Section 2038: Revocable Transfers and Your Gross Estate

The federal estate tax is a tax on the transfer of a person’s assets after death. While making gifts during one’s lifetime can help manage the eventual size of a taxable estate, simply giving an asset away does not guarantee its exclusion from this calculation. Internal Revenue Code Section 2038 addresses this specifically. It dictates that if an individual transfers property but retains significant control, the Internal Revenue Service (IRS) can include that property’s value in the gross estate. Even if a transfer was considered a completed gift when made, these retained powers can pull assets back into the estate’s final valuation.

Understanding Revocable Transfers

Section 2038 applies when a person transfers property but, at death, still holds a power to change or undo the transfer. The existence of such a power is what matters to the IRS, not whether it was ever used. These powers are defined as the ability to “alter, amend, revoke, or terminate” the enjoyment of the transferred property. This power can be stated in a transfer document or arise from state law.

The most common illustration is the revocable living trust. When an individual, the grantor, places assets into a revocable trust, they often name themselves as the trustee and retain the right to take back any of the assets at any time. This right is a power to “revoke.” Because the grantor can reclaim the property, they have not fully relinquished control, and upon their death, the full value of the trust’s assets is included in their gross estate.

The powers to “alter” or “amend” have the same effect, involving the ability to change who benefits from the property or how they benefit. For instance, if a grantor creates a trust but keeps the right to change the beneficiaries, they have retained a power to alter the property’s enjoyment. This also applies to changing the timing of enjoyment, such as deciding a beneficiary receives their share at age 30 instead of 25.

A power to “terminate” a transfer, which ends the arrangement prematurely and accelerates when beneficiaries receive the property, also triggers inclusion. These powers must be distinguished from purely administrative ones. A retained power to direct a trust’s investment decisions does not cause estate inclusion, as it does not affect who gets the property or when.

Calculating the Estate Inclusion Amount

When a power covered by Section 2038 exists at death, the financial consequence is the inclusion of the asset’s value in the decedent’s gross estate. The amount included is the fair market value of the property interest subject to that power, determined as of the date of death. The rule does not automatically include the entire value of the transferred property; it specifically targets the portion over which the decedent retained control.

For example, an individual establishes a trust where income is paid to a sibling for life, with the principal passing to a niece upon the sibling’s death. If the trust’s creator kept the power to change who receives the income but not who receives the principal, only the value of the income interest is included in their estate. The principal’s value is excluded because it was not subject to the retained power.

If, in the prior example, the grantor had retained the power to revoke the entire trust, then the full fair market value of all the trust’s assets would be pulled back into the gross estate. The scope of the power directly dictates the amount of the inclusion.

Key Scenarios and Applications

Certain common situations can trigger Section 2038, sometimes in ways that are not obvious. These scenarios often involve the release of a power or specific types of gifts made to minors.

Relinquishment of Power

A person might relinquish a power to finalize a gift and remove an asset from their estate, but the timing is important. Under a “three-year rule” found in IRC Section 2035, if a power that would cause estate inclusion is given up within the three years before death, the property’s value is still included in the gross estate. This prevents individuals from avoiding estate tax with last-minute planning.

Jointly Held Powers

The inclusion rule applies even if the decedent did not hold the power alone. If the power was exercisable only in conjunction with another person, the property is still included in the gross estate. It does not matter if the other person had an adverse interest that would be harmed by the power’s exercise. The decedent’s ability to participate in the decision is what triggers inclusion.

Gifts to Minors

Gifts to children under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) can trigger inclusion. These custodial accounts hold assets for a minor until they reach the age of majority. If a parent transfers assets into an account for their child and names themselves as the custodian, they retain control over the property.

The parent-custodian has the power to decide when and how to use the funds for the child’s benefit, which the IRS considers a power to affect the time and manner of enjoyment. Should the parent-custodian die before the child reaches the age of majority and the custodianship ends, the account’s full value will be included in the parent’s gross estate.