Elective 706 Filings – Allocation of GST Exemption

No shortcuts here, unfortunately

In this series, I have examined whether there is a way to reduce the reporting requirements on IRS Form 706 in situations where such form does not have to be filed under IRC Section 6018.  Even if a 706 is not required, there are certain actions which must be taken on Form 706 – the main three include the QTIP election (which I discussed here), the portability election (which I discussed here), and finally the allocation of GST exemption, which will be the subject of this article. 

For ease of reading, I call a 706 which is not required under IRC Section 6018 an “elective 706.”  There are other elections which may impliedly require a 706, such as a 2032A special use valuation, a 6166 installment payment of estate taxes, a 303 stock redemption, or a prior transfer credit to name a few, but it is rare to make those elections on an elective 706.  In other words, these lesser-used elections often apply to an estate which is required to file Form 706. 

As a quick recap of the “why” behind everything, it helps to consider what processes we are trying to bypass.  The structure of a 706 generally consists of various schedules, upon which the fair market value (at date of death or alternate valuation date, if available) must be reported.  There are also schedules upon which various deductions are reported.  Finally, the figures from these Schedules are recapitulated on Part 5, Page 3 of the 706, and then wrapped into the calculation of estate tax on Part 2, Page 1. 

So, for purposes of this series, our concerns have been:

·         Can we limit an elective filing just to the Schedule to which it relates, without including the rest of the Schedules, the recapitulation, and the calculation of estate tax (which should be zero if no return is required)?

·         If not, can we avoid reporting the value of property which does not relate to the election which is being made?

As revealed in the last two articles, the answer to the first question is always no.  There is no procedure to limit the 706 to simply a Schedule filing.  This has special significance for the QTIP election, which is made on Schedule M, and the allocation of GST exemption, which is made on Schedule R (sometimes with Schedule R-1 added). 

There is a procedure, covered in the last article, to estimate values of assets for purposes of a portability return, but only to the extent the assets (1) create DSUE (by virtue of being used to satisfy the marital deduction or charitable deduction), and (2) to the extent another election (like the 2032A, 6166, or 303 elections cited above) is not reliant on this property that generates DSUE. 

Against this framework, we now consider the allocation of remaining GST tax exemption at death. 

Automatic Versus Manual Allocation

To start, you don’t have to file a 706 to allocate a decedent’s remaining GST tax exemption.  However, without filing, the results may be unpredictable. 

First, under IRC Section 2632(a)(a), a transferor has until the deadline for filing the 706 (including extensions) to allocate GST exemption both to transfers during life, and transfers at death.  IRC Section 2632(a)(2) notes that the Secretary of the Treasury shall prescribe by regulation which forms are to be used for this purpose. 

Assuming that no 706 is timely filed, effective on the due date for the 706, IRC Section 2632(e) generally sets forth the ordering rules for allocation of GST exemption at death.  First, it is allocated to direct skips which occur as a result of the decedent’s death.  Second, it applies to trusts for which the decedent is the transferor, and from which a taxable termination or taxable distribution may occur in the future. 

Before diving into this allocation, note that any gift tax transfers made by the decedent in the final year of life may be reportable on Form 709, if not included in the gross estate.  To the extent GST exemption is to be allocated to these gifts, the executor should avoid reporting them on Form 706.  But, the due date for the 709 may be earlier than April 15 (or October 15 with extension) of the year following death – if the 706 filing deadline is sooner, than the 706 filing deadline also becomes the 709 filing deadline. 

Also, the general procedure for filing is set forth in Treas. Reg. 26.2632-1(d).  This Regulation proscribes only the filing of Form 706 or Form 706NA in accordance with IRC Section 6075 (and the substantial disclosure principles and regulations of IRC Section 6501), and does not create an option for an abbreviated filing.  Indeed, as we will see below, the value reporting standards for the allocation of GST exemption are so intertwined with the value reporting standards for the 706 that the two cannot be mutually exclusive. 

Back to automatic allocation, it makes sense to allocate to direct skips first.  However, one should note that direct skips can occur with respect to trusts – both created during the decedent’s life, and created/funded at the decedent’s death with property in the gross estate.  A prime example may be property subject to an ETIP, for which no election out of automatic allocation was made during life.  Since the ETIP can end at the decedent’s death, a direct transfer to grandchildren or more remote descendants may occur at that time.  But, it is important to note that most (if not all) direct skips in this vein will be made from property included in the decedent’s gross estate, and not from inter vivos trusts outside of the decedent’s gross estate. 

Where things get hairy, however, is in the next rule – allocation to trusts for which there may be, in the future, a taxable termination or taxable distribution.  While GST exemption allocation relates back to values at time of death, the principle of “GST potential” comes back into play to test trusts as of a date 9 months after decedent’s date of death.  If, at that time, no generation-skipping transfers have been made from the trust, and if no future generation-skipping transfer can occur with the trust, then no GST exemption may be allocated.  This is buttressed in the second-to-last sentence of Treas. Reg. 26-2632-1(d)(1), which notes that an allocation of GST exemption to a trust with no GST potential (whether manual or automatic) is void. 

Which raises another important point – it is possible after death, regardless of whether a 706 is filed, that a reconciliation of GST exemption could occur.  For example, assume that a 709 is audited, and (which not typical but not inconceivable) the value of an inter vivos generation-skipping transfer is reduced.  In such a case, we also have a companion rule on over-allocation, found in the third-to-last sentence of Treas. Reg. 26.2632-1(b)(4), which states that allocation of GST exemption to a trust in excess of the amount necessary to give it an inclusion ratio of zero (other than a charitable lead trust) is void. 

I bring all of this up to circle back to an important point – the 706, or automatic allocation rules in the absence of a 706 (or in the absence of Schedule R on Form 706) create a reconciliation that can lead to unintended results.  I talk about this issue in the following video:

Long story short, automatic allocation of GST exemption at death (after taking into account direct skips) looks to all trusts with GST potential, whether inter vivos or funded at death, which may have an inclusion ratio of greater than zero.  In such a case, the allocation is based on the value of trust property as determined for federal estate tax purposes (in the case of property included in the gross estate) or the value of trust property at date of death (for property not included in the gross estate). 

Even worse, this automatic allocation does not apply one-by-one to optimally give trusts a zero inclusion ratio.  Instead, you must lump the nonexempt portions of all trusts together (determined by multiplying the value of each trust by its pre-allocation inclusion ratio), then allocate whatever GST exemption then remains proportionately by value.  This would, in theory, lead to a situation where no trusts end up with a zero inclusion ratio.

(Which, as an aside, raises an interesting question.  If you elect out of automatic allocation on a 709, beware that the election out may not always extend to allocation on the 706.  If you want to avoid this result, it helps to be clear that election out applies to automatic allocation both during life, and at death.  Where this is in doubt, the 706 can also be helpful to elect out of automatic allocation for lifetime transfers, even if it seems overkill.)

So where does this leave us with the 706 filing?  First off, it means that we probably cannot have a pared-down 706 filing limited to just Schedule R, or to a 706 with just the property subject to GST exemption allocating being reported.  Most likely, all property in the gross estate would have to be reported in the normal fashion, as we would see in a traditional 706.  Further, since over-allocation can be void if the (estate tax) value of property in the gross estate is later adjusted downward, it means we need a complete 706 to start the clock on the assessment period, and to dictate what might happen to extra GST exemption if we come across it. 

It is also important to note that the estate tax value of property for GST tax purposes is net of estate tax paid from that property, as well as estate tax deductions paid from or allocable to that property (including the charitable deduction).  To properly reconcile these deductions, a complete 706 is vital. 

Finally, I wrap back in the concept of the elective QTIP 706, which we earlier discovered was not possible.  A complete 706 is vital in situations where a reverse QTIP election will be made, to allocate the decedent’s GST exemption to a QTIP trust being created at death for a surviving spouse.  What’s worse is that, in this case, we cannot rely on a portability return with estimated value reporting.  Why?  Because allocation of GST exemption requires determination of the federal estate tax value of the QTIP property. 

Don’t Forget Schedule R (and R-1)

You would be shocked by how many estate and gift tax returns I review which completely omit any allocations of GST tax exemption.  As noted in the video I included above, even with a 706 which is complete from a value reporting perspective, you can still end up with automatic allocation of GST exemption if Schedule R is omitted.  Also, in the rare event a direct skip is made from an inter vivos trust at the decedent’s death which has an inclusion ratio of less than zero (after allocation of GST exemption at death), Schedule R-1 must be filed as a payment voucher for the payment of the GST tax attributable to that property. 

So, regardless of how unimportant Schedule R on the 706 (or Schedule D on the 709) might seem, please do not shortcut their completion. 

Conclusion

In a world where it is rare to ever have to file Form 706, it seems odd that there is no pared-down procedure for common estate tax elections such as the QTIP election, portability, and allocation of GST exemption.  Yet, this is where we find ourselves. 

In some ways, the “elective” GST 706 is even worse – accurate reporting may extend beyond property in the gross estate, to property contained in inter vivos trusts.  While, in such cases, late allocation should be made on Form 709, we can treat this as an extension of the complexities of the 706.