GST- The Automatic Exemption Allocation Trap

Background: Few of us feel comfortable when it comes the generation skipping transfer tax (GSTT.) Thankfully, that exemption is currently $15 million per donor, but that exemption is not portable to a surviving spouse. Which is why Congress decided to simplify (if such a word can be used with the GSTT) the rules to provide for an automatic allocation of a donor’s GSTT applicable exemption amount. However,  these automatic exemption allocation rules can be confusing and sometimes completely overlooked by a donor.

GST Rules Simplified? To avoid the automatic allocation of a donor’s GST exemption to lifetime transfer, several rules and definitions must be understood, all of which lead to the need to file a timely election to opt-out of the automatic exemption allocation to that lifetime transfer. [IRC 2632(c)(5).]

Three Types of Transfers: A federal tax is imposed on every generation-skipping transfer. (GST) A GST is either a (i) taxable distribution, (ii) a taxable termination, and (iii) a direct skip. [IRC 2811(a).]

GST Tax: The amount of the GST tax is the taxable amount multiplied by the tax appliable rate. [IRC 2602] The applicable rate is defined as the product of the maximum federal estate tax rate (40%) and the donor’s inclusion ratio with respect to the transfer. [IRC 2641(a).]

Inclusion Ratio: To determine the donor’s inclusion ratio, every individual is allowed a GST exemption amount ($15 million, currently) which may be allocated by that individual donor (or the Personal Representative of his/her estate)  to any property with respect to which that individual is the transferor. [IRC 2631(a).] Any allocation of this exemption once made is irrevocable. [IRC 2631(b).]

Exemption at Death: Any allocation by a Personal Representative of a decedent of his/her GST exemption may be made at any time on or before that is prescribed for filing the federal estate tax return for that individual’s estate (including extensions) regardless of whether such a Form 706 return is required to be filed. [IRC 2632(a)(1).]  Treasury Regulations prescribe the manner in which this GST allocation is to be made. {IRC 2632(a)(2).]

Exemption During Lifetime: If a donor makes an indirect skip transfer during his/her lifetime, any unused portion of his/her GST exemption must be allocated to the property transferred to the extent necessary to make the inclusion ratio of that property zero (0.00). If the amount of the indirect skip exceeds such unused portion of the donor’s GST exemption, the entire unused portion must be allocated to the transferred property. [IRC 2632(c)(1).]

Indirect Skip: Indirect skip means any transfer of property (other than a direct skip, which admittedly is not a helpful definition- think of it as a transfer to a trust rather than directly to an individual donee) subject to the GST tax to a GST trust. [IRC 2632(c)(3)(A).] A GST trust is described as a trust that could have GST with respect to the donor unless an exception (under IRC 2632(c)(3)(B)(i-vi)) applies. [IRC 2632(c)(3)(B).] The operative word is could, which is when complications arise.

GST Trust: A GST trust is defined in the Tax Code. As noted above, the important word is that the trust could or might result in a GST indirect skip based on the terms of the trust or the ages of the trust beneficiaries. This is where problems arise due to the fact intensive definition of a GST trust triggers the automatic allocation and the donor wants to save his/her GST allocation for other transfers, or the donor believes that the trust will never require the allocation of the donor’s GST exemption.

Definition of GST Trust:  There is a highly technical definition of a GST Trust.  “For purposes of this subsection-(B) the term GST trust means a trust that could have a generation-skipping transfer with respect to the transferor unless- (i) the trust instrument provides that more than 25% of the trust corpus must  be distributed to or may be withdrawn by one or more individuals who are non-skip persons, e.g., the donor’s children (1) before the date that the individual attains age 46, (2) on or before one or more dates specified in the trust instrument that will occur before the date that such individual attains age 46, or (3) upon the occurrence of an event that, in accordance with regulations prescribed by the Secretary, may reasonably be expected to occur before the date that such individual attains age 46, (ii) the trust instrument provides that more than 25% of the trust corpus must be distributed to or may be withdrawn by one or more individuals who are non-skip persons and who are living on the date of death of another person identified in the instrument (by name or class) who is more than 10 years older than such individuals, (iii) the trust instrument provides that, if one or more individuals who are non-skip persons die on or before ta date that is described in (i) or (ii) more than 25% of the trust corpus either must be distributed to the estate or estates of one or more such individuals or is subject to a general power of appointment exercisable by one or more of sch individuals, (iv) the trust is a trust any portion of which would be included in the gross estate of a non-skip person (other than the transferor) if such person died immediately after the transfer, (v) the trust is a charitable lead annuity trust…” (Asleep yet?)

Example: I create and fund an irrevocable trust. I name my children, ages 42 and 39, as the income beneficiaries of the trust. Each child has a complete withdrawal right over their respective share in the trust at age 47 (after age 46). If a child dies prior to age 47 his/her children, i.e., my grandchildren (skip persons), will become the trust beneficiaries.  Under the Tax Code’s definition this is a GST trust to which my GST exemption will be automatically allocated when I transfer assets to the trust. However,  in six short years my children, both of whom are healthy, non-skip persons, will be able to withdraw their entire share from the trust and no assets will ever be transferred to a skip person, i.e., my grandchildren. With an automatic allocation of my GST exemption to this trust, in my opinion I will be wasting my GST exemption since it is highly unlikely that my grandchildren will directly benefit from my transfer to the trust, which is why I will want to elect to opt-out of the automatic GST exemption allocation rule. Conversely, if the trust was to pay income to my children for their lifetimes, but with no withdrawal rights at any specified age, there is a good chance my grandchildren will benefit from the trust, and consequently I will want to apply my available GST exemption to my transfer to the trust. Accordingly, I will be content to rely on the Tax Code’s automatic allocation of my GST exemption to this trust in the latter situation.

The automatic GST exemption allocation is thus tied to the unusual, and trust-specific terms-definition of a GST trust, when it may be unlikely that a skip person will ever benefit from the lifetime transfer, yet the donor’s GST exemption is deemed allocated on that basis alone.

Donor’s Opt-Out Election: A donor can elect to have the automatic allocation of the donor’s GST exemption rules do not apply to either (i) an indirect skip, e.g., to a trust, or (ii) any or all transfers made by that donor to a identified trust. [IRC 2632(c)(5)(A)(i).] This opt-out election can be made on a timely-filed federal gift tax return for the calendar year for which the election is to become effective. [IRC 2632(c)(5)(A)(i).]

Automatic GST Allocation: In the case of an indirect skip, the donor’s unused GST exemption is automatically allocated to the property transferred (but not in excess of the fair market value of the property on the date of the transfer.) This automatic allocation of the donor’s GST exemption is effective whether or not a Form 709 is filed that reports the transfer and it is effective as of the date of the transfer to which it relates. An automatic GST exemption allocation is irrevocable after the due date of the Form 709 for the calendar year in which the transfer is made.

ETIP: If it is an indirect skip transfer to which IRC 2642(f) applies, the indirect skip transfer is deemed to be made at the close of the estate tax inclusion period (ETIP, i.e., where during the donor’s lifetime transfer the value of the transfer might still be included in the donor’s gross estate at death), and the GST exemption is deemed to be allocated at that time.

Expansive GST Opt-Out Election: The donor may prevent or opt-out of the automatic allocation of his/her GST exemption with regard to an indirect skip transfer with regard to that indirect skip by making an election as described in the Regulations. [Regulation 26.2632-1(b)(2)(iii)(A).] This Regulation permits a donor to opt out of the automatic allocation of his/her GST exemption to a transfer that constitutes an indirect skip transfer that is made to a trust or to one or more separate shares that are treated as separate trusts. [Regulation 26.2654-1(a)(1).] To be specific, a donor may elect-out of this automatic allocation of his/her GST exemption with respect to (i) one or more prior-year transfers (that are subject to IRC 2642(f) regarding an estate tax inclusion period, i.e., ETIP), made by the donor to a specified trust or trusts; (ii) one or more (or all) current-year transfers made by the donor to a specified trust or trusts; (iii) one or more (or all) future transfers made by the donor to a specified trust or trusts; and (iv) all future transfers made by the donor to all trusts (whether or not in existence at the time of the election out; or (v) any combination of (i) through (iv.)

Opt-Out Election Statement: To elect-out of the automatic allocation of the donor’s GST exemption the donor must attach an election-out statement to a Form 709 that is filed within the normal filing period. [Regulation 26.2632-1(b)(2)(ii)i)(B).] This election-out statement must identify the trust and must specifically provide that the donor is electing out of the automatic allocation of his/her GST exemption with respect to the described transfer or transfers. To elect out, the Form 709 with the attached election-out statement must be filed on or before the due date for timely filing the Form 709 for the calendar year in which either (i) a transfer is subject to IRC 2642(f), i.e., the ETIP period and when the ETIP closes, or (ii) for all other elections-out, when the first transfer to be covered by the election-out was made.

Value of Exemption Allocation: If the GST exemption allocation to any transfers of property is made on a Form 709 gift tax return filed on or before the date prescribed to report that gift, or it is deemed to be made, the value of such property for purposes of the allocation will be its value as finally determined  for purposes of the GST or in the case of an allocation deemed to have been made at the close of an estate tax inclusion period (ETIP), it value at the time of the close of the ETIP period. [IRC 2642(b)(1)(A), and IRC 2632(b)(1) or (c)(1).]

Unwinding an Automatic GST Exemption Allocation: What happens when a lifetime gift triggers the automatic allocation of the donor’s GST exemption when the donor did not want to allocate his/her GST exemption to the transfer, which is often the case when the automatic allocation is associated with a gift to a GST trust which, by its technical definitions, triggers the automatic GST exemption allocation? The Regulations provide guidance when a late GST exemption allocation can be made and when an automatic allocation of the donor’s GST exemption can be ‘unwound’ by filing a late opt-out election. This starts by asking the IRS for an extension of time in which to make an opt-out election of the automatic GST exemption allocation. [IRC 2642(g)(1)(B).; Regulation 26.2642-7.] In this situation the donor’s request for relief must be filed with the IRS in which the donor (or the Personal Representative) must provide evidence that establishes that the donor or Personal Representative acted reasonably and in good faith, and that the requested relief “will not prejudice the government.”

Factors:  Some of the factors that the IRS will consider in granting the requested relief to file a late opt-out election include: (i) the donor’s intent to timely make an election under IRC 2632(b)(3) or (c)(5); (ii) intervening events beyond the control of the donor that caused the donor to fail to make an election; (iii) the lack of awareness, despite the exercise of reasonably diligence by the donor, taking into account the experience of the donor and the complexity of the GST tax issue as the cause of the failure to make an election; (iv) consistency by the donor with regard to the allocation of the donor’s GST exemption to one or more trusts or skip persons; and (v) the reasonable reliance by the donor on the advice of qualified tax professionals.

PLR:  In a recent Private Letter Ruling the IRS granted such relief to an individual to file a late opt-out election. [PLR 202622003, released May 29, 2026.] The relief was granted because the donor’s accountant did not understand that the automatic allocation of the donor’s GST exemption would apply to the assets passing to a trust. The accountant did not advise the donor to election out of the automatic allocation of his GST exemption, and the donor was unaware of or otherwise advised of his ability to make an election to opt out. Apparently after the accountant retired, his successor discovered this failure and brought it to the donor’s attention.

Conclusion: To say the GST rules are complex is a gross understatement!

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