Incident of Ownership within Three Years of Death: Section 2035 Explained

Code section 2035 is entitled “Adjustments for certain gifts made within three years of decedent’s death.” The statute states that transfers in certain situations will be brought back into the gross estate for estate tax purposes if the decedent held at death an interest which would have been included under one or more of the following sections:

  • Section 2036 (transfers with retained life estate)
  • Section 2037 (transfers taking effect at death)
  • Section 2038 (revocable transfers)
  • Section 2042 (proceeds of life insurance)

Inclusion is also mandated if the property would have been included under one of those four IRC sections but the decedent gave up fatal rights within three years of death.3

Section 2042 inclusion will be discussed in detail below. For purposes of section 2035, it is sufficient to understand that section 2042 requires inclusion if either:

  1. policy proceeds are payable to or for the benefit of the insured’s estate; or
  2. the insured, at the time of death, held one or more incidents of ownership (i.e., valuable property rights) in the contract.

Adequate Consideration Rule

However, section 2035 specifically excludes from estate tax inclusion a sale of property made for an adequate and full consideration in money or money’s worth.4 So, if life insurance is sold for adequate and full consideration in money or money’s worth, it should not be included in the insured’s gross estate under section 2035 in any event.

It would appear at first glance that all problems under section 2035 could easily be avoided by selling the policy rather than giving it away. Planners should proceed with caution because of:

  1. the “transfer for value” rule; and
  2. the problems inherent in a situation in which the IRS finds the consideration inadequate.

“Adequate” is often (but not always) measured (by the IRS) relative to what would have been included in the estate had no transfer been made rather than the value of what was transferred. However, no one in the real world would pay, even on the life of a terminally ill insured, the full face amount because such a payment would ignore the cost of the time value of money. Some discount should be taken for the fact that some time (that proceeds could have been earning money) will pass before the proceeds are actually paid. Nevertheless, the courts have generally supported the IRS’s interpretation of how adequate consideration is measured. Absent extenuating circumstances such as a terminal illness, the IRS has indicated that the Interpolated Terminal Reserve (ITR) value constitutes adequate and full consideration for purposes of section 2035.5

Example. Your client is a client was a doctor who knows he was dying of cancer. So, rather than give the policy on his life away, he sells them to his wife in return for her check in an amount equal to the policy’s cash value. The IRS would claim that in the light of the actual circumstances, the policies were near to maturity and therefore worth much more than the cash values. It would include the difference between actual worth under the circumstances and the amount paid by the doctor’s wife in the client’s estate on the grounds that he had not, in fact, received adequate and full consideration.

Premiums Not Brought Back

Does the language of the Internal Revenue Code encompass a bring-back of cash the donor intended the donee to use for paying premiums on life insurance? In other words, does the mere payment of premiums within three years of death cause the death proceeds of a policy to be brought back into the estate? It is clear now that it does not.

Gifts of Policies within Three Years of Death

A gift of a life insurance policy or a release or transfer of any of the incidents of ownership in a life insurance policy by the insured within three years of the insured’s death will result in inclusion under section 2035 regardless of the insured’s motive for the transfer.

Note that section 2035 applies only to transfers of policies (or transfers or releases of incidents of ownership) by the insured. There will be no inclusion under section 2035 if someone else transfers a policy on the life of the insured within three years of the insured’s death or within three years of the owner’s death. (Section 2042 pertains only to proceeds of insurance on the decedent’s life. A policy owned by a third party on the decedent’s life would be includable, if at all, under Code section 2033. But section 2035 pulls back the proceeds only if it would have been includable in the insured’s gross estate under Code sections 2036, 2037, 2038, or 2042.)

Example. If a daughter owned a policy on the life of her eighty-five-year-old father and the daughter made a gift of the policy to her niece, no inclusion under section 2035 would be required even if the father died within three years of the daughter’s transfer to the niece.

In the case of second to die policies, the three year period is measured back from the death of the surviving insured since inclusion under section 2035 is conditioned on a section 2042 inclusion (but for the policy transfer). Since the only inclusion possible at the first death was under section 2033, section 2035 does not begin to apply until the second death. For example, if a client and her husband purchase a second to die policy and assign it to an irrevocable trust for their children, there will be no section 2035 inclusion unless both spouses have died within three years of the gift to the trust.

Gifts of Policies beyond the Three Year Period

What if an insured pays premiums within three years of his or her death but the policy itself was purchased more than three years prior to the insured’s death by a third party and the insured never had an incident of ownership? What if the insured pays premiums within three years of death and the policy was purchased by the insured but he or she transferred it to a third party more than three years prior to death? The answer to both questions is the same: there should be no inclusion since no section 2042 rights were transferred within three years of death and none of the other sections (2036, 2037, or 2038) apply.

Payment of Premiums by Third Party Owner

What if the donee of the policy pays some or all of the premiums on the policy? According to several cases and regulations, if the donee rather than the insured pays premiums after the policy is received, even if the transfer from the insured occurred within three years of death, only a portion of the policy proceeds would be includable in the insured’s estate. The inclusion ratio is:

Example. Assume a client purchases a $1,000,000 policy on his or her life. Premiums are $25,000 payable semiannually. One year after purchasing the policy and paying $50,000 in premiums, she or he transfers the policy to his or her thirty-eight-year-old son who pays–out of his own personal funds–the next four semiannual premiums of $25,000 each. If the insured client died at that point, the client would have paid $50,000 out of the total of $150,000 (i.e., one-third of all premiums). Therefore, one-third of the $1,000,000 death benefit ($333,333) would be includable in his or her estate.

The “Beamed Transfer” Theory

Why has section 2035 caused such a multiplicity of court cases? The answer lies in the less than clear manner in which section 2035 was previously written and in this common fact pattern: A third party such as a spouse, child, or irrevocable trust purchases a life insurance policy on the life of a client but pays premiums with funds provided by the insured. In this scenario, the insured typically (but not always) has initiated the insurance purchase. The insured dies within three years of the issuance of the policy.

In the past, the IRS has argued that if the insured significantly participated in the procurement of a policy on his or her own life, that action, together with the transfer of amounts to pay premiums on the policy, was equivalent to purchase and transfer of the policy by the insured to the third party. This has been called the “beamed transfer” theory. After a number of losses in court, the IRS has announced that it will no longer pursue this theory.

For those preferring to play it safe, the odds of avoiding the issue generally increase if:

  • the insured never owns the policy (it should be owned from inception by a third party);
  • an adult beneficiary or independent trustee takes all the actions to purchase the policy on the life of the insured and place the policy into effect;
  • the trustee, if a trust is used, is authorized but not required, to purchase insurance on the life of anyone on whose life the trust’s beneficiaries have an insurable interest;
  • the trust specifically prohibits the insured from obtaining any rights in any policy the trust may ever hold on the insured’s life;
  • the trust permits, but does not require, the trustee to pay premiums;
  • the insured gives the trustee enough money to pay premiums for more than one year;
  • the cash gift to the trust (or adult policyowner) is given outright with no strings attached;
  • the gift is made well in advance of the date on which premiums are due;
  • the facts indicate that the trustee or adult policyowner is not acting mechanically as the insured’s agent but is in fact making an independent decision to purchase the insurance without direction from the insured;
  • the document (in the case of a trust) contains as few references as possible to life insurance and is not titled “Irrevocable Life Insurance Trust”; and
  • the actual policyowner could, for at least the first three years, pay premiums from a source other than from gifts from the insured and if necessary borrow from another relative or bank.

Exchange of Contracts within Three Years of Death

What is the impact of an exchange of policies within three years of death? For instance, say the client transfers a policy on his life to an irrevocable trust or adult child. More than three years later, the trustee exchanges that policy with the insurer for a new one on the insured’s life. Assume the client is not in any way involved in the replacement except for a written acknowledgement that the trustee’s statements were correct. If the insured dies within three years of the exchange (i.e., the acquisition of the new policy), will the proceeds of the new policy be includable in the client’s gross estate?

The answer is, “no.” The exchange of policies by an irrevocable trust should not be treated as a transfer within three years of death if the original transfer occurred more than three years before death and the decedent possesses no interest in the policy at the date of the exchange. The key to success in policy exchanges is: (a) be sure the facts don’t indicate that the trustee’s actions can be imputed to directions from the insured; and (b) be sure the facts indicate that there was no transfer from the insured.

Group Term Life

An employee can successfully transfer all incidents of ownership in group term life coverage if:

  • the master contract or state law gives the employee a conversion privilege; and
  • both state law and the master contract allow assignment of all the covered employee’s rights including the right to convert the contract to permanent coverage at termination of employment.
  • An assignment of the policy must transfer all of the insured’s interest in the group coverage including any right to convert the protection to permanent coverage. (These general rules are covered in more detail under the section 2042 discussion.)
  • In the context of the “Transfers within Three Years of Death” statute, it is clear that the transfer by the insured of group term life insurance to another within three years of the insured’s death will result in federal estate tax inclusion under section 2035. It is also certain that a transfer (within the scope of section 2035) takes place when—at the inception of coverage—someone other than the insured employee is named as owner of the group term coverage.

Can the transfer of group term life ever escape the three year limit? The problem is that, by definition, group term life is typically annually renewable. Each year’s premium automatically renews the coverage. If the IRS took the position that each payment created new coverage, it would be impossible to escape the three year limit.

Fortunately, the IRS has stated that the mere payment of the renewal premium does not create a new agreement. It merely continues the old agreement and therefore, with respect to an employee who has absolutely assigned his coverage, renewal is not a new transfer of insurance coverage for purposes of section 2035. This favorable position is contingent on two conditions: first, no additional evidence of insurability can be required of the insureds in the group; second, there can be no variation or break in the coverage.

One issue that often comes up pertains to a change in insurers. Assume, for example, that a corporate client finds the rates of one carrier more favorable than those of the current insurer and decides to switch. Each employee receives a new piece of paper with the name of a new insurer. Assume a client had transferred his coverage to his daughter more than three years ago. Does that transaction constitute new coverage and therefore start the three year clock ticking all over again? The answer depends on how much real change (if any) occurred from the covered employee’s perspective.

In all probability, the clock will not start to tick again and the IRS will consider the three year period begun when the assignment of the first policy was executed if “the new arrangement is identical in all relevant aspects to the previous arrangement.” So if the client dies more than three years after the first assignment, according to this ruling, there will be no inclusion of the group term life even if he dies within three years of the second assignment.

Practitioners should view this seemingly favorable viewpoint with caution, however, because of its unusual condition: a new arrangement must be identical in all relevant respects to the previous arrangement. In one favorable ruling, the employee did not use the company’s standard assignment form. Instead, his attorney drew a form assigning not only all his rights in the original group coverage but also any right he might have in any future group term coverage. Although this technique of assigning present and future rights would seem to be a solution to the change in carriers issue, it creates a potential practical trap; if the employee assigns all present and future coverage to his current wife, for example, how will he feel if he later becomes divorced and his then ex-wife reaps the benefits of every increase he enjoys in group coverage, with him paying ever increasing Table I costs as well as possible gift taxes on the annual gifts?

Obviously, if the insured under a group contract is notified by the employer and the new carrier that any prior assignments are void because of the change of carriers and will not be recognized by a new insurer, the section 2035 clock will tick anew when the new coverage begins. No protection would be afforded by the standard assignment of coverage form in this type of situation. The insured would have to make a new absolute assignment of his coverage and outlive the three year period beginning at the date of the new assignment.

Clients with substantial amounts of group term coverage who wish to remove that insurance from their estates should therefore consider an absolute assignment to a trust or named beneficiary and make the transfer as quickly as possible. A new assignment should be made every time an employer changes group carriers.

Corporate Owned Life Insurance

Section 2042 treats a shareholder who owns more than 50 percent of a corporation’s stock as if he owned life insurance actually owned by the corporation. This provision applies only to the extent insurance owned by the corporation is payable to or for the benefit of a party other than the corporation or its creditor. If the corporation holds the policy insuring the controlling shareholder at such shareholder’s death, the proceeds would be includable in his estate under section 2042.

If the corporation transfers the policy to a third party within three years of the insured’s death, for purposes of section 2035, the insured would be deemed to have made a fatal transfer and inclusion of the proceeds would be the result.

Example. Suppose a client owned 80 percent of the stock of a closely held corporation. The business owned a $1,000,000 life insurance policy on the client’s life but the proceeds were payable to the client’s children. Upon learning that Code section 2042 would require inclusion of the proceeds in the client’s gross estate, the client’s corporation immediately transfers ownership of the policy to the client’s children but the client dies within several months of the transfer. The IRS would argue that the corporation’s transfer of the incidents of ownership was really an indirect transfer by the insured and since the transfer occurred within three years of the insured’s death, section 2035 applies.

Can a client who is a controlling shareholder avoid the 2035 problem by transferring just enough stock so that he no longer meets the more than 50 percent test and then have the corporation transfer the life insurance? The IRS has answered these questions by stating that a transfer of a majority shareholder’s stock within three years of death could itself trigger taxation under section 2035. A gift of a controlling interest in the stock of the corporation is considered a release of the incidents of ownership in the corporate owned policy on the insured’s life that in turn is deemed to constitute a transfer of the policy by the insured. The IRS would make this argument even if the insured owned no stock in the corporation at death, because its argument rests on the constructive transfer within three years of the insured’s death rather than on the insured’s control of a corporation that owns insurance on his life when he dies.

Example. A corporation owns a $1,000,000 policy on the life of a client who owns 80 percent of the voting stock of the corporation. The client is deemed to own the policy on her life that is actually owned by the corporation (to the extent that it was payable to someone other than the corporation or its creditors). Assume further that the proceeds are payable to the client’s son. Two years ago, the company transferred the policy to the son who became owner as well as beneficiary. The client has contracted terminal cancer and has only days to live. She makes an immediate gift of 20 percent of her voting stock to her daughter who runs the business. Two days later, the client dies. The IRS would argue that by giving up control of her corporation, the client made a transfer of incidents of ownership in the life insurance and thereby made a transfer within three years of death and the $1,000,000 of proceeds are included in her estate. On the other hand, a sale of the stock for a price based on all the assets and liabilities of the corporation, i.e., for fair market value, is much more likely to be successful.6

Community Property Issues in Section 2035 Situations

Community property laws, if applicable, add another layer of complexity to the already difficult section 2035 issues. These laws may work for or against the taxpayer, as the two examples below illustrate.

Example 1. Assume a client lives and works in a community property state. The client’s employer applies for a policy on the life of the client but all the facts, including the policy itself, indicate that the client’s husband is the policy owner. Even if the client does not control the employer corporation, the IRS would argue that there was a constructive transfer of the insurance by the decedent to her husband. If the client died within three years of that constructive transfer, the IRS would include half the proceeds in her estate because the policy payments by the corporation would be deemed as compensation to the client and under community property law, only one half of that money would be hers to transfer.

Example 2. Assume a policy was issued in which the insured’s wife was named owner and beneficiary and the first premium was paid from the couple’s community property checking account. Say the insured dies two months after the policy was issued. The use of community funds to pay the premium would be considered tantamount to a transfer by the insured of his interest in community funds that, in turn, would constitute a transfer of the policy itself. The IRS would include a percentage of the proceeds equal to the insured’s community property portion of the premium multiplied by the insurance proceeds.

Techniques for Success

To obtain the highest probability of success, be sure the insured never possesses an incident of ownership. This technique will work in most cases where a policy is about to be issued.

But suppose a client transferred a policy to a trust more than three years ago and therefore has already outlived the statutory three-year period. Assume a new insurer is willing to assume the obligations of the old insurer and issue a new policy to the trust with more favorable terms. Even if the insured died within three years of the issuance of the new policy, no inclusion would be required if the facts indicate that the exchange occurred strictly between the independent trustee and the insurance company. Note that from the date of the original transfer the insured never held an incident of ownership. Clearly, no incident was held at the date of the exchange and therefore none could have been released or transferred by the insured. If this technique is used, it is important that the trustee be independent and act as trustee rather than as the insured’s agent. The insured should not be involved in the transaction in any way except to sign as insured.

A sale of an existing policy may avoid the three year rule but result in the unfortunate income tax consequences with regard to the transfer for value rule. Even if the transfer for value problem is not an issue, the IRS could argue that the amount paid for the policy was not a full and fair payment (especially if the insured was ill at the time of the transfer). But if the insured is healthy, the problem may be cured by transferring the policy to a spouse for full and adequate consideration (from the spouse’s funds) and at some later date from the spouse to a trust for the couple’s children or other mutually acceptable beneficiary (selected independently by the noninsured spouse). The transfer from the spouse to the trust would not be within the reach of Code section 2035.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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