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George F. Bearup, J.D. Senior Legal Trust Advisor

November 25, 2022

Late GST Allocations for 2021 Gifts

Take-Away: It may make sense to opt out of the automatic GST exemption allocation for gifts that were made in 2021 in light of 2022’s market ‘meltdown’ for gifts that are soon to be reported on an extended federal gift tax return on October 17, 2022.

Background: Many individuals who made large gifts to trusts last year are soon going to file their income and gift tax returns on the six-month extension. It will be helpful to remind those individuals  that at least for generation skipping transfer (GST) tax purposes, the Tax Code provides a donor with 20/20 hindsight for gifts that have declined in value. By making a late, rather than timely, allocation of the donor’s GST exemption, that decision could possibly save millions in eventual federal GST taxes.

Form 709: Specifically, the reporting of taxable gifts, and the allocation of the donor’s GST exemption is accomplished by filing Form 709. Once Form 709 is filed, that then starts the statute of limitations running on the IRS contesting the valuation of the disclosed gifts. Form 709 is also where the donor elects whether to allocate his/her GST exemption to any gifts made to trusts. Usually, if the trust is dynastic, i.e. one that does not distribute or terminate to the donor’s child’s generation, this GST allocation is done automatically under the Tax Code, which means that the donor must affirmatively opt out of that GST allocation for their gift to the trust. (More on this automatic allocation below.)

Alternate Valuation by Opting Out: Unlike the federal estate tax, there is no alternate valuation date for federal gift tax purposes. However, the late GST allocation rules indirectly enable a donor to achieve the equivalent result, if the underlying facts permit. If the donor affirmatively allocates GST exemption, or it is automatically allocated to the donor’s 2021 gift to a trust, the value of the gift for both gift tax and GST allocation purposes will be set at the fair market value at the time the donor’s gift became complete. In contrast, if a donor timely files a Form 709, the donor can opt out of what is usually referred to as an automatic GST allocation and/or decline to use the donor’s GST exemption with regard to the gift to the trust. This delay, or ‘opt out,’ of the automatic GST allocation will not, however, prevent the donor from subsequently making a late GST exemption allocation after the due date of the donor’s federal gift tax return.

Example: Seth made a $10 million gift of his marketable securities to a dynasty-type trust on December 1, 2021. If Seth timely files his Form 709 on April 15, 2022, he will report the $10 million gift. Instead, by opting out of the automatic GST allocation, Seth will report $0.00 of his GST exemption used for that gift on the Form 709. In July, 2022, Seth files a subsequent Form 709 on which he makes a late GST allocation. At that time the Form 709 is filed by Seth, the $10 million of gifted securities to the trust have dropped in value to $8,185,000. Consequently, Seth will use $1,815,000 less of his available GST exemption, not $10 million of his GST exemption. If Seth filed for a six-month extension of time in which to file his income tax and gift tax returns for 2021, which is common, Seth can file a first timely filed return by that date, or opt out of the automatic GST allocation, and make a late GST allocation on the late Form 709 filed on October 17, 2022, using that October 17, 2022 date as the value of the gift (made on December 1, 2021) for GST tax purposes.

Donor’s Death: As noted above, a late GST allocation can be done at any time by the donor- even after the donor-settlor’s death. If Seth had a crystal ball and actually knows that his gifted assets to the trust will go down in value even further than their October 2022 values, he can wait until November, December, or any future date. Even if Seth dies, that may not pose that big a problem. For example, if Seth dies, the value of the $10 million trust that he funded dropped to $8.1 million today, but then bounces back in value to $8.9 million in December, 2022 and Seth unexpectedly dies when the trust is worth $8.9 million. The Personal Representative of Seth’s estate can make a late GST allocation of $8.9 million rather than $10 million. Thus,  the delayed GST exemption allocation will still be a smart move in a bear market.

  • Life Insurance Complication: Continuing with the Seth example, assume the trustee of the trust that Seth funded on December 1, 2021 purchases a $10 million life insurance policy on Seth’s life, which has has little cash surrender value at the time of Seth’s death. If the trust assets are worth $8.9 million at the time of Seth’s death before making a late GST allocation, the value of the trust on Seth’s death will balloon to $18.9 million. That will make it necessary for the trustee of the trust to use a mixed GST inclusion ratio, or a severance of the trust into a GST exempt trust  and a non-GST exempt trust, since the Personal Representative of Seth’s estate would need a full $18.9 million of GST exemption to make the trust fully GST exempt.

Automatic GST Exemption Allocation Exception- Hanging Withdrawal Powers: However, with some dynastic-type trusts, there may be not be an automatic GST exemption allocation which may make a late allocation possible. If the donor timely filed a Form 709 reporting their taxable gift, they might reasonably think that the automatic GST allocation rule applied their GST exemption to gift to the trust, and that it is too late to opt out of the automatic GST allocation. However, many dynastic long-term trusts use Crummey withdrawal rights with ‘hanging powers’ for amounts in excess of $5,000 or 5% of the trust corpus,  to better exploit their federal gift tax annual exclusion. The key point is that a such a Crummy  withdrawal right coupled with a ‘hanging power’ does not fall within the definition of a GST Trust to which the donor’s GST exemption is automatically allocated. Consequently, this ‘loophole’ might still be exploited if the value of the gifted assets has substantially dropped in the current bear market. This is admittedly a highly technical ‘loophole’ to the automatic GST exemption allocation rule, but it is something to keep in mind if a gift tax return was previously filed and the trust used a ‘hanging withdrawal powers’ in conjunction with a beneficiary’s Crummey withdrawal right.

Conclusion: While the tax savings are not immediate by opting out of an automatic GST exemption allocation, the projected tax savings from using less GST exemption now could easily be in the millions for high-net-worth individuals in the years to come. This is especially so in light of the scheduled sunset of an individual’s $12.06 million  applicable GST exemption amount, starting in 2026 when it is cut in half.