In 1981 with the passage of the Economic Recovery Tax Act (ERTA), Section 2035 of the Internal Revenue Code was amended so that most gifts made within three years of death were no longer pulled back into the estate.  The 3-year rule was not eliminated completely, however.  Transfers of life insurance within three years of death can still cause inclusion of the death benefit in the estate and transfers of the "strings" under IRC Sections 2036, 2037 and 2038 that cause estate inclusion can cause a pull back. 

Also, any gift tax paid within three years of death is pulled back into the estate.   The reason for this gift tax rule is that the federal estate tax is a tax inclusive tax and the gift tax is a tax exclusive tax.  These examples illustrate the point:

Gift:         Donor has $150; transfer tax rate is 50%. Donor can give $100 to donee and pay $50 gift tax.

Bequest:       Decedent dies with $150; transfer tax rate is 50%. Decedent can leave $75 to beneficiaries and pay estate tax of $75. 

Without the 3-year pull back for gift tax paid with 3 years of death, one could cut the federal transfer tax payable by 1/3 simply by transferring everything days or moments before death.  OK.  So, decedent made taxable gifts and paid gift tax within three years of death.  Gift tax is brought back into the estate.  Who pays the estate tax on the gift tax?

See Gary Freidman’s blogpost about  Matter of Rhodes, __ Misc.3d __, __ N.Y.S.2d __, 2008 NY Slip Op 28472 (Sur. Ct. Westchester Co. 2008), where the issue was whether donees of gifts made within three years of death are responsible for paying estate tax attributable to the inclusion of the gift tax paid on such transfers.

The Court held that the donees of the gifts made within three years of decedent’s death are responsible for paying their ratable share of the estate tax attributable to the inclusion of the gift tax paid.  Ouch!  

Here is what the tax clause in the will said:

All inheritance, succession, transfer and estate taxes . . . payable by reason of my death in respect of all items included in the computation of such taxes which shall have passed under the provisions of this Will, shall be paid by my Executors as follows:

(A) All taxes with respect to property passing under this Will shall be apportioned in accordance with the law of New York, notwithstanding the foregoing, I direct that any such taxes resulting from the bequests under Clauses SECOND, THIRD and FIFTH of this Will shall be paid by my Executor out of my residuary estate, without apportionment or reimbursement from any beneficiary.

(B) I intend that all taxes described in paragraph (A) of this Clause with respect to property passing outside of the provisions of this Will shall be apportioned in accordance with the law of New York . . ..

(D) I wish to record that I have given great consideration as to how I have directed that the taxes described in paragraph (A) of this Clause are to be paid with respect to property passing under and outside my Will and to whom I have burdened with the payment of such taxes. I believe that the provisions which I have arrived at are equitable for all of my family members.

Looks like the decision is correct.  The gift tax paid certainly didn’t "pass under the terms of the will."   Another reminder to be very careful with tax clauses.