What Is Section 2035 and How Does It Impact Estate Taxes?

Estate taxes can be complex, and certain rules determine what is included in a taxable estate. Section 2035 of the Internal Revenue Code affects gifts made shortly before death and can have significant tax consequences for heirs.

Types of Transfers Covered

Section 2035 applies to asset transfers that impact an estate’s taxable value. One key category includes gifts made within three years of death. While gifts are generally excluded from estate tax calculations, this rule ensures that certain transfers remain taxable if they would have been included in the estate had they not been given away.

Another category involves relinquishing rights or interests in property. If someone gives up control over an asset—such as canceling a life insurance policy or removing themselves from a trust—this action may still count toward the estate’s value. The IRS closely examines these transactions to prevent individuals from artificially reducing their taxable estate.

Life insurance policies are particularly relevant. If a policyholder transfers ownership of a policy to another person or an irrevocable trust within three years of death, the death benefit may still be included in the estate. Since life insurance payouts can be substantial, this rule can push an estate above the federal exemption threshold, increasing tax liability.

The Three-Year Rule

Section 2035 requires that certain gifts or relinquished interests made within three years of death be added back into the taxable estate to prevent last-minute transfers designed to avoid estate taxes.

A key impact of this rule is on taxable gifts that exceed the annual exclusion limit. In 2024, the annual gift tax exclusion is $18,000 per recipient. If a gift surpasses this amount, it must be reported on a gift tax return (Form 709). If the donor dies within three years, the value of the gift is included in the estate, potentially increasing tax liability. This is especially relevant for estates near the federal exemption limit of $13.61 million per individual in 2024.

The rule also applies to certain prepaid expenses. If someone prepays legal fees or taxes related to their estate within three years of death, these amounts may still be counted as part of the estate.

Estate Inclusion Process

When an asset falls under Section 2035, its fair market value at the time of death—not at the time of transfer—is included in the estate. This is significant because assets like stocks, real estate, or business interests may appreciate in value. If a transferred asset increases in worth after being gifted but within three years of death, the higher valuation is used for estate tax calculations.

Estate administrators must review financial records to identify transactions subject to this rule. This includes examining bank statements, trust documents, and property deeds. The IRS may request supporting documentation to verify the timing and nature of these transfers. Proper recordkeeping is essential to ensure compliance and avoid disputes during estate settlement.

Life insurance proceeds also factor into estate valuation. If a policy was transferred to an irrevocable trust or another beneficiary within three years of death, the full death benefit is included in the estate. Since life insurance payouts can be large, this inclusion may push an estate above the federal exemption threshold, triggering estate tax liability.

Penalties for Non-Disclosure

Failing to disclose transactions subject to Section 2035 can lead to financial and legal consequences. The IRS requires full transparency in estate filings, and omissions—whether intentional or accidental—can result in audits, penalties, and interest charges. Executors and trustees must ensure all relevant transfers are reported to avoid disputes with tax authorities.

If an estate tax return (Form 706) omits assets that should have been included under Section 2035, the IRS may impose accuracy-related penalties of up to 20% of the underpaid tax under IRC 6662. In cases of fraud, penalties can rise to 75% under IRC 6663. Additionally, interest accrues on any unpaid tax from the original due date, increasing the total liability. This can be problematic for estates that have already distributed assets, as heirs or executors may be responsible for unpaid taxes.