Three-Year Inclusion Rule

A potential problem arises if the gift falls into the context of IRC Sec. 2035. Through 1976, the IRC stated that any property gratuitously transferred by an individual "in contemplation of death" and within three years of death was includible in the decedent's gross estate, valued at the fair market value on the date of death. The Tax Reform Act of 1976 eliminated the "contemplation of death" clause because the test was considered to be too subjective. Thus, between 1977 and 1981, IRC Sec. 2035 brought into the gross estate all gratuitous transfers made within three years of death. Post-gift appreciation would be subject to estate tax if the gift was made within three years of death.

The enactment of the Economic Recovery Tax Act of 1981 (ERTA), severely restricted the applicability of IRC Sec. 2035. The three-year inclusion rule was essentially eliminated for most gifts, allowing post-gift appreciation to go untaxed. However, there are exceptions to this provision, the most troublesome being its relationship to IRC Sec. 2038.

Revocable Trusts and the Three-Year Rule

The three-year rule continues to apply to certain transfers of property interests that have been transferred by the decedent during the three- year period ending on the decedent's death. Specifically, IRC Sec. 2035(d)(2) requires the gross estate to include an interest in property that was (1) transferred by the decedent within three years of death and (2) would have been included under IRC Sec. 2038 had such interest been retained by the decedent. IRC Sec. 2038 requires the inclusion of any property interest over which the decedent had the power to alter, amend, revoke, or terminate the enjoyment thereof. A revocable trust would fall under the purview of IRC Sec. 2038. Therefore, IRC Sec. 2035 and 2038 work together to require the inclusion of an interest in property previously subject to a power to revoke, where the power to revoke has been relinquished during the three years ending with the decedent's death. Ed. Note - The last clause of IRC Sec. 2038 alone, without IRC Sec 2035, is sufficient to require inclusion, thereby creating overlap of the two sections.

The question at hand is whether a gift to a third party made from a revocable trust within three years of the grantor's death is includible in the grantor's estate under IRC Sec. 2035.

IRS Conclusions

The IRS position on this issue has been consistent: gifts made from revocable trusts within three years of the grantor's death should be includible in the grantor's gross estate under both IRC Sec. 2035 and 2038. As discussed in PLR 8609005, the IRS applied the three-year rule to gifts from a revocable trust where the trustee was authorized under the terms of the trust agreement to make annual gifts to specified beneficiaries. Similar conclusions were reached in TAM 9015001, 9016002 and 91139002 as the trustees in these instances were given the authority by the grantor to pay principal of the trust directly to third parties. In each of these cases, the IRS asserted these distributions were essentially relinquishments of a revocable power as they were made under the direction of the grantor and thus should be includible in the decedent's estate if made within three years of death.

This is not to imply that there are no instances where the IRS has accepted the defense such distributions were outright gifts rather than relinquishments of the IRC Sec. 2038 power. In TAM 9010004, 9010005, 9017002, 9018004, 9141005 and 9309003, the IRS ruled that in cases where the only distributions permitted by the trust instrument during the grantor's lifetime were distributions to the grantor, any third party distributions were clearly gifts made directly by the grantor. Thus, the three-year-transfer rule under either IRC Sec. 2035 or 2038 would not be applicable to these distributions.

The Courts' Conclusions

The courts have also relied on the terms of the trust agreement in determining the applicability of IRC Secs. 2035 and 2038. in Jalkut Est. v Comr., 96 T.C. 675 (1991), acq., 1991-2 C.B., the court held that where the grantor was the trustee and sole permissible beneficiary of the trust income and corpus, gifts made from the revocable trust within three years of the grantor's death were not includible in his gross estate. The grantor was deemed to have exercised his power to withdraw the assets and to have subsequently made the gifts directly. However, prior to the grantor's death and within the three-year-transfer period, the grantor lost legal capacity. The court ruled that distributions made during this period of incompetency were includible in the grantor's estate as he lacked the capacity to make withdrawals and gifts directly. Rather, these distributions were considered relinquishments of the grantor's power to revoke a portion of the trust.

Legislative Efforts and Recent Developments

In an attempt to broaden the interpretations reached by the IRS and the Tax Court, Congress proposed a change to IRC Sec. 2035 and 2038 (Sec. 4602, H.R. 11, R.A. of 1992). The proposed legislation required that transfers from a trust over which the grantor held a power to revoke be treated as if they had been made directly by the grantor. Unfortunately, this bill was never passed.

However, the intent of Congress was not lost on either the IRS or the Tax Court. In the recent TAM 9413002, the IRS did not agree with the court's conclusions in Jalkut that incompetency affected the character of revocable trust distributions. Rather, the IRS ruled that distributions made by a court-appointed guardian from a revocable trust within three years of death were not includible in the grantor's gross estate even though the gifts were made after the grantor became incompetent. As the trust instrument did not permit distributions to anyone other than the grantor during the grantor's lifetime, the IRS concluded that the distributions were essentially withdrawals and not relinquishments of the power to revoke.

The courts have been even more aggressive in broadening the interpretation of this issue. In McNeely v. U.S., 16 F. 3d 303 (8th Cir. 1994), the court rejected the IRS position that distributions from the revocable trust should be included in the grantor's gross estate. The distributions in question had occurred within three years of the death of the grantor and the trust instrument did permit the trustee to pay principal to one or more persons other than the grantor. The court concluded, however, that the power of the grantor to direct the withdrawal of the trust assets did not constitute a relinquishment of any of the grantor's revocable powers. Rather, the distributions represented the exercise of the grantor's right to invade trust corpus and, therefore, were not includible in her gross estate.

A similar conclusion was reached by the Tax Court in Barton Estate v. Comr., T.C. Memo. 1993-583. According to the terms of the trust agreement, the grantor had retained the power to terminate the trust and to invade trust corpus. The court concluded that when Barton withdrew stock from the trust and gifted it within three years of her death, she had exercised, not relinquished, the powers defined in her trust. Thus, the Tax Court concluded that these stock transfers were not includible in Barton's estate.

In Kisling Estate v. Comr., CA 8, No. 933528, 8/10/94, the United States Court of Appeals (8th Circuit) overturned the Tax Court decision that the grantor had not retained the express power to withdraw trust principal and, therefore, was relinquishing assets when making transfers from the trust. The Court of Appeals held instead that as the terms of the trust provided Kisling with the power to modify the trust without restriction, such power is considered to include the power to revoke the trust and, therefore, to make withdrawals. The court held that the manner in which Kisling exercised her power to withdraw from the trust (by irrevocably assigning fractional share interests in her revocable trust to her children) did not change the substance of the transaction. The Court concluded that in creating these fractional share interests the grantor had exercised, not relinquished, her powers under the trust and such transfers should not be included in her estate.

Proposed legislation to clarify these sections is once again before Congress. The Tax Simplification and Technical Corrections Act passed the House on May 17, 1994 and is currently awaiting approval by the Senate. Should the bill pass as written, it will provide for an amendment requiring all transfers from revocable trusts to anyone other than the grantor to be treated as gifts made directly from the grantor. Thus, such gifts would be excluded from the grantor's estate regardless of when made.

Conclusions

Until legislation is passed, the terms of a revocable trust instrument should be closely examined to determine the most appropriate structure for making gifts from the trust's assets. The powers given to the grantor/trustee in the instrument must be examined to determine if gifts made from the trust to third parties represent the exercise of such powers or the relinquishment of the grantor's revocable powers over the trust. If the instrument does not specifically prohibit distributions to third parties during the grantor's lifetime, the grantor/trustee would be best advised to withdraw the property from the trust and make an outright gift of it. This approach would ensure that no transfer tax is assessed on the post-gift appreciation of the property gifted, as well as make certain that the donor's annual exclusion is utilized where intended. Where third party distributions are specifically prohibited under the terms of the trust instrument, recent IRS and court rulings have held that gifts of trust property have been made directly by the grantor and are not subject to estate tax inclusion.

Margaret Conway, MBA, CPA, is an assistant professor at Kingsborough Community College.