generation skipping transfer tax exemption

GENERATION-SKIPPING TRANSFER TAX EXEMPTION ALLOCATION RULES AND SECTION 9100 RELIEF American Bar Association Section of Real Property, Probate & Trust Law 14th Annual Estate Planning Symposium New York, New York April 3, 2003 BARBARA A. SLOAN McLAUGHLIN & STERN LLP NEW YORK, NEW YORK JULIE K. KWON BESSEMER TRUST CHICAGO, ILLINOIS TRENT S. KIZIAH JONES, FOSTER, JOHNSTON & STUBBS, P.A. WEST PALM BEACH, FLORIDA GENERATION-SKIPPING TRANSFER TAX EXEMPTION ALLOCATION RULES AND SECTION 9100 RELIEF Amount of the GST Exemption .......................................................................................1 Allocation by Transferor or Representative....................................................................1 Allocation to Transferor's Transfers ...............................................................................2 Irrevocable Allocation .......................................................................................................3 Void Allocation...................................................................................................................5 Formula Allocation ............................................................................................................6 Deemed Allocation Rules to Lifetime Direct Skips.........................................................8 Deemed Allocations to Lifetime Indirect Skips.............................................................11 A. First Exception. Section 2632(c)(3)(B)(i)................................................................12 B. Second Exception. Section 2632(c)(3)(B)(ii)...........................................................14 C. Third Exception. Section 2632(c)(3)(B)(iii)............................................................16 D. Fourth Exception. Section 2632(c)(3)(B)(iv)..........................................................17 E. Fifth Exception. Section 2632(c)(3)(B)(v)...............................................................17 F. Sixth Exception. Section 2632 (c)(3)(B)(vi) ............................................................17 G. Annual Exclusion Rule .............................................................................................18 H. ETIP Rule ..................................................................................................................19 I. Exception with Respect to Indirect Skips................................................................19 J. Procedure for Elections ............................................................................................20 K. Priority of GST Tax Exemption ..............................................................................20 L. Practical Application.................................................................................................21 IX. Post-Mortem Deemed Allocation Rules .........................................................................22 X. Late Allocations................................................................................................................25 XI. Estate Tax Inclusion Period (ETIP) ...............................................................................28 XII. Relief for Late Allocations and Elections.......................................................................30 A. Statutory Change ......................................................................................................31 B. Legislative History.....................................................................................................31 C. Treasury Response....................................................................................................32 D. Treasury Reg. § 301.9100-3......................................................................................32 E. Technical Requirements ...........................................................................................34 F. Brief Summary of Issued Rulings ............................................................................35 XIII. Retroactive Allocations....................................................................................................40 XIV. Severing of Trusts: Qualified Severances .....................................................................42 XV. Substantial Compliance...................................................................................................46 XVI. Valuation of Transfers for GST Tax Exemption Allocations ......................................47 I. II. III. IV. V. VI. VII. VIII. GENERATION-SKIPPING TRANSFER TAX EXEMPTION ALLOCATION RULES AND SECTION 9100 RELIEF The GST exemption is an extremely significant exemption available to taxpayers. Its sheer size causes many taxpayers and their tax counsel to ignore the GST tax altogether. They do so at their own risk, however. Unlike the unified credit, the GST exemption is not automatically allocated to all transfers that may later give rise to generation-skipping transfer tax (“GST tax”). Conversely, automatic deemed allocation rules may operate to allocate GST exemption to transfers that are unlikely to give rise to a GST tax. Taxpayers have demonstrated the difficulty they have with optional elections, such as whether to elect alternate value under Section1 2032A, whether to elect Section 6166 deferment, and most particularly whether to and how to properly make the QTIP election under Section 2056(b)(7). Taxpayers are having the same difficulty with elections relating to the GST exemption. A complete understanding of the voluntary and deemed allocation rules and how to allocate GST exemption is a necessity for proper planning. These concepts, and related rules, are discussed in this outline. I. AMOUNT OF THE GST EXEMPTION As originally enacted, the GST exemption was $1,000,000. IRC 2631(a). In the Taxpayer Relief Act of 1997, the exemption was indexed for inflation. P.L. 105-34, enacted IRC §2631(c). The exemption increased as follows: Year 1999 2000 2001 2002 2003 Amount $1,010,000 $1,030,000 $1,060,000 $1,100,000 $1,120,000 See IRC §2631(c). After December 31, 2003, the GST exemption will be equal to the applicable exclusion amount. See IRC §2631(c). II. ALLOCATION BY TRANSFEROR OR REPRESENTATIVE The taxpayer may allocate his or her GST exemption. IRC §2631(a). Presumably, the taxpayer’s legal representative holding a power of attorney can allocate the GST exemption for the taxpayer. Likewise, the taxpayer’s legal or natural guardian has the power to allocate the GST exemption. 1 Unless otherwise specified, references to Sections herein refer to Sections of the Internal Revenue of Code of 1986, as amended, and references to “Regulations” refer to Treasury Regulations. The taxpayer’s executor may also allocate the taxpayer’s GST exemption. Id. Section 2652(d) defines “executor” has having the meaning given such term by Section 2203. Section 2203 defines “executor” to mean the executor or administrator of the decedent’s estate, or, if there is no executor, then any person in actual or constructive possession of any property of the decedent. If a court appointed executor or administrator has been appointed, the law clearly provides that that person is empowered to allocate the transferor’s GST exemption. If no executor or administrator has been appointed, then any person in actual or constructive possession of the decedent’s property may allocate the transferor’s GST exemption as illustrated in the following example. Example 1: Alberta dies having previously transferred all of her assets to a revocable trust. Because Alberta successfully avoided probate, no executor or administrator will be appointed for her estate. Her trust directs her entire estate to her granddaughter, Connie (Connie is also Bonnie’s daughter). Bonnie (Alberta’s daughter) survives Alberta. Included in Alberta’s federal gross estate is a QTIP Trust established by her late husband, Albert, of which the QTIP election of Section 2056(b)(7) has been made. The reverse QTIP election of Section 2652(a)(3) was not made as to the QTIP trust because Albert had previously used all of his GST exemption. The QTIP trust directs the trust estate on Alberta’s death to Connie’s half-brother, Curt. In Example 1, both the trustee of Alberta’s trust and the trustee of the QTIP trust are empowered to allocate Alberta’s GST exemption. If the same individual or entity serves as trustee of both trusts, the trustee will face a dilemma if the combined net worth after apportioned estate taxes exceeds Alberta’s available GST exemption. If the trustees are not the same, each trustee may file an estate tax return and allocate Alberta’s GST exemption. Neither the Code nor the Regulations provide guidance as to which estate tax return will govern. In certain situations, it will be advantageous for an executor to be appointed even though distribution could occur without probate administration. Only the taxpayer, or those legally empowered to act or his or her behalf, and the taxpayer’s executor may allocate the taxpayer’s GST exemption. The taxpayer’s spouse or children are not empowered to do so merely because of their relationship to the taxpayer. III. ALLOCATION TO TRANSFEROR’S TRANSFERS The “transferor” of property for GST purposes generally is (i) the decedent, with respect to property subject to the federal estate tax, and (ii) the donor, with respect to property subject to the federal gift tax. IRC §2652(a)(1). (Exceptions to this general definition apply where the married donor elects to split gifts under Section 2513, where the reverse QTIP election is made and where multiple skips occur with respect to trust property. See IRC §2652(a) and §2653.) An individual (or his or her executor) may allocate such individual’s GST exemption to any property with respect to which such individual is the transferor. IRC §2631(a). If the 2 individual is not the transferor of the property, the individual cannot allocate his or her GST exemption to the property. While the GST exemption is not transferable between spouses under current law, options exists such as the split-gift election, general powers of appointment and the QTIP election to shift the deemed transferor to the person’s spouse, as illustrated in the following Example 2. Example 2: Alberta has previously used all of her GST exemption. While Bonnie (Alberta’s daughter) is alive, Alberta gifts $100,000 to Connie (Alberta’s granddaughter). Albert (Alberta’s husband) has not consumed any of his GST exemption. Even though Albert has his full GST exemption and even though he and Alberta are husband and wife, he cannot allocate his GST exemption to the transfer made by Alberta in Example 2. The obvious remedy to the dilemma in Example 2 is for Alberta to transfer $100,000 to Albert followed by Albert transferring $100,000 to Connie. Assuming the step-transaction doctrine does not apply, then Albert becomes the transferor and may allocate his GST exemption to the transfer and avoid GST tax. In the alternative, the split-gift election may be made under Section 2513. The split-gift election operates to treat $50,000 as having been transferred by Alberta and $50,000 as having been transferred by Albert. IRC §2652(a)(2). In Example 2, a GST tax is owed on Alberta’s $50,000 gift to Connie. Another option is for Alberta to transfer $100,000 in trust for Albert providing him all of the net income for life and granting him all of the net income for life and providing him a general power of appointment. By granting him a general power of appointment, Albert becomes the new transferor and is thereby able to allocate his GST exemption to the transfer. Similarly, Alberta could transfer $100,000 into a trust qualifying for QTIP treatment and make the QTIP election, in which event Albert becomes the new transferor. Allocation of GST exemption is not effective till Alberta’s demise. The reverse QTIP election of Section 2652(a)(3) should not be made. The reverse QTIP election would leave Alberta as the transferor. IV. IRREVOCABLE ALLOCATION Any allocation of GST exemption is irrevocable once the period in which a timely return has expired. IRC §2631(b). With respect to an affirmative timely allocation of GST exemption, the GST exemption allocation becomes irrevocable after the due date of the return. Treas. Reg. §26.2632-1(b)(1)(ii). Example 3: On June 20, 1999, Albert gifts $100,000 to a trust that provides all the net income to Bonnie (Alberta’s daughter) for life and on Bonnie’s death, to Connie 3 (Alberta’s granddaughter and Bonnie’s daughter). On April 15, 2000, Albert files a federal gift tax return, Form 709, affirmatively allocating $100,000 of his GST exemption to the transfer. The GST exemption allocation in Example 3 becomes irrevocable on April 16, 2000. Id. A Form 709 is timely filed if it is filed on or before the date required for reporting the transfer if it were a taxable gift, including any extensions to file actually granted. Id. The Regulations point out that a prior allocation of GST exemption may be amended if amended prior to the due date of the gift tax return and the amendment clearly identifies the transfer and the nature and the extent of the modification. Treas. Reg. §26.26321(b)(1)(ii)(A)(1) Treas. Reg. §26.2632-1(b)(2)(iii) gives the following example: “Example 1…. T transfers $100,000 to an irrevocable generationskipping trust on December 1, 1996. The transfer to the trust is not a direct skip. The date prescribed for filing the gift tax return reporting the taxable gift is April 15, 1997. On February 10, 1997, T files a Form 709 allocating $50,000 of GST exemption to the trust. On April 10 of the same year, T files an amended Form 709 allocating $100,000 of GST exemption to the trust in a manner that clearly indicates the intention to modify and supercede the prior allocation with respect to the 1996 transfer. The allocation made on the April 10 return supercedes the prior allocation because it is made on a timely filed Form 709 that clearly identifies the trust and the nature and extent of the modification of GST exemption allocation. The allocation of $100,000 of GST exemption to the trust is effective as of December 1, 1996. The result would be the same if the amended Form 709 decreased the amount of the GST exemption allocated to the trust.” The foregoing example illustrates that the allocation is not irrevocable until after the due date of the Form 709 reporting such transfer, plus extensions actually granted, has passed. Example 2 of the same regulation points out that if the second return attempting to amend the prior return is filed after the due date of a timely-filed Form 709, the prior allocation remains in effect because an effective allocation, once made, is irrevocable if it is not modified before such due date. This Example 2 fails to address that, while the latter return cannot affect the prior allocation, it could serve as an additional late allocation of GST exemption. Provided the transferor has remaining GST exemption, the transferor can, in most cases, allocate additional GST exemption to a trust on a late Form 709, even after a timely Form 709 can be filed. [Such an allocation is known as a late allocation]. A late allocation is also irrevocable once made. Treas. Reg. §26.2632-1(b)(2). The transferor’s executor can allocate GST exemption on a timely filed Form 709 and on the estate tax return, Form 706. Treas. Reg. §26.2632-1(d). An allocation of GST exemption on 4 a Form 706 is irrevocable once the time for filing a Form 706, including granted extensions, has expired. V. VOID ALLOCATIONS Because allocations once made are irrevocable, the taxpayer should cautiously allocate GST exemption. To assist taxpayers, the Regulations contain provisions that prevent wastage of GST exemption in certain cases. An allocation of GST exemption is void if the allocation is made with respect to a trust that has no GST potential with respect to the transferor making the allocation, at the time of the allocation. Treas. Reg. §26.2632-1(b)(2) and §26.2632-1(d). Example 4: Albert executes a trust funding it with $100,000 on November 15, 1999. The trust provides that all the net income shall be paid quarter annually to Bonnie (Albert’s daughter) (who is 20 years of age upon trust funding) until the earlier of Bonnie reaching age 45 or Bonnie’s death. At the earlier of such events, the trust is to terminate and the trust assets distributed to Bonnie if she is then living, and if not, then to such person or persons as Bonnie directs in her will, including Bonnie’s estate, and to the extent the power is not fully exercised, to Bonnie’s issue, per stripes. The trust in Example 4 has no GST potential with respect to Albert because Bonnie is a non-skip person and before a transfer to a skip person can occur, Bonnie will become the transferor. If Bonnie lives to age 45, she receives the trust estate. If Bonnie dies before age 45, the trust estate is included in Bonnie’s federal gross estate because of the power of appointment that she possesses. If Albert allocates GST exemption to the trust, the allocation is void because the trust has no GST potential while he remains the transferor. A trust has GST potential even if the possibility of a GST is so remote as to be negligible. Treas. Reg. §26.2632-1(b)(2) and §26.2632-1(d)(1). Contrast the following example with Example 4 supra: Example 5: Albert executes a trust funding it with $100,000 on November 15, 1999. The trust provides that all the net income shall be paid quarter-annually to Bonnie (Albert’s daughter) (who is 20 years of age on trust funding) until the earlier of Bonnie reaching age 45 or Bonnie’s death. At the earlier of such events, the trust is to terminate and the assets distributed to Bonnie if she is then living, and if not, then to Bonnie’s issue, per stripes. The only difference between Example 4 and Example 5 is the general power of appointment Bonnie possesses in Example 4. The trust in the latter example has GST potential. 5 It is possible that Bonnie will die before reaching age 45 and the trust estate will pass to her issue. Bonnie’s issue are skip persons as to Albert. Bonnie does not become the transferor because she does not possess a power that includes the trust in her federal gross estate. The predeceased parent rule of Section 2651(e) would not be applicable because Bonnie was alive when the trust was established. If Albert allocates GST exemption to the trust set forth in Example 5, the allocation will be valid since there is a possibility of a GST. The deemed allocation rules will not operate to allocate GST exemption to the trust, because the transfer does not constitute a direct skip or indirect skip subject to those rules. See §2632(b) and (c)(3)(B)(i). The Regulations do not define how insignificant “negligible” must be, but it can be assumed it is a very small percentage. In most cases, even if there is the slightest possibility, the allocation of GST exemption will be effective. For example in Example 5, if Bonnie is 43 years of age, the affirmative allocation of GST exemption to the trust would likely be valid even though there is a substantial likelihood that Bonnie will live to age 45. The Regulations further provide that an allocation of GST exemption to a trust is void to the extent the amount allocated exceeds the amount necessary to obtain an inclusion ratio of zero with respect to the trust. Treas. Reg. §26.2632-1(b)(2)(i). The preferred inclusion ratio is zero because in such event, no GST tax will be owed in connection with a distribution from or termination of the trust. Viewed another way, an allocation of GST exemption on a timely filed gift tax return in excess of the fair market value of the transferred property as of the date of the transfer is deemed void. For example, if Albert allocated on a timely filed gift tax return $110,000 of GST exemption to the transfer reflected in Example 5, the allocation is effective only as to $100,000. The remaining $10,000 allocated is void. Similarly, a late allocation of GST exemption in excess of the fair market value of the trust property as of the date of the late allocation is deemed void. In addition, an allocation of GST exemption to a trust subject to an ETIP in excess of the fair market value of the trust property as of the date of the termination of the ETIP is deemed void. These saving provisions provide some relief from gross errors but do not provide absolute protection from a poorly decided allocation. Further, provisions only prevent the inadvertent waste of GST exemption and do not protect against a failure to allocate (which is addressed by the deemed allocation rules discussed in Sections _____ of this Outline below). VI. FORMULA ALLOCATIONS When property other than cash is transferred to a trust and the transferor (or his or her executor) desires to reach an inclusion ratio of zero, the Regulations permit allocation of GST exemption by use of a formula. Treas. Reg. §26.2632-1(b)(2)(i) and §26.2632-1(d)(1). The following formula allocation is given as an example in the Regulations: “The amount necessary to produce an inclusion ratio of zero.” Treas. Reg. §26.2632-1(b)(2)(i). (An exception to the use of a formula exists with respect to charitable lead annuity trust.) 6 The use of a formula is preferred when the transferred asset is any thing other than cash as illustrated in the following example. Example 6: Alberta transfers 10% of the outstanding stock of a closely held corporation into an irrevocable trust of which Bonnie (Alberta’s daughter) is entitled to the income until reaching age 45. At age 45 the trust is distributed to her. Distributions of principal may be made in the trustee’s discretion to Bonnie and Connie (Bonnie’s daughter and Alberta’s granddaughter). Upon Bonnie reaching age 45, the trust is assets are distributed to Bonnie. Should Bonnie die before age 45, the assets are to be distributed to her then living issue in shares, per stirpes. If the company were liquidated, the value of the 10% distributive share would be $500,000. After assumed applicable discounts, the appraised value is $400,000. In the year after the transfer, $100,000 is distributed from the trust to Connie. The trust in Example 6 is a non-skip person and therefore the transfer is not a direct skip. In addition, the transfer is not an indirect skip. See Section VIII of this Outline. Consequently, the deemed allocation rules will not automatically allocate GST exemption to the trust. If Alberta wishes to allocate GST exemption to the trust and allocates $400,000 of GST exemption to the trust, $400,000 of GST exemption will be allocated to the trust. If the value of the trust remains at $400,000 then the trust will not be subject to GST tax because it will have a zero inclusion ratio. The transfer of $100,000 in the following year will not be subject to GST tax nor will GST tax be imposed should Bonnie die before reaching age 45 provided no additions are made to the trust. If the IRS successfully asserted the value is greater than $400,000, then the trust will not have a zero inclusion ratio. The distribution to Connie will be subject to GST tax. The GST tax is likely past due since the resolution of the valuation issue will likely be after the due date of the return that should have been filed reflecting the taxable distribution to Connie. If the trust set forth in Example 6 were to continue for Bonnie’s lifetime, it would be a GST Trust and the deemed allocation rules for indirect skips would apply. If the taxpayer did not allocate GST exemption on the return at all, the deemed allocation rules would allocate an amount of GST exemption necessary to reach an inclusion ratio of zero. If the taxpayer affirmatively allocated $400,000 of GST exemption without saying more, then query whether the taxpayer would be deemed to have elected out of the deemed allocation rules. If the taxpayer allocated $400,000 of GST exemption to the return and indicated that the inclusion ratio was zero, then that allocation may be sufficient to indicate that the taxpayer meant to allocate sufficient GST exemption to result in a zero inclusion ratio. To avoid a fractional inclusion ratio, a gift tax or estate tax return should describe the allocation in terms of the amount of GST exemption necessary to produce an inclusion ratio of zero, rather than allocating a specific dollar amount. The return can state that the figure is assumed to be $X, but if the value of the transferred assets is determined to be greater than $X, then the amount of the GST exemption allocated to the trust is correspondingly increased. Allocation by formula suggests that the value of the transferred asset may be different than that reported on the gift tax return. It could be argued that a formula suggests that the 7 taxpayer is unsure of the value and serves as a red flag to the IRS. In light of the box requiring one to indicate whether a discount has been taken and the fact that the valuation of any asset other than cash and marketable securities is subject to some degree of variance, the benefits of the use of a formula in most cases will outweigh any risk of increased audit or heightened IRS scrutiny. The use of a formula leaves the taxpayer in some degree of doubt as to the amount of GST exemption actually used. Certainty can be obtained after the statute of limitations has ran if the gift is adequately disclosed, after resolution with the IRS or Treasury as to the value, or after court determination. Until the earlier of these events, the taxpayer is left with uncertainty. However, the alternative of allocating a numerical amount of GST exemption may expose the taxpayer to greater risk of allocating an insufficient amount. Again, for most situations the use of a formula generally outweighs the disadvantages associated with the uncertainty. When the transfer is a direct skip, use of a formula is also recommended even though it is unclear what effect an increase in value would have. Assume the same facts as set forth in Example 6 except the transfer of the stock is directly to granddaughter, Connie. Assume Alberta allocates $400,000 of GST exemption on a timely filed gift tax return rather than allocating by means of a formula. If the value is adjusted to $500,000, it is unclear whether the deemed allocation rules will automatically allocate $100,000 of additional GST exemption or whether GST tax will be due. The result may depend on whether the affirmative allocation of $400,000 is treated as an election to opt out of the deemed allocation rules. An allocation of GST exemption on a timely filed gift tax return becomes irrevocable after the due date of the return. Treas. Reg. §26.2632-1(b)(2) VII. DEEMED ALLOCATION RULES TO LIFETIME DIRECT SKIPS Generally, it is preferable to affirmatively allocate GST exemption to control the manner of allocation. In certain events, the transferor’s GST exemption will be deemed allocated unless the transferor timely elects out of the deemed allocation rules. The deemed allocation rules are best divided between those that operate during the transferor’s lifetime and those that operate post-mortem. During a transferor’s lifetime, the deemed allocation rules allocate GST exemption to direct skips and indirect skips. IRC §2632(b) and (c). If the transfer is not a direct or indirect skip, then GST exemption will not be allocated even though a GST event subject to payment of GST tax then occurs, or may occur later with respect to the transferred property. Internal Revenue Code Section 2632(b)(1) and Treas. Reg. §26.2632-1(b)(1) automatically allocate the transferor’s GST exemption to direct skips made by the transferor. Any unused portion of the transferor’s GST exemption is deemed allocated in an amount equal to the fair market value of the property involved in the direct skip. Treas. Reg. §26.2632-1(b)(1). If the amount of the direct skip exceeds the transferor’s unused portion, the entire unused GST exemption is allocated to the property transferred. IRC §2632(b)(1). 8 The term “unused portion” of an individual’s GST exemption is defined in IRC §26332(b)(2) as that portion of such exemption which has not previously been allocated by such individual, or deemed allocated pursuant to the lifetime deemed allocation rules. The lifetime deemed allocation rules are illustrated in the following example. Example 7: Alberta gifted $210,000 to a granddaughter Connie in 1997. Connie’s mother who is also Alberta’s daughter is alive at the time of the transfer. Alberta makes no other gifts to Connie in 1997. Alberta does not file a gift tax return by April 15, 1998. Alberta has not previously used any of her GST exemption. The taxpayer in Example 7 failed to timely file a gift tax return. Even though Alberta failed to timely file a return, because she has unused GST exemption, the lifetime deemed allocation rules allocate $200,000 of Alberta’s GST exemption to the transfer to Connie. (The remaining $10,000 of the gift qualifies for the annual GST tax exclusion under Section 2642(c) and does not require allocation of GST exemption.) The deemed allocation avoids a current GST tax from being due. If the lifetime deemed allocation rules did not automatically allocate GST exemption to direct skips, then a GST tax will be due. The lifetime deemed allocation rules operate to prevent GST tax from being due on direct skips if the transferor has any remaining unused portion of his or her GST exemption. If in Example 7, Alberta had timely filed a gift tax return and allocated $200,000 of GST exemption to the transfer to Connie, then no GST tax would be due. Note, the result of timely filing and allocating an amount of GST exemption equal to the value of the property transferred in the direct skip and the result of the lifetime deemed allocation rules are identical. Even though the result is identical, affirmative allocation of GST exemption on a timely filed gift tax return serves as an excellent bookkeeping record that will assist in later allocations. If a taxpayer does not file a gift tax return, a portion of the taxpayer’s GST exemption will have been allocated to the direct skip in any event. A timely filed return will avoid the taxpayer inadvertently making too large of a direct skip in the future based on the assumption that he or she has a greater amount of GST exemption available than actually available. The lifetime deemed allocation rules could be a trap for the unwary as illustrated in the following example. Example 8: Albert gifted $110,000 to Connie (Albert’s granddaughter) in 1991 having made no other gifts to Connie in 1991. Connie’s mother is Albert’s daughter, and she was alive at the time of the transfer. Albert did not file a gift tax return being under the impression that a return was not required because of the unified credit. In January 2000, Albert seeks the advice of tax counsel because he wishes to gift $1,000,000 to Connie. He seeks advice as to the tax cost of the gift. In order to give accurate advice, tax counsel needs to know the prior amount of taxable gifts, if any, and to whom the gifts were made. Merely asking if a gift tax return was filed does 9 not provide the tax counsel with the accurate information. Most tax counsel would know to ask the taxpayer whether he or she has made any gifts in excess of $10,000 in any one year to a particular donee. The GST lifetime deemed allocation rules require the tax counsel to ascertain the identity of the donee. Even if a gift tax return was filed, tax counsel should review the accuracy of the return. Tax Counsel should not merely rely upon Page 4 of the gift tax return since many taxpayers and their tax counsel are uninformed concerning the GST tax. The transferor may prevent the automatic allocation of GST exemption by describing on a timely filed gift tax return the transfer and the extent to which the automatic allocation is not to apply. Treas. Reg. §26.2632-1(b)(1)(i).] A less preferred but viable alternative is timely filing a gift tax return and paying the GST tax shown on the return. Id. Electing out of the deemed allocation rules is available only on a timely filed return. Id. In Example 8, if Albert filed a gift tax return on November 1, 1992 attempting to elect out of the deemed allocation rules, the election would be untimely. Most taxpayers will not opt out of the lifetime deemed allocation rules respect to direct skips because to do so will result in the imposition of GST tax. A taxpayer may choose to opt out, however, if he or she is considering making a substantial transfer into a generation-skipping trust. Allocations to transfers that will later give rise to a taxable termination or taxable distribution is a more effective GST allocation than an allocation to a direct skip. An untimely filed gift tax return reflecting an allocation of GST exemption to a direct skip is ineffective because the deemed allocation rules will have already allocated GST exemption to the transfer. Assume the same facts as set forth in Example 8 but in addition assume Albert filed a gift tax return on January 15, 1994 allocating $100,000 of GST exemption to the transfer to Connie in 1991. The allocation is ineffective in that the lifetime deemed allocation rules would have already allocated $100,000 of GST exemption to the transfer. An additional allocation is void in that the inclusion ratio of the transfer is already zero. Consider the following example that serves to illustrate the options available to the taxpayer. Example 9: Albert gifts $40,000 to Connie (Albert’s granddaughter) in 2000. Connie’s mother is Albert’s daughter, and she was alive at the time of the transfer. The first $10,000 of the amount transferred is not subject to the GST tax. IRC §2642(c)(3). Albert has the following choices to make before April 15, 2001, or by the extended due date of the return if an extension of time is granted: 10 1. Timely file a gift tax return allocating $30,000 of GST exemption to the transfer. 2. Timely file a gift tax return allocating none or a portion of his GST exemption by affirmatively electing out partially or in whole out of the deemed allocation rules and paying the GST tax. 3. Not timely filing a return at all. In such event on April 15, 2000, or the extended due date, the deemed allocation rules will operate to apply $30,000 of Albert’s GST exemption to the subject transfer. Note the deemed allocation rules prevent Albert from electing out of the deemed allocation rules on a late return. A late allocation of GST exemption will also not avoid a GST tax on a direct skip. Example 10: Albert gifts $1,040,000 to Connie (Albert’s granddaughter) in 1997. Connie’s mother is Albert’s daughter, and she was alive at the time of the transfer. Albert does not file a gift tax return by April 15, 1998 and does not seek an extension of time to file a return. The deemed allocation rules will operate to allocate $1,000,000 of Albert’s GST exemption to the transfer. $10,000 of the subject transfer is exempt from the GST tax by reason of the annual exclusion. $30,000 of the transfer is a direct skip and subject to GST tax. If Albert files a gift tax return in 1999 and allocates $1,030,000 of GST exemption to the 1997 transfer, the allocation will be void. The deemed allocation rules will have already operated to apply all of Albert’s GST exemption available to the gift. The increase in the GST exemption due to the cost of living adjustment only applies to gifts made in the year of the increase and thereafter, not to prior direct skips. Furthermore, a late allocation cannot be made to a lifetime direct skip. VIII. DEEMED ALLOCATIONS TO LIFETIME INDIRECT SKIPS The Economic Growth and Tax Reform Reconciliation Act of 2001, P.L. 107-16 (June 7, 2001) (“EGTRRA”) added a new subsection (c) to IRC §2632 to expand the deemed allocation provisions to include lifetime transfers to trusts that are presumably intended to remain exempt from GST tax. Prior to the addition of new Section 2632(c), failures to comply with GST allocation rules occurred frequently, resulting in failures to allocate exemption and unintended GST tax obligations. Allocations to trusts for lifetime gifts were especially confusing because Form 709 provides no place for such allocations and, instead, requires that the preparer create a separate Notice of Allocation to attach to the return. Section 2632(c) provides the general rule that: 11 (1) In General. If any individual makes an indirect skip during such individual’s lifetime, 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 indirect skip exceeds such unused portion, the entire unused portion shall be allocated to the property transferred. The following words are defined in the statute: 1. Indirect skip. IRC §2632(c)(1) coins a novel term - “indirect skip” - which is defined as “any transfer of property (other than by direct skip) subject to the tax imposed by chapter 12 made to a GST trust.” IRC §2632(c)(3)(A). GST trust. (a) This provision should make estate planners watch their language more closely since this term, which many planners have used casually to refer to a trust which the transferor intends to pass to skip persons, is now a defined term. True to classic Chapter 13 provisions, the term is defined broadly to include “a trust that could have a generation-skipping transfer with respect to the transferor unless --” the trust meets one of a number of extremely obtuse conditions. These exceptions reflect the presumption that the transferor would not intend to “waste” exemption on trusts that the transferor likely did not expect to make distributions to skip persons. (b) The exceptions, however, are extremely important to understand since transfers to a trust that does not meet one of them will now have GST tax exemption allocated to it automatically unless the transferor opts out of the automatic allocation. Thus, Section 2632(c) avoids the inadvertent creation of GST tax liabilities, but now increases the contrary risk that automatic allocations of GST exemption will occur in circumstances where they are not intended or appropriate. 2. A. First Exception The first exception to the term “GST trust” is located at IRC §2632(c)(3)(B)(i). That Code Section provides a trust is not a GST Trust if: (i) the trust instrument provides that more than 25 percent of the trust corpus must be distributed to or may be withdrawn by one or more individuals who are non-skip persons – (I) before the date that the individual attains age 46, 12 (II) on or before one or more dates specified in the trust instrument that will occur before the date that such individual attains age 46, or (III) upon the occurrence of an event that, in accordance with regulations prescribed by the Secretary, may reasonably be expected to occur before the date that such individual attains age 46. Example 11: Transferor creates a trust for her daughter which provides that the daughter will receive discretionary distributions of income and principal until she is 35, at which time the entire balance of the trust corpus will be distributed to her. If she dies before reaching age 35, the trust will be distributed to her issue who survive her, per stirpes. This is not a GST trust because the trust instrument requires that it must be distributed to the daughter before she attains age 46. Example 12: Same facts as Example 11 except that principal is required to be distributed to daughter in thirds at ages 30, 40 and 50. If she dies before reaching age 50, the trust will be distributed to her issue who survive her, per stirpes. This is not a GST trust even though it will not terminate prior to the daughter attaining age 46 because under the trust instrument more than 25% of the trust must be distributed to the daughter before she attains age 46. Example 13: Same facts as Example 11 except that the principal of the trust is required to be distributed to the daughter as follows: 25% at age 45, 33% at age 50, 50% at age 55 and the balance at age 60. If she dies before reaching age 60, the trust will be distributed to her issue who survive her, per stirpes. This is a GST trust because the trust instrument does not require that more than 25% be distributed to the daughter before she attains age 46. Example 14: Transferor creates a trust for her daughter which terminates and distributes the corpus to daughter in 10 years. If she dies before the trust terminates, the trust will be distributed to her issue who survive her, per stirpes. Daughter is 30 years old at the creation of the trust. This is not a GST trust because the date of required distribution will occur before the daughter reaches age 46. Example 15: Transferor creates a trust for her daughter (who is age 2 at the time) which pays its corpus to daughter when she marries. If she dies before the trust terminates, 13 the trust will be distributed to her issue who survive her, per stirpes (ignore any moral issues presented here), or if none, to her siblings. It cannot be determined whether this is a GST trust or not until Treasury issues regulations by which it can be determined whether it may reasonably be expected that the daughter will marry before she reaches age 46. The underlying assumption to this exclusion from the deemed allocation rules appears to be that a transferor would not want GST tax exemption allocated to a trust more than 25% of which is directed to be distributed to a non-skip person at an age the individual is expected to attain. The third alternative in this exception which requires the Secretary to issue regulations specifying the parameters to determine whether an event may reasonably be expected to occur before the date that an individual reaches the age of 46 is not likely to be of much use since it may be years before the regulations are issued. On the other hand, many events, for example, graduation from college, can reasonably be expected to occur before a student reaches age 46. It has been suggested that if technical corrections are enacted, this requirement for regulations be deleted. B. Second Exception Second exception to the term, “GST trust” is located at IRC §2632(c)(3)(B)(ii). It provides a trust is not a GST Trust if: (ii) the trust instrument provides that more than 25 percent of the trust corpus must be distributed to or may be withdrawn by one or more individuals who are non-skip persons and who are living on the date of death of another person identified in the instrument (by name or by class) who is more than 10 years older than such individuals. Example 16: Transferor creates a trust for her parents for their lifetimes, discretionary distributions of income and principal to either of them, remainder to daughter or, if she is not living at the death of the survivor of the transferor’s parents, to the daughter’s then living issue, per stirpes. At the time of the creation of the trust, the transferor’s parents are both 76 years old and the daughter is 20 years old. This is not a GST trust because the trust instrument provides that more than 25% of the trust will be distributed to the transferor’s daughter (a non-skip person) at the death of the survivor of the transferor’s parents who are more than 10 years older than the daughter. Example 17: Transferor creates a trust for the benefit of her husband and their children, discretionary distributions of income and principal to any of them during the husband’s life, and remainder to her issue who survive her husband, per stirpes. 14 This is not a GST trust since the transferor’s children will receive more than 25% of the trust at the death of their father who is more than 10 years older than any of his children. Example 18: Same facts as Example 17 except that the trust is for the sole benefit of the transferor’s second husband during his life who is the same age as her youngest child (35!), remainder to her issue who survive him, per stirpes. This is a GST trust because, although the trust instrument requires that the trust must be distributed to the transferor’s children if they are living at the death of her second husband, he is not more than 10 years older than they. Indeed, the second husband may outlive all of the transferor’s children and it may pass entirely to her grandchildren. This exception, similarly to the first exception, appears to assume that a transferor would not want GST tax exemption allocated to a trust which is likely to be distributed to non-skip persons at the death of an individual whom they are expected to survive. Note that the typical insurance trust will meet either the first exception or the second exception but will not clearly fall within either exception taken alone. This is extremely troubling because this means transfers to insurance trusts made after December 31, 2000, will automatically attract GST exemption unless the transferor elects to opt out of the automatic allocation rules as described below. Many clients are likely unaware of this requirement. Hopefully, this problem will be corrected by technical corrections to provide a new category of exception, a trust that requires distribution of more than 25% of the trust corpus on the later of the event described in exception one or exception two. In addition, note that some trusts may currently constitute a GST trust, but could potentially qualify for an exception at a later point in time, as illustrated in the following example: Example 19. Assume Transferor creates a trust for the benefit of his 50-year old wife, their 5 children who are all under the age of 30. The trust provides that it will terminate and distribute per stirpes to Transferor’s descendants upon the later to occur of the spouse’s death or the date when the youngest beneficiary reaches age 40. The exception for distributions to non-skip individuals prior to age 46 likely does not apply because the spouse’s death may not reasonably be expected to occur before any of the children reach age 46. The exception for distributions to non-skip individuals who outlive a person 10 or more years older does not apply, because the spouse’s death could occur before any of the children reach age 40. Assuming no other exception applies, the trust initially is a GST trust. To avoid automatic allocation of GST exemption to the trust pursuant to Section 2632(c), the transferor must elect to prevent application of this Section to transfers to the trust. Note that the trust later could qualify under this second exception so that it is no 15 longer a GST trust. Once the youngest child reaches age 40, the trust will qualify for an exception if the spouse is living at that time because the children will receive the trust property upon the death of a person more than 10 years older. Alternatively, if the spouse dies prematurely, the trust will qualify for the first exception if the children are close enough in ages such that more than 25% of the trust will be distributed to children who have not reached age 46 on the date when the youngest reaches age 40. No automatic allocation would occur as to transfers to the trust while it is not a GST trust. C. Third Exception It Third exception to the term, “GST trust” is located at IRC §2632(c)(3)(B)(iii). provides a trust is not a GST trust if: (iii) the trust instrument provides that, if one or more individuals who are non-skip persons die on or before a date or event described in clause (i) or (ii), more than 25 percent of the trust corpus either must be distributed to the estate or estates of one or more such individuals or is subject to a general power of appointment exercisable by one or more of such individuals. Example 20: Transferor creates a pot trust for her issue which provides that her children will receive discretionary distributions of income and principal for their lives. At the death of each child (provided the child has then attained her majority), the child has a general power of appointment over her then existing pro rata share of the trust and, in default of the exercise of the power, her share passes to her issue who survive her, per stirpes. The transferor has 3 children. This is not a GST trust because it provides that if a child dies prior to attaining age 46 (an event described in exception 1), more than 25% of the trust is includible in the child’s estate as a result of her power of appointment. In this example, one-third of the trust would be includible in the child’s estate. However, presumably the same result would be obtained even if the transferor had 10 children since the trust provides that the shares of each of them would be includible in their respective estates if they died prior to attaining age 46. In effect, this exception covers trusts which do not meet the requirements of exceptions 1 and 2 so long as more than 25% of the trust is includible in the non-skip person’s estate if she were to die “young” (before age 46), even if the non-skip person does not otherwise have a right to distributions of or withdrawals from the trust prior to the specified events. Apparently, the underlying assumption is that a transferor does not generally intend to allocate GST tax exemption to a trust which is structured to be includible in a non-skip person’s estate. Example 21: 16 Same facts as Example 20 (trust is for the sole benefit of the transferor’s second husband during his life who is the same age as her youngest child (35!), remainder to her issue who survive him, per stirpes), except that the second husband is entitled only to income and upon a child’s death during the trust, the child has a general power of appointment over her share of the remainder at the death of the husband. This is not a GST trust because each child’s share will be includible in her estate if she dies prior to age 46 and because it meets the fourth exception described below. Thus, a trust which was otherwise a GST trust under exception 2 is not a GST trust if it meets the requirement of exception 3 or 4. D. Fourth Exception Fourth exception to the term, “GST trust” is located at IRC §2632(c)(3)(B)(iv). It provides that a trust is not a GST trust if: (iv) the trust is a trust any portion of which would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer. Example 22: Transferor creates an inter vivos QTIP trust for her spouse, remainder to her issue who survive her husband, per stirpes. This is not a GST trust because it would be includible in the spouse’s estate if he died immediately after the transfer. (Note that this may also qualify under the second exception.) E. Fifth Exception Fifth exception to the term, “GST trust” is located at IRC §2632(c)(3)(B)(v). It provides that a trust is not a GST trust if: (v) the trust is a charitable lead annuity trust (within the meaning of section 2642(e)(3)(A)) or a charitable remainder annuity trust or a charitable remainder unitrust (within the meaning of section 664(d)). Apparently, the rationale for this exception is simply that these forms of trusts have characteristics which would generally lead a transferor not to allocate GST tax exemption to them. F. Sixth Exception Sixth exception to the term, “GST trust” is located at IRC §2632(c)(3)(B)(vi). It provides that a trust is not a GST trust if: (vi) The trust is a trust with respect to which a deduction was allowed under section 2522 for the amount of an 17 interest in the form of the right to receive annual payments of a fixed percentage of the net fair market value of the trust property (determined yearly) and which is required to pay principal to a non-skip person if such person is alive when the yearly payments for which the deduction was allowed terminate. Example 23: Transferor creates a charitable lead unitrust and provides that at the end of the lead interest, the remainder is paid to her then living issue, per stirpes. At the time of creation of the trust, the transferor has 2 children. This is not a GST trust. Example 24: Same facts as Example 23 except that the transferor’s then living grandchildren are named as the remaindermen of the trust. This is a GST trust. Given the complexity of this type of planning, apparently Congress felt that if a non-skip person is named as a remainderman, no automatic allocation of GST tax exemption should be made and that inadvertent failures to allocate exemption under these circumstances were less likely. G. Annual Exclusion Rule Special rule for annual exclusion withdrawal amounts. Flush language in IRC §2632(c)(3) provides that in applying the requirements of the exceptions to the definition of GST trust, amounts includible in a non-skip person’s estate or a subject to a power to withdraw by a non-skip person which do not exceed the amount of the annual exclusion from gift tax with respect to a transferor are not considered. Withdrawal powers normally would prevent treatment as a GST trust, because a portion of the trust would be “included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer” and the fourth exception described above would apply. IRC §2041 and §2632(c)(3)(B)(iv). The drafters apparently recognized that allocations of GST exemption are often made to generation-skipping trusts that provide powers of withdrawal to qualify gifts for the annual gift tax exclusion. Thus, a withdrawal power limited to the annual gift tax exclusion amount will not, by itself, disqualify a trust as a GST trust and preclude automatic allocation of GST exemption. The effect of this provision is interesting. If amounts transferred to a Crummey trust do not exceed the amount of the annual exclusion each year for each Crummey beneficiary for each transferor, and lapse annually, the trust will be a GST trust unless it meets the requirements of one of the exceptions. However, if the amounts subject to Crummey withdrawal powers do not fully lapse each year, but instead “hang” and accumulate to a value in excess of the annual exclusion amount, the trust will not be a GST trust (non-skip persons will hold general powers of appointment over more than 25% of the trust) and there will be no automatic allocation of GST 18 tax exemption. This makes analysis of whether insurance trusts are GST trusts much more complex than most other types of trusts because they may switch back and forth depending on the amount the Crummey beneficiaries can withdraw. Generally, insurance trusts are unlikely to meet the requirements of an exception and will be GST trusts unless the Crummey beneficiaries have withdrawal rights in excess of the annual exclusion amount. This provision also provides that it is assumed that powers of appointment held by nonskip persons will not be exercised. This provision should be modified by technical corrections to provide that it does not include amounts transferred in prior years which are subject to unlapsed powers of withdrawal. H. ETIP Rule Special estate tax inclusion period (“ETIP”) rule. Since trusts can be subject to an ETIP (a period during which the value of the transferred property would be includible in the estate of the transferor or the transferor’s spouse if such individual died, discussed below at XI) and GST tax exemption allocations to such trusts are not effective until the close of the ETIP (see IRC §2642(f)), an indirect skip subject to these rules is deemed made at the close of the ETIP. For purposes of the automatic allocation of GST tax exemption to an indirect skip, the fair market value of the transfer is the fair market value of the trust property at the close of the ETIP. IRC §2632(c)(4). This means that for trusts subject to an ETIP for which transfers occurred prior to the enactment of EGTRRA, such transfers will be deemed to occur at the end of the ETIP and may be subject to the deemed allocation to indirect skips. Example 25: Transferor creates an insurance trust for the benefit of her husband and issue. She gives her husband Crummey withdrawal powers of $10,000 a year which lapse at the rate of $5,000 a year. During the period that her husband has hanging withdrawal rights, the amount subject to his hanging powers is includible in his estate and the transfers are thus subject to an ETIP. Assuming the trust is otherwise a GST trust, automatic allocation of GST tax exemption will not occur until the trust has sufficient assets to permit the last of the husband’s hanging powers to lapse and the ETIP ends. The amount of the transfer to which automatic allocation will be made will be the fair market value of the trust at that time. I. Election With Respect To Indirect Skips. Opt “out” election. An individual may elect to have the automatic allocation to indirect skip provisions not apply to a particular indirect skip or to any transfers made by the individual to a particular trust. IRC §2632(c)(5)(A)(i). 19 This election to prevent application of Section 2632(c) to a trust merely prevents the automatic allocation of exemption as of the date of the transfer – it is not an election to prohibit all allocations of GST exemption. Thus, the transferor can make this election and later voluntarily allocate GST exemption to the trust (for example, when choosing to make a late allocation because the trust assets have declined in value from the date of the transfer). Opt “in” election. Alternatively, an individual may elect to treat any trust as a GST trust with respect to all transfers that she makes to the trust. IRC §2632(c)(5)(A)(ii). Unlike the election “out,” Section 2632(c) did not need to specify that a transferor can elect “in” for a single transfer, because the transferor already had the ability to allocate GST exemption to a single transfer by affirmative allocation on a gift tax return. The law does not address the question of whether an election to treat a trust as a GST trust is irrevocable. J. Procedure for Elections. An election to opt out with respect to an indirect transfer is timely made if made on a timely filed gift tax return for the calendar year in which the transfer was made or in which the ETIP ended. The Code also provides that such an election may be timely made on such later date or dates as may be prescribed by the Secretary. IRC §2632(c)(5)(B)(i). An election to opt out of automatic allocation of GST tax exemption with respect to any or all transfers made to a particular trust may be made on a timely filed gift tax return for the calendar year in which the election is to become effective. IRC §2632(c)(5)(B)(ii). An election to treat a trust as a GST trust with respect to any or all transfers made by an individual to the trust may also be made on a timely filed gift tax return for the calendar year in which the election is to become effective. IRC §2632(c)(5)(B)(ii). Irrevocability? Section 2632(c)(5) does not address the question of whether an election to opt in or opt out is irrevocable. Irrevocability would be inconsistent with the overriding purpose of this provision to simplify allocations reflecting transferors’ intentions. Hopefully, technical corrections will address this issue by providing that an election is irrevocable with respect to all transfers made prior to the revocation of the election. However, even if the elections are irrevocable, the harm of an inappropriate election may be reparable. Where an election has been made to “opt in” and treat a trust as a “GST trust,” the statute does not indicate that a subsequent election to “opt out” should apply to this GST trust any differently than it would apply to a trust that constitutes a GST trust due to its terms. After all, the “opt out” election prevents deemed allocations to a particular indirect skip or all transfers to the trust, and does not require the taxpayer to “reverse” the status of a GST trust. Conversely, where an election has been made to “opt out” of treatment as a GST trust, the election does not preclude future voluntary allocations of GST exemption. However, the taxpayer and his or her return preparer must affirmatively allocate instead of relying on the automatic allocations. K. Priority of GST tax Exemption. 20 Priority of GST tax exemption allocations. In determining the amount of a transferor’s unused GST tax exemption available to be automatically allocated to an indirect skip, allocations are deemed to occur in the following order: (i) (ii) (iii) L. allocations by the transferor, automatic allocations to direct skips occurring during or before the calendar year in which the indirect skip is made, automatic allocations to indirect skips with respect to prior indirect skips. Practical Application. Opt out. Generally, for sophisticated planners who are tracking their clients’ available GST exemption, it will be preferable to opt out of the deemed automatic allocations to indirect skips. For example, this will permit late allocations where the value of the assets transferred to a trust has declined in value. The simplest route in these circumstances is to opt out with respect to all transfers to a trust. However, it is important to be sure the client understands that this means each transfer to the trust will require attention to the question of whether GST tax exemption should be allocated to the trust, just as it did prior to EGTRRA, so that if the client is at a cocktail party receiving the usual excellent estate planning advice generally available at such events, she will be aware of the specifics of her situation and will not assume that deemed allocations are being made to transfers to her trusts. Opt in. The election to “opt in” may be helpful to ensure consistent treatment of a trust that does not uniformly remain a GST trust from year to year, but is intended to remain exempt from GST tax. For example, generation-skipping trusts often include cumulative “hanging” withdrawal powers to qualify contributions for the annual gift tax exclusion while preventing the creation of a gift from the power holder. As discussed above, a trust with such hanging powers may not be a GST trust eligible for automatic allocation in all years as the withdrawal amount fluctuates with each year. The transferor can elect to treat the trust as a GST trust with respect to all transfers, to ensure consistent allocations to the trust. Copies of filed gift tax returns. It has always been important to get copies of all of a client’s filed gift tax returns. However, going forward, in the case of new clients with existing trusts in place, it is more important than ever to actually get the client to provide copies of all filed gift tax returns to determine whether an opt out or opt in election has been made for each trust. Identify GST trusts. It is now necessary to identify existing trusts which are GST trusts and file a timely gift tax return on April 15, 2003, for each of them to opt out of the deemed allocation for these trusts (unless the deemed allocation is desirable). In some cases, this may require a substantial effort. Trusts to look for: (i) Insurance and other Crummey trusts to which annual contributions are being made. Trusts in which children hold hanging powers should not be 21 GST trusts. However, trusts for which the Crummey power fully lapses each year may be GST trusts and will require closer analysis. In some cases, it may not be clear whether the trust is a GST trust. In this case, the safest course of action is to file an election opting out with respect to this trust. Then, whether or not it is a GST trust, no deemed allocations to transfers to the trust will occur. (ii) Trusts currently subject to an ETIP. Even if additional contributions are not still being made to a trust, if the trust is subject to an ETIP, the deemed automatic allocation to such a trust will not occur until the end of the ETIP and will allocate exemption equal to the value of the trust property at the close of the ETIP. Although lower generations are not usually included as beneficiaries of QPRT’s, for example, this would be a good time to be sure that they are not, particularly if the QPRT is followed by a continuing trust for the grantor’s life. Trusts which will pass to children upon the death of a second (or third) spouse who is young in relation to the children. Review them. Any other trusts to which clients may make additional contributions. Although standard drafting provisions may have typically included a contingent general power of appointment for any trust for a child to the extent that a GST tax would apply to a distribution at the child’s death, such a trust may not satisfy any of the requirements of the exceptions to GST trusts if the trust is not required to terminate before the child reaches the age of 46 or it terminates at the death of an individual who is not more than 10 years older than the child. (iii) (iv) As a standard procedure when creating new trusts, determine whether the trust is a GST trust and if so, make a timely election on a timely filed gift tax return for the year in which the first transfer to the trust is made. Extensions. If a timely election to opt out of a deemed allocation to an indirect skip will be made on a gift tax return where the taxpayer’s income tax return is going on extension, be sure to check the box for the gift tax return on the extension. IX. POST-MORTEM DEEMED ALLOCATION RULES The post-mortem deemed allocation rules are designed to utilize all of the decedent’s unused GST exemption. If the decedent has made an inter vivos direct skip or an indirect skip during the year prior to the decedent’s death or in the year of the decedent’s death, the inter vivos deemed allocation rules will allocate GST exemption to the direct or indirect skip when the gift tax return is due, including extensions. If the direct skip or indirect skip is made in the year of the decedent’s death, then the deemed allocation rules will allocate exemption no later than the date the estate tax return is due since the gift tax return is due on that date, unless extended. 22 Treasury Regulation §26.2632-1(d)(2) provides “a decedent’s GST exemption is automatically allocated on the due date for filing Form 706 or Form 706NA to the extent not otherwise allocated by the decedent’s executor on or before the due date. The post-mortem deemed allocation rules allocate any unused portion of an individual’s GST exemption first to property which is the subject of a direct skip occurring at such individual’s death. If decedent’s unused GST exemption is less than the value of all direct skips at death, then the decedent’s GST exemption is allocated to the direct skips in proportion to the respective value of the direct skips. IRC §2632(c)(2)(A). Allocation in this fashion serves to reduce, and often eliminate, any GST tax being due at the time of the decedent’s death. Similar to the lifetime deemed allocation rules, the post-mortem deemed allocation rules operate to postpone GST tax. After such deemed allocation, any remaining GST exemption is allocated to trusts with respect to which such individual is the transferor and from which a taxable distribution or a taxable termination might occur at or after such individual’s death. IRC §2632(c)(1). This rule will allocate GST exemption to trusts to which the transferor has contributed to during his lifetime and to trusts to which the transferor’s wealth is transferred at death. Allocation will be made to the extent of the nonexempt portion of each trust. The term “nonexempt portion” means the value of the trust at the time of the decedent’s death multiplied by the inclusion ratio with respect to the trust. If the decedent’s unused GST exemption is insufficient to result in an inclusion ratio of zero for all such transfers, then the unused exemption is allocated pro rata among the trusts in proportion to the respective amounts of the nonexempt portion of the trust at the time of the decedent’s death. These rules are illustrated by the following example: Example 26: Albert gifted $210,000 to Connie (Albert’s granddaughter) on January 5, 2000. Albert died on November 10, 2000. Albert’s will devises $600,000 to Connie and directs the balance of his estate, estimated at a net value after administration expenses and estate taxes (all estate taxes are charged to the residue) of $1,000,000 in trust. The trustee is to distribute the net income at least quarterannually to Bonnie (Albert’s daughter and Connie’s mother) for her life. On Bonnie’s death, the trust estate is to be distributed to Bonnie’s then living issue in shares, per stirpes. Albert has not previously made any direct skips or transfers that would later give rise to a taxable distribution or taxable termination. The estate tax return is due August 10, 2001. If Albert’s executor fails to allocate Albert’s GST exemption, Albert’s GST exemption will be deemed allocated by the lifetime and post-mortem deemed allocation rules as follows: (1) $200,000 of GST exemption will be allocated to the gift made on January 5, 2000 by the lifetime deemed allocation rules. $10,000 of the $210,000 gift is excluded by the annual exclusion pursuant to IRC §2642(c). This deemed allocation occurs 23 on April 15, 2001 (or such later date if an extension to file the return has been granted). (2) (3) $600,000 of GST exemption will be allocated to the devise to Connie in Albert’s will pursuant to the post-mortem deemed allocation rules. The balance of the Albert’s GST exemption ($240,000) [the GST exemption for gifts made in 2000 and decedent’s dying in 2000 is $1,040,000] will be allocated to the residuary trust. The deemed allocation rules would allocate GST exemption to the entire residuary trust resulting in an inclusion ratio greater than zero but less than one. It is recommended in most cases, that the executor separate the residuary trust into two separate trusts, one in the amount of $240,000 to which the executor would allocate $240,000 of GST exemption leading to an inclusion ratio of zero, and the balance of the residuary trust which would have an inclusion ratio of one since GST exemption has not been allocated to the trust. The post-mortem deemed allocation rules operate to apportion the unused exemption prorata to all trusts with the possibility of a GST transfer without regard to the relative possibility of the later GST skip. This principle can be illustrated by the following example: Example 27: D dies never having used any of his GST exemption. D’s will devises his residuary estate with a net value after payment of debts, administration expenses, and estate taxes of $1,800,000 into three separate trusts for each of his three children. Each trust continues till the child reaches age 50, at which time the trust is to be distributed to such child. If the child dies before age 50, the property is distributed to the child’s issue. The child has no power over the trust that would require inclusion in his or her estate. The children are ages 25, 35 and 49, and all are healthy. The deemed allocation rules would allocate one-third of D’s unused GST exemption to each trust. Allocation is made regardless of the relative actuarial possibility of each child reaching age 50. From a pure statistical probability, allocation to the trust for the child who is age 49 is less opportune than allocation to the trusts for the children age 25 and 35. For this reason, an ideal allocation of D’s GST exemption would occur first to the trust for the child age 25 until that trust reaches an inclusion ratio of zero, in contrast to the equal allocation to each trust under the current rules. The following example further illustrates that the post-mortem deemed allocation rules fail to differentiate between trusts that will have a GST skip and those that may have a GST skip. Example 28: Albert executes a trust agreement (Trust A) on June 15, 1996 funding it with $600,000. Trust A permits distribution of income and principal to Bonnie (Albert’s daughter) and Connie (Albert’s granddaughter and Bonnie’s daughter). On Bonnie’s death, the trust estate is to be distributed to Bonnie’s then living 24 issue in shares, per stirpes. Albert files a gift tax return reflecting the gift but does not complete that portion of the gift tax return pertaining to the allocation of GST exemption. Note that the lifetime deemed allocation rules in effect in 1996 did not allocate any GST exemption to Trust A because Trust A is a non-skip trust. If the trust were funded or if contributions were made after January 1, 2001, the lifetime deemed allocation rules would allocate GST exemption to the later transfer to the trust because it is a GST trust as that term is defined in IRC §2632. Albert dies on June 15, 1999. Albert’s will contains devises of $100,000 to Connie and directs all estate taxes on said devise be charged to the residue. The residue of Albert’s estate having a net value of $1,000,000 after payment of debts, administration expenses, and all estate taxes, is devised in trust (Trust B) for Bonnie providing her all the net income until the earlier of her death or her reaching age 65. Upon the earlier of such event, the trust estate is to be distributed outright to Bonnie if she is then living and if not, then to her surviving issue in shares, per stripes. Bonnie is age 60 on Albert’s demise. Trust A has a value of $1,000,000 on Albert’s demise. Other than the transfers set forth in these facts, Albert has made no other transfers subject to the GST tax or that would later give rise to GST tax. As to Trust A, a taxable termination will occur upon Bonnie’s death, provided she dies with surviving issue. As to Trust B, a taxable termination will only occur if Bonnie dies before reaching age 65 leaving issue surviving her. As to both trusts, there is some probability that a GST event will not occur because Bonnie may die without issue or, with respect to Trust B, may survive to the age of distribution to her. Trust A has a much greater likelihood of facing GST tax than Trust B. Any GST exemption allocated to Trust B will be wasted if Bonnie lives to age 65. Consequently, it would be wiser to allocate GST exemption to Trust A than to Trust B. However, the post-mortem deemed allocation rules would allocate Albert’s GST exemption as follows: 1. 2. 3. $100,000 to the direct skip to Connie. $500,000 to Trust A. $500,000 to Trust B. This example illustrates the disadvantages of allowing the deemed allocation rules to apply, which fail to allocate GST exemption in the most efficient manner. Example 28 further illustrates that the post-mortem deemed allocation rules allocate to both inter vivos and testamentary trusts, and to both direct skips and to trusts from which any other type of GST may occur in the future. In contrast, the lifetime deemed allocation rules for transfers prior to January 1, 2001, only allocates GST exemption to direct skips. X. LATE ALLOCATIONS After the due date of the gift tax return, a transferor may make a late allocation of GST exemption to a prior transfer, assuming that the transfer was not a direct skip or indirect skip 25 subject to the deemed allocation rules that would automatically allocate exemption to the transfer. Example 4 of Treasury Regulation §26.2632-1(b)(2)(iii) illustrates the effect of a late allocation: “T transfers $100,000 to a generation-skipping trust on December 1, 1996, in a transfer that is not a direct skip. T does not make an allocation of GST exemption on a timely filed Form 709. On July 1, 1997, the trustee makes a taxable distribution from the trust to T’s grandchild in the amount of $30,000. Immediately prior to the distribution, the value of the trust assets was $150,000. On the same date, T allocates GST exemption to the trust in the amount of $50,000. The allocation of GST exemption on the date of the transfer is treated as preceding in point of time the taxable distribution. At the time of the GST, the trust has an inclusion ratio of .6667 ( 50,000/150,000).” Example 4 illustrates the following principles: (1) A taxpayer may allocate GST exemption to a trust with GST potential and to a GST trust after the due date for a timely filed gift tax return. Note that the taxpayer must have affirmatively elected out of the deemed allocation rules to make a late allocation to a GST trust. The late allocation is deemed to precede in point of time any taxable event occurring on the same date of the allocation. Treas. Reg.§26.2632-1(b)(2)(ii)(A)(1). The late allocation is deemed to have been made on the date it is filed. Id. The inclusion ratio of the trust is determined using the value of the trust on the date of the late allocation, rather than the value of the initial contribution on the date of the transfer. (2) (3) (4) The transferor also may elect to use the value of the trust assets as of the first day of the month during which the late allocation is made, unless the asset is a life insurance policy and the insured has died. Treas. Reg.§26.2632-1(b)(2)(ii)(A)(1). Because the late allocation is deemed to precede in point of time any taxable event occurring on the same date of the late allocation, the inclusion ratio of the trust in Example 4 of Regulations §26.2632-1(b)(2)(iii) is .6667 rather than one. As a result, the taxable distribution incurs a smaller GST tax than it would if the taxable event was deemed to precede the late allocation. In Example 4, the taxpayer needs to allocate GST exemption on the date that the taxable distribution occurs in an amount equal to the then value of the entire trust to avoid payment of GST tax completely. Example 4 was issued prior to the tax changes in 2001 that made the deemed allocation rules applicable to GST trusts. Under current law, Example 4 generally would not apply to a GST trust because on the day after the due date of the timely filed gift tax return, the deemed allocation rules would allocate an amount of GST exemption necessary to reach an inclusion ratio of zero. Example 4 would remain relevant if the taxpayer did not have sufficient GST 26 exemption to achieve a zero inclusion ratio under the GST deemed allocation rules. taxpayer could later allocate additional GST exemption if the exemption increased. Assume the following facts: Example 29: On June 15, 2001, Albert transfers $250,000 to an irrevocable trust that directs that all the net income be distributed to Bonnie (Albert’s daughter) until she reaches age 40. When Bonnie reaches age 40, the trust terminates and all of the trust assets are to be distributed to her. If Bonnie dies before age 40, the trust terminates with all of the assets being distributed to Bonnie’s then living issue in shares, per stirpes. Bonnie is age 35 on June 15, 2001. The The transfer in Example 29 is not a direct skip and is not an indirect skip. Consequently, the lifetime deemed allocation rules would not allocate GST exemption to the trust. Albert may timely file a gift tax return on April 15, 2002, or on the extended due date, and allocate $250,000 of GST exemption on the return to the trust to reach an inclusion ratio of zero for the trust. Albert may also file a gift tax return after April 15, 2002, and make a late allocation of GST exemption to the trust. The allocation of GST exemption on a timely filed return relates back to the value of the transferred asset at the time of the transfer. In contrast, when making a late allocation, the transferor must allocate an amount of GST exemption equal to the value of the trust on the date of the late allocation (or on the first day of the month in which the late allocation is made, if eligible to elect such valuation date). If Albert allocates GST exemption to the trust on a timely filed return, the allocation can be amended on a subsequent return filed before the due date for a timely filed return, but becomes irrevocable on such due date. However, a late allocation made on a return filed after such due date is irrevocable from the date of the allocation. Any allocation that he makes to the trust is not void because the possibility of a GST event is not so remote as to be negligible. If Bonnie (Albert’s daughter) reaches age 40, the trust terminates in her favor. The prior allocation of GST exemption to the trust will have wasted a portion of Albert’s GST exemption. If Bonnie dies before age 40, with a distribution to Connie (Albert’s granddaughter), the allocation of GST exemption to the trust will have been a good idea. If Albert dies before Bonnie reaches age 40, his executor may allocate GST exemption to the trust. Albert’s executor will be in the position of knowing which transfer to allocate GST exemption to. If his executor fails to allocate GST exemption, the post-mortem deemed allocation rules may allocate exemption to the trust. If Albert makes no direct skips or any other transfers which may later give rise to GST tax then the allocation of exemption to the trust set forth in Example 29 will be fine since there is no other place to allocate the exemption. However, if the value of the trust assets exceeds his remaining unused GST exemption, the trust will not have an inclusion ratio of zero. Albert may choose to delay allocating GST exemption to the trust, assuming that if Bonnie becomes ill he can allocate GST exemption at that time, referred to herein as the “wait 27 and see doctrine.” The wait and see doctrine carries a certain amount of risk because the value of the trust assets could increase significantly, so that the late allocation requires a much greater amount of GST exemption to reach an inclusion ratio of zero or making it impossible to achieve an inclusion ratio of zero. The taxpayer should be advised of these risks before adopting this approach. The taxpayer may consider giving Bonnie a general power of appointment that would ensure estate tax inclusion in Bonnie’s estate and eliminate the GST potential. Example 5 of Regulations §26.2632-1(b)(2)(iii) is a limited exception to the rule that a GST allocation is irrevocable. In Example 5, T transfers $50,000 to a trust in a direct skip on May 15, 1996. T does not file a timely gift tax return. The deemed allocation rules operate to allocate $50,000 of T’s GST exemption to the trust. On April 30,1998, T and T’s spouse, S, file a gift tax return for 1996 electing to split the gift pursuant to IRC §2513. The election is retroactive to the May 15, 1996 transfers. Thus, $25,000 of T’s unused GST exemption and $25,000 of S’s GST exemption is automatically allocated to the trust. XI. ESTATE TAX INCLUSION PERIOD (ETIP) The amount of GST exemption sufficient to achieve a zero inclusion ratio for a trust, and thereby avoid GST tax, depends on the value of the transferred assets at the time when the allocation of GST exemption is deemed to be effective. For example, where the transferor allocates GST exemption to a lifetime transfer on a timely filed gift tax return, the value of the transfer for purposes of calculating the inclusion ratio is determined as of the date of the transfer. If a late allocation is made, the value of the trust for purposes of calculating the inclusion ratio is determined as of the date of the allocation (or if the necessary election is made, on the first day of the month of the late allocation). Assuming that assets generally appreciate in value, an earlier allocation will require less GST exemption than a later allocation to achieve an inclusion ratio of zero. Thus, it would be opportune for a transferor to make a transfer retaining the use of the property for life and allocate GST exemption now rather than wait until the transferor’s death, when the assets may have a substantially greater value. Furthermore, if a zero inclusion ratio could be reached by only allocating GST exemption in an amount equal to the value of the remainder interest, the exemption could be leveraged. The possibility of abuse could be substantial under this type of scenario. To address this scenario, the Code provides that an allocation of GST exemption to certain property will not be effective until the close of the “estate tax inclusion period” (ETIP). These are rules one commonly referred to as the ETIP rules and property subject to the ETIP rules is referred to as ETIP property. See IRC §2642(f) and related Treasury Regulation Sections. ETIP property is property transferred by the transferor during life the value of which would be includible in the gross estate of the transferor or the transferor’s spouse if the transferor died immediately after making the transfer, other than by reason of section 2035. The most common examples of ETIP property are revocable trusts, qualified personal residence trusts (QPRTs), grantor retained income trusts (GRITs), grantor retained annuity trusts (GRATs), legal life estates, and life insurance with retained incidents of ownership. 28 There are three exceptions to the general ETIP rules: (1) the negligibility exception, (2) the 5 and 5 exception and the (3) reverse QTIP exception. (1) The value of transferred property is not considered as being subject to inclusion in the gross estate of the transferor or the transferor’s spouse if the possibility that the property will be included in the gross estate is so remote as to be negligible. Negligible is defined as being so remote that by actuarial tables there is less than a 5% probability that the property will be included in the gross estate. A Crummey withdrawal right in the transferor’s spouse will not create an ETIP if the right to withdraw is no more than the greater of $5,000 or 5% of the trust corpus and such withdrawal right terminates no later than 60 days after the transfer to the trust. The ETIP rules do not apply to a QTIP as to which the reverse QTIP election under Section 2652(a)(3) is made. (2) (3) The ETIP period ends with respect to ETIP property on the earliest to occur of: (A) The date when the value of the property would no longer be included in the transferor’s gross estate (other than by reason of Section 2035); or if the individual is treated as transferor solely due to a split-gift election under Section 2513, the date when the value of the property would no longer be included in the gross estate of his or her spouse (other than by reason of Section 2035); Where the ETIP exists due to the power or interest held by the transferor’s spouse, the earlier to occur of (i) such spouse’s death or (ii) the date when the value of the property would no longer be included in the gross estate of his or her spouse (other than by reason of Section 2035); The date on which there is a GST with respect to the ETIP property (but only with respect to the property subject to the GST); and The date of the transferor’s death. (B) (C) (D) The ETIP rules postpone the date on which the value of the transferred asset is determined for purposes of calculating the inclusion ratio until the end of the ETIP. If the transferor allocates GST exemption to the trust prior to the end of the ETIP, the allocation will be irrevocable and will not become effective until the end of the ETIP. The transferor can allocate GST exemption to the trust on a timely filed gift tax return for the period when the ETIP ends, even though no taxable gift occurs at that time. If the ETIP ends due to the transferor's death and the ETIP property is included in the transferor’s estate (other than due to Section 2035), the value of the property for purposes of the allocation and calculating the inclusion ratio is its estate tax value; otherwise, the value of the property for these purposes is determined as of the end of the ETIP. For example, if the ETIP ends prior to the transferor’s death because of a taxable distribution, then the value of the distribution is determined as of the time of the distribution, which terminates the ETIP with respect to that property. 29 The transferor also could make a late allocation of GST exemption after the due date for a timely gift tax return for the year in which the ETIP ended, but the allocation would be effective when made and property would be valued as of the date of the late allocation (similar to other late allocations to non-ETIP property). A common example of ETIP property and how the ETIP rules operate is illustrated in the following example: Example 30: Alberta executes a revocable trust agreement on November 14, 1995 transferring to it publicly traded securities having a value of $1,000,000 on the date of the transfer. Alberta dies on May 15, 2001. The value of the assets in the trust on her date of death is $2,000,000. The revocable trust in Example 30 is ETIP property. The trust is included in Alberta’s estate. The ETIP ends at Alberta’s death. The value of the trust property for purposes of calculating the inclusion ratio of the trust is $2,000,000. The following example illustrates ETIP that ends before the transferor’s death. Example 31: Alberta executes a qualified personal residence trust (QPRT) on June 11, 1995 retaining the right to occupy the residence for five years at the end of which the trust terminates in favor of Connie. The residence has a value of $500,000 on June 11, 1995 and $1,000,000 on June 11, 2000. Alberta dies after June 11, 2000. The ETIP ends in Example 31 on June 11, 2000, when Alberta’s initial term interest in the QPRT ends. The value of the trust for purposes of calculating the inclusion ratio of the trust is $1,000,000, the value of the trust assets at the termination of the ETIP. Alberta could allocate her GST exemption to the QPRT at any time prior to the end of the ETIP, but the allocation is not effective for determining the inclusion ratio until the ETIP ends on June 11, 2000. Thus, if Alberta allocated $500,000 of GST exemption to the QPRT on a timely filed gift tax return filed on April 15, 1996, the inclusion ratio would not be determined until June 11, 2000. If Alberta did not allocate any more GST exemption, then the inclusion ratio would be .5 ($500,000/$1,000,000). Alberta can allocate her GST exemption to the QPRT on a gift tax return filed on or before the due date for a gift tax return for the period when the ETIP ended. Thus, if Alberta filed a gift tax return by April 15, 2001, on which she allocated $1,000,000 of GST exemption to the QPRT, the trust would have an inclusion ratio of zero. XII. RELIEF FOR LATE ALLOCATIONS AND ELECTIONS Under pre-EGTRRA law, it was unclear whether taxpayers could obtain extensions of time to make allocations of GST exemption under Regulations Sections 301.9100-1 to 301.910030 3 (“Section 9100”). See PLRs 9827032, 9813013, 9840011, 9835025, 9226014. EGTRRA introduced new Section 2642(g)(1) to provide relief for missed GST exemption allocations and missed elections out of or into the deemed allocation rules. A. Statutory Change Section 2642(g)(1) provides “the Secretary shall by regulation prescribe such circumstances and procedures under which extensions of time will be granted to make(i) an allocation of GST exemption described in paragraph (1) or (2) of subsection (b) [which address affirmative GST exemption allocations for gifts reported on timely filed gift tax returns or on estate tax returns], and an election under subsection (b)(3) or (c)(5) of section 2632 [which address elections out of the deemed allocation rules applicable to lifetime direct skips and indirect skips, and into treatment as a GST trust].” (ii) Section 2642(g)(1) further specifies that, in deciding whether to grant relief, the IRS must consider “all relevant circumstances, including evidence of intent contained in the trust instrument or instrument of transfer and such other factors as [the IRS] deems relevant.” Thus, transferors now can seek relief to make allocations of GST exemption that will be treated as if timely made. Such relief spares the transferor from making a late allocation that requires more GST exemption to shelter the trust if the assets have appreciated since the date of transfer. Transferors also can seek relief to elect out of the automatic allocation rules, which might easily be overlooked due to their operation without affirmative action and because practitioners might not yet be familiar with the new rules for indirect skips to GST trusts. B. Legislative History The Committee Reports on P.L. 99-514 (EGTRRA) provide: Under the bill, the Treasury Secretary is authorized and directed to grant extensions of time to make the election to allocate generation-skipping transfer tax exemption and to grant exceptions to the time requirement. If such relief is granted, then the value on the date of transfer to trust would be used for determining generation-skipping transfer tax exemption allocation. In determining whether to grant relief for late elections, the Treasury Secretary is directed to consider all relevant circumstances, including evidence of intent contained in the trust instrument or instrument of transfer and such other factors as the Treasury Secretary deems relevant. For purposes of determining whether to grant relief, the time for making the allocation (or election) is treated as if not expressly prescribed by statute. 31 C. Treasury Response Elections “whose due date is prescribed by statute” generally are ineligible for Section 9100 relief. See Treas. Reg. §§301.9100-1 to 301.9100-3. However, for purposes of determining whether to grant relief under Section 2642(g)(1), “the time for making the allocation (or election) shall be treated as if not expressly prescribed by statute.” This specific language indicates the drafters’ intent that these allocations and elections should be treated as regulatory elections eligible for Section 9100 Relief. Accordingly, the IRS issued Notice 2001-50, I.R.B. 2001-34, August 20, 2001, to provide guidance regarding requests for an extension of time to allocate GST exemption under Section 2642(b)(1) or (2), or to elect out of the deemed allocation rules applicable to lifetime direct skips or indirect skips or into treatment as a GST trust under Section 2632(b)(3) or (c)(5). The Notice states: In general, under Section 301.9100-3, relief will be granted if the taxpayer establishes to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith and that the grant of relief will not prejudice the interests of the government. Taxpayers requesting relief should follow the procedures for requesting a private letter ruling under Section 301.9100 contained in section 5.02 of Rev. Proc. 2001-1 (or its successor), 2001-1 I.R. B. 1, 28. D. Treasury Reg. § 301.9100-3 Treasury Regulation §301.9100-3 governs requests for extensions of time for regulatory elections. Requests for relief will be granted when the taxpayer provides the evidence to establish to the satisfaction of the Commissioner that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. Treasury Regulation §301-9100-3(b) provides that a taxpayer is deemed to have acted reasonably and in good faith if the taxpayer(i) (ii) (iii) Requests relief under this section before the failure to make the regulatory election is discovered by the IRS; Failed to make the election because of intervening events beyond the taxpayer's control; Failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer's experience and the complexity of the return or issue), the taxpayer was unaware of the necessity for the election; Reasonably relied on the written advice of the IRS, or (iv) 32 (v) Reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election. A taxpayer will not be considered to have reasonably relied on a qualified tax professional if the taxpayer knew or should have known that the professional was not(i) (ii) Competent to render advice on the regulatory election; or Aware of all relevant facts. A taxpayer is deemed to have not acted reasonably and in good faith if the taxpayer(i) Seeks to alter a return position for which an accuracyrelated penalty has been or could be imposed under section 6662 at the time the taxpayer requests relief (taking into account any qualified amended return filed within the meaning of §1.6664-2(c)(3) of this chapter) and the new position requires or permits a regulatory election for which relief is requested. Was informed in all material respects of the required election and related tax consequences, but chose not to file the election; or Uses hindsight in requesting relief. If specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer, the IRS will not ordinarily grant relief. In such a case, the IRS will grant relief only when the taxpayer provides strong proof that the taxpayer's decision to seek relief did not involve hindsight. (ii) (iii) The Commissioner will grant a reasonable extension of time to make a regulatory election only when the interests of the Government will not be prejudiced by the granting of relief. Treasury Regulation § 301.9100-3(c) provides the following standards the Commissioner will use to determine when the interests of the Government are prejudiced: (i) Lower tax liability - The interests of the Government are prejudiced if granting relief would result in a taxpayer having a lower tax liability in the aggregate for all taxable years affected by the election than the taxpayer would have had if the election had been timely made (taking into account the time value of money). Similarly, if the tax consequences of more than one taxpayer are affected by the election, the Government's interests are prejudiced if extending the time for making the election may result in the 33 affected taxpayers, in the aggregate, having a lower tax liability than if the election had been timely made. (ii) Closed years - The interests of the Government are ordinarily prejudiced if the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made are closed by the period of limitations on assessment under section 6501(a) before the taxpayer's receipt of a ruling granting relief under this section. The IRS may condition a grant of relief on the taxpayer providing the IRS with a statement from an independent auditor (other than an auditor providing an affidavit pursuant to paragraph (e)(3) of this section) certifying that the interests of the Government are not prejudiced under the standards set forth in paragraph (c)(1)(i) of this section. E. Technical Requirements Treasury Regulation §301.9100-3(e)(2) provides the taxpayer, or the individual who acts on behalf of the taxpayer with respect to tax matters, must submit a detailed affidavit describing the events that led to the failure to make a valid regulatory election and to the discovery of the failure. When the taxpayer relied on a qualified tax professional for advice, the taxpayer's affidavit must describe the engagement and responsibilities of the professional as well as the extent to which the taxpayer relied on the professional. The affidavit must be accompanied by a dated declaration, signed by the taxpayer, which states: “Under penalties of perjury, I declare that I have examined this request, including accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete.” The individual who signs for an entity must have personal knowledge of the facts and circumstances at issue. Treasury Regulation §301.9100-3(e)(3) requires the taxpayer to submit detailed affidavits from the individuals having knowledge or information about the events that led to the failure to make a valid regulatory election and to the discovery of the failure. These individuals must include the taxpayer's return preparer, any individual (including an employee of the taxpayer) who made a substantial contribution to the preparation of the return, and any accountant or attorney, knowledgeable in tax matters, who advised the taxpayer with regard to the election. An affidavit must describe the engagement and responsibilities of the individual as well as the advice that the individual provided to the taxpayer. Each affidavit must include the name, current address, and taxpayer identification number of the individual, and be accompanied by a dated declaration, signed by the individual, which states: “Under penalties of perjury, I declare that I have examined this request, including accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete.” The request for relief filed under Treasury Regulation §301.9100-3 must also contain the following information34 (i) The taxpayer must state whether the taxpayer's return(s) for the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made is being examined by a district director, or is being considered by an appeals office or a federal court. The taxpayer must notify the IRS office considering the request for relief if the IRS starts an examination of any such return while the taxpayer's request for relief is pending; The taxpayer must state when the applicable return, form, or statement used to make the election was required to be filed and when it was actually filed; The taxpayer must submit a copy of any documents that refer to the election; When requested, the taxpayer must submit a copy of the taxpayer's return for any taxable year for which the taxpayer requests an extension of time to make the election and any return affected by the election. (ii) (iii) (iv) See Treas. Reg. §301.9100-3(e)(4). F. Brief Summary of Issued Rulings The IRS has not officially specified what “other factors” it will consider in this determination. However, since the issuance of IRS Notice 2001-50, the IRS has liberally granted Section 9100 relief in response to requests for extensions of time under Section 2642(g)(1) to make allocations of GST exemption effective as of the date of the initial transfer in numerous rulings. Some of the rulings in which the IRS has granted Section 9100 relief are summarized below. 1. PLR 200212025, December 21, 2001 Inter vivos trust agreement empowers trustee to make discretionary distributions of income and principal to transferor’s child for child’s life. On child’s death, trust is to be distributed to child’s issue. Child does not have a power which would require inclusion in child’s federal gross estate. Taxpayer transferred cash and marketable securities to trust having an aggregate value of $X. Accountant listed gift on Form 709 at Schedule A, Part 2, where one is to list direct skips. The taxpayer did not prepare the Schedule C (page 4 of the Form 709) or a Notice of Allocation. Taxpayer died. While not stating specifically, ruling relies on: (1) listed as a direct skip. 35 Nature of the trust; and (2) transfer was 2. PLR 200218010, January 29, 2002 Husband and wife create two identical trusts, one for each of their children. Each trust permits discretionary distribution of income and principal to descendants until 21 yeas after current lives in being with distribution to living descendants at termination. Law firm hired to prepare gift tax return failed to timely file return. Taxpayer had reasonably relied upon lawyer to file gift tax return. 3. PLR 200218001, February 5, 2002 Trust company failed to properly label transfer to Dynasty Trust and failed to allocate GST exemption on gift tax return filed by trust company. 4. PLR 200235013, March 24, 2002 Accountant failed to properly allocate GST exemption on gift tax return to trust which continued for children and grandchildren’s lifetimes with eventual distribution to greatgrandchildren. Life insurance purchased on son and son’s wife’s lives. 5. PLR 200227017, March 29, 2002 Taxpayers relied on accountant who assumed if gift qualified for annual exclusion it qualified for GST purposes and assumed transfers to trust of which children were income beneficiaries did not need GST exemption allocation. Request was made by T's executor. 6. PLR 200237021, June 11, 2002 Gift tax returns failed to allocate GST exemption to generation-skipping trust. 7. PLR 200240030, June 27, 2002 Lawyers recommended GST exemption allocation to Dynasty Trust but due to miscommunication between lawyer and accountant, accountant failed to allocate GST exemption to the trust. 8. PLR 200243042, July 30, 2002 Settlor had attorney prepare GST trusts. Attorney advised client to prepare gift tax return but Attorney failed to address who would file the gift tax return. Settlor died. Estate sued lawyer who put aside money to cover damages. 9. PLRs 200238003, 200238018, 200238028, 200238035. September 20, 2002 Taxpayer relied upon accountant to properly prepare gift tax return and taxpayer failed to allocate GST exemption. 10. PLR 200240019, October 4, 2002 36 T, T’s legal counsel and T’s tax attorney formed trust which would provide mandatory income to T’s child for life. Trust empowered trustee to making discretionary distributions of principal to T's child C and granted C a limited testamentary power of appointment with default to C’s issue. T’s legal counsel and T’s tax attorney discussed with T need to allocate GST exemption to the trust. Letter to accountant failed to specifically provide that GST exemption needed to be allocated. Gift tax return filed. No GST exemption allocated. Child died. T filed a late return attempting to file late allocation. T filed GST return and paid GST tax. 11. PLRs 200240029 and PLR 200240030, October 4, 2002 Miscommunication between tax lawyer and accountant led to failure to allocate GST exemption. 12. PLR 200241021 and PLR 200241022, October 11, 2002 Taxpayer relied on accountant. 13. PLR 200241040, October 11, 2002 Accountant failed to prepare gift tax return properly by allocating GST exemption to generation-skipping trust. Late allocations were deemed void. 14. PLR 200241043, October 11, 2002 Error made on estate tax return because Executor failed to file timely estate tax return, and when 706 was filed Schedule R was not completed. Relief was granted to file Schedule R. No indication as to how deemed allocation rules would have applied. 15. PLR 200242002, October 18, 2002 Late reverse QTIP allocation at issue. 16. PLRs 200242016 and 200242017, October 18, 2002 Accountant failed to complete Schedule C of the 709 when trust was a generationskipping trust. 17. PLR 200242020, October 18, 2002 Taxpayer relied on accountant. 18. PLRs 200242029 and 200242030, October 18, 2002 Trust to continue for 21 years after certain lives in being. Trustee advised gift tax return not needed because only $5,000 transferred to each trust. In Year 2 and Year 3, Trustee made gifts of $10,000 in cash to each trust. No gift tax return was filed. 37 19. PLRs 200243037 and 200243038, October 25 2002 Generation-skipping trusts created. GST exemption allocated in Years 1 through 3 to the trusts, but not for years thereafter. A letter from the taxpayer’s attorney to the accountants indicates a clear intent that GST exemption be allocated annually to the transfers to the Trust. Accountant represents that certain administrative problems in its office caused it to fail to advise Trustee to file gift tax returns for later years. 20. PLR 200243039, October 25, 2002 Additional time granted to allocate GST exemption to a GRIT to alleviate taxable termination due to failure to allocate at end of ETIP. 21. PLR 200243042, October 25, 2002 Attorney failed to allocate GST exemption. 22. PLR 200245018, November 8, 2002 Bank failed to allocate GST exemption and attorney failed to notice error. 23. PLRs 200247008 and 200247009, November 22, 2002 Accountant failed to make any allocation of GST exemption to generation-skipping trust providing for ultimate distribution to grandchildren or more remote issue. PLR 200247038, November 22, 2002 GST trust with eventual distribution to grandchildren. Tax professional in accounting firm hired to prepare gift tax return. Accounting firm overlooked filing gift tax returns. 24. PLR 200247039, November 22, 2002 Gift tax return prepared for Year 1 and GST exemption allocated and mailed to taxpayer. Taxpayer asserts she signed 709 and mailed it to the IRS. Year 2 gift tax return was lost by IRS or never filed. 25. PLR 200247042, November 22, 2002 Accountant failed to allocate GST exemption to generation-skipping trust. 26. PLRs 200248009 and 200248010, November 29, 2002 Law firm failed to allocate GST exemption on gift tax return to generation-skipping trust. 27. PLR 200248012, November 29, 2002 T said he was unaware of need to file gift tax return and the need to allocate GST exemption. 38 28. PLR 200252065, December 27, 2002 Extension of time granted to executor of T’s estate to allocate exemption based on date of transfer value when accountant inadvertently failed to allocate T’s GST exemption on timely filed gift tax return. It must be assumed value of assets had increased so that remaining GST exemption at death was insufficient. 29. PLR 200252076, December 27, 2002 Concerns transfers between September 25, 1985 and prior to October 13, 1987. 30. PLR 200252086, December 27, 2002 T and T’s spouse made transfer on Date 1 to trust which will continue for children’s lifetime with eventual distribution to grandchildren. Accountant prepared gift tax return which was timely filed but failed to allocate any GST exemption to transfer. 31. PLRs 200301027 and 200301028, January 3, 2003 Taxpayer creates Dynasty Trust and transferred assets to trusts over five year period. Accountant prepared gift tax return for Year 1 but failed to allocate any GST exemption. Accountant advised that gift tax returns were not needed for Years 2-4 because the value of each transfer to such trust was less than the gift tax annual inclusion. In Year 5, taxpayer engaged new legal counsel who discovered no GST exemption had been allocated and that if a late allocation were made insufficient GST exemption existed to reach zero inclusion ratio due to appreciation in the assets. To mitigate damages, trusts were divided and a late filed GST exemption was made. Taxpayer sought 9100 relief and requested to undo the late allocation. IRS grants 9100 relief and determines late allocation is ineffective. 32. PLR 200301037, January 3, 2003 T sets up irrevocable trust for son, son’s spouse’s and son’s descendants. On death of son and son’s spouse, the trust assets are to pass to son’s descendants, if any, and if none, to T’s grandchildren. T’s accountant timely filed gift tax return but was unaware of the need to allocate GST exemption. Son and son’s spouse’s died without issue. Trustee requested 9100 relief which was granted even though taxable transaction had already occurred. 33. PLR 200302038, January 10, 2003 Taxpayer granted extension of time to allocate GST exemption to transfers to trust based on value at date of initial transfer when taxpayer relied upon accountant to allocate exemption to a Dynasty Trust but accountant failed to properly prepare the gift tax return. 34. PLR 200302017, January 10, 2003 39 Taxpayer and Spouse created irrevocable life insurance trust which is to continue for children’s lifetimes with distribution to children’s issue. Accountant prepared gift tax returns under extensions. Insufficient GST exemption was allocated (no explanation was given why) to the trust on the gift tax returns. Taxpayer was deemed to have relied on a professional. XIII. RETROACTIVE ALLOCATIONS. Purpose of provision. Transferors typically do not allocate GST exemption to trusts that primarily benefit non-skip persons. However, a non-skip person/beneficiary could unexpectedly predecease the transferor, thereby causing a taxable termination or increasing the likelihood of future GSTs from the trust. No means existed under pre-EGTRRA law to make a late allocation of GST exemption effective as if the allocation had been made on a timely filed gift tax return reporting the transfer. EGTRRA introduced new Section 2632(d) to allow such allocations where certain nonskip beneficiaries predecease the transferor. This provision is designed to help provide relief when an unnatural order of deaths occurs and a trust which was not expected to benefit a skip person becomes distributable to a grandchild because her parent has predeceased. Under these circumstances, a GST tax could be due even though the transferor is still alive and has unused GST tax exemption. Change in law. A new subsection (d) is added to IRC §2632 which provides that under certain circumstances, a transferor may make a retroactive allocation of GST exemption to any previous transfers to a trust on a chronological basis. The circumstances required are if a non-skip person: (i) (ii) (iii) (iv) who has an interest or a future interest in a trust, is a lineal descendant of a grandparent of the transferor or the transferor’s spouse, is assigned to a generation lower than that of the transferor, predeceases the transferor. Procedures for retroactive allocation. (i) (ii) (iii) The allocation must be made on a timely filed gift tax return for the year of the non-skip person’s death. For purposes of the retroactive allocation, the value of a transfer is its gift tax value at the time of the gift. The transferor’s unused GST tax exemption is determined immediately prior to the non-skip person’s death. 40 (iv) The retroactive allocation is effective immediately prior to the non-skip person’s death. Valuation of Transfers. If the transferor makes the retroactive allocation under Section 2632(d) on a timely filed gift tax return for the calendar year in which the non-skip person’s death occurred, then the allocation will be treated as if made on a timely filed gift tax return for each such transfer. Where GST exemption is allocated on a timely filed gift tax return, the inclusion ratio of the trust is determined using the value of the transfer as of the date of the transfer (or for an ETIP, as of the close of the ETIP). In contrast, a transferor making a late allocation normally must use the value of the trust as of the late allocation to calculate the inclusion ratio. This late allocation is advantageous if the trust assets have declined in value from the date of transfer. However, this retroactive allocation under Section 2632(d) uses less GST exemption to shelter the trust from GST tax where the trust assets have grown in value since the original transfer. Split Gifts. If the gift to the trust was split between spouses pursuant to Section 2513, each spouse is treated as the transferor of one-half of the trust. IRC §2652(a)(2). If one spouse predeceases the non-skip person, then the one-half portion of the trust of which that spouse is the transferor will not be eligible for this retroactive allocation under Section 2632(d). Amount of Available GST Exemption. The amount of the transferor's unused GST exemption available to be allocated will be determined immediately before such death. Thus, the allocation will be made using the original value of each prior transfer, but the transferor’s available GST exemption as of those prior dates is not relevant. The transferor cannot take full advantage of this new retroactive allocation under Section 2632(d) if he has insufficient exemption remaining immediately before the non-skip person’s death. Effective date. The provision is available for deaths of non-skip persons which occur after December 31, 2000. This means it applies to any deaths which occurred in 2001 and thereafter. Example 32: Many years ago, Transferor created a trust for her 17 year old daughter, discretionary income and principal, which terminates and pays out when the daughter reaches age 35. If the daughter dies before reaching age 35, the trust passes to her issue, per stirpes. The trust was funded in a single transfer with real estate that is expected to appreciate dramatically. The value of the initial transfer, after a discount for a partial interest in the real estate, was $50,000. Indeed the real estate appreciated, was sold and the trustee has invested the proceeds successfully in the market. Unfortunately, the daughter died unexpectedly in 2001 at the age of 29. The trust was then worth $500,000. Absent this new provision, at the daughter’s death, a taxable termination would have instantly occurred and the distribution to her children would be reduced by approximately one-half the value of the trust to be paid in GST tax. However, under the new 41 provision, the transferor can allocate $50,000 of GST tax exemption on a gift tax return filed by April 15th of this year and protect the entire trust from GST tax. Practical Application. The practical application of this provision is obvious and represents one of the more humane tax provisions in the Code. The only limitations of this provision, both unavoidable, are that the transferor must still be alive and must still have unused GST tax exemption. XIV. SEVERING OF TRUSTS: QUALIFIED SEVERANCES. Purpose of provision. Under pre-EGTRRA law, the only severances recognized for GST purposes were those dividing single trusts already treated as separate trusts under Section 2654(b), based on the different beneficiaries’ separate and independent shares or its multiple transferors. See Treas. Reg. §26.2654-1(a)(3), including Example 8. In addition, even if the severance of a single trust with an inclusion ratio between zero and one was recognized, it resulted in separate trusts with the same fractional inclusion ratio as the original single trust. EGTRRA introduced new Section 2642(a)(3), which describes “qualified severances” that will be recognized for GST purposes. This provision permits any trust to be severed into multiple trusts and permits a trust which has an inclusion ratio of greater than zero but less than one to be severed into two trusts, one with an inclusion ratio of one and the other with an inclusion ratio of zero, if certain requirements are met. This will greatly reduce complexity in drafting and trust administration and permit more effective use of the GST tax exemption allocated to the trust. Change in law. IRC §2642(a) is modified to add a new provision which permits a trust to be severed into separate trusts which are thereafter treated as separate trusts if the severance is a “qualified severance.” A qualified severance is one in which a single trust is divided into two or more trusts “by any means available under the governing instrument or under local law” if: (i) (ii) (iii) it is divided on a fractional basis and the new trusts provide for the same succession of interests as the original trust. IRC §2642(a)(3)(B)(i). In addition, if the trust has an inclusion ratio of greater than zero and less than one, the severance must be into two trusts, one of which receives a fractional share of the total value of all trust assets equal to the applicable fraction of the single trust before the severance and which will have an inclusion ratio of zero and the other of which will receive the balance of the trust assets and will have an inclusion ratio of one. IRC §2642(a)(3)(B)(ii). A glitch in the language of the statute makes it unclear what happens when a trust with an applicable fraction of 50% is severed because both trusts would receive “a fractional share of the total value of all trust assets equal to the applicable fraction.” Presumably, regulations 42 to be issued under the statute will permit the trustee to specify which trust receives the inclusion ratio of zero. (iv) A qualified severance will also include any other severance permitted by regulations. IRC §2642(a)(3)(B)(iii). “Same succession of interests.” The phrase, “same succession of interests,” has its origins in Regulations §26.2654-1(b)(ii)(A) and means that although the trusts need not be identical, the linear succession of beneficiaries’ interests cannot be different. Thus, a trust which provides for income to spouse, remainder one-half to child and one-half to grandchild, can be divided into two trusts both of which distribute income to spouse, one of which distributes the remainder to child and one of which distributes the remainder to grandchild. However, a trust which provides for income to child, remainder to grandchild cannot be divided into two trusts, one with an actuarial value of the child’s income interest and one for grandchild. See 26.26541(b)(1), example 1. The IRS has issued several private letter rulings regarding the application of Section 2642(a)(3), but the qualified severances in these rulings appear to result in separate trusts with terms identical to the original trust. PLRs 200223016, 200213014, 200302004. Thus, these rulings have not addressed how the trusts resulting from a qualified severance may differ while preserving the same succession of beneficial interests under the original single trust. However, trust instruments commonly describe provisions applicable for trusts with an inclusion ratio of zero that differ from the provisions applicable to trusts with an inclusion ratio of one or a fraction. For example, assume that a trust instrument provides for mandatory or more liberal discretionary distributions to non-skip persons from any trust created thereunder with an inclusion ratio of zero. In contrast, the trust instrument includes narrower standards for distributions from any trust with an inclusion ratio other than zero, to preserve the assets for skip persons. The aggregate beneficial interests in the resulting trusts with inclusion ratios of zero and one could be deemed substantially different in nature, amount or timing from those under the single trust prior to severance while it had an inclusion ratio between zero and one. In such circumstances, severance of the single trust on the basis of its fractional inclusion ratio might not constitute a “qualified severance,” even if the original trust instrument remains unchanged. For these reasons, until the IRS provides further guidance, trust instruments contemplating a future qualified severance could include flexible terms standards, to give the trustee sufficient discretion to administer and make distributions from the trusts as appropriate, considering their inclusion ratios, to permit severance resulting in trusts with terms to the original trust. Procedure for severing. The provision provides that a severance may be made at any time, but that regulations or forms will prescribe the way in which a severance will be reported to the IRS. Effective date. The provision applies to any severance made after December 31, 2000. This provision also should be clarified through technical corrections: 43 (i) (ii) (iii) To permit severance of a trust with an inclusion ratio greater than zero and less than one into more than two trusts To specify that “same succession of interests” means that the interest of a remainder beneficiary is not accelerated; and To provide that severance on a fractional basis does not require that each asset be divided among the resulting trusts, but rather that the total value of the trust be divided on a fractional basis. Example 33: The Will of a client who has no children and died in January, 2002, creates a credit shelter trust of $1 million for the benefit of her husband and at his death distributes 40% to nieces and nephews and 60% to grand-nieces and grandnephews. Her executor allocates $600,000 of her GST exemption to the trust giving it an inclusion ratio of 40%. If her husband then dies in December of 2002, assuming no change in the value of the trust, the share passing to grandnieces and grand-nephews will be worth $600,000 and will be subject to GST tax of $120,000 (50% GST tax rate x 40% inclusion ratio = 20% effective tax rate applied to the distribution). If the trustee has the power to sever the trust into two trusts, one with the nieces and nephews as beneficiaries and one with the grandnieces and grand-nephews as beneficiaries, both of which will make pro-rata distributions to the testator’s husband, the entire share passing to the testator’s grand-nieces and grand-nephews can be protected from GST tax at a savings of $120,000. Practical Application. One interesting feature of this provision is that it can be combined with the provision permitting retroactive allocation of GST tax exemption in the event of an unnatural order of deaths. For example, if a trust provides for income to transferor’s husband for his life, remainder to transferor’s issue, per stirpes, and a daughter predeceases the husband during the transferor’s life, it would be possible to retroactively allocate sufficient GST exemption to the trust to protect the daughter’s share (thus creating a trust with an inclusion ratio greater than zero and less than one) and then sever the trust into two trusts for the husband, one with an inclusion ratio of zero which passes to the daughter’s issue at the husband’s death and one with an inclusion ratio of one which passes to the surviving children at the husband’s death. The qualified severance also can be combined with a late allocation of GST exemption, where the transferor lacks sufficient exemption to entirely shelter the trust. A late allocation resulting in a trust with a fractional inclusion ratio can be combined with a qualified severance to create separate trusts with inclusion ratios of zero and one. Similarly, a transferor can combine a qualified severance with a request for Section 9100 relief to obtain an extension of time make an allocation of GST exemption that will be treated as if timely made. See e.g., PLR 200223016 (where IRS granted extension of time to allocate GST exemption to QTIP trust and sever the QTIP trust based on the resulting inclusion ratio into separate trusts with inclusion ratios of zero and one). 44 The qualified severance also may be combined with a CLAT or any trust subject to an ETIP, as the inclusion ratio of these trusts cannot be determined upon creation (i.e., until the termination of the charitable lead annuity or the close of the ETIP). Prior to EGTRRA, planners typically did not allocate GST exemption to such trusts because they were likely to have fractional inclusion ratios. Transferors now can allocate GST exemption to such trusts and use the qualified severance, if necessary, to create separate trusts with inclusion ratios of zero and one. (Transferors still, however, cannot reproduce the “leverage” benefit of an allocation that is effective from the initial transfer to shelter the entire trust, including subsequent appreciation, from GST tax.) However, note that the benefits of planning with qualified severances may be lost if a GST occurs before the severance is accomplished or if the severance, itself, creates a GST. Example 34. Assume that Transferor creates a GRAT that passes the balance at the end of the lead term interest to a trust benefiting Transferor’s grandchildren. Transferor allocates GST exemption to the GRAT as he plans to use a qualified severance, if necessary, to create separate trusts with inclusion ratios of 0 and 1 when the lead term expires. However, a taxable termination occurs immediately upon the end of the lead term while the trust for grandchildren has a fractional inclusion ratio, before the transferor can sever the trust. Consequently, some GST tax will be payable due to this taxable termination. Accordingly, trusts drafted to undergo a qualified severance in the future should incorporate provisions postponing potential GSTs until a severance can be accomplished. The easiest way to prevent such GSTs is to include non-skip beneficiaries with interests recognized for GST purposes. (See Regulations Section 26.2612-1(e). A trust that merely prohibits distributions for a period will not be sufficient to avoid a GST if skip persons remain the only beneficiaries entitled to distributions at the end of that period. See Regulations § 26.2612-1(d) and (e).) Practitioners considering qualified severances of preexisting trusts with inclusion ratios other than zero should consider whether the severance will create a GST. Another application, particularly useful in irrevocable insurance trusts, would be to include a discretionary spray trust at the death of the insured for the benefit of the insured’s issue to last for a period of up to 9 months. Then, if a child has predeceased the insured and no retroactive allocation was timely made to the trust, the executor can allocate sufficient GST exemption to protect the share passing to the deceased child’s issue and the trustee can sever the trust into two trusts (the one for grandchildren with an inclusion ratio of zero and the one for children with an inclusion ratio of one), and distribute the shares to the deceased child’s issue, protecting the grandchildren’s share with the full benefit of the GST exemption allocated to the trust. Note that a retroactive allocation would be preferable here because it permits allocation of GST exemption to the transfer at the value it had at the time it was made. In the event that the date for retroactive allocation was missed (the due date for the transferor’s gift tax return for the year in which the child died), it may also be possible to request 9100 relief, discussed below, although it is not clear that the transferor could meet the requirement for an intention that the trust qualify for exemption from GST tax necessary to obtain that relief. 45 One significant issue to consider is the scope of local law to permit trust severances, especially those severances that result in trusts with different terms. For example, it may not be possible under local law to sever a trust into two trusts with different remaindermen, even when done on a fractional basis. Drafters anticipating qualified severance of a trust could include express authorization in the trust instrument for divisions resulting in trusts with different terms, as long as they constitute qualified severances under the Code. Note that if allocation of GST exemption and severance of a trust occur on the same day, the allocation of exemption will be deemed to have occurred prior to the severance. This may be significant if the severance creates a trust in which no non-skip person has an interest. Other Tax Considerations. Section 2642(a)(3) only addresses the recognition of the creation of separate trusts resulting from a qualified severance. However, Regulations Section 26.2601-1(b)(4) describes rules for determining whether a modification, judicial construction, settlement agreement, or trustee action with respect to a grandfathered “exempt trust” (as defined in Treasury Regulations Section 26.2601-1(b)(4)) will cause it to lose its exempt status. Thus, a qualified severance of an exempt trust also must satisfy these rules to avoid becoming subject to GST tax. In addition, before proceeding with a qualified severance, practitioners should consider whether the severance might result in taxable gifts among the trust beneficiaries, or cause any trust or beneficiary to recognize gain or loss from the sale or disposition of other property. The practitioner could request a private letter ruling from the IRS to seek guidance on these issues. See, e.g., PLR 200213014. XV. SUBSTANTIAL COMPLIANCE. Purpose of provision. In view of the complexity and highly technical nature of the GST tax exemption allocation rules, an allocation may be attempted but not be effective. A substantial compliance standard helps to avoid this unfortunate result. Prior to EGTRRA, the IRS had granted relief to taxpayers under a substantial compliance standard to recognize allocations of GST exemption even where the taxpayers failed to comply with all of the necessary procedural requirements. See PLRs 199937026 and 200224018 (in each, the language of the trust agreements attached to the estate tax return provided sufficient information to constitute allocation of GST exemption). See also Hewlett Packard Co. v. Comm’r., 67 T.C. 736 (1977), acq. in result, 1979-1 C.B. 1. (holding that literal compliance with procedural instructions to make an election is not always required, and relied upon in PLRs 199937026 and 200224018). EGTRRA introduced a forgiving new Section 2642(g)(2) that now recognizes by statute an allocation of GST exemption where the transferor has indicated the intent to make such allocation. Change in law. If an allocation of GST tax exemption is made under section 2632 that demonstrates an intent to have the lowest possible inclusion ratio with respect to a transfer, the 46 allocation will be deemed to be an allocation of so much of the transferor's unused GST tax exemption as will produce the lowest possible inclusion ratio for the transfer. IRC § 2642(g)(2). “In determining whether there has been substantial compliance, all relevant circumstances shall be taken into account, including evidence of intent contained in the trust instrument or instrument of transfer and such other factors as the Secretary deems relevant.” Note that this substantial compliance rule recognizes imperfect allocations as occurring at the time when they are made, but does not “perfect” the timing of the allocation. For example, it does not permit treatment of a late allocation as if it had been made timely. Instead, a botched late allocation may be recognized under the substantial compliance rule, but it remains a late allocation. Practical Application. It seems that the most significant change under this standard to permit taking full advantage of this provision is to prominently state the grantor's intentions regarding the inclusion ratio of a trust in the trust instrument and related documentation, including gift or estate tax returns. This new provision contemplates the facilitation of allocations of GST exemption to achieve the lowest possible inclusion ratio for a trust. However, expression of the transferor’s final intentions regarding allocation of GST exemption is also important where the actual allocation, or lack of allocation, on the return is intended to prevent the application of the substantial compliance rule and supersede any contrary intent reflected in the trust instrument or related documents. XVI. VALUATION OF TRANSFERS FOR GST TAX EXEMPTION ALLOCATIONS. Purpose of provision. Regulations Section 26.2642-5 prescribes the time when the inclusion ratio applicable to each type of GST becomes final. Such time as determined under this regulation does not always coincide with the time when the value of the relevant transfer becomes final for gift or estate tax purposes. However, prior to EGTRRA, Section 2642(b) stated that the inclusion ratios for timely and automatic allocations of GST exemption are determined using the “value for purposes of [federal gift tax]” for lifetime transfers, and “value for purposes of [federal estate tax]” for transfers at death. Regulations Section 26.2642-2 indicates, though Section 2642(b) did not specify, that these references mean the values as finally determined for gift or estate tax purposes. Thus, these various rules apparently conflicted to the extent they overlapped. Change in law. EGTRRA amended Sections 2642(b)(1) and 2642(b)(2)(A) to clarify the valuation provisions relating to timely and automatic allocations. These provisions clarify that for purposes of determining the inclusion ratio of a transfer, if the allocation of GST tax exemption is made on a timely filed gift tax return or is automatically allocated, the value of the transferred property is its value as finally determined for gift tax purposes (within the meaning of IRC §2001(f) -- the gift tax finality rules). IRC §2642(b)(1)(A). This clarifies that if a taxpayer adequately discloses a gift on a gift tax return and the statute of limitations runs on that return, the value of the gift cannot be revalued for any purpose, including determining the amount of the transfer with respect to the inclusion ratio of the transfer. The statute is also modified to provide that the value of transfers made at death are their value as finally determined for estate tax 47 purposes. IRC §2642(b)(2)(A). December 31, 2000. These provisions are applicable to transfers made after Section 2642(b) still conflicts with Regulations Section 26.2642-5, but the statute should override the regulation where they overlap. Presumably, the rules described in Regulations Section 26.2642-5 continue to apply in to allocations where the final gift tax or estate tax value is not relevant (for example, late allocations). In the ongoing discussion of whether or not taxpayers who make gifts should report these transfers on their gift tax returns in a manner which meets the adequate disclosure rules to obtain finality with respect to revaluation for purposes of future gifts and adjusted taxable gifts included on the taxpayer’s estate tax return, this is one more reason to take the plunge and adequately disclose the gift. Taxpayers may also reexamine whether or not to disclose transactions for consideration that may result in a gift if the finally determined value of the purchased property could result in a gift to the trust (for example, installment sales to a defective grantor generationskipping trust). Transferors desiring finality of the inclusion ratio will report any transfers involving the trust on a timely filed gift tax return, including the information required under Regulations Sections 301.6501(c)-1(f)(2) (safe harbor provisions for adequate disclosure). Failure to file, or failure to adequately disclose a transfer on a filed return, will postpone the finality of the inclusion ratio until it is finally determined in a contest with the IRS. 48