How Can I Avoid the Three-Year Rule on the Transfer of a Policy?

Situation: I’m often confronted with the situation where an individual has purchased a policy on his or her life and retained an “inci­dent of ownership” causing the proceeds to be included in his or her taxable estate. To avoid estate inclusion the insured may seek to transfer the policy to an ILIT. Unfortunately, certain transfers of life insurance within three-years of an insured’s death continue to be included in an insured estate and are subject to estate tax.

 This has caused advisors to ask, “Are there strategies for avoiding or minimizing the application of the three-year rule in the situation where an insured wants to transfer a policy, he or she owns to a life insurance trust or third party?” This Counselor’s Corner describes strategies to undo this error.

Solution: Before we identify strategies to undo or minimize application of the three-year rule, it’s first helpful to have a general un­derstanding of when the rule applies.

When Does the Section 2035 Transfer Within Three-Years Rule Apply? Section 2035 originally required that all gifts made within three years of a donor’s death be pulled back into his/her gross estate.1 The Economic Recovery Tax Act of 1981 repealed this all-in­clusive version of the three-year pullback rule, replacing it with one that applies to certain narrowly defined transactions. One of the transfers where the three-year rule continues to apply is the transfer of life insurance.

Application of the three-year rule to transfers of life insurance was initially clouded in controversy. Today its application is clear in most situations. The consensus is that Section 2035 requires that life insurance proceeds be included in a decedent’s gross estate only where:

• The policy is on the decedent’s life and the decedent had a power or interest in the life insurance within the meaning of Section 2042 (policy is payable to, or for the benefit of, the insured’s estate, or the insured had an “incident of ownership” in the policy) at some time during the three-year time period before his or her death;
• There was a transfer of an interest in the policy within three years of the decedent’s death; and
• The transfer was for less than full and adequate consideration in money or money’s worth.

 Transfers Not Subject to Section 2035. It’s clear that a life insurance policy is includable in a decedent’s gross estate under Section 2035 only if the policy would have been included under Section 2042. For Section 2042 to apply the policy must be made payable to, or for the benefit of, the estate, or the decedent must have an “incident of ownership” in a policy on his or her life.

Consequently, the following common transfers are not subject to the three year estate inclusion rule under Section 2035:

• Where a decedent transfers a policy that he or she owns on the life of another and dies within three years of the transfer, neither the cash value or death proceeds are included in the decedent’s estate.
• Likewise, if someone other than the decedent/ insured owns the policy, the proceeds are excluded from the insured’s estate even if the insured makes a cash gift to the owner who uses the cash to purchase a life insurance policy.
• Of course, where the decedent/insured outlives the three-year pullback period and has divested himself/ herself of all rights, powers or interests in the policy, none of the proceeds will be includable in his or her gross estate under Section 2035. This is true regardless of whether the insured continued to pay the premiums.

Where an individual possesses an “incidents of ownership” in a policy on his or her life there are basically two alternatives for removing the policy from the estate – to sell the policy or to gift it away. Each strategy has its issues.

Gift of an Existing Life Insurance Policy. If an individual gifts a policy he or she owns on his or her life and continues to pay premiums and dies within three years of the transfer, the full death proceeds will be included in the insured’s gross estate. In this situation, it may be possible to exclude a proportionate share of the proceeds included in the insured’s gross estate if the donee (the third-party recipient) pays some of the premi­ums out of his or her own separate funds after the transfer. The portion excluded bears the same relationship to the total policy proceeds as the premiums paid by the donee bears to the total premiums paid. Thus, one strategy to lessen application of the three-year rule is to have the donee pay the premiums from his/ her separate funds after the transfer.

Sale of Policy to a Third Party for “Full and Adequate Consid­eration.” The three-year estate inclusion rule does not apply to a “bona fide sale for adequate and full consideration in money or money’s worth.” This exception presents an opportunity to sell an existing life insurance policy to avoid the three-year rule.

However, unless a policy is sold for an amount at least equal to the policy’s fair market value, the transaction will fail to meet the “bona fide” sale exception, resulting in estate inclusion under IRC § 2035 if the insured dies within three years. The problem: What constitutes adequate and full consideration?

While the IRS has issued regulations and rulings on the valuation of life insurance, there still remains a great deal of uncertainty as to what measure of value to use in many situations, including transfers subject to the three-year inclusion rule. In addition, the variety of elements that make up an insurance product, the differences in the health of the insured and other circumstances mean the same type of life insurance policy may have different values.

For example, for gift tax purposes, the regulations provide that the value of an unmatured life insurance policy that has been in force for some time and on which premiums are still being paid is the interpolated terminal reserve plus unearned premium. However, it does not necessarily follow that the gift tax regula­tions will be used when reviewing the adequacy of consideration for the “bona fide sale” exception for estate tax purposes. The IRS’s position in private letter rulings has been inconsistent.

In Technical Advice Memoranda (TAM) 8806004 the IRS held that consideration paid for a policy is not adequate for purposes of the three-year rule, unless it is equal to the face amount of the policy. The TAM relied on United States v. Allen, which held that the sale of a retained life estate for its gift tax value under the IRS’s tables did not constitute adequate and full consideration. Many advisors question whether this retained interest valuation rationale is appropriate when valuing the outright sale of a life insurance policy.

In a more recent letter ruling where a husband and wife creat­ed a new trust that purchased joint survivor policies from two pre-existing trusts for an amount equal to the interpolated termi­nal reserve plus unearned premium, the IRS concluded that the purchase of the policies was for adequate and full consideration and met the bona fide sale exception. Again, in private letter rul­ing (PLR) 199905010, where a corporation sold a policy it owned on the majority shareholder to the shareholder’s children for “the greater of its interpolated terminal reserve value or its cash value,” the IRS concluded that the transfer met the adequate and full consideration standard for purposes of the bona fide sale exception. Thus, the most recent position of the IRS appears to acknowledge that the Allen rationale is not applicable to the sale of a life insurance policy.