It seems strange to get penalized for dying, doesn’t it? If you really think about it, that’s what the IRS’s three-year rule does. At least, that’s how I explained it to a client who wanted to transfer a life insurance policy to someone else after his health took a turn for the worse and he was looking to minimize his estate tax. It turns out, even if he had transferred that policy, it still would have been counted as part of his estate because of the three-year rule. Luckily, we were able to help the client, but so many others don’t realize the risk they’re running when they transfer assets without thinking of the three-year rule. Prior planning is the key to getting by this tricky estate tax loophole.
What Is the Three-Year Rule?
The three-year rule is a way of preventing people from mass transferring their assets out of their estate to avoid imminent estate taxes. Consider the case of someone who is extremely property wealthy but cash poor, and has just learned they have a serious illness. They know that if they don’t reduce the size of their estate tax now, their heirs will have to liquidate their property to pay the tax later.
So this individual transfers property, or money, to a trust, hoping to get it out of their name. Then, within a few months of the transfer, they pass away. Unfortunately, at estate tax time, everything that the person transferred would still be considered part of their estate because it was transferred within the three years prior to their death.
Specifically, the three-year rule is covered under Section 2035 of the US tax code and is designed to prevent people from transferring ownership when death is imminent. In this section, they’re talking about something called a gratuitous transfer, or when a major asset is “bestowed or granted without consideration or exchange for something of value.” It mainly applies to deeds, contracts, and other contractual holdings of property or money. This includes life insurance policies.
In short, the three-year rule is a catch-all clause that could catch your heirs by surprise if you’re not transferring your holdings properly. One way to work around this rule is through life insurance trusts.
How Life Insurance Can Be Exempt from the Rule
Gifting or transferring life insurance would fall under the “gratuitous transfer” provision, meaning the three-year rule could apply. To avoid this, the policy can be sold to an irrevocable life insurance trust, which would remove the gratuitous transfer provision. The key here is that the sale would have to be a “bona fide sale for adequate and full consideration in money or money’s worth.”
This is often known as a “Sale to a Grantor Trust.” A grantor trust is one in which the insured remains the owner of the trust for tax purposes only, while still allowing the trust to remain outside of their taxable estate. In a way, the owner sells the life insurance policy to themselves. They loan the cash to the trust to buy the policy, then the trust buys the policy and becomes its owner, so when the owner passes away, the trust remains outside of their estate. While it helps to avoid the three-year provision, it can also be a complex process that’s filled with pitfalls.
Pitfalls of the ILIT
Keep in mind that on this grantor trust, the grantor of the trust only remains the owner for tax purposes. Any income generated from trust assets would be part of that grantor’s income for the year. Despite this ownership for tax purposes, the “owner” still has to avoid other incidents of ownership, such as having the right to change beneficiaries, borrowing against the policy, or using it as collateral. The insured loses the right to control the trust, but still has to handle taxes on it during their lifetime.
An alternative to doing one of these grantor trusts is to have the trust set up to purchase policies from the outset. In this case, the trustee would be the one who applies for a policy against the person’s life, pays the premium, and manages the beneficiaries and future payments. This bypasses the three-year rule entirely because the individual is never the named owner of the policies or the trust and does not have to transfer them.
Determining which one is right for you is a matter of hedging your life expectancy. For many, the risk of the three-year rule is minor and it’s fully expected they’ll outlive that provision. If you only have one policy to transfer and believe it’s unlikely the three-year rule will come into play, you could take the risk. However, if you intend to continue buying policies, your best bet is to establish the trust first and have it purchase policies on your behalf. Finally, if you are concerned about your ability to outlive the three-year rule, then a sale to a grantor trust is a bit more complex, but can be accomplished to work around that provision.
The best way to deal with the three-year rule is to get with a qualified professional who is well-versed in estate planning and estate taxes. Call us at 800-DIE-RICH to get more information on how life insurance trusts can reduce your taxable estate.