How to Avoid the Reciprocal Trust Doctrine

Often times when irrevocable trusts are created for the benefit of husband and wife, the “reciprocal trust doctrine” may rear its ugly head. The doctrine applies to trusts that have substantially identical terms and are part of the same transaction; such as when a husband and wife create two irrevocable insurance trusts at the same time.

Since most estate planning involves planning for the couple, husband and wife, the creation of mutually beneficial trusts is used to provide equal protection and equivalent benefits for each spouse. It is imperative that one apply careful planning to the estate and life insurance trusts in order to ensure sufficient differentiation between the terms of the various trusts used.

Careful planning must be adhered to in order to provide variation in the terms of the trusts as well as in the funding and timing of the execution in order to reduce the danger of creating reciprocal trusts.

The doctrine applies what is known as a substance-over-form approach to uncross transfers of interrelated trusts thus identifying the true transferor for purposes of the gift or estate tax. The doctrine relies heavy on the analysis of the facts and circumstances of each case. However, having said that, generally trusts are deemed reciprocal if they meet the two-prong test which includes interrelated and same economic position, developed by the U.S. Supreme Court in U.S. v. Grace.

Trusts are treated as interrelated if the analysis includes any of the following:

  1. Whether the trusts were created as part of a single transaction.
  2. The relationship between the Grantors.
  3. The date the trusts were created.
  4. The identity of the beneficiaries and trustees.
  5. The similarity between the trusts’ terms.

If a set of trusts can be proven to be reciprocal, then the doctrine will, in essence, defeat the estate and or gift tax benefits of the irrevocable trust planning. In order to preserve the tax planning benefits of the irrevocable trust, one must ensure the trusts are drafted to avoid reciprocal classification.

The second prong is same economic position. If the trust arrangement leaves the Grantors in approximately the same economic position, as if they had not created the trusts, then the test is passed. The Grantors need not receive a direct, personal or economic benefit for the reciprocal trust doctrine to apply; simply the retention of powers or indirect benefits will cause the doctrine to become operational.

In order to preserve the tax planning benefits of the irrevocable trusts, it is important to ensure that the reciprocal trust doctrine is not applicable. If it should become applicable, then it could defeat the estate and or gift tax benefits thus causing inclusion of the assets in the grantors’ estate or attributing gifts made by others to the grantors.

In order to limit the exposure of the doctrine, it is suggested that the following are incorporated within the trusts:

  1. Consider naming different remainder beneficiaries after the death of the beneficiary–spouse.
  2. Create the trusts at different points in time and, if possible, pursuant to different plans.
  3. Consider using different standards for trust distributions.
  4. Different trust powers under the trusts and use different trustees.
  5. Consider using a marital deduction trust in one trust but not in the other.
  6. Consider using a $5,000 or 5% withdrawal right in one trust but not the other.
  7. Vary the beneficiaries; such as creating a discretionary pot trust for the spouse and children in one trust and naming the spouse as the only beneficiary in the other trust.

Unfortunately there is no clear cut test in which to assess whether trusts are reciprocal under the doctrine. In an effort to make sure the doctrine does not apply, thus defeating the transfer tax benefits associated with irrevocable trust planning, make sure that the terms vary and the funding occurs at different times as does the execution of the trusts.