Take-Away: Some gifts made within three years of a donor’s death are ‘added back’ to the donor’s taxable estate. More to the point, if the donor’s lifetime gift is subject to a retained interest or power over the gifted asset, the full value of the gift is included in the deceased donor’s taxable estate at its date-of-death value. This creates a tax trap that can burden the donor-decedent’s estate, as only the value, not the asset itself, is included in the taxable estate.

Background: The Tax Code used to call its 3-year retroactive estate inclusion section “gifts in contemplation of death,” or at least that was what it was called decades ago when I was in law school. [IRC 2035.] In 1976 Congress amended IRC 2035 to eliminate the ‘contemplation of death’ test, which had precipitated a lot of litigation over determining the donor’s motive. That ‘test’ was replaced in 1976 with the following:

  • It substituted a flat 3-year rule of estate inclusion: all gifts, or relinquished powers, made by the donor-decedent within three years of death, regardless of the decedent’s motive, will be included in the decedent’s gross taxable estate, but only if such property would have been included in the donor-decedent’s estate pursuant to one of the ‘string provisions.’ In other words, an outright gift is removed from the decedent’s estate tax base at death. However, if the transfer would have resulted in estate inclusion by virtue of one of the string provisions of the Tax Code, then the phantom value of that lifetime gifted asset is included in the decedent’s estate tax base. [IRC 2035(a)(1).]
  • A transfer of assets from a revocable trust will be treated as a transfer made directly by the settlor-donor; thus, the value of those transferred assets will be included in the donor-decedent’s taxable estate. [IRC 2035(e).]
  • The value of all gift taxes paid by the donor on lifetime gifts made within 3 years of the donor-decedent’s death will be added back to the donor-decedent’s taxable estate. [IRC 2035(b).]
  • Excluded from the 3-year rule are gifts that qualify for the federal gift tax annual exclusion ($15,000 per donee). [IRC 2035(c)(3).]
  • Excluded from the 3-year rule are gifts that would qualify for the federal gift tax marital deduction. [IRC 2035(c)(3).]
  • Excluded from the 3-year rule are transfers that are bona fide sales for adequate and full consideration in money or money’s worth. [IRC 2035(d).]

Purpose: The purpose behind IRC 2035(b), which includes in the donor-decedent’s estate the amount of any gift taxes paid within the 3 years prior to the decedent’s death, is to prevent avoidance of the federal estate tax by removing the preference or incentive to make deathbed transfers. Recall that federal gift taxes are tax-exclusive while federal estate taxes are tax-inclusive, thus making the federal gift tax much more efficient to pay for donors. Accordingly, one of the primary purposes of IRC 2035 is to prevent a donor from making death-bed gifts that would otherwise be taxexclusive.

‘’String” Provisions: While the string provisions are a bit cumbersome, they are fairly understandable. What is a much more complex, though, is the implementation of IRC 2035 that pertains to the string provisions of the Tax Code. These string provisions, in general, apply to lifetime transfers where the transferor retained an interest in, or control over, the transferred property interest. Because of that string, the value of the assets subject to that right or power is included in the transferor’s taxable estate at their fair market value at the time of the transferor’s death, even though the transferor has no ownership over the transferred assets. IRC 2035(a)(2) provides:

“If the value of such property (or an interest therein) would have been included in the decedent’s gross estate under section 2036, 2037, 2038 or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included.”

Tax Trap: In essence what IRC 2035(a)(2) means is that if the donor later realizes that he/she holds an impermissible right or power over previously transferred assets, and thus attempts to release or relinquish that right or power within three years of death, the release or relinquishment of that right or power will not be sufficient to keep the value of the previously transferred assets from being included in the transferor-decedent’s taxable estate.

String Provisions: A short summary of each of the string provisions follows:

  • IRC 2036: This section includes in the decedent’s gross estate the value of property that the decedent-transferor had transferred, by trust or otherwise, in which he retained for his life or for any period not ascertainable without reference to his death, or for any period which does not in fact end before his death- (1) the possession or enjoyment of, or the right to the income from, the transferred property or (2) the right, either alone or in conjunction with any person, to designate the persons who possess or enjoy the property or the income from the transferred property. The relinquishment or cessation of retained voting rights will also be treated as a transfer of the property made by the decedent-transferor. [IRC 2036(3).]

Example: I transfer my home to an irrevocable trust of which my children are the beneficiaries. Yet I continue to occupy the home, rent-free, for my life. There is an implied arrangement that I can continue to use and enjoy the home that I gave away. The fair market value of the home held in trust as of the date of my death is included in my taxable estate.

  • IRC 2037:  This section includes in the decedent’s gross estate the value of property that the decedent transferred during his life if possession or enjoyment of the property, through ownership of the property (or interest in the property) can be obtained only by surviving the decedent, i.e. the transferor retained the right to revoke ownership or enjoyment of the transferred property while still alive, or if the decedent-transferor retained a reversionary interest in the transferred property that, immediately before his death, exceeds 5% of the value of such property.

Example: I transfer assets into an irrevocable trust and direct the trustee to pay the income to Angie for life. On Tom’s death, the trustee is directed to distribute the rest of the trust property to me if living, otherwise to Jeff. I have retained a reversion in the transferred property. Therefore, at the time of my death, IRC 2037 brings back into my gross estate the full value of the trust property, less the value of Tom’s outstanding life estate

  • IRC 2038: This section includes in the decedent’s gross estate the value of property that the decedent transferred during his life, by trust or otherwise, where the enjoyment of the property was subject at the date of the transferor’s death to any change through the exercise of a retained power by the decedent-transferor acting either alone or in conjunction with any other person, to alter, amend, revoke, or terminate the transfer, or where any such power is relinquished during the three year period ending on the date of the decedent’s death.

Example: I create an irrevocable trust and direct the trustee to pay Eddie trust income for his lifetime, with the remainder of the trust assets passing to Cory after Eddie’s death. I reserve to myself the right to add or delete other beneficiaries to the trust, other than myself. The reservation of the power to add other beneficiaries to the trust renders the initial transfer to the trust incomplete for gift tax purposes and would bring the value of the trust corpus into my gross estate. Either IRC 2036(a)(2) or IRC 2038(a)(1) causes this result.

  • IRC 2042: This is not necessarily a string provision, yet this section is also covered in IRC 2035. This section includes in the decedent’s gross estate the amount receivable by the decedent’s personal representative as insurance on the life of the decedent. It also includes amounts received by others under insurance policies on the life of the decedent, if the decedent retained and possessed at his death any incidents of ownership, exercisable either alone or in conjunction with any other person.

Example: I own a term life insurance policy on my life with a face value of $1.0 million. The premium for that insurance is $1,000 a year. [Ha!] If I gave away the policy at the beginning of the term to my children, the value of that gift of the policy would be $1,000. If I died six months later, I would have removed $1.0 million from my taxable estate at a minimal gift tax cost. The three year rule is intended to bring the full death benefit into my taxable estate if the gift of the policy occurs within three years of my death. Consequently, if I gave away the term life insurance policy to my children, yet I retained the right to pledge that policy to secure loans I might take out, that retained ‘incidence of ownership’ would cause the full $1.0 million value to be included in my taxable estate.

  • These retained interest sections are the some of the most complex provisions of the federal transfer tax to avoid. Most of their interpretation is found in the case law and administrative rulings, not in the bare statutory provisions or in implementing Treasury Regulations.
  • There are numerous Tax Court decisions where an implied agreement was found to exist to support a finding that the transferor retained an implied right to use or control the transferred property, where IRC 2036 or IRC 2038 applies, to bring the value of the transferred asset into the deceased transferor’s taxable estate.

Example: The transferor takes all of his income producing marketable portfolio and transfers it to a family limited partnership (FLP.) The transferor then transfers all of the general partnership interests to his children, retaining only the non-voting limited partnership interests. By virtue of transferring all of his income producing portfolio to the FLP, the transferor has not retained enough income to pay his bills and support himself. From these bare facts the IRS has successfully persuaded the Tax Court that there must be an implied agreement between the general partners and the transferor that the FLP will make distributions of its income to the transferor sufficient to cover his customary living expenses, and from that implied agreement arises a retained right to the income from the transferred assets.

  • The fair market value of the transferred asset as of the date of the transferor’s death is included in the transferor’s taxable estate, not its value at the time of the lifetime transfer. Therefore, post-transfer appreciation is also brought back into the transferor’s taxable estate.
  • It is only the value of the transferred asset, not the asset itself, that is included in the transferor’s taxable estate. Consequently, other assets that the transferor actually owned at the time of his death will be depleted to pay the federal estate tax on the phantom value that is included in the taxable estate caused by any of the string provisions.

Release, Relinquishment, and Waiver: Why raise the topic of IRC 2035 in the context of the string provisions of the Tax Code? IRC 2035 also treats as a transfer subject to those provisions a release or waiver of one of the retained rights. A release of a right or power within three years of death  will cause IRC 2035 to apply. Making lifetime gifts from a revocable trust, or ‘fixing’ a problematic trust that may result in an impermissible string which can cause unnecessary estate tax traps.

  • Revocable Trusts: A revocable trust is created to hold his assets in order to avoid probate. The transfer of assets to a revocable trust is treated as an incomplete gift, until the property is distributed from the trust to someone other than the settlor.  The settlor is taxed on the income generated by his revocable trust’s assets. [IRC 676.] The value of the revocable trust’s assets are included in the settlor’s taxable estate on death.
  • Example #1: Andrew creates a revocable trust and transfers $10 million to the trust. The trustee is directed to pay income to Andrew’s child for his child’s lifetime, and then distribute the trust property to the child’s descendants on the child’s death. This transfer of $10 million into the trust does not subject Andrew to a gift tax because Andrew retained the power to revoke the trust- it is an incomplete gift. [Treasury Regulation 25.2511-2(b).] If Andrew dies, that transferred  property would be included in his gross estate due to IRC 2038. During Andrew’s lifetime he would be taxed on the income generated by the trust, since it is a grantor trust. [IRC 676.]
  • Example #2:  Andrew creates an irrevocable trust which pays to Andrew’s child income for life, and the remainder to Andrew’s grandchildren. Andrew retained no powers over the trust to which he transfers $10 million. The creation of the irrevocable trust is a completed gift. If Andrew dies within three years of creating and funding the trust, the trust property would not be included in  Andrew’s gross taxable estate for purposes of calculating federal estate taxes. IRC 2035 applies only to lifetime transfers where an impermissible retained right or power, string, would cause the transferred property to be included in the transferor’s estate.
  • Example #3: Andrew creates and funds a revocable trust. Andrew releases the retained power to revoke within three years of his death. The releases of the power to revoke the trust creates a taxable gift by Andrew. The result is the same as if Andrew had never retained the power to revoke, and it should be taxed the same. However, because Andrew’s release of his power to revoke the trust, he implicates IRC 2038, causing his estate to include the value of the trust assets as of the date of Andrew’s death, if Andrew’s release is within three years of his death. If the release is more than three years before Andrew’s death, then the value of the trust’s assets are no longer included in his taxable estate.
  • Example #4: Avoiding the Tax Trap: If, instead of releasing his power to revoke the trust, Andrew  instead had withdrawn the assets from the revocable trust and then gifted those assets to his child outright, the value of that lifetime gift would not be brought back into Andrew’s gross estate pursuant to IRC 2035, even if the gift was made within three years of Andrew’s death. With the lifetime gift, while Andrew pays the gift tax, all future appreciation of the gifted asset is removed from Andrew’s taxable estate. In contrast, if Andrew releases his power to revoke the trust, that too is a taxable gift, but because IRC 2035 is implicated, the value of all future appreciation, post-release, of the gifted trust’s assets is also included in Andrew’s taxable estate. Take-Away: Rather than release a power to revoke a revocable trust, resulting in a lifetime gift of the trust’s assets but exposing that release to IRC 2035, the assets should be withdrawn from the trust and gifted directly to the former trust beneficiary, where IRC 2035 is not implicated.

Fixing Problematic Trusts and Estate Plans: Back in 2017 we were surprised by the Tax Court decision Estate of Powell v Commissioner, 148 Tax Court 392 (2017.) In that decision the Court held that a limited partner, acting in conjunction with the general partner, could vote to liquidate a limited partnership in an expansive interpretation of acting in conjunction with under IRC 2036.(a)(2), which caused all of the limited partnership assets to be included in the transferor’s taxable estate. The thought had been that the limited partner could not, acting alone, vote and control partnership matters and thus, there was no IRC 2036 or 2038 exposure. However, the Tax Court held that IRC 2036(a)(2) applied because the decedent, acting in conjunction with all of the other partners, could vote to dissolve the partnership, even when the limited partner could not force the partnership’s dissolution on her own as she was only a limited partner. IRC 2036(a)(2) also applied because the decedent could control the amount and timing of distributions acting ‘in conjunction with the general partner’ to dissolve the FLP.

  • This expansive  ‘ in conjunction with’ interpretation in the Powell decision caused many who have created family limited partnerships and LLC’s with marketable securities, where the senior family member only retained an illiquid and unmarketable non-voting limited partnership interest, to have second thoughts about that planning structure. The motive was for the senior family member to only own limited partnership interests at the time of death.
  • But if the retained limited right to act with others to liquidate the partnership was considered a sufficient string to cause the partnership (without its valuation discounts) to be ignored, maybe it was time for the senior member to fix the problem, and release any of those retained liquidation rights, or alternatively gift those retained limited partnership interests so as to avoid any string arguments from the IRS in the future.
  • In other words, estate planners are concerned that because partners can always unanimously agree to terminate a partnership, any of the assets contributed to the partnership could be brought back into the estate of the decedent under IRC 2036(a)(2).
  • If a decedent transfers by gift those remaining limited partnership interests through a gift, sale or charitable contribution, then IRC 2035 could still possibly bring those assets back into the estate if the decedent dies within three years of the transfer, since those assets “would have been included in the decedent’s estate” under IRC 2036(a)(2).
  • Similarly, the release of a power to act in conjunction with another over a trust might be not be available to avoid the problems caused by the now-expansive interpretation of in conjunction with caused by the Powell
  • Thus, even fixing a troublesome partnership or trust with a release or renunciation will not have any certainty for at least three years due to IRC 2035.

Life Insurance: The scope of IRC 2035 is really pretty tricky and can sometimes lead to mistakes. As noted earlier, if I own a life insurance policy on my life and I transfer that policy to my son within three years of my death, the face value of the death benefit is included in my taxable estate (even though I did not own the policy, nor did my estate receive any of the death benefit.) Suppose, instead, I gift cash to my son, the intended beneficiary of the life insurance policy, and he then purchases from me the insurance policy on my life. Under the latter scenario, the life insurance proceeds are not in my gross estate, even if the purchase was made within three years of my death. In short, I can do indirectly through a purchase of the policy by my son, the intended beneficiary, what I could not do directly by transferring the existing life insurance policy to my son. Form over substance defeats IRC 2035, if that makes any sense.

Conclusion: IRC 2035(a) creates a trap for unwary taxpayers and their attorneys. In light of the tax consequences of retaining a string power or right, a settlor might be better off retaining a right to revoke an entire trust. The settlor could then revoke the trust, retitle the property in the settlor’s own name, and then make gifts of the trust property that would avoid the reach of IRC 2035 and its three-year look-back rule.