When an individual dies, estate taxes may apply to the transfer of the individual’s property at death. The estate tax is a tax on the transfer of the estate from the deceased person (decedent) to their beneficiaries. The tax is imposed on the estate itself, not upon the beneficiaries. The total tax owed is calculated by adding up the fair market values of all the decedent’s assets (real and personal property) as of their date of death.

Before they die, individuals may seek to reduce the amount of estate tax, by making gifts to others. Making gifts reduces the total value of the estate. Therefore, if the estate tax applies at death, then it will apply to an estate whose value has been reduced by the amount of the gifts. A smaller estate is subject to a smaller amount of estate tax, than is a larger estate.

Tax laws prohibit individuals from “gifting” their entire estate, if the gifts are made sufficiently close to the date of death. This prohibition is designed to prevent “escapes” from having to pay estate taxes.

How Does Tax Law Treat Gifts Made Within Three Years of Death?

Under federal tax law, if an individual makes a gift of property within three years of the date of their death, the value of the gift is included in the value of the gross estate (total dollar value of the estate at death). A gift made during the lifetime of the person who makes it, is caused an “inter-vivos” gift (gift between living persons).

Gifts, like estates, are subject to tax. The person who makes the gift must pay the tax – not the person who receives the tax. The amount of gift tax paid by a decedent while they are alive, is also included in the value of the estate.

When an individual makes a gift, the first $15,000 of the gift is not taxed. In other words, the first $15,000 is excluded from tax (this exclusion is referred to as the “gift tax exclusion”; the amount of the exclusion is set by law and may change from year to year). If a gift exceeds $15,000 in value, then the value of the gift that exceeds $15,000 will be subject to a gift tax. The percentage of that tax may range from anywhere from 18% to 40% of the value of the gift that exceeds $15,000. 

The amount of the gift tax paid, will be included in the value of the decedent’s estate, if the gift that was taxed, was made within 3 years of the date the decedent died.

The gift itself is only included in the total estate value, to the extent the gift is more than $15,000. Therefore, if a gift is made within 3 years of death, and the gift is worth $25,000, only $10,000 of the gift – the amount above the sum excluded from tax – is included in the gross estate. The gross estate, as discussed above, will also increase by the amount of the gift tax paid on the gift.

Are There Exceptions to the Rule for Gifts Made Within Three Years After Death?

To avoid having the value of a gift from being included in the gross estate, an individual can set up  a revocable trust. A revocable trust is also referred to as a “living revocable trust.” This type of trust is created by an individual, known as a “settlor,” during the settlor’s lifetime.

Typically, the settlor may cancel or revoke the living revocable trust as they choose. Generally, if the settlor wishes to control the assets of the trust during the rest of their life, then they may do so.

If a settlor continues to control the trust assets until the settlor dies, the assets of the trust are included in the value of the estate. As such, these assets are subject to estate tax. The law regards trust assets that were within the actual control of the settlor at death, as assets of the estate.

There is one circumstance under which the three-year rule – the rule requiring the amount of a gift made by someone within 3 years of death to be included in an estate – does NOT apply. IF the settlor of the revocable trust makes a gift of the trust assets to another person during the settlor’s life, then the value of the gift(s) will not be included as part of the gross estate. The value of the gift will not be included as part of the gross estate even IF the gift is made within three years of the Settlor’s death.

Do I Need an Attorney If I Am Dealing with a Gift Made Within Three Years After Death?

Tax law and estate law can be very complicated, especially when they overlap and apply at the same time. If you are dealing with tax issues due to a gift made within three years after death or if you have questions about taxes that you may face while estate planning, then you should consult with a wills, trusts, and estates lawyer  A lawyer near you can advise you as to what options you have to limit the tax liability on your estate at the time of your death.