What are the estate planning issues for the terminally ill?

Even though we avoid thinking about it, we would be wise to make plans in case we become sick, disabled, or otherwise incapacitated for a short or a long period. If you are terminally ill, now is the time to quickly put your plans into place. Regardless of your situation, there are three estate planning issues you should understand: (1) the three-year rule that applies to certain gifts you may have considered giving, (2) the Uniform Rights of the Terminally Ill Act that explains why you may want to adopt an advance medical directive for your health care, and (3) because the use of life actuarial tables is prohibited, you may not want to arrange an annuity.

What is the three-year rule?

Discourages deathbed gifts

The so-called three-year rule is a tax rule that discourages taxpayers from making certain gifts from their deathbeds by removing some of the usual gifting tax advantages.

A quick lesson on the federal estate tax system

To understand the three-year rule, you need a basic understanding of how the federal gift and estate tax system works. When you die, your estate (your assets and liabilities) may be subject to transfer taxes. One of these transfer taxes is the federal gift and estate tax. What follows is a brief lesson.

The federal gift and estate tax system is a unified system. In 1976, the IRS combined the gift tax system with the estate tax system. Before 1976, the gift and estate tax systems were separate. Gifts (i.e., taxable gifts) made during life were reported and any gift tax owed was paid on an annual basis. After death, estate tax was imposed only on transfers made at death (i.e., bequests or the gross estate).

Since 1976, taxable gifts are still reported and any gift tax owed is paid annually. Generally, you must file a gift tax return and pay any tax due by April 15 of the year following the year you make a taxable gift. However, at your death, all taxable gifts are added together with your gross estate for estate tax calculation purposes, even though a gift tax return may already be filed and a gift tax paid. The gift tax paid is deducted from estate tax owed.

By unifying the gift tax system with the estate tax system, lifetime gifts and transfers made at death are taxed using the same tax rates (under the Unified Tax Rate Schedule); an applicable exclusion amount can be applied to lifetime gifts and transfers made at death; and finally, estate tax imposed at death is computed by adding together lifetime gifts and transfers made at death, which pushes your estate into a higher tax bracket.

Why lifetime gifts are preferable to testamentary transfers

Even though the tax system is unified, there is still good reason to make lifetime gifts as opposed to testamentary transfers. Here’s why:

  • You take advantage of the annual gift tax exclusion — The annual gift tax exclusion allows you to give $16,000 (in 2022) per donee without incurring federal gift tax or federal generation-skipping transfer tax. This exclusion allows you to distribute your property tax free and potentially put your estate into a lower tax bracket. If you are married and both spouses are U.S. citizens who make a gift jointly, gift-splitting will double the annual gift tax exclusion.
  • You remove future appreciation from your gross estate — Testamentary transfers are valued at the time of death, whereas inter vivos transfers are valued at the time of the gift. If the property is appreciating, then the value at death may be higher, and therefore give rise to a higher tax.
  • You remove gift tax from your taxable estate — The tax you pay on lifetime gifts is tax-exclusive. The tax paid on transfers made at death is tax-inclusive. This means that funds used to pay tax on transfers made at death are included in your gross estate, whereas funds used to pay tax on lifetime gifts generally are not. You can save tax overall by making lifetime gifts because the amount of the tax you pay on those gifts is removed from your gross estate.

The three-year rule keeps you from avoiding estate tax

This tax rule brings back into your estate (for estate tax purposes) certain gifts you make in the three-year period before your death. The IRS considers that property you give away three years before you die is given away in contemplation of your death and to avoid estate taxes. Indeed, this was a common practice. So, the IRS adds these gifts back into your estate for purposes of evaluating the amount of your gross estate and any estate tax you may owe.

Applies to certain gifts only

The three-year rule does not apply to all gifts, but only certain transfers where ownership rights were not clearly abdicated or you retained certain control over the transferred property.

The following transactions undertaken within three years of your death and involving either the transfer of property or a relinquishment of powers over property will cause the affected property to be brought back into your gross estate:

  • Certain life insurance proceeds — The value of life insurance proceeds is includable in your gross estate if either at the time of your death or within the three years before your death, the proceeds were payable directly or indirectly to your estate, you owned the policy, or you possessed any incidents of ownership.

Example(s):   In 2018, Ken took out a life insurance policy naming his estate as the beneficiary. In 2020, Ken changed the beneficiary and owner of the policy to his daughter, Sue. Ken kept no incidents of ownership and then he died in 2022. The value of the proceeds is includable in Ken’s gross estate because his interest was transferred within three years of his death.

Technical Note:   Incidents of ownership is a legal term that means any right to benefit economically or control the policy (for example, name the beneficiary, surrender the policy, or borrow on its cash value).

  • Certain gift tax paid — Your gross estate must be increased by the amount of gift tax paid by you or your estate on gifts made by you and your spouse within the three-year period ending on the date of your death. Your gross estate also includes any federal generation-skipping transfer tax you pay on any direct skip-gifts you make at death.
  • Life estate — Property from which you retained the right to enjoy the property or the income from it (this right is called a life estate) is includable in your gross estate if owned at your death or within three years of your death. Certain other rights to control property, such as determining who gets distributions and when they receive them, can also cause property to be included in your gross estate.

Example(s):   Ken transfers title to his home to his sons, John and Fred, with the condition that he be allowed to remain in the home for as long as he lives. Ken dies. The full value of the home is includable in Ken’s gross estate because he retained an interest in the home and will be treated as if he still owned it.

  • Right of reversion — The right to regain property if the person to whom you have transferred it dies before you do, and this right is worth more than 5 percent of the value of the property. This property is includable in your gross estate if it is owned at your death or you transferred the property within three years of your death.

Example(s):   Dick signs over his stock in the power company to Martha for her lifetime. At her death, the stock is to revert to Dick if he is still alive. If Dick is not alive, the stock is to go their son, Frank. The value of Dick’s right is worth more than 5 percent of the value of the stock. Dick dies. The value of the stock is includable in Dick’s gross estate.

  • Powers of appointment — Includable in your gross estate are assets you have transferred where you alone or with certain others retain the right to designate who will possess or enjoy property or its income if the property is held at your death or within three years of your death. However, if you only have certain limited control over the property, it won’t be considered part of your estate (e.g., you only retain ministerial control over a trust or you can only exercise control with the consent of adverse parties or only under specified conditions).

What is the Uniform Rights of the Terminally Ill Act?

This is legislation that permits a competent adult to execute a declaration (witnessed by two individuals) to authorize a physician to withhold or withdraw life-sustaining treatment. Additionally, the act allows you as a competent adult to designate another person to make these medical decisions in case you become unable to make them for yourself.

This process has relieved many people who feel they would rather not have their life prolonged by extraordinary means if they become permanently unconscious or terminally ill.

Advance medical directives come in several forms and may be called by several different names. The ones you can use effectively depend on your state laws.

  • Living will — A living will allows you to approve or decline certain types of medical care even if your death will occur as a result. However, in most states, living wills take effect only under certain circumstances, such as terminal injury or illness. Generally, a living will can be used to decline medical treatment that serves only to postpone the moment of death.
  • Durable power of attorney for health care or a health-care proxy — A durable power of attorney for health care, also called a health-care proxy in some states, lets you appoint a representative to make medical decisions on your behalf. This representative has the authority to consent to or decline medical treatments for you. You decide how much power your representative will have.
  • A “Do Not Resuscitate” (DNR) order is a doctor’s order that tells all other medical personnel not to perform cardiopulmonary resuscitation (CPR) if you go into cardiopulmonary arrest. There are two types of DNR. One is effective only while you are hospitalized and the other is used by people outside the hospital.

Why is the use of life expectancy actuarial tables prohibited in certain circumstances?

Frequently, an interest in property is specifically set up to last for the duration of the owner’s life. The owner, however, may designate that the interest pass to someone else upon his or her death. This kind of ownership is tied to what is called a “measuring life,” either the owner’s or someone else’s. At any given time, then what is the value of the interest?

The IRS has adopted life expectancy actuarial tables to establish the value of such interests, which include annuities, interests for life or for a term of years, and remainder or reversionary interests. Generally, the remainder or reversionary interests are those received after some occurrence such as the present owner’s death.

Example(s):   Bob has an annuity that will pay him a set amount monthly when he reaches age 65 and continuing until he dies. The IRS will use its tables to determine the value of the annuity, based on general life expectancy.

However, if the person who is the “measuring life” is known to have an incurable illness or deteriorating physical condition with a 50 percent probability of not living for a year, the IRS cannot use those tables. Rather, the IRS values the interest based on the person’s actual life expectancy. If the individual is still alive 18 months later, the presumption is that he or she was not terminally ill. You can attempt to disprove this presumption, however.

Example(s):   Bob has the same annuity. However, Bob has a terminal illness, and there is a 50 percent probability that he will die within a year. The IRS will calculate the value of the annuity based on his actual life expectancy.

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