In a prior article, I wrote about the importance of properly prepared Form 706 Estate Tax Return, discussing a Private Letter Ruling (“PLR”) that highlighted some common mistakes made on the Form 706.[1] In that article, I discussed issues related to the marital deduction and the allocation of a decedent’s unused Generation Skipping Transfer Tax (“GSTT”) exemption.
In this article, I’d like to discuss a similar, but less tricky tax return, the Form 709 Gift Tax Return (the “709”). A recent PLR highlights the primary issue or mistake made when filing a 709, or in this case, not filing a 709, that of timely and properly allocating the taxpayer’s GSTT exemption.[2] In the present case, the decedent made lifetime gifts to certain irrevocable trusts but did not file a 709 reporting such gifts, as the decedent had never been advised of the filing requirements. Fortunately, in this case, as was the case in my article on the 706, the decedent’s estate was granted a 120 day extension to file the 709 and was allowed to treat the allocation of GSTT exemption made on the 709 as having been made timely, a potentially large benefit, as can be seen in my discussion below. While the PLR does not say it directly, it is evident that the automatic allocation rules of Sec. 2632 discussed below did not apply to the transfers, or this would have been a non-issue, though the information is not provided in the PLR to determine why not.
Schedule A to the 709 – Listing Transfers in the Right Part and Why It Matters for GSTT
Schedule A of the 709, where the gifts are reported, is the most common place for mistakes to be made when preparing a 709. Schedule A contains three parts, Part 1, for gifts only subject to gift tax, Part 2 for Direct Skips, and Part 3 for Indirect Skips. In order to properly prepare Schedule A, the preparer must first understand the differences between Parts 1, 2, and 3. That understanding requires a working knowledge of the GSTT provisions, and more specifically, of the definition of a Direct Skip[3], a transfer to someone or a trust that is a skip person, and that of an Indirect Skip[4], a transfer to a trust that has both non-skip and skip persons as beneficiaries. When reviewing a 709, it’s quite common to see that all of the taxpayer’s gifts, even those which are to trusts and qualify as indirect skips,are listed on Part 1 of Schedule A.
The issue with this lies not in the use of the gift tax exemption but in the use of the GSTT exemption. A close look at the differences between Part 1 and Part 3 reveals that Part 3 has a Box C to make the Sec. 2632(c) election[5], while Part 1 does not have that option and simply has a grayed out Box C. In many cases, this may not matter at all due to the automatic allocation rules found in Section 2632, commonly called the dumb-but-lucky rules. If the Trust is a GST Trust as defined by Sec. 2632(c)(3)(B), then automatic allocation will apply even if no allocation is listed on the 709, and Part 2 of Schedule D, the GST reconciliation statement, is left completely blank. If automatic allocation applies, then listing the gift to a GST Trust in Part 1 of Schedule A, rather than Part 3, is most likely a no-harm, no-foul error. While not the primary focus of this article, I’m going to go a tangent here and discuss why I say “most likely” in the prior sentence. There is a potential scenario whereby a Trust that has existing hanging Crummey powers could fail to qualify as a GST Trust if the value of the currently exercisable hanging powers are in excess of the annual exclusion amount for gift tax purposes due to the flush language in 2632(c)(3)(B), which reads as follows: “For purposes of this subparagraph, the value of transferred property shall not be considered to be includible in the gross estate of a non-skip person or subject to a right of withdrawal by reason of such person holding a right to withdraw so much of such property as does not exceed the amount referred to in section 2503(b) with respect to any transferor, and it shall be assumed that powers of appointment held by non-skip persons will not be exercised.”
While it may be a no harm, no foul error, the best practice is to list the gift in Part 3 of Schedule A and make a protective election to treat the respective trust as a GST Trust to avoid the hanging Crummey power issue above. This is done by making the Sec. 2632(c) election on the return and attaching an affirmative statement that the taxpayer is electing to treat the respective trust as a GST Trust for the current return and all future returns, thus ensuring automatic allocation regardless of whether the hanging Crummy power issue is applicable.
Back on point now, what if automatic allocation does not apply but the allocation of GSTT exemption is still desired? In that case, there is no option to do so on Part 1 of Schedule A, and the gift must be reported on Part 3 of Schedule A. The 2632(c) box must be checked along with the inclusion of an allocation statement to affirmatively allocate GSTT exemption to the desired transfer or a statement that the taxpayer is electing to treat the respective trust as a GST Trust.
PLR 202247007
Getting back to the PLR where the decedent failed to timely file a 709, why does it matter that the 709 was filed late? Well, for purposes of gift tax, it likely doesn’t matter one bit, unless gift tax was actually owed, in which case there would be late payment penalties and interest on the gift tax owed. But for GSTT, it matters a great deal. The reason is due to the valuation of transfers and how it relates to the timeliness, or lack thereof, of a GSTT exemption allocation. Automatic allocations, as well as those made on a timely filed gift tax return, use the value of the property as of the date of the transfer[6], while untimely allocations use the value of the property as of the date the untimely allocation is made.[7] So let’s say you transfer some appreciating property to a trust when it is worth $1M, and you timely file a 709 allocating GST exemption to the trust, you have used $1M of exemption even if the property is worth $2M at the time of filing of the 709. But what if you fail to timely file a 709? Assuming automatic allocation does not apply to the transfer, you’ve lost your opportunity to fully exempt the trust from GSTT by only using $1M of your exemption unless the property value is $1M at the time of the untimely allocation. If you later try to allocate GSTT exemption to the trust when the property is worth $3M, you will have to allocate $3M of GSTT exemption to the trust to make it fully GSTT exempt.
That is the importance of a timely filed return with properly allocated GSTT exemption and the proper GSTT elections made.
Gift Splitting
While the focus of this article is on the GSTT, I must mention another common mistake I see relating to the 709. Couples who gift split, that is, one person makes a gift and elects treat it as having been made one half by him or her, and one half by his or her spouse, should both file a gift tax return in order to properly consent to the gift splitting.[8] Gift splitting does not happen automatically, it must be consented to by the spouse whose annual exclusion is being used by the other spouse.[9] A common scenario is for couples to make gifts that are double the annual exclusion amount and assume gift splitting applies when, absent proper consent, it does not. Thus, even if couples are gift splitting only up to the annual exclusion amount of both spouses, 709s should still be filed by each consenting to the gift splitting. I see couples gift splitting all the time without filing a 709 to consent to the gift splitting. While potentially a no harm, no foul mistake, the IRS could take a hard line and treat the amount in excess of the donor’s annual exclusion as a taxable gift, thus either using gift tax exemption if available or generating gift tax if not.
With that said, couples who are planning to gift split need to be aware of the how it works, that being an all or nothing proposition. Couples cannot elect to split one gift and not another if both gifts were made in the same year[10], subject to a limited exception for gifts for the benefit of the consenting spouse.[11] This can frequently cause issues where one spouse may be making a large gift to a spousal lifetime access trust[12], or in the case of a blended family, to one spouse’s children from a prior relationship. In this case, couples should not plan to gift split annual exclusion gifts unless they also want to split all gifts made during the year, something that could cause some pretty disastrous unintended consequences. I often have seen this issue come up when it comes time to file a gift tax return, at which point the gifts have long been made, and it is too late to fix the issue, often resulting in the decision to not gift split and just use more exemption than planned. However, this can all be avoided with proper planning and thus, those who are gift splitting should make sure they inform their advisor of all gifts being planned for the year.
Conclusion
As is evident from the discussions above, while the 709 may seem pretty straightforward, when trusts and GSTT planning are involved or desired, the 709 is anything but. In short, the most common errors I see on a 709 are related to the GSTT exemption and the allocation, or lack thereof, of the GSTT exemption. As discussed above, failure to have a timely allocation of GST exemption can result in a waste of a large amount of GSTT exemption, or perhaps result in unnecessary GSTT being paid down the road. Additionally, couples who are planning to gift split should plan their gifts out carefully and also plan to file 709s, even if just gift splitting for annual exclusion gifts. In the PLR discussed, the decedent’s estate was lucky to avoid the untimely allocation valuation rule discussed above, but, as with the PLR related to the 706, I’m sure obtaining the PLR was costly and time consuming.
[1] https://esapllc.com/the-importance-of-a-properly-prepared-form-706/.
[2] PLR 202247007.
[3] Sec. 2612(c).
[4] Sec. 2632(c)(3)(A).
[5] While not the focus of this article, I must voice a complaint here, that being that checking the box for the Sec. 2632(c) election on Part 3 of Schedule A could mean three things so merely checking the box without further explanation in the way of a statement is a trap for the unwary. See Sec. 2632(c)(5)(A) and the Instructions to the Form 709 discussing the 2632(c) election.
[6] Sec. 2642(b)(1).
[7] Sec. 2642(b)(3).
[8] Treas. Reg. Sec. 25.2513-2(a), but note in the flush language, that the IRS will allow split gifts if only one spouse file a return if consent is made on that one return by both spouses. Nevertheless, as the flush language notes, it is preferred by the IRS and best practices by practitioners to have both spouses file returns and consent to the gift splitting on each other.
[9] Sec. 2513(a)(2).
[10] Treas. Reg. Sec. 25.2513-1(b).
[11] Treas. Reg. Sec. 25.2513-1(b)(4). Note this can be complex issue due to the difficulty in determining whether the spouse’s interest is “ascertainable…and hence severable from the interest transferred to [the consenting] spouse.” It is possible to split gifts where the consenting spouse is a beneficiary of the trust as long as the trust is drafted appropriately to address this issue.
[12] https://esapllc.com/slat-planning-2022/; https://www.esapllc.com/advanced-slat-issues-2022/.
