What pulls a trust back into an estate

In short

A friend of mine once gave away a fine piece of property and kept the keys in his pocket, and he never saw the trouble in that. If you have set up a trust to move wealth out of your estate, you have probably wondered whether it will hold. It will only hold if the giver truly lets go. A trust gets pulled back into the estate when the giver keeps certain strings, such as the right to use the property, the power to change who gets it, or the power to take it back. The tax code names these strings in Sections 2036 through 2038, and Section 2042 covers life insurance. Giving a gift also leads to a filing, so a gift tax return on IRS Form 709 matters. Ask a good estate lawyer to check every trust against these sections before the papers are signed. Letting go is the whole point.

The whole of it

What it is

I once watched an old farmer sell his barn to his son and then keep right on storing his own hay in it. Everybody in town knew whose barn it really was. The tax law sees things much the same way. When a person puts assets into a trust, the hope is that those assets and all their future growth leave the taxable estate. For a family with tens of millions, that can save a great deal of tax at death. The federal estate tax exemption is the current figure, which the official source publishes each year, and the top estate tax rate is the current figure, which the official source publishes each year. Both are set by law and can change by year.

The catch is that the law looks past the label on the paper. If the giver keeps enough control or benefit, the law treats the trust as if the giver never gave anything away. The assets are then counted in the gross estate, which is the total the tax is figured on. That is what people mean when they say a trust is pulled back into the estate. The trust still exists. It just no longer does its job.

How it works

You have likely heard that a gift is a gift, plain and simple. For estate tax purposes it is not so simple, and four parts of the Internal Revenue Code do most of the pulling back. Each one targets a different kind of string.

Section 2036 reaches property when the giver keeps the right to its income or its use. Suppose a man puts his lake house in a trust but keeps living there. The house comes back into his estate. The same holds if the giver keeps the right to say who gets the income, whether that right is held alone or together with someone else.

Section 2037 is rarer. It covers a gift that only takes hold if the giver dies first, and where the giver keeps a meaningful chance of getting the property back. It shows up in odd arrangements, so lawyers watch for it but meet it less often.

Section 2038 reaches property when the giver can change, end, or cancel the trust. A power to revoke is the plainest case. A power to change who gets what counts too, even if it can only be used with someone else's consent.

Section 2042 deals with life insurance. If the insured person holds any incident of ownership in a policy at death, the death benefit counts in the estate. An incident of ownership means a power over the policy itself, such as naming who gets the money, borrowing against it, or cancelling it. Many families use an irrevocable life insurance trust to keep the policy out of the estate. If the insured keeps a power over that policy, the plan fails.

There is also a timing rule. Under Section 2035, certain gifts made within three years of death are pulled back. This mostly touches life insurance and the release of powers that would otherwise have caused inclusion. A sick person who hurries to fix a trust may find this rule waiting.

The numbers, and where to find yours

Folks want a single number, and I wish I had one that fit everybody. The figures that matter here move with the law, so look them up fresh. The exemption is the current figure, which the official source publishes each year. The yearly gift exclusion is the current figure, which the official source publishes each year. The top rate is the current figure, which the official source publishes each year. Each is set by statute or adjusted by the IRS each year.

Your own numbers live in a few places. The trust document itself lists every power the giver holds. The gift tax returns you filed, on IRS Form 709, show what you used of your exemption. The policy owner records show who holds incidents of ownership on each life insurance contract. The IRS publishes the Instructions for Form 709 and the Instructions for Form 706, the estate tax return, and both explain how gifts and inclusion are counted. Some states also have their own estate or inheritance tax with a much lower threshold, so check your state tax agency too.

A worked example

Let me tell you about a man I will call Walter Haines. Walter is 68. He owns a business worth $40,000,000 and a vacation home worth $3,000,000. He sets up a trust for his two children and puts both in it.

In the first version, Walter names himself trustee and writes in a right to take back any asset whenever he likes. That is a power to revoke, so Section 2038 pulls everything back. The trust holds $40,000,000 plus $3,000,000, which is $43,000,000. All of it counts in his estate, and the trust saved nothing.

In the second version, Walter gives up the power to revoke. But he keeps the right to stay in the vacation home for life. Section 2036 now pulls back the house. The business, worth $40,000,000, stays out. The house, worth $3,000,000, comes back in. His taxable estate rises by $3,000,000 for that one string.

Now suppose the business grows. Walter dies fifteen years later and the business is worth $90,000,000. Because he kept no strings on it, that $90,000,000 stays outside his estate. The growth of $90,000,000 minus $40,000,000, which is $50,000,000, was never taxed in his estate. That is what a clean gift can do.

The top rate is the current figure, which the official source publishes each year. Apply that rate to the $3,000,000 of pulled back house, and the tax on that one string is the house value times the rate. Check the rate and the exemption on the IRS page for estate tax before relying on any such math. And remember that Walter reported his gifts on Form 709 when he made them. Gifts of this size still count against his exemption of the current figure, which the official source publishes each year.

Where it goes wrong

I have seen smart people trip on small things, and no one thinks less of them for it. Most of the trouble comes from a few spots.

The first is a quiet understanding. A giver says the trust is irrevocable, but the family all knows he can still use the money whenever he wants. Courts and the IRS look at what really happened, not only the words. An informal habit of drawing on the trust can be enough to support inclusion. Keep the habits as clean as the paper.

The second is a retained power over who benefits. A trustee who is also the giver, and who can decide who gets income, risks Section 2036. Naming an independent trustee usually keeps that string from forming.

The third is life insurance held in the wrong name. A policy that the insured owns, or controls in even a small way, is counted. The policy can also be moved into a trust late. Then the three year rule under Section 2035 may pull it back anyway.

The fourth is a gift that is not really complete. If the giver can still change the trust, the gift may be incomplete for gift tax and also included at death. Both problems come from the same retained power.

The fifth is assuming the trust works because it was expensive. A costly document with one stray power can fail. Price tells you nothing. Care does.

Questions to answer before you leave this page

If you gave assets to a trust, can you still use them, borrow from them, or direct who gets their income? Does any document let you cancel, change, or amend the trust, alone or with anyone else's consent? Who owns each life insurance policy, and who can change the beneficiary? Did you file Form 709 for each gift, and do your records show what you reported? Are you within three years of a change that could trigger Section 2035? Is the trustee someone other than you, and would the trustee act without your say? Has an estate lawyer read your trust against Sections 2035, 2036, 2037, 2038, and 2042? And does your state have its own estate or inheritance tax that works by different rules?