Why is This Topic Important to Wealth Managers? This blogticle discusses one area that is well known to many wealth managers. However, this reexamination of a topic is designed to provide a refresher to wealth managers. Here we discuss the three year bring-back rule.

With certain exceptions, there is a general rule with respect to estates which requires that any property transferred by gift within three years prior to the transferor’s death has 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). [1] This rule is sometimes referred to as the “three year rule” or the “bring-back rule”.

The 3-year “bring-back” rule is applicable with respect to dispositions of retained interests in property which otherwise would have been includable in the gross estate.[2] All of these sections 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

Under I.R.C §2035, if an insured individual transfers an insurance policy to a trust or another individual, 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 having the death benefits payable outside the estate.

For the most part, this problem can be eliminated by establishing a 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 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, the 3-year bring back rule.

In situations where a decision is made to establish an irrevocable life insurance trust with a policy to be newly issued, the §2035 problem (the 3-year rule) 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.

The critical factor in assuring the inapplicability of I.R.C. §2035 (the 3-year rule) is that the grantor/insured not have possessed at any time anything that might be deemed an incident of ownership with respect to the policy.

Generally it is the IRS’ position that reapplication by third party owner after decedent initially applied for the insurance within three years of death does not present a three year rule problem. Central to the position 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.[3]

Tomorrow’s blogticle will continue to discuss issues surrounding wealth management.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

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[1] I.R.C. §2035.

[2] For example, under I.R.C. §§ 2036, 2037, 2038, or 2042.

[3] See Technical Advice Memorandum (TAM) 9323002.

Tags: Business, Death, Estate (law), insurance, Insurance policy, Internal Revenue Service, Ownership, Wealth

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