By: Christopher Ha, Staff Attorney

 

“In this world, nothing is certain but death and taxes.”

– Ben Franklin

 

“You must pay taxes. But there’s no law that says gotta leave a tip.”

– Morgan Stanley

 

Purpose of this Blog Post

 

The purpose of this blog post is to give an overview of the “3 Year Look Back Rule” as it relates to federal estate (death) taxes.

 

The 3 Year Look Back Rule is in Internal Revenue Code Section 2035. We cover some of the history of the rule for context and then discuss how the rule works now (2021).

 

We hope this is helpful!

 

60 Second Summary

 

  1. The 3 Year Look Back rule used to allow IRS to ignore many gifts made within 3 years of death and assess estate (death) taxes on the value of those gifts.

 

  1. Congress implemented a coordinated estate and gift tax system in 1981 and significantly reduced the scope of the 3 Year Look Back Rule.

 

  1. Result – post 1981 the 3 Year Look Back Rule primarily affects gifts of life insurance policies. Other gifts made within 3 years of death are largely respected.

 

Part 1: The 3 Year Look Back Rule Rule Circa 1976

 

Some background:

 

Gift tax = tax you owe to Uncle Sam for gift transfers made during your life. Many gifts are not subject to gift tax because they fall under the $15,000 annual exclusion (2021).

 

Estate (death) tax = tax owed on value of your assets at the time of your death. Many decedents do not owe federal estate (death) taxes because the estate tax exemption is $11,000,000 (rounded, 2021).

 

Prior to 1976, the (a) gift tax system and the (b) estate (death) tax system were like two different government departments: ships passing in the night that did not talk to one another!

 

Clever tax planners realized that the estate (death) tax system assessed estate (death) taxes as of moment of death.

 

Solution: have clients gift everything they own on their deathbed a day or so before death. Result: client does not owe estate (death) taxes on assets that client does not own on his date of death!

 

Congress learned of this estate tax planning and passed several laws, including the 3 Year Look Back Rule contained in Internal Revenue Code Section 2035 (IRC 2035).

 

Originally, IRC 2035 functioned like an enormous vacuum cleaner: almost ANY gift transfer made in the 3 years before client’s death was DISREGARDED for estate tax purposes and subjected to estate (death) taxes.

 

Example with hypothetical rounded numbers:

 

Client’s net worth at death                             $2,000,000

 

Client’s estate tax exemption                          $1,000,000

 

Client’s net worth exposed to estate taxes      $1,000,000

 

Hypothetical estate tax rate                            40%

 

In this hypothetical case, if client does nothing, he has $1,000,000 exposed to estate taxes. If his estate tax rate is 40%, then he would owe $1,000,000 x 40% = $400,000 at death.

 

The old estate tax planning strategy was to have client gift $2,000,000 to his kids a day or so before his death.

 

Result = Client net worth at death = $0.

 

Congress learned of this estate (death) tax planning strategy and passed legislation to put a stop to it by passing the early versions of the 3 Year Look Back Rule.

 

The old 3 Year Look Back Rule asked Decedent’s Executor: “did that $2,000,000 transfer occur within the 3 years before Father’s death?”

 

The Executor would reply that the $2,000,000 transfer happened 2 days before Father’s death, which was definitely within the 3 year look back window.

 

Result: the $2,000,000 gift transfer was completely ignored and Father’s estate was treated as though it owned the $2,000,000 on date of death for estate tax purposes! This means that the Executor of Father’s estate owed $400,000 to IRS instead of $0!

 

Part 2: 1981 and Introduction of Integrated Estate and Gift Tax System

 

Now 1981: Congress substantially scrapped the old gift and generation skipping tax system. The updated estate and gift tax system now works in unison.

 

The new 1981 system dealt decisively with the old strategy of gifting all of a client’s assets to his or her kids a day or so before death.

 

How? Every gift in excess of the annual exclusion ($15,000 per year per person in 2021) gives the person making the gift a choice:

 

  1. Pay gift taxes on that transfer, or

 

  1. Reduce your estate (death) tax exemption by the amount of the gift.

 

  1. If you have no estate tax exemption remaining, you owe gift taxes on the transfer

 

Result: making a big transfer of assets a day or so before death does NOT result in major estate tax savings.

 

Example with hypothetical rounded numbers:

 

Client’s net worth at death                             $2,000,000

 

Client’s estate tax exemption                          $1,000,000

 

Client’s net worth exposed to estate taxes      $1,000,000

 

Hypothetical estate tax rate                            40%

 

Say client makes large gift day before death $2,000,000. That gift is subject to the new 1981 gift tax system and that gift tax system says:

 

  1. Pay IRS gift taxes on that transfer of $2,000,000, or

 

  1. Use up your estate tax exemption to prevent the gift tax. If the estate tax does not fully cancel out the taxable gift, you owe gift taxes on the difference.

 

In this example, client can use up his entire $1,000,000 estate tax exemption but that still leaves him a $1,000,000 unshielded gift that is subject to gift taxes.

 

The author posits that Congress was pleased with itself and busied itself with new ways to torment the American taxpayer.

 

Part 3: The 3 Year Look Back Rule in Effect Now (2021)

 

As a result of the new integrated estate (death) tax and gift tax system, one could argue that IRC 2035’s 3 Year Look Back Rule is no longer needed because all gifts are either subject to gift taxes or consume a client’s estate tax exemption.

 

Congress felt differently.

 

Result: Congress kept IRC 2035’s 3 Year Look Back Rule on the books but limited its application to the following cases:

 

  1. IRC 2036 – Transfers with a retained life estate

 

  1. IRC 2037 – Transfers occurring at death

 

  1. IRC 2038 – Revocable transfers

 

  1. IRC 2042 – Transfers of life insurance policies.

 

 

Part 4: What Does This Mean for Me (in 2021)?

 

IRC 2035’s 3 Year Look Back Rule still exists but it is substantially limited in scope.

 

If you have a well-prepared estate plan, the 3 Year Look Back Rule primarily affects you if you are planning on gifting a life insurance policy.

 

Example: you are considering an irrevocable life insurance trust (ILIT) to shield your life insurance proceeds from estate (death) taxes when you die.

 

If you gift an existing life insurance policy into your ILIT entity (e.g., say you have a universal life insurance policy with substantial cash value) and you die within 3 years of the transfer then the transfer CAN BE IGNORED for estate tax purposes under the IRC 2035’s 3 Year Look Back Rule and you can owe estate (death) taxes on the full death benefit of the life insurance policy EVEN THOUGH you gifted the policy to someone else before death.

 

In contrast, if you gifted real estate or cash to a child within 3 years of death, that gift is NOT subject to IRC 2035’s 3 Year Look Back Rule (but it is still subject to the gift tax rules described above).

 

Call to Action

If you have questions about the 3 Year Look Back Rule, need to update an estate plan that is out of date, or have estate (death) tax planning questions, please feel free to call our office to schedule a consultation with one of our estate planning attorneys!

 

We hope this has been helpful.