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Student Question of the Week: Estate Planning – 3-Year Rule

Student Question from: Steve
Course:  Estate Planning

Student Question:

Hello Dan,

The topic of “Transfers within three years of death” has been very confusing to me. My attempts to research this further on the Internet makes it even more confusing because of either incomplete or flat out incorrect information being provided. It seems that a lot of people do not understand this rule, including estate planners. Are all gifts made within 3 years of death, no matter the nature of the gift, brought back into the estate as if the gifts were never made? Or is this done only on gifts where gift taxes were paid within 3 years of death? Thanks, Steve.


Instructor Response:

Hi Steve!

Yeah, there is a lot of misinformation out there in regards to estate planning, and the rule regarding transfers within 3 years specifically.

First, let’s clarify what gifts always get added back to your estate when you die. Second, let’s clarify what gifts get added back only if made within three years of death.  And third, let’s clarify the issue of adding back taxes.

First, ALL lifetime gifts made after 1976 are added back to your estate when you die except for the following:

  • Transfers to your spouse
  • Annual exclusion gifts
  • Gifts to charities
  • Direct payment of medical care for someone
  • Direct payment of tuition for someone

ALL lifetime gifts outside these exclusions are considered “taxable gifts” and are subject to taxation (much of which, if not all, will be covered by use of your Applicable Credit).

Second, SOME gifts, if made within 3 years of death, are treated as DEATH BED transfers intended to escape taxation and are added back to your estate. For our purposes, the only “gift” you need to be concerned with here is the transfer of ownership of a life insurance policy on your life.

Obviously, life insurance can be transferred at values far less than the face amount of the policy, and often can be classified as annual exclusion gifts.  Getting  such assets out of your estate can be very good estate planning. However, if you make this transfer and die within three years, it raises the suspicion of the IRS that you may have known you were going to die and did this as a “death bed” transfer to avoid taxes. Thus, they make you add back the full date of death value of the policy when you die if you don’t outlive the 3-year rule.

Third, GIFT TAXES, if paid on lifetime transfers made within three years of death, must be added back to your estate.

In other words, while you must add back all lifetime gifts under our first category above, if you made any such transfers within 3 years of death and had to pay a tax on them, then the tax paid must also be added back. Why? The reason is that when you make a lifetime gift on which you have to pay the tax, the money that goes to pay the tax is not part of the tax base (no tax ever gets figured on it).

For example, if you transfer $100,000 on which you must compute a tax, you compute 40% of $100,000 tax base, for a tax of $40,000. However, if you held all that money in your estate, your estate tax will be computed on a $140,000 tax base (for a tax of $56,000), not on a tax base of $100,000. Thus, the IRS says the transfer you made within three years of death may have been in anticipation of your death and an attempt to use a smaller tax base and pay a lesser tax. Therefore, they make you not only add back the gift (as they would have done anyway, regardless of the 3-Year Rule) but also make you add back the tax you paid (just on those transfers within three years of death), thereby requiring you to recalculate the full amount in your estate as if you had never made the lifetime transfer. When it comes time to pay your estate tax bill, you will be given a credit for the gift tax you already paid so that you don’t pay double taxes, but you will end up with a higher tax bill than you would have otherwise incurred.