Grandfather with Grandchild

Taxpayer’s GST Tax Exemption Automatically Allocated to Direct Skips

Opt-out election was irrelevant, according to the IRS.

In Private Letter Ruling 201921012 (May 24, 2019), the Internal Revenue Service concluded that a taxpayer’s election to opt out of the automatic allocation of generation-skipping transfer (GST) tax exemption was irrelevant because all of the taxpayer’s transfers were direct skips and the opt-out election was incorrectly made with respect to all indirect skips.

Gifts to Trusts for Grandchildren

A taxpayer created separate trusts for the benefit of each of his grandchildren and transferred an interest in a partnership to each trust. The terms of each trust were identical with the exception of the beneficiaries and trustees. Each trust provided the trustee with discretion to make income and principal distributions to the beneficiary (that is, the taxpayer’s grandchild) in the trustee’s discretion. On the beneficiary attaining age 30, that beneficiary’s trust would terminate, and the remaining property would be distributed outright to the beneficiary. If the beneficiary died before age 30, the remaining property would be distributed to the beneficiary’s descendants (that is, the taxpayer’s great-grandchildren or a more remote descendant) or, if none of the beneficiary’s descendants survive the beneficiary, to the taxpayer’s other grandchildren.

The taxpayer and his spouse each timely filed a gift tax return reporting these gifts and signifying their consent to split the gifts pursuant to Internal Revenue Code Section 2513. However, the gifts to the trusts were incorrectly reported on Part 3 of Schedule A of Form 709 as indirect skips, rather than on Part 2 as direct skips. Attached to each return was a statement that the GST automatic allocation rules wouldn’t apply to any transfers to the trusts pursuant to IRC Section 2632(c)(5)(A)(i) and Treasury Regulations Section 26.2632-1(b)(2)(iii) (the opt-out election).  Neither the taxpayer nor his spouse paid any GST tax with respect to these gifts.

Errors on Gift Tax Returns

The taxpayer and his spouse should have reported these gifts as direct skips on Part 2 of Schedule A of Form 709, not indirect skips on Part 3 of Schedule A of Form 709. Direct skips are one of three types of GST transfers for which GST tax is immediately imposed unless GST tax exemption is allocated to the transfer, whereas indirect skips are transfers to trusts that could have GST tax imposed at a later date if GST tax exemption isn’t allocated.

More specifically, direct skips are defined in IRC Section 2612(c)(1) as transfers subject to gift or estate tax of an interest in property to a skip person. A skip person is: (1) any natural person assigned to a generation that’s two or more generations below the generation assignment of the transferor (for example, a grandchild or a more remote descendant of the transferor), or (2) a trust if all interests in such trust are held by skip persons. 

Here, each trust was a skip person, and every transfer made by the taxpayer or his wife to each trust was considered a direct skip because all of the potential beneficiaries (current and remainder) were the taxpayer’s grandchildren or more remote descendants. Therefore, every transfer by taxpayer or his wife to each trust would have had GST tax imposed unless GST tax exemption was allocated with respect to such transfer.

Automatic Allocation

At issue for the IRS in this PLR was whether the taxpayer’s wife’s available GST tax  exemption was automatically allocated to the transfers to the trusts despite the opt-out election (the PLR didn’t request a similar ruling regarding the allocation of taxpayer’s available GST tax exemption). If GST tax exemption wasn’t allocated to the transfers to the trusts, the GST tax would have been imposed.

The IRS concluded that the taxpayer’s wife’s GST tax exemption was automatically allocated to the transfers to the trusts because no election to opt out of the automatic allocation of GST tax exemption to direct skips was made pursuant to Section 2632(b)(3). Furthermore, the IRS concluded that the opt-out election attached to the gift tax return was irrelevant because it was an opt out of the automatic allocation of GST tax exemption to indirect skips pursuant to Section 2632(c)(5)(A)(i).

Section 2632(b)(2) provides that a transferor’s unused GST tax exemption is automatically allocated to a lifetime direct skip unless the transferor makes an election pursuant to Section 2632(b)(3) to have the automatic allocation rule not apply to a transfer. Treas. Regs. Section 26.2632-1(b)(1) provides that a transferor may prevent the automatic allocation of GST tax exemption by describing on a timely filed gift tax return the transfer and the extent to which the automatic allocation of GST tax exemption isn’t to apply. 

Similarly, Section 2632(c)(1) provides that a transferor’s unused GST tax exemption is automatically allocated to any indirect skip unless the transferor makes an election pursuant to Section 2632(c)(5)(A)(i). Treas. Regs. Section 26.2632-1(b)(2)(iii) provides that a transferor may prevent the automatic allocation of GST tax exemption to any transfer constituting an indirect skip by attaching a statement (election-out statement) to a timely filed gift tax return, which must identify the trust and specifically provide that the transferor is electing out of the automatic allocation of GST tax exemption with respect to the described transfer or transfers.

In determining that taxpayer’s wife’s GST tax exemption was automatically allocated to the transfers to the trusts, the IRS concluded that that the opt-out election was irrelevant because all of the transfers to the trusts were direct skips, and the opt-out election was made pursuant to Section 2632(c)(5)(A)(i) and Treas. Regs. Section 26.2632-1(b)(2)(iii), which apply only to indirect skips.  In other words, by mistakenly reporting the gifts on the wrong part of the gift tax return and referencing the wrong IRC and Treasury regulation sections in the opt-out election, the opt-out election was ineffective, and the automatic allocation rules for direct skips applied.

Formalistic Approach

While the mistakes on the gift tax returns resulted in a favorable outcome for the taxpayer and his wife in this instance, the IRS appears to create formalistic approach to electing out of the automatic allocation of GST tax exemption. To opt out of the automatic allocation of GST tax exemption for direct skips, Treas. Regs. Section 26.2632-1(b)(1) merely requires a description of the transfer and the extent to which the automatic allocation rules aren’t to apply. Here, the statement attached to the gift tax returns filed by the taxpayer and his wife expressly provided that the automatic allocation rules weren’t to apply to any transfers to the trusts. And yet, the IRS still concluded that this statement was ineffective for purposes of electing out of the automatic allocation of GST tax exemption for direct skips because the election was made pursuant to the wrong IRC and Treasury regulation sections.

Query whether the result would have been the same had the opt-out election not referenced any IRC and Treasury regulation sections at all. Would the failure to have reported the gifts on the correct part of the gift tax return been sufficient to make the election out irrelevant? 

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