Automatic allocation of GST exemption to GST trust allowed

In IRS Letter Ruling 202210010 released on March 11, 2022, the IRS ruled that an individual’s generation-skipping transfer (GST) exemption was automatically allocated to a transfer to a trust even though the individual improperly reported the transfer on her gift tax return.

The taxpayer established an irrevocable trust for the benefit of her descendants. During the taxpayer’s lifetime, the trustee could distribute the income and principal of the trust to her descendants in the trustee’s discretion to provide for their health, education, maintenance, and support. Upon the taxpayer’s death, the trust would divide into separate shares for the benefit of each of her children and his or her descendants. During each child’s life, the trustee could distribute principal and income in the trustee’s discretion to the child and his or her descendants to provide for their health, education, maintenance, and support.

At the death of a child, he or she would have a limited power to appoint the remainder of his or her trust to any person or entity other than the child’s estate, the child’s creditors, or the creditors of the child’s estate. Each child also would have a general power to appoint to the creditors of his or her estate an amount with a value equal to the greatest amount that produces the lowest sum of: (1) the transfer taxes payable with respect to the child’s estate and (2) the GST tax payable with respect to the trust. Any unappointed assets of a child’s separate trust would continue in trust for the benefit of his or her descendants.

The taxpayer transferred nonvoting partnership units in a limited partnership to the trust. The taxpayer reported the transfers to the trust on her Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for the year of the transfers. However, the transfers to the trust were incorrectly reported on Form 709, Schedule A, Part 1, Gifts Subject Only to Gift Tax, instead of on Schedule A, Part 3, Indirect Skips and Other Transfers in Trust. Furthermore, the automatic allocation of the GST exemption was not reported on Schedule D, Computation of Generation-Skipping Transfer Tax.

The taxpayer requested a ruling that GST exemption was automatically allocated to the transfers of the partnership units.

The IRS first addressed whether the trust was a “GST trust” to which GST exemption is automatically allocated. Sec. 2632(c)(3)(B) defines a “GST trust” as a trust that could have a generationskipping transfer with respect to the transferor. However, this provision also lists six exceptions to the definition. In particular, Sec. 2632(c)(3)(B)(ii) provides an exception if more than 25% of the trust corpus must be distributed to, or may be withdrawn by, nonskip persons who are living on the date of death of another person identified in the trust who is more than 10 years older than such person. Sec. 2632(c)(3)(B)(iii) provides an exception if the trust instrument provides that if one or more skip persons die on or before a date described in Sec. 2632(c)(3)(B)(ii), more than 25% of the trust corpus either must be distributed to the estate or estates of one or more of such individuals or is subject to a general power of appointment exercisable by one or more such persons.

The IRS concluded that more than 25% of the trust would be subject to a general power of appointment held by the children (nonskip persons) if GST exemption was not allocated to more than 25% of the trust. It then concluded, however, that the general power of appointment contingent upon the inclusion ratio of the trust did not, in this case, prevent the trust from being a GST trust at the time of the transfer to the trust.

The IRS next addressed the failure to correctly report the transfers on the taxpayer’s gift tax return. The IRS concluded that the failure to correctly report the transfers did not amount to an election out of the GST exemption automatic allocation rules to a GST trust because no election statement making the election was attached to the gift tax return. Because the trust met the definition of a GST trust, the IRS ruled that GST exemption was automatically allocated to the transfers to the trust even though the gift tax return failed to properly account for the automatic allocation.

The key to the IRS’s ruling is that the testamentary general power of appointment was a “contingent” power that had not yet manifested at the time of the transfers to the trust. Therefore, the testamentary general power of appointment at the time of the transfers was not an absolute right to withdraw more than 25% of the trust corpus.