IRC 2038: Revocable Transfers and Your Gross Estate

Many people make gifts during their lifetime to reduce the size of their eventual taxable estate. However, simply transferring an asset to someone else does not guarantee it will be excluded for federal estate tax purposes. Under Internal Revenue Code (IRC) Section 2038, if you give away property but keep significant control over it, the Internal Revenue Service (IRS) can include the value of that property in your gross estate.

The core issue is the retention of control. Even if a gift is considered complete for gift tax purposes when made, the strings attached can cause it to be viewed as incomplete for estate tax purposes. This means assets you thought were no longer part of your financial footprint could be included in the final calculation of your estate’s value, potentially increasing an estate tax liability. Understanding how these revocable transfer rules work is a component of effective estate planning.

Powers That Trigger Estate Inclusion

IRC Section 2038 is triggered when a person who has transferred property retains the power to alter, amend, revoke, or terminate the enjoyment of that property. The mere existence of one of these powers at the time of death is enough to cause the property’s value to be included in the gross estate. It is not necessary for the power to have been exercised, as the retained control makes the transfer incomplete.

A power to “alter or amend” is the ability to change the terms of the transfer. For instance, a grantor of a revocable living trust who names their children as beneficiaries but retains the right to change those beneficiaries holds a power to alter the enjoyment of the trust assets. This applies even if the change only affects the timing or manner of enjoyment, such as a power to decide if trust income is paid out immediately or accumulated.

The power to “revoke” is the ability to take the property back entirely, while a power to “terminate” allows the decedent to end the arrangement, which could accelerate the beneficiaries’ enjoyment of the property. This ability to control the timing of a gift is considered a significant degree of control. Because of these retained powers, assets in a common revocable living trust are not removed from the grantor’s taxable estate.

The rule applies whether the power is held by the decedent alone or in conjunction with another person, even if that person has an adverse interest. The source of the power also does not matter, as it can be stated in a document or arise from state law. If a decedent has the unrestricted power to remove a trustee and appoint themselves as the successor, they are considered to hold all the powers of that trustee. This can trigger inclusion if the trustee’s powers include the ability to alter, amend, revoke, or terminate.

Determining the Included Property Value

If a power covered by IRC Section 2038 exists, the next step is determining what value is included in the gross estate. The rule does not include the entire value of the transferred property. Instead, it targets the value of the specific property interest that is subject to the decedent’s power at the date of death, as the control might only affect a portion of the assets.

For instance, imagine a person creates a trust where the income is payable to one beneficiary for life, and the principal is designated to go to another beneficiary upon the first beneficiary’s death. If the creator of the trust, the grantor, retains the power to change only the income beneficiary but has no power over the principal, then only the value of the income interest would be included in the grantor’s estate. The value of the principal, which was irrevocably given away, would not be pulled back into the estate.

The rules also address conditional powers. If exercising a power requires giving notice or only takes effect after a set period, it is still considered to exist at death, though the included value may be adjusted for the delay. However, if a power is subject to a contingency beyond the decedent’s control that has not occurred by death, the property is not included. An example is a power that can only be exercised after the death of another person who is still living.

Relinquishment of Powers

Giving up a power that would trigger IRC Section 2038 is known as a relinquishment. While this action can complete the gift and remove the property from the gross estate, timing is a factor. If a decedent relinquishes a power to alter, amend, revoke, or terminate within the three-year period ending on the date of their death, the “three-year look-back rule” applies. Under this rule, the value of the property subject to the relinquished power is brought back into the gross estate as if the power had been retained until death.

This provision, found in IRC Section 2035, prevents individuals from avoiding estate tax by giving up control shortly before death. For example, if a grantor of a revocable trust amends it to become irrevocable two years before passing away, they have relinquished their power to revoke. Because this occurred within three years of death, the full value of the trust assets will be included in their gross estate.

An exception to this rule exists if the power was relinquished as part of a “bona fide sale for an adequate and full consideration in money or money’s worth.” If the decedent received fair market value for giving up their power, the property is not included in their estate. This is uncommon in most gift and trust situations, as relinquishment is done for estate planning rather than as a commercial transaction.

Interaction with Retained Interest Rules

The provisions of IRC Section 2038 often overlap with IRC Section 2036, which deals with transfers with a retained life estate. Both sections can cause transferred property to be included in a gross estate, but they focus on different types of retained “strings.”

IRC Section 2036 is triggered when a decedent transfers property but retains the enjoyment of it, the income from it, or the right to designate who receives them. The primary difference is that Section 2036 looks at retained benefits, while Section 2038 focuses on retained control. For example, transferring a house to a child but continuing to live in it rent-free would trigger inclusion under Section 2036. If the transfer document also allowed the parent to change the ultimate owner, Section 2038 would also apply.

When both sections apply, the IRS will use the provision that results in the largest inclusion in the gross estate. The amount included under each section can differ. For instance, a retained power to alter income distribution might only include the value of the income interest under Section 2038. In contrast, a retained right to receive that same income could cause the entire property value to be included under Section 2036. The interaction between these rules shows the tax code’s broad approach to capturing transfers where a decedent has not completely severed their connection to the property.