Form 709 Traps for the Unwary By: Bunker L. Highmark, Esq (1)
Every year Forms 709 are prepared to report, among other things, the latest gift to a grandchild, contribution to a trust, or transfer of an interest in a family controlled entity. Is the gift split with a spouse? How much exemption has already been used? Is the gift to a skip person? Simple enough, right? Many times, yes, it is. Unfortunately, that isn’t always the case. Quite often the mistakes made on Form 709 aren’t related to complex transfers, but rather to gifts that on their face seem quite ordinary. Below, some of these common mistakes are identified along with strategies to address them, as well as unique approaches for certain 2010 transfers.
Gifts to a Trust and the Gift and GST Tax Annual Exclusions
Consider the following scenario: A client comes in to talk about preparing a Form 709 for the past year and mentions that rather than continue to make outright gifts to her three grandchildren each year, she has created a trust for their benefit and made one lump sum gift to that trust. She says that her attorney told her that by proper use of Crummey powers, her lump sum gift of $39,000 qualifies for the gift tax annual exclusion.
While this is true, the mere fact that a transfer qualifies for the gift tax annual exclusion does not automatically mean that the transfer also qualifies for the GST tax annual exclusion. The GST tax annual exclusion rules include two additional requirements for transfers to a trust: (1) the trust must be for the benefit of a single “skip person” and (2) the trust must be includible in that skip person’s gross estate if the trust does not terminate before his or her death. If your client’s transfer does not meet these extra tests, while the gift tax annual exclusion applies, the GST tax annual exclusion does not, which means that your client has used up $39,000 of GST tax exemption (assuming she has some available). This key difference between the annual exclusion rules of the two taxes could have little impact on your client, or it could result in an unexpected tax bill. The ultimate consequences will depend on each person’s individual situation, but you must first recognize the situation and prepare the return accordingly.
Multiple Gifts During the Year: Timing Problem
The fact that a gift must qualify for the gift tax annual exclusion in order to qualify for the GST tax annual exclusion can lead to a very common error on Form 709. Building on the previous example, assume that a gift of $39,000 is made to a trust for the benefit of three grandchildren, and, as discussed above, the gift qualifies for the gift tax annual exclusion, but not the GST tax annual exclusion. Later on in the same year the client makes additional $13,000 cash gifts directly to each of her grandchildren. These gifts do not qualify for the GST tax annual exclusion! Why? The answer lies in the timing of the gifts. Since the gifts to the trust qualified for the gift tax annual exclusion (and used up the entire annual exclusion amount for each grandchild), the later cash gifts do not similarly qualify, and instead result in taxable gifts. If a gift does not qualify for the gift tax annual exclusion, it cannot qualify for the GST tax annual exclusion. In most years, this would result in the client using an additional $39,000 ($78,000 in total) of her GST tax exemption; however, for 2010 transfers, this is not necessary, as discussed in the following section.
2010 Transfer to Skip Persons
In the case of many 2010 transfers to a skip person, the standard approach of applying exemption does not apply. Why? Because while GST tax applies to transfers made in 2010, the effective tax rate on those transfers is zero percent (0%). Whether the transfer is an outright gift, such as the transfers to grandchildren described above, or the distribution of assets to a skip person from a trust subject to the expiration of its estate tax inclusion period (“ETIP”) you should generally want these transfers to be taxed for GST tax purposes in 2010. The key, however, is to remember that GST tax exemption is still automatically allocated in 2010. Therefore, it is essential to opt out of automatic exemption allocation for these transfers, thereby triggering the zero percent (0%) tax.
An additional word of caution: do not confuse the ETIP scenarios discussed below, with that described in this section. A trust which (1) does not have an ETIP expiration date in 2010 and (2) does not make distributions to skip persons in 2010 should not opt out of automatic GST tax exemption allocation. This is because distributions from such a trust to a skip person in future years will be subject to the GST tax at the rate applicable in that year, which will most likely not be zero percent (0%).
Transfers to GST Trusts with ETIPs
This scenario begins with a client creating and funding a GST Trust subject to an ETIP, during which, if the transferor dies, the transferred property will be includible in his or her estate for estate tax purposes. This type of trust is typically a grantor retained annuity trust (“GRAT”) or qualified personal residence trust (“QPRT”), and for our purposes we will use a 10-year QPRT as the example. Typically, GST exemption is automatically applied to a QPRT, barring an election to opt out on the 709.
Under IRC Section 2632(c)(4), allocation of GST exemption does not occur until the expiration of the ETIP, rather than at the time of transfer. For many preparers, this seems ideal, since they know that while it is unlikely the client will want to apply GST exemption to the QPRT, they can wait until the end of the 10-year term and make the decision at that time, based on the current circumstances. The client, however, may not be too happy with this result. First, you obviously need to remember to file at the end of the ETIP and opt out, if the client so desires; failure to do so simply wastes a portion of the client’s GST exemption. The real drawback to the second filing, however, is that in most cases it generates additional cost for the client since you have to prepare 2 returns for what he or she sees as a single event (i.e. to report the initial gift to the QPRT and the later return to opt out).
For most clients, the more efficient approach to this situation is to opt out of automatic GST exemption allocation when filing the initial gift tax return. In most cases, this will be the desired result at the end of the ETIP, therefore eliminating the extra expense to the client of filing a second 709, or of forgetting to do so and wasting GST exemption. Of course, if allocation of GST exemption is desired, you can still file a second return and opt in.
ETIP Trusts and Gift Splitting
Let’s look at one more issue that involves trusts with an ETIP. Assume that your client decides to create and fund a 10-year QPRT with property that is solely in his name. Due to previous gifts, the client does not have sufficient gift tax credit remaining to avoid paying some gift tax upon funding the QPRT unless he splits the gift with his wife. This is not a good option! If the client dies prior to the end of the 10-year term the entire gifted property is included in his estate for estate tax purposes, and his half of the initial gift (split on the 709) is removed from his “adjusted taxable gifts”. However, neither the client nor his spouse can reduce his or her “adjusted taxable gifts” for the spouse’s half of the gift. The net result of this split QPRT gift is essentially taxation of the same property 1½ times.
The easiest solution to this problem (if one spouse cannot fully fund a QPRT without paying gift tax) is for each spouse to own a partial interest in the property, and to transfer his or her interest to his or her own QPRT. However, if your client makes regular gifts each year that are always split on the 709, you may still have a problem. Under IRC Section 2513, the splitting of any gift in a particular year requires the splitting of all other gifts within that same year (unless the spouse is a beneficiary of a particular gift). As discussed above, you never want a gift to a QPRT (or any ETIP trust) to be split, even if you are using separate QPRTs. Therefore you must make sure that any gifts made by the clients during a year in which they fund a QPRT, GRAT, or similar ETIP trust be made separately by each spouse rather than split on the 709.
Don’t miss the nuances
As the above examples have shown, what appear to be simple transfers that are easy to report may in fact be traps that could cost your client at best wasted exemption or at worst quite a bit of money. When reviewing a transfer for purposes of preparing Form 709 it is important to consider the GST and gift tax implications separately, as well as future ramifications of any decision you make when reporting the transfer.
Bunker L. Highmark, a lawyer in the Wellesley, MA office of Gilmore, Rees & Carlson, P.C., concentrates his practice in estate and tax planning and estate administration. He can be reached at [e-mail bhighmark]">[e-mail bhighmark].