Reciprocal Trust Tax Trap

A popular strategy allowing for family members, i.e., parents, siblings, or spouses, to create a trust for the benefit of each other in very identical terms in order to benefit the other spouse in a like manner may cause the trust to be disqualified for tax purposes. The Reciprocal Trust Doctrine states, as an example “If a husband creates a trust for his wife and the wife then creates a nearly identical trust for the husband, then the two trusts may be uncrossed and thus treated for tax purposes as if each spouse had created a trust for himself or herself.

In today’s world where the estate tax exemption available per spouse is equal to $5,120,000 or $10,240,000 combined for a husband and wife, it is extremely tempting to make gifts on behalf of children and grandchildren. However, many high net worth clients are not comfortable in transferring such large sums as they might need those assets someday into the future. It is possible, however, that either spouse or both may establish trusts that are located in asset protection jurisdictions in an effort to allow the transferor to remain a discretionary beneficiary.

By way of example, it is possible for the husband to establish a trust for the benefit of his spouse and issue contributing $5,120,000 to the trust. This trust will look and feel like a credit shelter or bypass trust except that it will be created during life rather than at the time of death of the husband. At the same time, the wife can also create a trust for the benefit of her husband and issue and contribute $5,120,000 to that trust.

If both trusts have nearly identical language, then the Reciprocal Trust Doctrine trap could be sprung, thus causing the gifting to those trusts to backfire and the entire $5,120,000 per trust to be brought back into the estate at the time of death for estate tax purposes.

The first Reciprocal Trust case reported was reached by the Second Circuit Court in 1940 in Lehman v. Commissioner where there were two brothers who each settled a trust for the other brother and his descendants. The courts listed three stipulations when they determined that the trusts were reciprocal and therefore resulted in estate tax exclusion. Those three stipulations were:

  1. The parties were left in the same economic position they were before the trusts were established because each brother created a trust for the other brother and his descendants;
  2. There was a similarity of trust provisions (i.e., the trust were interrelated); and
  3. There was a quid pro quo (i.e., consideration) for each brother to create a trust for the other brother.

Through the years, several other courts of claims came to similar but yet a little different conclusion. The Seventh Circuit and the Third Circuit only had two requirements: 1) the parties were left in the same economic position; and 2) the trusts were interrelated. So while these cases did not provide precise language for the term interrelated, in general terms interrelated meant some combination of the following components were present:

  1. The trusts were created at approximately the same period of time;
  2. The trusts had substantially identical terms;
  3. The trusts had the same trustee;
  4. The trusts were funded with the same assets.

The Supreme Court stepped in to resolve the conflict under the court case U.S. v. Grace wherein they stated that trusts only need to be:

  1. Interrelated; and
  2. Creation of the trusts put them in the same economic position (reciprocal beneficiaries).

The Supreme Court also held that the IRS did not have to prove that there was quid pro quo when the trusts were created.

One of the traps that many estate planners unwittingly incur is that they misconstrue the notion of “trust creation at the same time.” These planners will have one spouse settle the irrevocable trust in the current year while the second spouse will settle the trust in another year. As explained in the case law, the real factor is whether the trusts were created pursuant to the same plan. A distance in time, such as a couple of years, provides some evidence that the trusts were not part of the same plan; however, if in the original planning stages it was contemplated and intended that two trusts would be set up, then the fact that the trusts were created one or two years apart would probably have little bearing since the factor of creating the trusts is part of the “same plan” would be met. So while Grace holds that only two factors are needed to prove the trusts are interrelated, subsequent law seems to allow other factors to also conclude that trusts are interrelated such as in Kraus in the Seventh Circuit, following Grace, held that the trusts with reciprocal beneficiaries were interrelated because 1) the trusts were created on the same day, i.e., part of the same plan; 2) the trusts contain substantially identical provisions; and 3) the trusts named the same trustee.

The second case after Grace was Exchange Bank & Trust. Here the listing factors in an effort to meet interrelated by the Court of Appeals expanded the literal language of Grace stating that the Reciprocal Trust Doctrine was in essence a “substance over form” argument. This may imply that the Doctrine could well be applied outside of the two Grace requirements needed to prove that trusts were interrelated. In addition the Exchange Bank & Trust court referred to the fourth factor under prior case law to determine whether the trusts were interrelated. That is where the same asset was contributed to both trusts.

So, in summary, if you were to look at the cases prior to Grace and after Grace, this is what you would come up with:

Grace provides the following two-prong test:

  1. The Settlors must be left in the same economic position; and
  2. The trusts must be interrelated.

Cases subsequent to Grace appear to use the following same four factors as articulated by cases prior to Grace:

  1. Created under the same estate plan;
  2. Substantially identical terms;
  3. The same trustee is appointed on both trusts; and
  4. The trusts are funded with the same assets.

Though, as you can see, prior to Grace it was uncertain if one factor might carry more weight; however, under Grace the first two factors when combined prove to be fatal.

Planners must take into consideration that breaking just one of the first prongs relating to reciprocal beneficiaries really only accomplishes half of the goal. Therefore, it is important to also break the second prong of interrelated trusts.

In an effort to avoid the Reciprocal Trust Doctrine, unfortunately there is no bright line or safe harbor as to what clearly constitutes a sufficient difference between two trusts. Therefore, in an effort to avoid the Reciprocal Trust Doctrine, the best approach is to make the trusts as different as is practicable under the circumstances. Here are some alternative methods for differentiating trusts:

  1. When drafting the trusts, make sure that you use different plans. A separate memorandum or portions of a memorandum dealing with each trust separately may support this;
  2. If possible try not to put the husband and wife in the same economic position following the establishment of both trusts;
  3. Use a different distribution method in each trust;
  4. Use different trustees or co-trustees;
  5. Give one spouse a noncumulative five-and-five power but not the other;
  6. Give one spouse a special power of appointment (POA) but not the other. The negative to this approach is that the absence of a POA will reduce the flexibility of the trust and this might be a significant deterrent to creating the trust in light of the continued estate tax uncertainty;
  7. Give one spouse the broadest possible special POA and the other spouse a special POA exercisable only in favor of a narrower class of appointees;
  8. Give one spouse a POA exercisable both during lifetime and by will and the other only by will;
  9. In the case of insurance trusts, include a marital deduction savings clause but not the other;
  10. Create different vesting provisions for each trust;
  11. Give the beneficiaries control or a different degree of control at different ages as opposed to mandating distribution;
  12. Vary the beneficiaries;
  13. Create the trusts at different times even though in Lueders which preceded Grace where the trusts were created two weeks apart, the Supreme Court held that the motive for creating the trusts wasn’t relevant. Unfortunately, the closer we get to the end of 2012 in an effort to preserve the $5,120,000 Gift Tax Exemption, the more difficult it will be to have any form of meaningful time difference;
  14. Contribute different assets to each trust. As an example, if one trust is funded with illiquid assets or assets subject to contractual restrictions that may be viewed as a more meaningful difference since the assets may not be susceptible to ready modification.

Remember the trap of uncrossing trusts means that the money in the Reciprocal Trusts will be treated as if it benefits the person from whom it came. In other words, the reciprocal nature of the trusts will be undone. If this should happen after one of the reciprocal trust creators dies, which is typically when it does happen, the results will be devastating since there will be no opportunity to pursue any effective estate tax strategies. Hence it is critical that you utilize an experienced, professional estate planner in an effort to avoid having trusts uncrossed and the devastation of paying estate taxes that at one point you thought were not going to have to be paid.