University of HoustonLawCenter

Special Research & Writing Assignment

You must receive a minimum grade of “C” to receive credit. Papers must be completed and submitted to the professor during the semester in which you registered for the course. Students whose papers are not submitted within this time frame may be administratively withdrawn from the course: Incompletes (“I”) are not given. The paper must 15 pages plus footnotes for one credit, 25 pages plus footnotes for two credits, or 40 pages plus footnotes for three credits.

Student: Finis Cowan

Email

Course No. 5398 Section 18548 Semester/Year Spg 09

No. of Credits:1

Faculty Advisor - Supervising Professor Approval:

______

Ira B. Shepard

Date: ______, 2009.

Form 709 Preparers Ask,

“Why Elect Out of the GST Exemption Automatic Allocation Scheme?”

(Short Answer: Elect out for appreciating property, indirect transfers

including mostCrummey ILITs, and trusts less likely to have GSTs.)

© Finis Cowan JD, CPA

LLM Tax Candidate

University of HoustonLawCenter

July 31, 2009

Table of Contents(§ References are to IRC)

  1. Purpose and Scope of Article………………………………………………………….4
  2. Caveat re: Anticipated Statutory Amendment and Sunset….……………………...... 4
  1. 2009 Planning Opportunities……………………………………………………...... 5
  1. GST Exemption Allocation Basics
  2. Definitions ……………………………………………...…………………...5
  3. Exemption§ 2631……………………………………………………………6
  4. Deemed Allocation§ 2632……………………………………………...... 7
  5. Zero Inclusion RatioMeans No GST Tax § 2642…………………………...7
  6. Election Planning, Separate Trusts……………………………………...... 8
  7. When Do GSTs Occur With Trusts?...... 9
  8. Complete v. Partial Allocation…………………………………………...... 9
  9. Annual Exclusion Only To Direct Skips and Certain Trusts...……………....9
  10. Valuation Timing……………………………………………………...... 10

i.Automatic Allocations…………………………………...... 11

ii.Timely 709………………………………………………...... 11

iii.Late 709, Electing Out…………………………………...... 11

iv.Other Returns……………………………………………...... 11

v.ETIP……………..………………………………………...... 12

J. Irrevocability of Allocations and Elections………………………………….13

5. Deemed Allocation………………………………………………………………...... 13

  1. Explanation of Statutory Terms § 2632(b)-(c)………………………………....13
  2. Form 709 Unnecessary But Good Recordkeeping………………………...... 13
  3. Order of Deemed Allocation ………………………………………………….14
  4. GST Trusts………………………………………………………………...... 14

6. Preventing Deemed Allocations…………………………………………………...... 15

A. ReasonsToElect Out…………………………………………………………..15

B. How To Elect Out………………………………………………………………16

C. Notice Of Allocation……………………………………………………………16

D. Use Formula……………………………………………………………………...19

E. When to Elect…………………………………………………………………….19

F. Five Statutory Allocation Options………………………………………………..19

G. Termination of Election Out……………………………………………………..19

7. LateAffirmative Allocations

A.Relief for late allocations where good faith and no IRS prejudice………………20

B. Substantial Compliance…………………………………………………………..21

C. Intentional Late Elections………………………………………………………...22

D. First Day of Month Value Election, Except Life Insurance and Death………….23

E. Same Day Tie Goes to the Late Allocation………………………………………23

F. Retroactive Allocation If “Unnatural Order of Death”…………………………..23

8. Crummey ILITs – Whether To Allocate Or Not………………………………………..24

A. Term Insurance

(i) Periodic Allocation Is Safest……………………………………………..24

(ii) Wait-and- See May Save Tax……………………………………………25

B. Non-Term…………………………………………………………………………26

(i) Periodic Allocation……………………………………………………….26

(ii) Wait-and-See…………………………………………………………….26

(iii) Expedited Due Date for Late Allocations……………………………….26

Conclusion. Affirmative Allocation for ILITs Recommended……………………………....27

  • Table of Authorities
  • Appendix A: Checklist For Information and Documents Needed
  • Appendix B: Checklist For Information and Documents Needed For ILIT Allocation
  • Appendix C: Checklist for GST Tax Exemption Allocation Analysis
  • Appendix D: Checklistfor GST exemption analysis

Special thanks to Professor Ira Shepard, my colleagues at Prather Kalman PC and my wife Lori for their kind patience and generous support.

Pursuant to Regulations Governing Practice Before the Internal Revenue Service (Circular 230) this communication is not intended or written to be used as legal or accounting advice, and it cannot be used by a taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.

Purpose and Scope of Article:

“A recurring problem is the failure to make an allocation of this (GST) exemption when making lifetime gifts.”[1] First-time preparers of IRS form 709[2]are likely to be confused as to whether to elect to not follow the automatic GST exemption allocation scheme.[3] The reasons are not in the form’s instructions,[4]IRC §2632 or Regs. §26.2632-1.[5] This article is intended to familiarize the beginner or generalist form 709 return preparer with the rationales for electing out of the deemed allocation scheme and for affirmatively allocating the exemption for GST transfers during the transferor’s lifetime.

  1. Caveat Re: Anticipated Legislative Changes:

For individuals dying and transfers made in 2009, the lifetime GST tax exemption (like the estate tax exemption) is $3.5 million per individual and $7 million per married couple. Absent probableCongressionalamendment,[6]there will be no GST or estate tax in 2010 and starting in 2011, the GST tax and exemption will revert to the year 2001 rules, a lifetime exemption of $1 million adjusted for inflation and the 55% GST tax rate will apply again.[7] “Total permanent repeal is doubtful”[8]but in case amendment is delayed it would be wise to avoid strategies that trigger GST taxes payable in 2009 that might be avoided if the transfer is delayed to 2010. Practitioners should monitor Congressional developments.

  1. 2009 Planning Opportunities:

“Since the $3.5 million GST exemption available in 2009 may be smaller in the future, it may make senseto make plans to maximize its use now.”[9] For example, a transferor could allocate up to $3.5 million of one’s remaining GST exemption to property with growth potential in a trust in 2009 and that trust asset would be GST exempt regardless of future changes in value.

Since it is unclear whether new legislation will allow Qualified Severances (“QS”) which sunsets at the end of 2010, consider a QS before the end of 2009 if Congress acts this year without reenacting them and before 2010 if they do not. Consider a QS if a trust’s inclusion ratio (discussed below) is between zero and one.IRC § 2642(a)(3); Regs. Sec. 26.2642-6.

  1. GST Exemption Allocation Basics:[10]

A. A Few Definitions Translated Into Purportedly Plain English:

Skip Person means (i) a natural person donee who is a generation that is at least two generations below the transferor’s generation, i.e. a grandchild, great-grandchild, great-niece, etc., (ii) onestatutorily “assigned”[11] to such a generation (e.g. beneficiaries 37.5 years younger than the transferor) or (iii) trusts if all interests in property transferred to the trust are held by skip persons. I.R.C. § 2613(a).

One can affirmatively allocate GST exemption forunborn skip persons.[12]GST exemption allocations where there is no potential for GST taxation are void[13] so if no skip persons ever exist, there can be no GST tax and allocation has no effect. However, a “trust will also be a skip person if there are no interests in the property transferred to the trust held by any person, and future distributions of terminations from the trust can be made only to skip persons.” (709 instructions, p. 7 and I.R.C. § 2613(a)).[14]

Three types of transfers are subject to the GST tax: direct skips, terminations and distributions. I.R.C. § 2611(a)

Direct Skip means a transfer subject to gift or estate tax made to a skip person including a trust if all trust beneficiaries are skip persons.IRC § 2612(c)(1). Transfers to trusts having both non-skip and skip persons as beneficiaries are not direct skips.

Indirect Skipmeans any transfer of property (other than a direct skip) subject to gift tax made to a GST trust.

A GST trust is any trust that may incur GST tax unless any of six alternative exceptions apply that indicate significant benefits will go to non-skip persons, (e.g., grantor’s children rather than her grandchildren) or certain charitable trusts. IRC § 2632(c)(3)(B).

Taxable distribution ”means any distribution from a trust to a skip person (other than a taxable termination or a directskip).” IRC Sec. 2612(b). Exemptions and exclusions aside, payment from a trust to a grandchild would be a taxable distribution.

Taxable terminationsof interests in trusts “occur when there are no more nonskip persons ahead of the skip person”[15] as a result of “termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in a trust unless—

(A) immediately after such termination, a non-skip person has an interest in such property, or

(B) at no time after such termination may a distribution (including distributions on termination) be made from such trust to a skip person. IRC 2612(a)(1); Regs. § 26.2612-1(b)(1)(iii).

For example, death of a transferor’s only child, which by the terms of a trust terminated the trust in favor of skip persons, would be a taxable termination.

B. Exemption: Each individual may transfer a maximumcumulative amount of property ($3.5 million in 2009) during life or at death free of the GST tax. This exemption may be allocated by transferors against their lifetime gifts on Form 709and by the transferor's executoron Form 706.[16] IRC §2631(a). The allocation is made to transfers or to trusts, not to transferees.[17] For direct skip transfers to a trust, allocations are made to the entire trust rather than to specific assets. Regs. § 26.2632-1(a).

C.Deemed Allocationrules“represent the IRS’ attempt to alleviate the harsh consequences of misunderstanding the complex GST tax rules”[18]and automatically apply to direct skips and lifetime indirect skips to GST trusts if the transferor or executor fails to elect otherwise. IRC § 2632(b)-(c)

Reliance onthis default rule may result in significant additional taxes. Electing out of the default rule and affirmatively allocating the exemption can avoid GST tax on future appreciation.[19] Timely affirmative use of the exemption can shield more than the nominal ($3.5 million in 2009) GST exemption from GST tax.[20] The following example demonstrates this “leveraging” of the GST exemption and a disadvantage of the automatic allocation rule: it doesn’t know the most appropriate property or trust that the exemption should be applied to.

Grandpa has two inter-vivos trusts that were drafted by different lawyers for the benefit of his kid and grandkids “from which a generation-skipping transfer may occur.”[21]In January 2009, when Grandpa had $3.5 million of GST exemption available, he transferred $3.5 million cash to Trust A. He did not elect out of the deemed allocation rule and it automatically allocated $3.5 million of his GST tax exemption to Trust A.One month later he transferred a life insurance policy worth (pre-death) $2 million to Trust B, whose terms made it more likely than Trust A to result in a GST. Unfortunately, because the deemed allocation rule had already consumed all the GST exemption, there was none left to allocate to Trust B.[22] When Grandpa’s kid reached the age specified in Trust A for the trust’s termination in 2013, the Trust A cash went to Grandpa’s kid and thus no GST tax would have been incurred on it regardless of the GST exemption. When Grandpa died later that year, the insurance policy paid $10 millionfor the benefit of his grandkids. All of it was subject to GST tax that would not have been owed had Jake elected out for the transfer to Trust A and allocated his exemption to Trust B.The exemption automatically allocated to Trust A was wasted and would have been more profitably allocated to Trust B. Had Jake’s CPA elected out of the deemed allocation scheme, or at least for transfers to Trust A, on a Form 709 due on April 15, 2010, Jake could have left $4,500,000 to his offspring instead of to the U.S. Treasury[23] or at least saved a lot on his insurance premiums for the same amount of after-tax insurance proceeds.

D.Zero Inclusion Ratio Means No GST Tax. The GST exemption “is not a true exemption from GST tax, nor does it operate as a credit against tax as the applicable (annual) exclusion amount does. Rather, it is a rate reducer. The effective rate of generation-skipping tax (called the ‘applicable rate,’ I.R.C. § 2641) is determined by multiplying the ‘inclusion ratio’ (I.R.C. § 2642(a)), which essentially is the percentage of the property to which GST exemption has not been allocated, by the maximum federal estate tax rate (45% in 2009).”[24]

IRC § 2632(b) and(c) providefor automatic allocation of an individual’s available GST exemption to lifetime direct skips and to indirect skips to a GST Trust “to the extent necessary to produce an inclusion ratio of zero,”[25] i.e., to the extent necessary to avoid GST tax.[26] The trust’s inclusion ratio will need to be recalculated when additional GST tax exemption is allocated to the trust and when additional property is contributed to the trust.[27]

E. Election Planning: The “goal is to ensure that all trusts are assigned an inclusion ratio of either zero or one; that is, either wholly exempt or wholly taxable. A fractional inclusion ratio results in the ‘wasting’ of the transferor's GST tax exemption and the likelihood of unnecessary taxation.”[28]

Separate GST-Exempt and Non-Exempt Trusts:The usual practice“when property will be placed in trust and the generation skipping transfer will occur at a later time, (is) to allocate GST exemption to one trust (orgroup of trusts) so that it (or they) will be entirely exempt from the tax and for the othertrust (or trusts) to not be exempt at all, rather than creating partially exempt trusts.”[29] This may be accomplished by specific GST exempt gifts, judicial reformation or use of a qualified severance.[30] IRC §§ 2632, 2642(a).

A trust is made GST tax exempt by allocating a sufficient amount of the exemption to achieve a zero inclusion ratio, i.e., equal to the value of the transferred property or by only making transfers to which the GST annual exclusion applies. The exempt trust should be used to(1) make generation skipping transfers and (2) hold property for younger generation beneficiaries that has the potential for significant appreciation. “If possible, transfers to which the GST tax exemption will be allocated should be made during lifetime so that additional appreciation in the transferred assets will be excluded from the GST tax.”[31]

A nonexempt trust should (1) have no exemption allocated to itand (2) be used to benefit older generation beneficiaries by making distributions which are not generation skipping.[32]

F. When Do GSTs Occur With Trusts?

“A generation-skipping transfer, however, may occur in two instances. First, if one or more of the children die before the grantor and under the trust agreement the deceased child’s share passes to the child’s descendants, some of the trust assets may pass to skip persons (the child’s descendants). (However, IRC 2632(d)(1) may allow retroactive allocation of the GST tax exemption under these circumstances).[33]

Second, if the trust agreement provides that a child’s interest does not vest until the child reaches a certain age and the child dies after the grantor but before the assets vest in the child, the assets also may pass to skip persons.”[34]

G. Complete vs. Partial Allocations:Where a trust has been allocated an amount of the transferor's exemption equal to the entire amount of the trust, “distributions or terminations therefrom will always be exempt from GST tax, regardless of the amount to which the trust may have grown in the interim.”[35]

A partial allocation of the GST tax exemption “will always result in a GST tax.”[36] That is, if the amount of exemption allocated is less than the transfer, GST tax is owed for that year. Accelerating the tax may still be cheaper in the long run than incurring tax on appreciation, e.g., wouldn’t you rather pay tax on the life insurance premiums than the proceeds?

The GST tax exemption may be allocated even if there is no current generation-skipping transfer, e.g., it is permissible to allocate a portion of the GST exemption upon the funding of a trust for the benefit of the transferor's child and grandchild.[37]

H. Annual Exclusions:[38]The annual gift and GST exclusions are the same quantitatively ($13,000 for 2009) but not qualitatively. TheGST exclusion only applies to direct skips which are outright transfers directly to skip persons and transfers to certaintrusts the beneficiaries of which are skip persons.[39] IRC § 2642(c). No GST exemption allocation or election is necessary if suchdirect skip transfersare below the annual exclusion[40]or for medical or tuition payments paid directly to medical providers and qualified educational organizations.[41] If the transferor uses the gift tax exclusion for contributions to qualified tuition programs or education savings accounts, such contributions also qualify for the GST annual exclusion.[42] A split gift between married people for gift tax purposes is also a split gift for GST purposes. “A transfer in trust for the benefit of both nonskip persons and skip persons (such as a trust for the benefit of one’s children and grandchildren) may qualify for the annual exclusion for gift tax purposes, but it cannot qualify for the exclusion for generation-skipping transfer purposes.”[43]

Transfers to Most GST Trusts are Not Eligible for Annual GST Exclusion

The GST tax annual exclusion does not apply to direct skip transfers in trust for the benefit of an individualunless the trust provides that:

1. Distributions cannot be made to anyone other than a singleskip person beneficiary during that skip person’s life; and

2. If the skip person dies prior to the termination of the trust, the trust assets must be included in the skip person’s estate.IRC Sec. 2642(c)

If these two conditions are not met, the annual exclusion will not be available for GST tax purposes, and the transferor’slifetimeGST tax exemption will have to be allocated to shelter the transfer from the tax.[44] The inapplicability of the GST annual exclusion to most Crummey trusts is discussed more fully below.[45] “(T)his type of trust would not apply to the typical irrevocable life insurance trust for the benefit of a spouse, children and multiple grandchildren even though contributions might be sheltered from gift taxation by the gift tax annual exclusion.”[46]

Form 709 must be filed to elect out of the deemed allocation rule, even if the annual gift tax exclusion would normally apply. See Form 709 Instructions and Regs. § 26.2632-1.

Whenever a transfer exceeds the annual GST exclusion, consider allocating some of the lifetime GST tax exemption or making a record of the deemed allocation.[47]

I. Valuation Timing is the key to maximizingthe value of the GST exemption.

“The transferor or his executor may allocate the GST exemption at any time from the date of the transfer through the date for filing the estate tax return.” Regs. § 26.2632-1(a). However, the timing (or deemed effective date) of the allocation and the type of transfer determine the amount of exemption allocated.

(i) Automatic Allocations To Lifetime Direct Skips and GST Trusts[48]are “effective as of the date of the transfer.” Reg. 26.2632-1(b)(ii) and (iii)(2). This means the value of the allocation is the value on the date of the transfer whether or not a Form 709 is filed.Id. Form 709 need not be filed to report an automatic allocation. “Nevertheless, it is often desirable to do so for record keeping and to begin the running of the statute of limitations on the valuation of the gift and the inclusion ratio. IRC § 6501(a).”[49]