Gifts Made Within Three Years of Death – I.R.C. §2035

Decedents who died prior to 1982 were subject to a rule requiring that any property transferred by gift within three years prior to the transferor’s death had to be included in the gross estate of the deceased transferor, at its date-of-death value (even though the transferor may have had no ownership interest or retained rights of any kind when she died). I.R.C. §2035(a). This rule, sometimes referred to as the “gift-in-contemplation-of-death” rule or the “bring-back” rule, had its historical origins when the gift tax and the estate tax operated independently of one another.

With certain exceptions, this general rule was made inapplicable with respect to decedents dying after December 31, 1981. The 3-year “bring-back” rule is still applicable, however, with respect to dispositions of retained interests in property which otherwise would have been includable in the gross estate under I.R.C. §§ 2036, 2037, 2038, or 2042. All of these sections, discussed in a series of blog posts, involve transfers of property as to which the transferor retained some form of continuing interest or right, which, if still retained when the transferor dies, is deemed sufficient to require the inclusion of the property in the gross estate of the transferor:

§2036 – Transfers with certain life interests retained

§2037 – Transfers with a reversionary interest retained

§2038 – Transfers with a right retained to alter, amend or revoke the transferee’s beneficial interest

§2042 – Transfers of life insurance policies with an incident of ownership retained.

The application of the 3-year rule of §2035 is not to the original property transfer with strings attached, but to a subsequent action by the transferor to divest himself of the strings within three years prior to death.

Transfers of Insurance Policies Within Three Years of Death

Under I.R.C. §2035(d), if an insured person transfers an insurance policy to a trust, even though the insured may no longer retain any incidents of ownership, if he dies within the 3-year period following the transfer, the entire policy proceeds will be includable in the insured’s gross estate, effectively defeating the major objective of the irrevocable trust plan. For the most part, this problem can be eliminated by establishing the trust with a new policy (i.e., never owned by the insured). This, of course, may not be a viable alternative when an existing policy is involved. While consideration might be given to cancellation of an existing policy and replacement with a new one, such a course of action should probably be based more upon the non-tax aspects of a policy change (e.g., premium costs, contractual terms, quality of carrier, etc.) than purely the tax risk of §2035(d), the 3-year bring back rule. For more details see: Three Year Rule and Life Insurance Estate Taxation.