Section 2037: Transfers Taking Effect at Death
Understand how the value of certain lifetime gifts may be included in a taxable estate if the transfer only takes full effect upon death.
Internal Revenue Code Section 2037 addresses certain lifetime transfers that are not fully completed until the transferor’s death. This provision is designed to prevent federal estate tax avoidance by including the value of certain gifted property in a decedent’s taxable estate. It specifically targets transfers where the beneficiary’s possession or enjoyment of the property is delayed until the person who made the gift has passed away. This rule allows the Internal Revenue Service (IRS) to review gifts made during a person’s life and determine if they functioned more like an inheritance than a completed gift. If a transfer meets specific criteria, its value is pulled back into the gross estate for tax calculation purposes.
Conditions for Estate Inclusion
For a transfer to be included in a decedent’s gross estate under Section 2037, several conditions must be met. First, the transfer must have been made for less than “adequate and full consideration,” meaning it was a gift or partial gift. Second, the beneficiary’s ability to possess or enjoy the property must be dependent on them outliving the transferor. This is the survivorship requirement, such as a deed granting property to a niece only if she is living at the time of the grantor’s death.
If a beneficiary could have obtained the property through other means, such as reaching a certain age, the survivorship condition is not met. The final requirement is that the decedent must have retained a “reversionary interest” in the property. This interest, which is the possibility of the property returning to the decedent or their estate, is subject to a specific valuation test.
The Reversionary Interest Test
A reversionary interest can be explicitly written into a transfer document or arise by operation of law. For instance, if a person transfers property into a trust and the document states the property reverts to the transferor if the beneficiary dies without heirs, that is an express reversionary interest.
A strict mathematical test applies. The value of the reversionary interest, calculated just before the decedent’s death, must be greater than 5% of the transferred property’s value. This 5% rule excludes transfers where the chance of the property returning was minimal. A 4% or 5% possibility is not enough to trigger inclusion; it must definitively exceed 5%.
This valuation is based on actuarial principles and mortality tables from the IRS under Section 7520, using factors like age and interest rates. For example, the value of a 70-year-old’s reversionary interest would be low if it depended on outliving a 40-year-old child. However, the value could exceed 5% if the reversion was based on outliving an elderly individual.
Determining the Amount Included
If a transfer meets all conditions of Section 2037, the entire value of the interest contingent on surviving the decedent is included in the gross estate. A common misconception is that only the value of the reversionary interest itself is included.
The amount included is the property’s fair market value at the decedent’s death or the alternate valuation date. The 5% rule acts as a switch: if the interest’s value is 5% or less, nothing is included. If it exceeds 5%, the entire value of the property is pulled into the estate. For example, if a decedent transferred a $2 million property and retained a 6% reversionary interest, the full $2 million is included in the gross estate.
Reporting on the Estate Tax Return
An executor must report a transfer includible under Section 2037 on Form 706, the U.S. Estate Tax Return. These transfers are reported on Schedule G, “Transfers During Decedent’s Life.”
On Schedule G, the executor must list each includible transfer separately. The description should include the recipient’s name, the transfer date, and a complete description of the asset.
A supplementary statement must also be attached to Form 706. This statement must provide the transfer’s full details and explain its inclusion under Section 2037. It should outline the facts proving the survivorship condition and detail the calculation showing the reversionary interest exceeded the 5% threshold.