IRC 2632: Special Rules for GST Exemption Allocation

Internal Revenue Code Section 2632 establishes the framework for applying the Generation-Skipping Transfer (GST) tax exemption. This section of the tax code dictates how an individual’s exemption is allocated to transfers they make, either during their lifetime or at death. The provisions within this statute govern whether the allocation happens automatically or if it requires specific action from the taxpayer.

The Generation-Skipping Transfer Tax Exemption

The Generation-Skipping Transfer (GST) tax is a federal tax imposed on transfers of property to individuals who are two or more generations younger than the donor. This tax was enacted to prevent families from avoiding estate taxes for a generation by transferring wealth directly to grandchildren. The GST tax is levied at a flat rate of 40 percent, the same as the highest federal estate tax rate, and is separate from any applicable federal gift or estate taxes.

Key terms associated with the GST tax include:

• A “skip person” is the recipient of a generation-skipping transfer, such as a grandchild or a non-relative more than 37.5 years younger than the transferor.
• A “direct skip” is a transfer made directly to a skip person, such as an outright gift.
• An “indirect skip” is a transfer made to a trust that could eventually make a distribution to a skip person.
• A “taxable termination” occurs when a trust’s interest held by a non-skip person ends, and the assets then pass to a skip person.
• A “taxable distribution” happens when a trust distributes income or principal to a skip person.

To mitigate this tax, every individual has a lifetime GST exemption. For 2025, this exemption is $13.99 million per person, meaning a married couple can shield nearly $28 million from the GST tax. This amount is indexed for inflation but is scheduled to be reduced by about half at the end of 2025 unless Congress acts. This exemption allows individuals to protect a significant amount of assets from the 40 percent tax.

Automatic Allocation Rules for GST Exemption

The tax code includes provisions that automatically allocate a person’s GST exemption to certain transfers. The automatic rules apply differently to transfers made during one’s lifetime versus those occurring at death, and they distinguish between direct and indirect skips.

Lifetime Direct Skips

When an individual makes a direct skip during their lifetime, the law automatically allocates enough of their unused GST exemption to the transfer to make the inclusion ratio zero. The inclusion ratio determines what portion of a transfer is subject to GST tax; a zero ratio means the transfer is fully exempt. If the value of the property transferred exceeds the unused exemption, the entire remaining exemption is allocated to that transfer.

Lifetime Indirect Skips

The rules for indirect skips are more intricate. An indirect skip is a transfer of property to a “GST trust” that is not a direct skip. A GST trust is broadly defined as any trust that could have a generation-skipping transfer, such as a distribution to a grandchild. For any transfer to a GST trust, any unused portion of the individual’s GST exemption is automatically allocated to the property transferred to make the inclusion ratio zero.

The tax code provides exceptions to the definition of a GST trust. For instance, a trust is not a GST trust if the instrument requires that more than 25 percent of the corpus must be distributed to a non-skip person before that person reaches age 46. Another exception applies if a significant portion of the trust assets would be included in a non-skip person’s gross estate if they died immediately after the transfer. These definitions help identify trusts where a generation-skipping transfer is likely.

Allocation at Death

Any portion of an individual’s GST exemption that has not been allocated by the time their estate tax return is due is automatically allocated at death. The law prescribes a specific order for this allocation. First, the exemption is allocated to any direct skips occurring at the individual’s death, and second, any remaining exemption is allocated pro-rata to trusts from which a taxable termination or taxable distribution might occur.

Electing Out of Automatic Allocation

The automatic allocation rules may not align with every individual’s strategic estate planning goals. A person might prefer to save their GST exemption for a different transfer, perhaps to a trust expected to appreciate significantly. In such cases, it is possible to affirmatively elect out of the deemed allocation rules.

To prevent the automatic allocation of the GST exemption, a taxpayer or their executor must make a formal election on a timely Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return. An election out cannot be made on a late-filed return. The taxpayer must attach a statement to Form 709 that identifies the transfer and states they are electing out of the automatic allocation rules.

The statement should describe the specific transfer, including the date and property involved. A taxpayer can elect out of the automatic allocation for a single transfer. For indirect skips, they can make a broader election to opt out of automatic allocation for all future transfers to a particular trust, preserving the exemption for more strategic uses.

Making Affirmative and Late Allocations

Taxpayers can also proactively direct their GST exemption to specific transfers through an affirmative or late allocation. These methods provide control over the exemption but are governed by different rules with distinct consequences.

Affirmative Allocation

A taxpayer can affirmatively allocate their GST exemption to any lifetime transfer by reporting it on a timely filed Form 709. This is done on Schedule D of the form, where the taxpayer specifies the amount of exemption being allocated to a particular transfer or trust. An affirmative allocation is irrevocable after the due date of the gift tax return. The benefit of a timely allocation is that the exemption is applied to the fair market value of the property on the date of the transfer, covering all future appreciation.

Late Allocation

If a taxpayer fails to allocate the exemption on a timely gift tax return, they may still make a late allocation on a return filed after the due date. For a late allocation, the GST exemption is applied to the fair market value of the trust assets on the date the late allocation is filed with the IRS. This valuation rule can have major consequences.

If the trust assets have appreciated, the taxpayer will need to use more of their GST exemption than if they had made a timely allocation. Conversely, if the assets have depreciated, a late allocation can be advantageous. A special rule allows the transferor to elect to use the fair market value on the first day of the month in which the late allocation is made.