IRC 2037: Transfers Taking Effect at Death

Internal Revenue Code Section 2037 is a federal estate tax rule that includes certain lifetime property transfers in a decedent’s gross estate. The provision applies when the beneficiary’s possession or enjoyment of the gifted property is contingent upon surviving the person who made the gift.

This rule prevents avoiding federal estate tax through lifetime gifts that function like inheritances. The Internal Revenue Service (IRS) examines these gifts to see if they were structured to only take full effect upon death. If a transfer meets a specific set of conditions, the property’s value is brought back into the decedent’s estate for tax calculation purposes.

The Survivorship Requirement

A primary condition for Internal Revenue Code (IRC) Section 2037 to apply is the survivorship requirement. For this rule to be triggered, the beneficiary must be able to obtain the property only by outliving the person who made the transfer (the decedent). This establishes a direct link between the decedent’s death and the beneficiary’s ability to take control of the asset.

Consider a scenario where an individual transfers property into a trust, with the terms stating, “income to my sister for her life, and upon my death, the remainder to my nephew if he is then living.” The nephew’s right to the property is entirely dependent on him surviving the decedent, satisfying the survivorship requirement.

The requirement is not met if the beneficiary has an alternative path to ownership that could occur during the decedent’s lifetime. For example, if a trust allows a beneficiary to receive property upon either the decedent’s death or upon reaching the age of 30, the condition is not satisfied. Because the beneficiary could take possession by reaching a specific age while the transferor is still alive, the transfer falls outside the scope of this test.

The Reversionary Interest Requirement

In addition to the survivorship condition, a transfer falls under IRC Section 2037 only if the decedent retained a “reversionary interest” in the property. This is a possibility that the property could return to the decedent or their estate, or that the decedent could control its disposition. The interest must be in the property itself, not just the income it generates.

A reversionary interest can be created expressly or by operation of law. An expressly retained interest is written into the legal document, such as a trust or deed. For instance, a trust might state, “to my son for life, then to his children. If my son dies without any children, the property shall revert to me.”

Another example is a transfer “to my spouse for life, then to me if I am living at my spouse’s death, otherwise to my daughter.” This retained possibility of getting the property back is also an express reversionary interest.

A reversionary interest can also arise “by operation of law,” meaning it is created automatically by the transfer’s legal structure, even if not stated. This occurs when a document fails to account for all contingencies. For example, a trust pays income to a child for life and then distributes the property to grandchildren. If the document fails to state what happens if the child dies without grandchildren, the property may revert to the decedent’s estate, creating a reversionary interest.

The definition of a reversionary interest also includes a retained power of disposition. This means the decedent kept the right to control who ultimately receives the property, even if they could not get it back themselves. For example, if a trust allows the grantor to change the remainder beneficiary, this power is treated as a reversionary interest.

Valuing the Reversionary Interest

Even with a survivorship condition and a reversionary interest, a third test must be met. The rule applies only if the value of the decedent’s reversionary interest, measured just before death, exceeds 5% of the transferred property’s total value. This test excludes cases where the chance of the property returning to the decedent was minimal.

This valuation is determined using actuarial methods prescribed by the IRS, not guesswork. The calculation uses mortality tables and life expectancies of the relevant individuals to compute the present value of the reversion. The valuation is made without regard to the actual fact of the decedent’s death.

For example, a decedent transferred property into a trust valued at $1,000,000 at their death. The trust stated the property would revert to the decedent’s estate if a younger beneficiary did not survive an older individual. To apply the 5% test, an actuary would calculate the statistical probability of this sequence of deaths.

If this calculation resulted in a value of $60,000, it would represent 6% of the total property value. Since 6% is greater than the 5% threshold, this condition would be met. If the value had been $40,000 (4%), the test would not be met, and Section 2037 would not apply.

Amount Includible in the Gross Estate

When all three conditions of Section 2037 are met, the value of the transferred property is included in the decedent’s gross estate. A common misunderstanding concerns the amount included. The entire value of the property interest subject to the survivorship condition is included, not just the value of the reversionary interest.

The full date-of-death value of the property is reported on the estate tax return. For instance, in the previous example, the transfer of a $1,000,000 property with a $60,000 reversionary interest results in the inclusion of the full $1,000,000 in the gross estate. The $60,000 value is only used to determine if the 5% test is met; it does not define the inclusion amount.

The included amount may be adjusted for preceding interests not affected by the survivorship condition. For example, consider a trust where income is payable to a spouse for life, and the remainder passes to a child only if the child survives the decedent. If the spouse outlives the decedent, the value of the spouse’s life estate is subtracted from the total property value, and only the remainder interest is included in the gross estate.

Planning to Avoid Section 2037

Careful estate planning can prevent the application of IRC Section 2037. The main strategy is to structure transfers to break one of the three required conditions. The most direct method is to eliminate any possibility of the property returning to the transferor or their estate, which addresses the reversionary interest requirement.

This is done by ensuring the transfer document, like a trust, accounts for all contingencies. For example, the document can name a final, contingent beneficiary, such as a charity, instead of allowing the property to revert if all other beneficiaries die. Naming a charity as the ultimate recipient can eliminate the reversion or make its value so remote that the 5% test cannot be met.

Another technique is the lifetime disposition of a retained reversionary interest. A grantor who has retained an interest that could trigger Section 2037 can sell or gift that interest. To be effective, this transfer must occur more than three years before the grantor’s death, due to the “three-year look-back rule” under IRC Section 2035. By disposing of the reversionary interest and surviving for at least three years, the grantor ensures the conditions for inclusion under Section 2037 cannot be met at the time of their death.