Five Common GST Allocation Mistakes and How to Avoid Them

By Carol G. Warley, Amber Waldman, and Rachel Ruffalo

Carol G. Warley is RSM’s Washington National Tax private client services tax practice leader. She is located in Houston, Texas. Amber Waldman is a member of RSM’s Washington National Tax Practice. She is located in McLean, Virginia. Rachel Ruffalo is a member of RSM’s Washington National Tax Practice. She is located in Miami, Florida.

The generation-skipping transfer tax (GSTT) is complex and often misunderstood. The GSTT was enacted to prevent attempts at avoiding estate tax. It ensures that large transfers of wealth are taxed at a similar rate, regardless of whether assets pass to children or to more remote descendants. To safeguard specific transfers from the GSTT, section 2631(a) established a lifetime generation-skipping tax (GST) exemption, analogous to the exemptions provided under the estate and gift tax frameworks. Taxpayers can allocate their available GST exemption during life or at death to shield assets from the GSTT.

To ensure the GST exemption is used effectively, it is essential to plan meticulously to prevent its underutilization or incorrect application. Below, we explore five common GST exemption allocation mistakes and outline strategies to avoid them.

Mistake 1: Failing to Account for the GST Exemption Already Automatically Allocated to Prior Unreported Gifts under the Gift Tax Filing Threshold

Generally, gifts less than the annual exclusion under section 2503(b) are not required to be reported on Form 709. Many taxpayers are inclined to avoid filing a gift tax return when it is not required. But neglecting to report certain generation-skipping transfers on Form 709 may lead to complications in tracking the associated allocation of the GST exemption over time.

The automatic allocation of the GST exemption to direct skips under section 2632(b) and indirect skips under section 2632(c) occurs whether or not the transfer is reported on Form 709. To illustrate, consider two unreported gifts. First, in 2023, a taxpayer made a $10,000 gift to a trust for the benefit of grandchildren. In the same year, the taxpayer makes a $10,000 gift to a trust for the benefit of children and descendants that is, by definition, a “GST trust” under section 2632(c)(3)(B). Both gifts qualified for the gift tax annual exclusion under section 2503(b) because of the beneficiaries’ right to withdraw the transfers. Since there are no taxable gifts, the taxpayer did not file a 2023 Form 709. But the transfers did not qualify for the GST annual exclusion under section 2642(c). Because these gifts were not reported on a gift tax return, the automatic allocations that occurred under section 2632(b) and (c) could be overlooked or forgotten.

Older gifts made below the annual exclusion amount often go unreported and are easily forgotten. These gifts can come back to haunt taxpayers many years later, however, when planning to make multigenerational gifts. Recreating a detailed gifting history to determine a taxpayer’s remaining GST exemption can be a costly and time-consuming process.

Planning point: Consider filing a gift tax return, even if it is not required, to track the automatic allocation of the GST exemption. If a taxpayer decides not to file, maintain records of the automatic allocation that occurred.

Mistake 2: Overfunding a Trust Intended to Be GST Exempt with Not Enough GST Exemption Remaining

Taxpayers often make gifts without consulting their advisors, leading to a common misunderstanding: The remaining gift tax exemption and remaining GST exemption are not always the same. This can cause confusion about how much can be transferred to a trust without causing a portion of the trust to be subject to GSTT. A taxpayer might be able to transfer a certain amount without paying gift tax, but the amount they can transfer while keeping the trust GST exempt is often different. Further, as highlighted in mistake one above, there may be prior unreported transfers, whether under the annual exclusion or more significant transfers that were not captured on a Form 709. These transfers may have used a significant portion of the remaining GST exemption but were not accounted for on the most recently filed gift tax return. This oversight underscores the importance of conducting a comprehensive review of prior GST exemption allocations before making significant transfers.

Overlooking prior automatic allocations of the GST exemption could result in future challenges for taxpayers. They could find themselves with less GST exemption than expected when making future multigenerational transfers. This could introduce complications where there is not enough GST exemption to protect a future transfer, resulting in a mixed inclusion ratio and an unintended future GSTT liability. For example, the same taxpayer from mistake one above decides to create a new trust that is intended to be exempt from the GSTT. The taxpayer contacts a tax advisor and ask how much gift exemption remains. Because all prior gifts were under the annual exclusion, the tax advisor informs the taxpayer that the full $13.61 million 2024 lifetime exemption remains. The tax advisor was not aware of the 2023 gifts that used $20,000 of the taxpayer’s lifetime GST exemption. The taxpayer funds the new trust with $13.61 million and wishes to allocate $13.61 million of GST exemption to the trust. The full $13.61 million GST exemption is not available, however, due to the 2023 gifts. The new 2024 trust now has a mixed inclusion ratio and is not fully exempt from the GSTT.

Planning point: A thorough examination of all prior transfers and their effect on the current available GST exemption is essential for multigenerational planning. Ensure that all advisors are informed of the past allocations of the GST exemption, especially if not shown on a Form 709. This proactive approach ensures that future planning endeavors consider the taxpayer’s accurate remaining GST exemption.

Mistake 3: Neglecting to Make an Affirmative Section 2632(c) Election and Relying Solely on Automatic Allocation Rules

The automatic allocation rules under section 2632(c) were designed to simplify the process of allocating the GST exemption to lifetime transfers. The rules under section 2632(c) automatically apply a transferor’s GST exemption to certain transfers considered “indirect skips,” which are transfers in trust that are not considered direct skips but that could potentially have a generation-skipping transfer with respect to the transferor. These rules apply to trusts that meet the definition of a GST trust under section 2632(c)(3) (B). The goal of these rules is to protect certain assets from the GSTT. But relying on the automatic allocation rules for indirect skip transfers without making an affirmative election can lead to unintended consequences and limit future estate planning opportunities.

Automatic allocation of the GST exemption becomes a problem when the transferor’s intentions do not align with the outcomes dictated by these rules. Two examples illustrate the potential pitfalls of an automatic allocation. First, consider a trust designed to benefit the transferor’s children (nonskip persons) and descendants. The transferor believes that the children will deplete the trust assets, leaving nothing for the skip person descendants. The trust does not meet any of the exceptions under section 2632(c) (3)(B), so absent an election out of the automatic allocation rules, the transferor’s available GST exemption would be applied to transfers made to this trust, potentially wasting the exemption on a trust that will never make generationskipping transfers. This misallocation would reduce the GST exemption available for other transfers that would directly benefit skip persons, leading to a potential GSTT liability in the future.

Next, consider a trust that does not meet the specific criteria to be classified as a GST trust under section 2632(c)(3) (B). The trust, however, contains provisions to allow it to benefit skip persons. If the transferor relies on the automatic allocation rules without making an affirmative election, GST exemption would not be allocated to this trust. This oversight could result in trust distributions to skip persons being subject to the GSTT.

Under section 2632(c)(3)(B)(iv), a trust will not be a GST trust if any part of the trust would be included in the estate of a non-skip person if that person were to die immediately following the transfer. Certain withdrawal rights are treated as equivalent to a general power of appointment before they expire, meaning the value would be included in the non-skip person’s estate. If a donor makes a gift to a trust that grants certain withdrawal rights, the trust would not be a GST trust in the years that withdrawal rights in excess of the section 2503(b) annual gift tax exclusion would be included in the non-skip person’s estate. Consequently, GST exemption would not be automatically allocated to such transfers. This can cause problems for trusts that would otherwise be considered GST trusts, and the transferor is relying on automatic allocation rules to protect the trusts from the GSTT.

Another common pitfall in the realm of automatic allocation of GST exemption involves the failure to make an affirmative opt-out election for transfers subject to an estate tax inclusion period (ETIP), such as transfers made to grantor retained annuity trusts (GRATs) or qualified personal residence trusts (QPRTs). The ETIP is a critical timeframe during which the value of the transferred property could be included in the transferor’s gross estate. Section 2642(f)(1) provides that any allocation of the GST exemption to property subject to an ETIP cannot be made until the ETIP concludes. This delay is significant because the value of the property, and consequently the strategic allocation of the GST exemption, can be accurately assessed only at the end of the ETIP, when, it is hoped, the assets have appreciated in value. Many taxpayers overlook the necessity of making an explicit opt-out election during the ETIP, leading to automatic allocations of GST exemption at the end of the ETIP. Such automatic allocations may not align with the transferor’s intentions, potentially resulting in the inefficient use of the GST exemption. For example, a taxpayer transfers an $8 million asset to a two-year GRAT in exchange for a qualified annuity in 2024. The taxable gift is $1. The taxpayer does not make a section 2632(c) election out on the taxpayer’s 2024 Form 709. The ultimate beneficiary of the GRAT is a GST trust under section 2632(c)(3)(B), but the taxpayer does not believe it will ever benefit skip persons. In 2026 when the GRAT term ends, it is successful and transfers $10 million to the ultimate beneficiary. The $10 million of the transferor’s GST exemption is automatically allocated to the transfer, which is a waste of the GST exemption to the extent non-skip persons deplete the trust.

Planning point: Determining whether the automatic allocation rules apply to a transfer is not a straightforward exercise. Instead, transferors can proactively control the application of the automatic allocation rules to indirect skip trusts by making an affirmative section 2632(c) election on a timely filed Form 709. They have the option to “opt-in,” under Treas. Reg. section 26.2632-1(b) (3), to treat the trust as a GST trust and allow the automatic allocation of their available GST exemption to both current and future transfers. Alternatively, they can “opt-out,” under Treas. Reg. section 26.2632-1(b)(2)(iii), to have the automatic allocation rules not apply to both current and future transfers. To avoid potential complications, consider making a preemptive affirmative optout election for transfers subject to an ETIP, especially if the trust will never benefit skip persons. Further, consider setting reminders for when the ETIP ends so that an informed decision can be made as to whether the transferor should allocate the transferor’s GST exemption to the trust.

To ensure the transferor’s intentions are accurately reflected, it is crucial to carefully consider making an affirmative election when initially funding an indirect skip trust. If an affirmative election is not made on the gift tax return reporting the initial transfer to the trust, it should be made as soon as possible to ensure allocation of the GST exemption is in line with the transferor’s intentions.

Mistake 4: Gifting to a Spousal Lifetime Access Trust (SLAT) without Understanding the GST Exemption Gift-Splitting Implications

Spousal lifetime access trusts (SLATs) are a common estate planning vehicle because they allow assets to be gifted and thus removed from an estate while offering the flexibility of spousal access to distributions, if needed. Issues may arise, however, when the transferor plans to make a gift-splitting election in the same year the transferor makes a transfer to a SLAT. This combination can often lead to unintended GST exemption allocation consequences.

Generally, section 2513(a) allows spouses to treat gifts made by one spouse to a third party as being made one-half by each spouse. This election applies to all gifts made by either spouse during the year. Section 2652(a) (2) states that when a gift-splitting election is made and one-half of such gift is treated as made by the donor’s spouse, it should be treated consistently for purposes of generation-skipping transfers. Treas. Reg. section 26.2652-1(a) (4) provides that when a gift-splitting election is made, the donor is treated as the transferor of one-half of the value of the entire property and the spouse is treated as the transferor of one-half of the value of the property, regardless of the interest the electing spouse is actually deemed to have transferred under section 2513. The regulations are silent as to the GSTT treatment when the entire gift is not eligible for gift splitting, and a gift-splitting election is made for other gifts that are eligible for gift splitting.

Gifts to SLATs are often not eligible for gift splitting under section 2513 because the donor spouse has a beneficial interest in the trust that is not severable. Only the severable portion, for example, withdrawal rights to individuals other than the spouse, can be split. The portion allocable to the spouse and the portion not allocable to a specific beneficiary cannot be split. This creates a potential misunderstanding of who the GST transferor is with respect to transfers to SLATs and how GST exemption is allocated between spouses when a gift-splitting election is made.

For example, a donor makes a $1 million gift to a trust in 2024 for the benefit of the donor’s spouse and descendants. The donor’s two children can withdraw $18,000 each of the 2024 contribution to the trust. Additionally, the donor made $36,000 gifts to other family members with the intent of making a gift-splitting election to treat those gifts as made $18,000 by the donor and $18,000 by the spouse, all qualifying for the gift tax annual exclusion. How is the donor’s and spouse’s GST exemption allocated to the transfer to the SLAT? Following Treas. Reg. section 26.26521(a)(4), because a portion of the gift is eligible for gift splitting, the donor is treated as a 50 percent GST transferor and the spouse is treated as a 50 percent GST transferor. Although only the $18,000 withdrawal right portions of the $1 million gift are eligible for gift splitting, $500,000 of the donor’s GST exemption can be allocated to the transfer and $500,000 of the spouse’s GST exemption can be allocated to the transfer. The donor may be surprised by this result. Having two transferors of a trust, rather than just one, can complicate future planning and available remedies.

Planning point: When funding a SLAT, carefully consider the impact of gift splitting on the allocation of the GST exemption. If possible, make the transfer in a year when gift splitting is not needed for other gifts to simplify the analysis needed to properly report the allocation of the GST exemption to the SLAT.

Mistake 5: Wasting the GST Exemption by Making Distributions to Non-skip Persons from a GST-Exempt Trust

When developing an estate plan, understanding the taxpayer’s intentions for each generation is fundamental in planning to maximize the use of the taxpayer’s available GST exemption. Ultrawealthy taxpayers may unintentionally waste their precious GST exemption when they establish trusts that provide benefits to both non-skip and skip persons. This oversight happens because any distribution to a non-skip person from a trust that is exempt from the GSTT is effectively a waste of the taxpayer’s exemption. The original intent behind allocating the transferor’s GST exemption to the trust was to shield the assets within the trust from being subject to the GSTT. Distributions made to non-skip persons, however, do not need to be shielded from the GSTT.

Planning point: When possible, exempt assets should be set aside for skip persons. Creating separate trusts for non-skip and skip persons could provide a more efficient use of a transferor’s GST exemption.

Conclusion

Navigating the complexities of the GSTT can be challenging. Unfamiliarity with the rules can lead to unintended tax consequences or inefficient use of a transferor’s valuable GST exemption. Awareness and careful consideration of these rules can help to prevent such outcomes.