Allocation of Indexed GST Exemption
Beth Shapiro Kaufman
As a part of the American Taxpayer Relief Act of 2012, Congress made permanent the law that provided for indexing of the exemption from the generation-skipping transfer (GST) tax. Under the Act, the first year for which indexing increased the exemption was 2012. The indexing is effected by tying it to the basic exclusion amount for estate tax purposes: "The GST exemption for any calendar year shall be equal to the basic exclusion amount under section 2010(c) for such calendar year."[1] Consistent with section 2010(c)(3)(B), Rev. Proc. 2013-15 provides that "[f]or an estate of any decedent dying during calendar year 2013, the basic exclusion amount is $5,250,000 for determining the amount of the unified credit against estate tax under § 2010."[2] Thus, the GST exemption for 2012 was $5,120,000, and the GST exemption for 2013 is $5,250,000, giving taxpayers an additional $120,000 of GST exemption to allocate for 2012 and $130,000 more for 2013. For the purposes of this article, the increase in exemption amount due to indexing will be referred to as "additional" GST exemption. It is reasonable to anticipate that taxpayers will receive additional GST exemption every year under the indexing provision.
Statutory and Regulatory Guidance on Allocating GST Exemption
Code Section 2632(a)(1) states that "[a]ny allocation by an individual of his GST exemption under Section 2631(a) may be made at any time on or before the date prescribed for filing the estate tax return for such individual's estate (determined with regard to extensions) regardless of whether such a return is required to be filed."[3] The Secretary of the Treasury is to "prescribe by forms or regulations the manner in which any allocation" is to be made.[4]
The regulations specify the time for filing. Reg. §26.2632-1(b)(1)(ii) states that "[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 (i.e., the date prescribed by section 6075(b), including any extensions to file actually granted (the due date))."[5] Thus, for taxpayers who have received an extension on their 2012 gift tax returns, a Form 709 filed before October 15, 2013, will be timely filed.
Code Section 2642 governs the computation of the inclusion ratio for a trust. Section 2642(b)(1) states that if the allocation of GST exemption is made on a timely filed gift tax return (including extensions) for such gift, the value of the property for GST purposes is its value as finally determined for gift tax purposes and the allocation of exemption to that property is effective "on and after" the date of the transfer.[6] Section 2642(b)(3) states that lifetime allocations that are not made on a timely filed gift tax return are applied to the value of the property as of the date the allocation is filed with the IRS and are effective on and after the date of such filing.[7] The regulations refer to these two possibilities as "timely allocations" and "late allocations."[8]
The date on which an allocation is effective depends on whether the allocation is timely or late. Treasury Regulation Section 26.2632-1(b)(4)(ii)(A)(1) gives the general rule for timely allocations: "an allocation of GST exemption is effective as of the date of any transfer as to which the Form 709 on which it is made is a timely filed return (a timely allocation)." A late allocation is an allocation made after the due date of the gift tax return and it is effective as of the date the late allocation is made.[9] A late allocation does not relate back to the date of the gift.[10]
With respect to a gift tax return reporting a 2012 gift, assuming the taxpayer has an extension, the return will be timely-filed, and a GST exemption allocation made on that return will relate back to the date of the gift, provided that it is postmarked by October 15, 2013. The GST exemption allocation made on such a return will be a "timely allocation." If a 2012 gift tax return is filed during 2013 but after the due date of the return as extended, an allocation made on that return will be a "late allocation" and it will be effective as of the date the return is filed.
How To Allocate Exemption To a Prior Year Gift In Trust
Suppose a taxpayer made a gift of $3,000,000 to a dynastic trust in 2008, when the GST exemption was $2,000,000.[11] That trust would have an inclusion ratio of 0.33, meaning that 1/3 of any distribution to a "skip person" would be subject to generation-skipping transfer tax. Assume that no distributions have been made and the assets of the trust are now worth $6,000,000. Since the taxpayer now has $3,250,000 of GST exemption available,[12] the taxpayer has determined that she wishes to allocate additional GST exemption to the trust to reduce its inclusion ratio to zero. Two-thirds of the trust is already exempt from GST, so it will take an additional allocation of $2,000,000 of GST exemption to give the trust a zero inclusion ratio. Any Form 709 filed in 2013 would be "late" with respect to the allocation of exemption to a 2008 gift. Thus, if the taxpayer wishes to allocate exemption to that 2008 gift, the allocation will be a "late allocation" effective on the date of the allocation.
The allocation of exemption to a gift made in a prior year is made by attaching a "Notice of Allocation" to a gift tax return and filing it. The amount of the exemption allocated using the Notice of Allocation is listed on Schedule D, Part 2, Line 6 of the Form 709. If valuation of the trust assets could possibly be an issue, a standard formula clause, such as this one, should be included on the Notice of Allocation: "Taxpayer allocates to the trust listed above the smallest amount of the Taxpayer's GST Exemption necessary to produce an inclusion ratio (as defined in Internal Revenue Code Section 2642(a)) for the trust that is closet to or, if possible, equal to zero. This is a formula election that will change if values are changed on audit. The Taxpayer hereby elects pursuant to Regulations Section 26.2642-2(a)(2) to treat the allocation of GST Exemption as having been made on the first day of the month during which this allocation is made. For purposes of this election, the applicable valuation date for this allocation is ________ 1, 2013."[13]
The procedure is less clear when the taxpayer wishes to allocate the additional GST exemption available in 2013 to a gift made in 2012. In this case, consider the situation of a taxpayer who made a gift of $5,200,000 in 2012 to a dynastic trust. At the time the gift was made, the taxpayer had GST exemption available of $5,120,000. If she were to allocate all of that exemption to the dynastic trust on her 2012 Form 709, the trust would have an inclusion ratio of approximately .015, meaning that 1.5% of any distribution to a skip person would be subject to GST.
However, by the time the taxpayer is preparing her 2012 gift tax return, the GST exemption has increased again due to indexing and she actually has $5,250,000 of GST exemption available. There is no question that the taxpayer is entitled to use $80,000 of the additional $130,000 of exemption granted under the indexing provision by applying it to her 2012 gift, the only questions are (i) on what date will the allocation be effective, (ii) to what value must the exemption be applied, and (iii) how should the allocation be made.
Effective Date of an Allocation of Additional Exemption to Last Year's Gift
Assuming that the taxpayer is filing the Form 709 before its due date, the allocation of the additional GST exemption for 2013 to the 2012 gift would not be a "late allocation" under the definition in the Code and regulations. In fact, the regulations give support for the position that the allocation of GST exemption on the timely 2012 Form 709 "is effective as of the date of any transfer" in 2012, except that $80,000 of the GST exemption amount that is needed to give the trust a zero inclusion ratio was not available to the taxpayer until January 1, 2013. It did not take any action of the taxpayer to make it available on January 1; sections 2631(c) and 2010(c)(3)(B) provided for that, and Rev. Proc. 2013-15 confirmed it. The only impediment to the effectiveness of the allocation of $80,000 of GST exemption as of the date of the transfer was that it was not available, not any untimeliness of the donor, and that impediment was removed by operation of law on January 1, 2013, arguably making that the effective date of the timely allocation of the 2013 additional GST exemption to the 2012 transfer. While the January 1 effective date of the allocation of the additional $80,000 of exemption is not explicitly prescribed by the regulations, that effective date does seem to enjoy the strongest support under the language of the current statute and regulations.
Another possible effective date for the allocation of additional exemption would be the date of the allocation, but this position is actually contrary to the regulations. Under the regulations, only a "late allocation" is effective on the date of its filing.[14] As discussed above, a "late allocation" is one that is made on a gift tax return filed after the due date for the return on which the gift is reported. Thus, there is no support in the regulations for the notion that the effective date for the allocation of the $80,000 of additional GST exemption attributable to 2013 in our example would be effective as of the date the return is filed. Thus January 1, 2013 is the only effective date for which there is statutory or regulatory support.[15]
Valuation Date for a Prior Year Gift in Trust
For a timely allocation of GST exemption, the property to which the allocation is made is valued as of the date of the gift for the purpose of determining how much GST exemption must be allocated to the trust.[16] Late allocations of GST exemption must be applied to the value of the property in trust as of the date of the allocation, unless the taxpayer elects to use the value of the first day of the month in which the allocation is made.[17] Having already established that an allocation of GST exemption to a 2012 gift on a timely-filed gift tax return is not a "late allocation," the Code and regulations would seem to indicate that the proper value to use is the date of gift value. That conclusion could be considered problematic as it does not align with the effective date of the allocation, which we believe to be January 1, 2013. In the absence of authority on this question, we believe that the taxpayer should recognize that the IRS may take the position that the value on the effective date of the election – January 1, 2013 – should be used.
How To Make the Allocation
The Form 709 and its instructions have not been modified to make it clear how to allocate the annual additional GST exemption amount to a gift in the immediate prior year. In the absence of IRS instructions, the following technique is recommended, with the objective of making the intention of the taxpayer abundantly clear.
Continuing with the example of a taxpayer who made a $5,200,000 gift to a dynastic trust in 2012, the 2012 gift tax return will be required to include a Notice of Allocation on which the $5,120,000 of GST exemption available in 2012 is allocated. The author recommends attaching a second, separate Notice of Allocation to the 2012 gift tax return on which the gift is reported. The separate Notice of Allocation would be used solely to allocate the $80,000 of additional exemption to the 2012 gift. Since the regulations and forms have not been updated since Congress passed the law that tied the GST exemption to the basic exclusion amount, there is no guidance on how to do this; however, the approach of including a second Notice of Allocation with the 2012 return seems like a reasonable one for allocating the additional exemption.
The second Notice of Allocation should clearly indicate that it is the additional exemption that is being allocated on the return, and it should contain an explanation that the taxpayers are entitled to use that additional exemption any time on or after January 1, 2013, because $5,250,000 is the GST exemption amount in effect as of January 1, 2013. The following language can be used for that purpose: "Pursuant to I.R.C. Section 2613(c) and Section 2.13 of Rev. Proc. 2013-15, 2013-5 I.R.B. 444, the taxpayer's exemption from GST is $5,250,000 as of January 1, 2013. The purpose of this Additional Notice of Allocation is to allocate part of the additional $130,000 of GST exemption available to the taxpayer on January 1, 2013, due to indexing of the GST exemption amount, to the [name of trust] dated ____________, 2012."
The standard language for formula allocation suggested by Harrington, Plaine, and Zaritsky should also be amended to take the position that the effective date of the $80,000 of additional exemption allocated to the 2012 gift is January 1, 2013. That can be accomplished by including the following italicized language in the standard formula clause: "Taxpayer allocates to the trust listed above the smallest amount of the Taxpayer's GST Exemption necessary to produce an inclusion ratio (as defined in Internal Revenue Code Section 2642(a)) for the trust that is closet to or, if possible, equal to zero as of the earliest date on which this allocation is effective, believed by the taxpayer to be [insert date of gift or if you wish to be more conservative, January 1, 2013]. This is a formula election that will change if values are changed on audit. Based on values as shown on this return, the amount of GST exemption allocated to this transfer is the amount shown above."
If the taxpayer has an extension until October 15 but has already filed the 2012 gift tax return, it is not recommended to file a second 2012 only allocating the additional 2013 exemption because the IRS may construe that second return to be an amended return that supersedes the first 2012 gift tax return filed.[18] A safer procedure would be to actually amend the earlier return and restate all of the gift and GST tax information initially reported on a second amended return filed before the due date (as extended).
If the value of the gifted property has declined by the time the gift tax return is ready to be filed, it may be in the taxpayer's interest to make a late allocation. If so, the allocation of the 2013 exemption should be delayed until after the due date of the 2012 gift tax return, so that the allocation will be a "late allocation" and it will not be effective until made. In that case, the amount of exemption that would need to be allocated would be based on the value of the trust assets as of the first day of the month the allocation is made.
Alternative Approach
Finally, as an alternative to using a second Notice of Allocation to allocate the additional exemption to the 2012 transfer to a dynastic trust, another option would be to do a qualified severance of the trust into two separate trusts, one with an inclusion ratio of zero and the other with an inclusion ratio of one.[19] Ideally the trust with the inclusion ratio of one would be funded with cash (which it could borrow from the donor, if necessary) so that it does not appreciate. After the severance, the trust with an inclusion ratio of one could be distributed to non-skip persons (the donor's children) and the trust terminated, or, alternatively, a timely or late allocation of additional exemption could be made to the trust with the inclusion ratio of one in 2013 or a later year, resulting in two fully-exempt trusts. If the latter course is chosen, in due course, the two trusts could be merged.
Conclusion
The availability of additional amounts of indexed GST exemption make it possible to improve the inclusion ratio of existing trusts by allocating additional exemption to them. While the procedure for making a late allocation to a trust is clear, the IRS has not provided any guidance on how to make a timely allocation of additional exemption. Use of a second Notice of Allocation included with a timely-filed gift tax return is the most logical way of making this allocation, and should result in the allocation being effective on the earliest possible date. The existing statutory and regulatory provisions support the use of this technique.
[1] Internal Revenue Code ("I.R.C.") Section 2631(c).
[2] Rev. Proc. 2013-15,2013-5 I.R.B. 444, § 2.13.
[3] I.R.C. § 2632(a)(1).
[4] I.R.C. § 2632(a)(2).
[5] I.R.C. § 2632(a)(2)Treas. Reg. § 26.2632-1(b)(1)(ii).
[6] I.R.C. § 2642(b)(1).
[7] I.R.C. § 2642(b)(3).
[8] Treas. Reg. § 26.2632-1(b)(4)(ii)(A).
[9] Id.
[10] Since it is often difficult (if not impossible) to know the value of a gift on the date of filing, Treasury Regulation Section 26.2642-2(a)(2) provides that in most circumstances a late allocation can use the value of the property to which GST exemption is allocated as of the first day of the month in which the allocation is filed. The election is still "effective" as of the date of filing
[11] Through out the examples in this article we will assume that the children of the donor are beneficiaries of the dynastic trust so that the gift to the dynastic trust is not a "direct skip" as defined in I.R.C. Section 2612(c).
[12] $5,250,000 less the $2,000,000 she used in 2008
[13] This sample language is taken from Appendix A, Gift Tax Return No. 2, Harrington, Plaine & Zaritsky, Generation-Skipping Transfer Tax (2d edition, 2001).
[14] Treas. Reg. § 26.2632-1(b)(2)(ii).
[15] Of course, if the allocation is made on a return filed on or after October 16, 2013, all uncertainty disappears and the late allocation rules apply.
[16] I.R.C. § 2642(b)(1).
[17] I.R.C. § 2642(b)(3); Treas. Reg. § 26.2642-2(a)(2).
[18] Treas. Reg. Section 26.2632-1(b)(4)(ii) states that if "more than one timely allocation is made, the earlier allocation is modified only if the later allocation clearly identifies the transfer and the nature and extent of the modification." Nevertheless, because of the way in which the Service Center processes gift tax returns, a taxpayer can reduce the possibility of processing errors by completely amending the return (and so indicating on the second timely-filed return).
[19] Treas. Reg. § 26.2642-6.
LISI Estate Planning Newsletter #2140 (September 11, 2013) at http://www.LeimbergServices.com Copyright 2013 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission.