Three Year Rule and Life Insurance Estate Taxation

Under Internal Revenue Code Section 2035(d) — the so-called three year rule, if an insured person transfers an insurance policy to an irrevocable life insurance trust, even though the insured may no longer retain any incidents of ownership, if he dies within the three 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, the three year rule 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.

Avoidance of the Three Year Rule Problem When a New Policy is Involved

In situations where a decision is made to establish an irrevocable life insurance trust with a policy to be newly issued, the §2035(d) three year rule problem can usually be avoided by simply having the policy applied for by, and initially issued to, the trust as owner. If this is properly accomplished, the insurance proceeds will not be includable in the insured’s gross estate even if he should have the misfortune of living less than three years thereafter.

In general, the trust should be established first, with a transfer of cash from the grantor to be used to pay the initial premium. The trustee would then submit the formal application, with the trust as the original applicant and owner. The grantor/insured would participate only to the extent of executing required health questionnaires and submitting to any required physical examination. The critical factor in assuring the in-applicability of I.R.C. §2035(d) (the three year rule) is that the grantor/insured not have possessed at any time anything which might be deemed an incident of ownership with respect to the policy. The foregoing planning technique is based upon case law and IRS pronouncements which have established that §2035(d) (the three year rule) will apply with respect to an insurance policy held by a trust only if the insured possessed and actually transferred an incident of ownership within three years of death.

In Technical Advice Memorandum (TAM) 9323002 the IRS held that reapplication by third party owner after decedent initially applied for the insurance within three years of death did not present three year rule problem. Central to the ruling is the notion that an application for insurance (as long as money is not submitted with the application) is only an offer to contract. There being no contract between the parties, decedent never held any incidents of ownership.

Planning For Mitigation of Potential Three Year Rule Impact When an Existing Policy is to be Transferred

In circumstances where the irrevocable trust is established for the transfer of an existing policy owned by the insured, the risk of an early death causing the policy proceeds to be included in the insured’s gross estate will remain during the first three years after the transfer. While this risk cannot be eliminated, the trust can contain certain contingency provisions designed to mitigate the adverse estate tax impact of inclusion of the insurance proceeds in the gross estate. These provisions represent, in effect, an alternative plan which would automatically go into effect only if the insurance proceeds ended up having to be included in the gross estate.

Backup Utilization of Marital Deduction (Through a So-Called Marital Deduction Savings Clause)

In a situation in which a surviving spouse is to be a major beneficiary of the insurance proceeds received by the trust, the first alternative for escaping estate tax, if the insurance proceeds must be included in the gross estate by reason of the three year rule, [Although this discussion of contingency planning for unexpected gross estate inclusion of trust-owned insurance proceeds centers upon the 3-year rule of IRC §2035(d), the operation of the contingency provisions in the trust should be triggered by any circumstances which result in the insurance proceeds being includable in the gross estate. This would cover such additional contingencies as changes in the tax law or IRS interpretation, and inadvertent or intentional retention by the insured of what IRS may deem an incident of ownership.] In general, property passing from an estate to a surviving spouse is fully deductible from the gross estate. Thus, the trust should contain contingency provisions which would transfer the property to the surviving spouse in such a manner that it would qualify for the marital deduction either outright or in trust.

Contingency Provision for Apportionment of Estate Tax Resulting From Inclusion Under The Three Year Rule

In a factual situation where the marital deduction is not a feasible contingency plan (e.g., a widow or widower who transfers a policy to a trust for the exclusive benefit of adult children), and the insured must run the risk of full estate taxation if he dies within three years, attention should be given to the issue of whether the estate tax on the insurance proceeds should be paid from the trust or from other assets in the estate, if the estate is expected to have sufficient other assets. This issue is only relevant if the estate will have assets (other than the insurance proceeds, owned by the trust) and if the estate beneficiaries differ from (or hold interests which are different from) the trust beneficiaries.