners. The $100,000 gift is reported on Part 1 of Form 709, Schedule A. The gift-splitting election is made in Part 3 of Schedule A, resulting in each spouse's total gift amount being reported at $50,000. The total gift amount is then reduced by annual exclusions of $20,000 ($10,000 for each donee), resulting in taxable gifts of $30,000 for each spouse. The resultant gift tax is then offset by the unified credit (assuming it has not been previously used) and no gift taxes are due with the returns.

Many practitioners, however, overlook reporting this transaction for GST tax purposes. Specifically, because the gift in trust was made for the benefit of both skip (grandchild) and nonskip (child) persons, the practitioner and his clients must make an express allocation of GST tax exemption to exempt the transfer from future GST tax. An automatic allocation of the donors' GST tax exemption to the gifts does not occur, because nonskip persons have an interest in the trust (Sec. 2613(a)(2)). The consequences of not making an affirmative allocation of GST tax exemption can be disastrous.

For instance, if an allocation of GST tax exemption is not made when the gift tax return is originally filed and the fair market value of the trust assets grows from the initial $100,000 to $5 million, at which time the child dies, a taxable termination has occurred for GST tax purposes, because only the grandchild remains as a trust beneficiary (Sec. 2612(a)(1)(A)). The entire $5 million of trust property is subject to GST tax at 55%, totaling $2,750,000.

The entire GST tax could have been avoided if the practitioner had made an allocation of the GST tax exemption when preparing Form 709. Such allocation should have been reported on Line 5 of Part 2 of Schedule C, together with the required allocation notice, presented in Exhibit 1. Based on the example, both H and W should have allocated $50,000 of their $1 million lifetime GST tax exemption to the original gift. In doing so, the trust property would have had an inclusion ratio of zero for GST tax purposes. Consequently, the taxable termination outlined above would not have resulted in GST tax, a savings of $2,750,000.

Exhibit 1

Notice of Allocation of GST Tax Exemption

The donor hereby allocates to the (Name) trust the smallest amount of GST tax exemption necessary to produce an inclusion ratio (as defined in Sec. 2642(a)), which is closest to, or, if possible, equal to, zero. If the donor has insufficient remaining GST tax exemption to obtain a zero inclusion ratio for the trust, the donor's remaining GST tax exemption will be allocated. This is a formula allocation that will change the amount being allocated if the values are changed on audit.

GST tax exemption has been previously allocated to the (Name) trust, so that immediately before the current transfer the trust had an inclusion ratio of zero.

Based on the return values, the total amount allocated on this notice is $xxxx, resulting in an inclusion ratio of zero.

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Signature of Donor

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Date

Practitioners should review previously filed gift tax returns to determine if any were fried for gifts in trust for the benefit of children and grandchildren. For those returns, practitioners should determine if an express allocation of GST tax exemption was made. If it would have been beneficial to make an express allocation of GST tax exemption, but it was inadvertently omitted, all is not lost. A taxpayer may still make an allocation of his GST tax exemption, thereby creating an inclusion ratio of zero for the trust property. However, instead of using the gift's FMV on the original gift date, the taxpayer must use the trust property's current FMV for the late GST tax exemption allocation, under Sec. 2642(b)(3). Accordingly, if the trust property has appreciated in value, more of the donor's $1 million GST tax exemption must be used to provide for a zero inclusion ratio, than would have otherwise been required. In many cases, however, the trustee is investing the donor's gift(s) in a life insurance policy insuring the life of the donor or spouse or both. Consequently, unless the insured has died, the trust property's value (approximately the cash surrender value of the life insurance policy) may be approximately the same (or less than) the value at the date of the donor's gift(s).

Note: For a discussion of the AICPA's legislative solution to this problem, see TTA, August 1998, p. 562.

FROM DENNIS J. SZYMKOWIAK, CPA, D'ALBA & DONOVAN, CPAs, EC., WILLIAMSVILLE, NY (NOT ASSOCIATED WITH SUMMIT INTERNATIONAL)

Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH