IRS Form 706-GS(D-1): An Often-Forgotten-Yet-Required Form

Deciphering information returns around taxable distributions

Table of Contents

1. Intro

2. A K-1 Companion?

3. The 706-GS(D-1), In General

4. Trustee Liability

5. Special Rules and Exceptions

6. Key Takeaways and Practice Pointers

Intro

What if I were to tell you there are some tax filings specific to the GST tax, that often fly under the radar or are often ignored by practitioners in this space? To set the stage, we are going to cover one IRS Form in particular that should perhaps be considered whenever Schedule K-1 to a Form 1041 is filed.

There are three types of transfers that generate generation-skipping transfer (GST) tax under IRC Section 2611(a). The third of these listed in this Code Section – the direct skip – usually generates GST tax concurrent with the application of gift tax or applicable credit for lifetime transfers, or estate tax/applicable credit for transfers at death. Simultaneous allocation of GST exemption can offset this tax, but GST exemption is allocated separately and independently from applicable credit since GST tax is a separate and additional tax from the gift or estate tax.

The other two transfers, however – taxable terminations, and taxable distributions – usually apply to trusts sometime after (1) gift/estate tax, and applicable credit against such taxes, has been applied, and (2) allocation, or an election not to allocate, GST exemption has been made. The potential GST tax on both of these transfers relates back to the allocation of GST exemption or lack thereof anytime between funding the trust and the due date for the grantor’s estate return, which in turn drives the inclusion ratio of the trust. IRC Sections 2641 and 2642 describe the mechanism by which ratio of GST exemption allocated to the value of the transfer (at the effective time of allocation) is subtracted from one, and then multiplied by the prevailing highest estate tax rate at the time of the taxable termination or distribution to determine the GST tax on these amounts.

Using the current prevailing top estate tax rate of 40%, this means a perfect dollar-for-dollar allocation of GST exemption to transfer value results in an inclusion ratio of zero and a GST tax rate of 0% (0 x 40% = 0%). No allocation means an inclusion ratio of one, and a GST tax rate of 40% (1 x 40% = 40%). Ideally, you want an inclusion ratio between zero and one. Why? Because this allows better control of whether or not to determine when and if GST tax applies, either looking at a trust in isolation or across several trusts in which one or more particular beneficiaries hold an interest. A “blended” trust that has an inclusion ratio between zero and one cannot achieve this certainty without going through the process of valuing the trust, making a qualified severance, and examining the effect of post-valuation gains on how each severed share of the trust will be funded.

This severance process is a subject for another time. For now, as low-hanging fruit, we will examine taxable distributions and their reporting obligations in general.

A K-1 Companion?

When distributions of income are made to beneficiaries from nongrantor trusts, the trustee usually must issue a K-1 to each beneficiary receiving income. As part of this process, the trust itself gets a deduction for some or all distributable net income (DNI). But, this is not the end of the story when examining the trustee’s information return filing requirements.