New regs. on elections for indirect skips: final regulations on indirect skip transfer elections give taxpayers many generation-skipping transfer tax planning options. This article explains the election rules and available planning opportunities under the new regulations.

EXECUTIVE SUMMARY

* The final regulations provide rules for making an election out of the automatic allocation of GST exemption to indirect skips, for any or all transfers to a particular trust.

* An example in the final regulations illustrates various transfers and contains sample language that may be used to satisfy the election-out statement requirements.

* The final regulations also provide rules for making an election into the automatic allocation of GST exemption to indirect skips, for any or all transfers to a particular trust.

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On May 29, 2005, the IRS issued final regulations setting forth procedures for making certain elections regarding indirect skips for generation-skipping transfer (GST) tax purposes. (1) These rules differ significantly from the 2004 proposed regulations, (2) by adding many taxpayer-favorable provisions suggested by commentators. This article explains the options available under the final regulations and illustrates why the elections are very important to GST tax planning, whether or not a particular transfer is an indirect skip.

Automatic Allocations to Indirect Skips

The Economic Growth and Tax Relief Reconciliation Act of 2001 added many new provisions to Chapter 13 of the Code, designed to make GST tax planning more flexible (and user-friendly). Significantly, it added Sec. 2632(c), regarding the automatic allocation of GST exemption to indirect skips. Sec. 2632(c)(3)(A) defines an indirect skip as a transfer of property (that is not a direct skip) to a GST trust. In general, a GST trust is any trust that could have a GST. (3)

Under Sec. 2632(c)(1), for lifetime transfers made after 2000 that are indirect skips, a taxpayer's available GST exemption is automatically allocated to a transfer, to the extent necessary to make the inclusion ratio zero for such transfer (i.e., to make it GST tax-exempt). Similar to regulations on automatic allocation of GST exemption to direct skips, (4) Regs. Sec. 26.2632-1(b)(2)(i) makes it clear that the automatic allocation of GST exemption to an indirect skip is effective whether or not Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, is filed, reporting the transfer, and is effective as of the date of the transfer to which it relates. The automatic allocation is irrevocable after the gift tax return due date for the calendar year in which the transfer is made. (5) For indirect skips that may be subject to an estate tax inclusion period (ETIP), (6) an automatic allocation is deemed to have been made at the close of the ETIP. In either case, the regulations clarify that the automatic allocation of GST exemption to an indirect skip applies even if a taxpayer has also made an affirmative allocation of GST exemption to a particular transfer. (7)

Sec. 2632(c) allows a taxpayer to choose whether he or she wants the automatic allocation rules for indirect skips to apply to a transfer(s) to a particular trust. Under Sec. 2632(c)(5), a taxpayer may elect (1) not to have them apply to a transfer to a trust, (2) not to have them apply to any and all transfers to a trust or (3) to have them apply to any and all transfers to a trust. These elections allow a taxpayer greater flexibility in determining whether the automatic allocation rules for indirect skips will apply to transfers to trusts. The regulations explain how these elections are made and their effect on the allocation of GST exemption to a transfer or trust.

Election Out

Sec. 2632(c)(5)(A)(i) allows a taxpayer to elect out of the automatic allocation rules for certain indirect skips or for any or all transfers made to a particular trust (election out). Under Regs. Sec. 26.2632-1(b)(2)(iii), an election out may be made for:

1. One or more prior-year transfers subject to an ETIP made by the taxpayer to a specified trust(s);

2. One or more (or all) current-year transfers made by the taxpayer to a specified trust(s);

3. One or more (or all) future transfers to a specified trust(s);

4. All future transfers by the taxpayer to all trusts (whether or not in existence at the time of the election out); or

5. Any combination of the categories of transfers listed above.

These categories of transfers are a significant modification of the proposed regulations, which provided only that a taxpayer could make an election for a current-year transfer and/or all future transfers to the same trust (i.e., only those transfers listed in #2 and #3 above). (8) According to the preamble, the new categories were added to the final regulations in response to various comments received by the IRS. The addition of #1 above is of particular interest to estate planners who must consider the GST tax consequences of transfers to a trust that may be subject to an ETIP. One of the more common situations is when a grantor retained annuity trust (GRAT) is used as part of a taxpayer's estate plan.

For example, assume that a taxpayer transfers property to a GRAT that meets the definition of a GST trust in Sec. 2632(c)(3)(B). Because the property in the GRAT will be included in the taxpayer's gross estate for estate tax purposes if he or she dies during the annuity term, (9) the transfer to the GRAT is subject to an ETIP. Sec. 2632(c)(4) provides that in the case of a transfer subject to an ETIP, an indirect skip is deemed to have been made only on the close of the ETIP. The proposed regulations would have allowed the taxpayer to make an election out only on the ETIP's expiration (i.e, when the indirect skip is deemed to have occurred). The regulations clarify that an election out with regard to a GRAT can be made up to and including the year in which the ETIP expires. Thus, the taxpayer can choose to elect out of the automatic allocation rules when the transfer is made to the GRAT or at any time up to and including the year in which the ETIP expires.

Procedure

To make an election out, a taxpayer must attach a statement to his or her gift tax return identifying the trust and stating that he or she is electing out of the automatic allocation of GST exemption with respect to the described transfer(s) (the election-out statement). Unless the election out is made for all transfers to the trust in the current and/or all future years, the current-year transfers and/or the future transfers to which the election out is to apply must be specifically described or otherwise identified in the election-out statement. (10) The final regulations omit the proposed regulations' requirement that the specific Code section be stated in the election-out statement. (11) Regs. Sec. 26.2632-1 (b)(2)(ii) clarifies that an election out does not apply to the automatic allocation rules at death set forth in Sec. 2632(e).

In addition, Regs. Sec. 26.2632-1(b)(2)(iii)(B) requires that prior-years' transfers subject to an ETIP for which an election out is to apply, must be specifically described or otherwise identified in the election-out statement. Thus, in the previous example using a GRAT, if the taxpayer is making an election out during the ETIP after the year of the transfer to the GRAT, he or she must identify the previous transfer. It is not sufficient to simply file an election out, stating that it applies to "any or all transfers to the identified trust." Because additions to a GRAT are prohibited by Regs. Sec. 25.2702-3(b)(5), the regulations would give such an election out no effect.

Regs. Sec. 26.2632-1(b)(2)(iii)(C) describes when to make an election out (other than a deemed election out). The gift tax return, with the election-out statement attached, must be filed by the due date of the return for the calendar year in which the first transfer to be covered by the election out was made. If the transfer is subject to an ETIP, the election out must be filed by the due date of the return for the calendar year in which the ETIP expires. Once an election out as to any or all future transfers to a particular trust is made, Regs. Sec. 26.2632-1(b)(2)(iii)(D) provides that a taxpayer need not file additional election-out statements for transfers to the trust.

Under Regs. Sec. 26.2632-1 (b)(2)(iii)(D), a properly filed election-out statement does not affect the application of the automatic allocation rules to indirect skips not covered in the election-out statement. Further, an election out does not pertain to indirect skip transfers that occurred in prior years (except when an indirect skip has not yet been deemed to have occurred). More importantly, an election out does not prevent the taxpayer from later affirmatively allocating GST exemption to a transfer (for which a previous election out had been made) on a timely filed gift tax return or an affirmative late allocation. For example, assume a taxpayer made an election out in a previous year for future transfers to a trust. In the present year, the taxpayer makes a transfer to the trust and wants to allocate GST exemption to it. The regulations affirm that the taxpayer may make an affirmative allocation of GST exemption to such transfer. The election out, however, will remain in effect as to the trust unless it is subsequently terminated.

Sample Statements

The final regulations add an example, (12) not included in the proposed regulations, which contains sample language that may be used to satisfy the requirements of an election-out statement. In addition to setting forth sample language, the example helps illustrate some of the above-listed categories of transfers for which an election out may be chosen.

Example 1: (13) On March 1, 2006, T transfers $100,000 to Trust B, a GST trust. On Sept. 15, 2006, T transfers an additional $75,000 to B. No other transfers are made to B in 2006. T attaches an election-out statement to a timely filed gift tax return for calendar-year 2006. Except with regard to the last sample language example discussed below (for which the identity of a trust is not required), the election-out statement identifies B as required by the regulations and contains the following alternative election-out statements.

Category 2 transfer: Statement: T hereby elects that the automatic allocation rules will not apply to the $100,000 transferred to B on March 1, 2006. Effect: The election out will be effective only for T's March 1, 2006 transfer and will not apply to T's $75,000 transfer made on Sept. 15, 2006.

Category 2 transfer: Statement: T hereby elects that the automatic allocation rules will not apply to any transfers to B in 2006. Effect: The election out will be effective for T's transfers to B made on March 1, 2006 and Sept. 15, 2006.

Combination category 2/3 transfer: Statement: T hereby elects that the automatic allocation rules will not apply to any transfers by T to B in 2006 or to any additional transfers T may make to B in subsequent years. Effect: The election out will be effective for T's transfers to B in 2006 and for all future transfers to be made by T to B, unless and until T terminates the election out.

Combination category 2/3 transfer: Statement: T hereby elects that the automatic allocation rules will not apply to any transfers T has made or will make to B in 2006-2008. Effect: The election out will be effective for T's transfers to B in 2006-2008. T's transfers to B after 2008 will be subject to the automatic allocation rules, unless T elects out of those rules for one or more years after 2008. T may terminate the election out for 2007, 2008 or both, in accordance with the regulations' termination rules. T may terminate the election out for one or more of the transfers made in 2006 on a later (timely filed) gift tax return for calendar-year 2006.

Category 4 transfer: Statement: T hereby elects that the automatic allocation rules will not apply to any current or future transfer that T may make to any trust. Effect: The election out will be effective for all of T's transfers (current-year and future) to B and to any and all other trusts (whether they exist in 2006 or are created in a later year), unless and until T terminates the election out. T may terminate the election out as to one or more (or all) of the transfers covered by the election out in accordance with the regulations' termination rules.

Deemed Election Out

Under Kegs. Sec. 26.2632-1(b) (2)(ii), a taxpayer may also prevent the automatic allocation of GST exemption to an indirect skip, by making an affirmative GST exemption allocation on a gift tax return filed by the due date for timely filing such return, of an amount less than the value of the transferred property as reported on the gift tax return. If a taxpayer chooses to make an affirmative allocation to an indirect skip that is not equal to the transfer value, the regulations treat the taxpayer as having made an election out equal to the transfer amount in excess of the affirmative allocation. According to the preamble, this alternative was added to the regulations in response to comments on the proposed regulations that such a result is probably the most likely intent of the taxpayer making such an affirmative allocation.

Regs. Sec. 26.2632-1(b)(4)(iii), Example 6, provides the following example illustrating a "deemed" election out:

Example 2: On Dec. 1, 2003, T transferred $100,000 to an irrevocable trust described in Sec. 2632(c)(3)(B). The transfer is not a direct skip. The date prescribed for filing the gift tax return reporting the taxable gift was April 15, 2004. On Feb. 10, 2004, T filed a Form 709 on which T allocated $40,000 of GST exemption to the trust. By filing Form 709 with a $40,000 partial allocation, T effectively elected out of the automatic rules for the remaining value of the transfer for which T did not allocate GST exemption.

Query whether this provision is always in the best interest of taxpayers.

Example 3: The facts are the same as in Example 2 above, except that the trust contained a Crummey (14) withdrawal power, so that T's child had a power to withdraw $11,000. X, T's return preparer, thinking that there was no need to allocate GST exemption to the $11,000 (because X believed this portion of the transfer to the trust was exempt from GST tax (under Sec. 2642(c)), allocated only $89,000 of GST exemption to the trust.

T would have been given incorrect advice, the injury from which would have been compounded by the regulations' assumption that the partial election out was intentional. It seems that this error is much more likely to arise, rather than the one set forth in Example 2 above. If T is making an affirmative allocation of GST exemption to part of the transfer, T is sufficiently intelligent to state therein that he or she is making an election out to the part of the transfer that exceeds the affirmative allocation.

Termination

One of the unanswered questions with regard to Sec. 2632(c)(5) elections was whether an election could be terminated. Regs. Sec. 26.2632-1(b)(2)(iii)(E) answers this affirmatively. It provides that a taxpayer may terminate a previously made election out at any time, by attaching a termination statement to his or her gift tax return, filed by the due date of the return for the calendar year in which is made the first transfer to which the election out is not to apply.

The termination statement must clearly identify the trust to which the termination statement is directed, describe the election out that is being terminated and either (1) the extent to which the prior election out is being terminated or (2) any current-year transfers to which the election out is not to apply. Thus, a termination of an election out does not have to be permanent; the taxpayer is allowed to determine the termination's extent.

Kegs. Sec. 26.2632-1(b)(2)(iii)(E) provides that a termination statement may be filed whether or not any transfer was made in the calendar year for which the gift tax return was filed, and whether or not a gift tax return would otherwise have been required to be filed in the year the termination statement is filed. Thus, the regulations do not require a current-year transfer to the trust for which the termination statement is being filed, nor do they require a gift tax return to otherwise be filed in the year a taxpayer elects to terminate a previous election out.

For transfers not subject to an ETIP the termination of the election out applies prospectively only. Thus, prior-years' transfers for which an election out had been made are not affected by the termination statement. If the termination statement is filed on or before the year in which an ETIP expires, the termination statement will apply to the previous years' transfers, because the indirect skip will not be deemed to have occurred before the ETIP's expiration. Regs. Sec. 26.2632-1(b) (2)(iii)(E) also clarifies that the termination of an election out does not preclude the transferor from making another election out in the same or any subsequent year.

Election In

Sec. 2632(c)(5)(A)(ii) allows a taxpayer to elect to treat a transfer to a trust that otherwise would not be an indirect skip, as an indirect skip and to apply the automatic allocation rules for indirect skips. Sec. 2632(c)(5)(A)(ii) accomplishes this by allowing a taxpayer to elect to treat a non-GST trust as a GST trust (GST trust election). This provision allows a trust (to which affirmative allocations of GST exemption would otherwise be required) to apply the automatic allocation rules for indirect skips to all transfers to such trust.

The regulations providing for the GST trust election are similar in nature to the provisions for electing out of the automatic allocation rules for indirect skips. However, while an election out may apply to a current-year transfer and/or any or all transfers to a trust, Sec. 2632(c)(5)(A)(ii) provides that the GST trust election applies to a trust, not to a particular transfer. As discussed below, however, the regulations allow a taxpayer to make a GST trust election for a particular transfer.

Regs. Sec. 26.2632-1(b)(3)(i) lists the following categories of transfers to which the GST trust election may apply (without regard to whether the transfer is subject to an ETIP): 1.Any current-year transfer (or any or all current-year transfers) by the electing taxpayer to the trust; 2. Any selected future transfers by the electing taxpayer to the trust; 3. All future transfers by the electing transferor to the trust; or 4. Any combination of the categories of transfers listed above.

Procedure

The GST trust election is made by attaching a statement to a gift tax return filed by the due date for the calendar year in which the first transfer to be covered by the GST trust election is made. Under Regs. Sec. 26.2632-1(b)(3)(ii), the election statement must (1) identify the trust, (2) specifically describe or otherwise clearly identify the transfers to be covered by the GST trust election and (3) specifically provide that the taxpayer is electing to have the trust treated as a GST trust for the described transfers. However, the regulations omit the requirement in the proposed regulations to state the specific Code section allowing the election in. Also, the regulations do not provide sample language for a GST trust election statement similar to that provided for an election out.

Termination

If a GST trust election is chosen, the taxpayer's unused GST exemption will be automatically allocated to transfers described in the GST election statement. Regs. Sec. 26.2632-1(b)(3)(iii)(A) allows a taxpayer to prevent the automatic allocation of GST exemption to future transfers to the trust, by either terminating the GST trust election or by making an election out as set forth in the regulations. Thus, the regulations allow a taxpayer to partially or wholly terminate a previously made GST trust election, by (1) terminating the election, (2) making an election out as to a particular transfer to the trust or (3) making an election out for any or all transfers to the trust. This is logical, because once the GST trust election has been made, the election-out options should be applicable to the trust.

If a taxpayer chooses to terminate the GST trust election, he or she must attach a termination statement to a timely filed gift tax return for the first year in which the GST trust election is no longer to apply, whether or not a transfer is made to the trust in such year. Under Regs. Sec. 26.2632-1(b)(3)(iv), the termination statement must identify the trust, describe the current-year transfer (if any) and provide that the prior GST trust election is terminated. As with the termination of an election out, the termination of a GST trust election does not prevent the taxpayer from subsequently making another GST trust election for such trust.

Like the termination of an election out, the termination of the GST trust election is generally prospective. However, if the taxpayer terminates a GST trust election for a trust for which transfers were subject to an ETIP and such termination is filed by the year in which the ETIP expires, the termination will effectively release prior transfers to the trust that were otherwise subject to a prior GST trust election.

ETIPs

The regulations also make certain revisions for ETIPs. Regs. Sec. 26.2632-1(c)(1)(i) clarifies that a direct skip or an indirect skip that is subject to an ETIP is deemed to have occurred only at the close of the ETIP. It also clarifies that a taxpayer may prevent the application of the automatic allocation rules (for both direct and indirect skips) at any time before the due date of the gift tax return for the calendar year in which the close of the ETIP occurs (whether or not any transfer was made in the calendar year for which the gift tax return was filed, and whether or not a gift tax return otherwise would be required to be filed for such year). However, under Regs. Sec. 26.2632-1(c)(1)(ii), this rule does not apply when an affirmative allocation of GST exemption has been made to a trust before the ETIP's expiration. Thus, a taxpayer cannot use an automatic allocation election to override an affirmative allocation of GST exemption to a trust that has been made before the expiration of an ETIP.

Conclusion

Although the automatic allocation rules have become much more user-friendly, there is no substitute for thinking through the GST consequences of a trust, making an affirmative decision as to allocation of the GST exemption and memorializing the decision. In fact, given that the new opt-out and opt-in provisions could reach transfers well into the future, a gift tax return preparer should review all prior gift tax returns to ensure that the GST exemption has been properly addressed. The preparation of gift tax returns has just become much more complicated.

(1) TD 9208 (5/29/05).

(2) REG-153841-02 (7/13/04).

(3) See Sec. 2632(c)(3)(B). This provision lists certain exceptions to the general rule that are not germane to this article.

(4) See Kegs. Sec. 26.2632-1(b)(1).

(5) Relief from this automatic allocation, however, may be available under Sec. 2642(g)(1).

(6) Sec. 2642(f) defines an ETIP as any period after a transfer, during which the value of the property involved would be includible in the transferor's gross estate for estate tax purposes, if he or she died.

(7) See Kegs. Sec. 26.2632-1(b)(2)(i). This rule applies unless the taxpayer has (1) elected not to have such rule apply pursuant to Sec. 2632(c) (5)(A)(i) or (2) made an affirmative partial allocation, as provided in Kegs. Sec. 26.2632-1 (b)(2)(ii).

(8) See Prop. Regs. Sec. 26.2632-1(b)(2)(ii) and (iii).

(9) See Secs. 2036 and 2039.

(10) See Regs. Sec. 26.2632-1(b)(2)(iii)(B).

(11) See Prop. Regs. Sec. 26.2632-1(b)(2)(iii)(A).

(12) See Regs. Sec. 26.2632-1(b)(4)(iv), Example 1.

(13) Adapted from Regs. Sec. 26.2632-1(b)(4)(iv), Example 1.

Justin P. Ransome, J.D., MBA, CPA 

Partner, Family Wealth Planning

National Tax Office

Grant Thornton LLP 

Washington, DC

Author's note: The author thanks Evelyn M. Capassakis, Partner, PricewaterhouseCoopers LLP, New York, NY, for her invaluable contributions to this article.