Is an Irrevocable Trust Included in Gross Estate?

An irrevocable trust is a financial tool where a person, the grantor, transfers assets to a trustee to manage for beneficiaries, surrendering control and ownership. For federal tax purposes, the gross estate is the total value of all assets a person owns or has an interest in at death. Assets placed within a properly structured irrevocable trust are not counted in the grantor’s gross estate. However, this exclusion is not absolute, as specific rules can cause trust assets to be pulled back into the gross estate, potentially creating a tax liability.

The General Rule of Exclusion for Irrevocable Trusts

The principle allowing an irrevocable trust to be excluded from a gross estate is the grantor’s complete relinquishment of control. The grantor must give up all rights to reclaim, amend, or benefit from the transferred assets, creating a distinct legal separation. This action reduces the size of the taxable estate by moving assets out of the grantor’s direct ownership. The Internal Revenue Service (IRS) will include the trust’s assets in the gross estate if it finds evidence that the grantor retained any connection or control over the property.

Conditions Causing Inclusion in the Gross Estate

While the goal of an irrevocable trust is often to remove assets from an estate, certain retained interests or powers by the grantor can negate this benefit. The Internal Revenue Code (IRC) outlines specific scenarios where trust assets are pulled back into the decedent’s gross estate. These provisions focus on situations where the grantor’s transfer of assets was not absolute, leaving them with some form of control or benefit.

Retained Interests and Powers

Under IRC Section 2036, if a grantor transfers property but retains the right to use, possess, or enjoy that property, or the right to its income, the property’s full value is included in their gross estate. A common example is a grantor transferring their primary residence to an irrevocable trust but continuing to live in it without paying fair market rent. In this case, the grantor has retained the “enjoyment” of the property, and the IRS will include the home’s value in their estate.

Similarly, IRC Section 2038 targets retained powers to alter, amend, revoke, or terminate the trust. Even if the grantor cannot take the assets back for themselves, holding the power to change the beneficiaries or alter their shares is a sufficient level of control to cause inclusion. For instance, if a grantor creates a trust for their children but retains the power to add a new beneficiary later, the value of the assets subject to that power will be included in the grantor’s gross estate.

Reversionary Interests

Another condition for inclusion falls under IRC Section 2037, which deals with reversionary interests. A reversionary interest is a possibility that the trust property could return to the grantor or their estate. This might happen if the trust document states that the assets will revert to the grantor if all named beneficiaries pass away before the grantor does.

For this rule to trigger inclusion, two conditions must be met. First, the beneficiaries’ enjoyment of the property must be contingent on them surviving the grantor. Second, the value of the grantor’s reversionary interest, calculated immediately before their death, must exceed 5% of the value of the transferred property. If both conditions are satisfied, the assets are brought back into the gross estate.

The Three-Year Look-Back Rule

The IRS also scrutinizes actions taken shortly before death through the “three-year look-back rule” under IRC Section 2035. This rule prevents grantors from avoiding estate tax by giving up certain rights or assets just before they die. If a grantor relinquishes an interest or power over property within three years of death, and that interest would have otherwise caused inclusion, the property’s value is still included in the gross estate.

For example, if a grantor gives up a retained right to trust income one year before death, the rule applies. The IRS will treat the situation as if the right was retained until death, pulling the trust’s value back into the taxable estate. This rule also applies to transfers of life insurance policies within three years of death.

Special Considerations for Life Insurance Trusts

An Irrevocable Life Insurance Trust (ILIT) is an estate planning tool designed to own a life insurance policy and keep the death benefit out of the grantor’s gross estate. When structured correctly, the proceeds can pass to beneficiaries free of federal estate tax. The effectiveness of an ILIT hinges on the grantor avoiding any “incidents of ownership” over the policy, as defined by IRC Section 2042. If the grantor retains any such incidents at death, the life insurance proceeds will be included in their gross estate.

Incidents of ownership are economic rights in the policy, and the grantor must sever all of them to shield the proceeds from estate tax. These rights include the power to:

• Change the policy’s beneficiaries
• Surrender or cancel the policy
• Assign the policy or revoke an assignment
• Pledge the policy as collateral for a loan
• Borrow against the policy’s cash value

The three-year look-back rule is relevant for ILITs. If a grantor transfers an existing life insurance policy into an ILIT or gives up any incidents of ownership, they must survive for three years after the action. If the grantor dies within that period, the death benefit will be included in their gross estate. For this reason, it is often advised that the trustee of the ILIT purchases a new policy directly.

Reporting an Included Trust on the Estate Tax Return

When an irrevocable trust’s assets must be included in a gross estate, the executor reports them on Form 706, the U.S. Estate Tax Return. These transfers are detailed on Schedule G, Transfers During Decedent’s Life. This schedule is for assets the decedent transferred but over which they retained some control or interest.

The executor must list any included trust on this schedule, providing a description of the trust property, the trustee’s name and address, and the trust’s creation date. The value of the trust assets as of the decedent’s date of death is also required. This value is then added to the total gross estate on the main part of Form 706. Failure to report these assets can lead to an understatement of the gross estate and potential penalties.