Automatic Allocation of GST Exemption: Traps to Avoid

The Generation-Skipping Transfer (GST) tax is a federal levy on transfers of wealth to individuals two or more generations younger than the donor. To soften this tax, each person has a GST exemption, which for 2025 is $14.12 million. The tax code includes rules that automatically allocate this exemption to certain transfers, a feature designed to protect taxpayers.

These automatic allocation provisions, however, can be a double-edged sword. While intended as a safeguard, they can operate silently, leading to the unintentional and irreversible consumption of the exemption on transfers that were never meant to be generation-skipping.

The Mechanics of Automatic Allocation

The Internal Revenue Code’s automatic allocation rules are a default mechanism designed to apply a transferor’s GST exemption to shield certain lifetime transfers from future tax. These rules operate differently depending on the nature of the transfer, distinguishing between “direct skips” and “indirect skips.” A direct skip is a straightforward transfer to a “skip person,” such as a grandparent giving money directly to a grandchild. In these cases, the GST exemption is automatically applied to the gift to the extent necessary to make the GST tax inapplicable.

The more complex application of these rules involves indirect skips. An indirect skip is a transfer made to a trust that is not a direct skip but could result in a generation-skipping transfer in the future. This occurs when a trust has beneficiaries from multiple generations, such as a child and a grandchild. The automatic allocation rules for indirect skips apply only to a specific type of trust defined in the tax code as a “GST trust.” It is this definition that creates many of the traps for those unfamiliar with its nuances.

A trust is considered a GST trust if there is a possibility that it could have a generation-skipping transfer. The law provides several exceptions that prevent a trust from being categorized as a GST trust. For instance, a trust is not a GST trust if its terms require that more than 25% of the trust assets must be distributed to a non-skip person before that person reaches age 46. Another exception applies if, should a non-skip beneficiary die before a certain date, more than 25% of the trust assets must be paid to their estate or be subject to their general power of appointment.

Consider a common trust created for a child, where the child receives all the assets at age 50. If the child dies before reaching 50, the assets pass to their children (the grantor’s grandchildren). This trust would likely be classified as a GST trust because none of the exceptions fit. As a result, every time the grantor contributes money to this trust, their GST exemption is automatically used, even if the primary goal is to benefit the child and the likelihood of assets passing to the grandchildren is remote.

Common Scenarios Leading to Wasted Exemption

Several common estate planning techniques can become inadvertent traps, consuming the exemption on assets that are unlikely to ever face the GST tax. These scenarios often arise from standard trust structures that were not created with generation-skipping as their primary purpose.

A frequent trap involves what can be termed an unintentional dynasty trust. A person might create a trust for their child, with the simple and common provision that if the child passes away unexpectedly, the remaining assets will go to the child’s descendants (the grantor’s grandchildren). While the grantor’s clear intent is to benefit their child, the contingent remainder interest for the grandchildren can cause the trust to be classified as a “GST trust.” Consequently, with each gift made to the trust, the automatic allocation rules apply, chipping away at the grantor’s GST exemption, even though the probability of a generation-skipping event is low.

Another trap lies within Irrevocable Life Insurance Trusts (ILITs), particularly those utilizing Crummey withdrawal powers. An ILIT is often established to hold a life insurance policy, with the death benefit intended to provide for a surviving spouse or children. To allow annual gifts to the trust to qualify for the annual gift tax exclusion, beneficiaries are given a temporary right to withdraw the contributed funds, known as a Crummey power. Each premium payment funded by a gift is a transfer to the trust, and if the trust qualifies as a GST trust, automatic allocation will occur with every payment.

A particularly complex trap involves transfers subject to an Estate Tax Inclusion Period (ETIP). An ETIP is a period during which the transferred property would still be included in the donor’s taxable estate if they were to die. Common examples include Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs). The law delays any allocation of GST exemption until the ETIP ends. The danger is that at the end of the ETIP, the trust assets may have appreciated substantially, and the automatic allocation will be based on this higher fair market value, consuming a much larger portion of the GST exemption than the donor ever anticipated.

Preventing Unwanted Automatic Allocation

Proactively managing the GST exemption is accomplished by making specific elections on a federal gift tax return. The key document for this purpose is the United States Gift (and Generation-Skipping Transfer) Tax Return, Form 709. This form is the exclusive venue for telling the IRS you want to override the default automatic allocation rules.

The Treasury Regulations provide taxpayers with several elections to prevent the unwanted application of their GST exemption. The most common is an election to opt out of the automatic allocation rules for a specific transfer to a trust. This is useful when you make a contribution to a trust that is technically a “GST trust” but you believe the assets will ultimately be distributed to non-skip persons, making an allocation of exemption wasteful. You can preserve your exemption for other, more strategic transfers.

For trusts that you know will never be the intended vehicle for generation-skipping gifts, you can make a broader election. This election opts out of automatic allocation for all future transfers to a designated trust, eliminating the need to make the election year after year. Conversely, there is also an election for situations where a trust does not meet the technical definition of a GST trust, but you want to ensure it is treated as one.

Making any of these elections requires attaching a carefully prepared statement to your Form 709. This election statement must clearly identify the election being made, provide the trust’s name and Employer Identification Number (EIN), and describe the specific transfer(s) covered. The deadline for making a timely election is tied to the due date of the gift tax return for the year in which the transfer occurred, generally April 15 of the following year, but the deadline is extended if you file for an extension of time to file your income tax return. It is advisable to send the return via certified mail with a return receipt requested to have documented proof of timely filing. After filing, you will not receive a specific confirmation from the IRS that your election has been accepted, so retaining a complete copy is the best practice.

Correcting Allocation Errors

Discovering that Generation-Skipping Transfer (GST) exemption was automatically allocated against your wishes can be a significant problem, but remedies are available. For taxpayers who failed to opt out on a timely filed gift tax return but can demonstrate they acted reasonably and in good faith, a powerful remedy exists. Relief for late elections is granted under the authority of Internal Revenue Code Section 2642. This provision gives the IRS discretion to grant an extension of time to make an election, including the election to opt out of automatic GST allocation.

Obtaining this relief is a formal and often expensive process. It requires submitting a request for a private letter ruling (PLR) to the IRS National Office. The request must include detailed affidavits from the taxpayer and any involved tax advisors explaining the circumstances that led to the failure to make a timely election. The taxpayer must also pay a significant user fee to the IRS, which can be over $10,000. The complexity and cost of seeking a PLR underscore the importance of proactively managing GST exemption allocations from the outset.