IRC 2642: Calculating the GST Tax Inclusion Ratio

Internal Revenue Code (IRC) Section 2642 provides the framework for calculating the inclusion ratio, a component of the Generation-Skipping Transfer (GST) tax. This calculation is an aspect of estate planning for individuals with significant wealth who intend to transfer assets to beneficiaries more than one generation below them, such as grandchildren. Understanding these rules is helpful for minimizing the tax impact on wealth passed to future generations.

The regulations govern how much of a transfer will be subject to the GST tax. This involves a formula and rules for when and how a taxpayer’s available exemption is applied to a transfer. Navigating these requirements allows planners to structure gifts and bequests in a tax-efficient manner, and the process requires attention to valuation, timing, and proper reporting on federal tax forms.

The GST Exemption and the Inclusion Ratio

The Generation-Skipping Transfer (GST) tax is a federal tax designed to prevent families from avoiding estate and gift taxes by transferring wealth directly to younger family members. The GST tax is a flat tax applied at the highest federal estate tax rate, which is 40 percent.

To mitigate this tax, every individual is granted a lifetime GST exemption, a specific dollar amount that can be transferred to skip persons without incurring GST tax. For 2025, this exemption amount is $13.99 million per person. This amount is indexed for inflation but is scheduled to be reduced by about half in 2026 unless Congress extends the current law. Proper use of this exemption is a central goal of multi-generational estate planning.

The mechanism for applying the exemption is the inclusion ratio. This ratio determines the portion of a transferred property that is subject to the GST tax. An inclusion ratio of zero means the transfer is fully exempt from GST tax, while an inclusion ratio of one means the entire transfer is subject to the tax.

A trust with an inclusion ratio between zero and one is sometimes called a “mixed inclusion ratio” trust, where a fraction of every distribution to a skip person will be taxed. For example, if a trust has an inclusion ratio of 0.500, then 50% of any distribution to a grandchild from that trust would be subject to the 40% GST tax. The objective for many estate planners is to strategically allocate the GST exemption to achieve an inclusion ratio of zero, thereby completely shielding the assets from this tax as they grow and are eventually distributed.

Calculating the Applicable Fraction

The inclusion ratio is calculated using the formula: one minus the “applicable fraction.” The goal is to make the applicable fraction equal to one, which in turn makes the inclusion ratio zero (1 – 1 = 0), rendering the transfer fully exempt from the GST tax.

The numerator of the applicable fraction is the amount of the GST exemption that the transferor allocates to the property transferred. This is the portion of the lifetime exemption that the individual chooses to apply to a specific gift or bequest, and the allocation is an affirmative step that must be properly documented.

The denominator of the applicable fraction is the value of the property transferred to the trust or given in a direct skip. This value is reduced by any federal estate tax or state death taxes that are paid from the transferred property. It is also reduced by any charitable deduction allowed under sections 2055 or 2522 with respect to the property.

For a numerical example, if an individual transfers $2 million to a trust for their grandchildren and allocates $2 million of their GST exemption, the applicable fraction is 1.0. The inclusion ratio is zero (1 – 1.0 = 0), making all future distributions from this trust to the grandchildren free of GST tax. If only $1 million of exemption were allocated, the applicable fraction would be 0.5, resulting in an inclusion ratio of 0.5.

Methods for Allocating the GST Exemption

The rules under IRC Section 2632 govern how and when a transferor can apply their GST exemption, which directly impacts the numerator of the applicable fraction. The method of allocation determines the effective date and valuation date of the transferred property.

A timely allocation is one made on a United States Gift (and Generation-Skipping Transfer) Tax Return, Form 709, that is filed by its due date for the year of the transfer. When an allocation is timely, the value of the property used for the denominator of the applicable fraction is its fair market value on the date of the gift. This allows planners to lock in the value at the time of the transfer.

In contrast, a late allocation occurs if the exemption is not applied on a timely-filed gift tax return. For a late allocation, the value of the property for the denominator is its fair market value at the time the late allocation is filed. If the property has appreciated, the transferor will have to use more of their GST exemption to achieve a zero inclusion ratio.

The tax code also provides for automatic allocation rules. The IRS automatically allocates a transferor’s unused GST exemption to certain transfers unless the transferor affirmatively elects out. This applies to “direct skips” and “indirect skips” to a “GST trust,” which is broadly defined as any trust that could potentially have a generation-skipping transfer occur, subject to several specific exceptions. A taxpayer can elect out of these automatic rules on a timely-filed Form 709.

Special Valuation and Timing Rules

The tax code contains special rules for specific situations that modify standard timing and valuation principles, including the Estate Tax Inclusion Period (ETIP) rules and provisions for Charitable Lead Annuity Trusts (CLATs).

An ETIP is a period during which transferred property would be included in the transferor’s gross estate for federal estate tax purposes if they were to die, such as with a Grantor Retained Annuity Trust (GRAT). The ETIP rule states that any allocation of the GST exemption to property subject to an ETIP will not become effective until the ETIP ends. The value of the property for calculating the applicable fraction’s denominator is its value at the end of the ETIP. This delay can expose significant appreciation in the asset’s value, potentially requiring a much larger exemption allocation to achieve a zero inclusion ratio.

Charitable Lead Annuity Trusts (CLATs) are also subject to a unique rule. For a CLAT, the denominator of the applicable fraction is the value of the trust property after the charitable lead annuity payments have concluded. The numerator is the “adjusted GST exemption,” which is the initial GST exemption allocated to the trust, increased by an interest factor for the term of the charitable annuity. This calculation makes it difficult to ensure a zero inclusion ratio from the outset if the trust’s assets outperform the assumed interest rate.

Reporting Allocations on Tax Forms

The allocation of the GST exemption, or electing out of automatic allocations, is a formal procedure completed on Form 709, the U.S. Gift (and Generation-Skipping Transfer) Tax Return. This form serves to report taxable gifts and to manage and document the use of the lifetime GST exemption.

Affirmative allocations of the GST exemption are reported on Schedule D, Part 2 of Form 709. This section tracks the total exemption available, the allocations made during the year, and the remaining exemption. For each transfer, the taxpayer must clearly identify the trust and the amount of exemption allocated. It is common to attach a “Notice of Allocation” to the return, which provides a statement identifying the trust, the value of the transfer, the exemption allocated, and the resulting inclusion ratio.

To prevent the automatic allocation rules from applying to a transfer, a taxpayer must affirmatively elect out on Form 709. The form includes checkboxes to elect out of automatic allocations for indirect skips or for all future transfers to a specific trust. A statement must be attached to the return describing the transfer and clarifying the extent to which the automatic allocation is not to apply.