The classic case scenario is a married couple that wants to avoid or reduce estate tax. They decide to each create and fund an irrevocable trust, such as an irrevocable insurance trust¹ or an irrevocable gift trust². This planning could take place in any county and any state. For example, Chris a resident of Cherry Hill, Camden County, New Jersey, creates and funds a trust that pays all of its income to Chris’ spouse, Jamie. Upon Jamie’s death, the remainder passes to their two children. At the same time, Jamie creates an identical trust, one that pays all of its income to Chris, and upon Chris’s death, the remainder passes to their two children. The ultimate goal of such a transaction (before the application of the reciprocal trust doctrine) – is that the assets of neither trust is included in the gross estate of either Chris or Jamie at their death, thus reducing or avoiding the federal and state transfer taxes.
So what just happened in this scenario? Each trust grantor (or trust settlor) created a trust with identical terms for the benefit of the other trust grantor. The two trusts are interrelated in that they are between spouses (however, this scenario would be the same had Chris and Jamie been brothers,³ sisters, partners, family members, etc.). The goal of the creating these trusts was obviously for a tax benefit – they wanted to reduce their taxes. The transfer leaves the grantors in the same economic situation as they were in before the transfer, meaning that they are receiving a lifetime income benefit. Though there are different trusts, it is as if Chris and Jamie had created trusts for themselves.
So what is wrong with this transaction? The IRS caught on with this tax avoidance technique and the reciprocal trust doctrine was born. The Court in U.S. v. Estate of Grace, 395 U.S. 316 (1969) formulated the test for the reciprocal trust doctrine. In Grace, the decedent husband executed a trust instrument, in which the trustees were directed to pay trust income to decedent’s wife during her lifetime, as well as a part of the principal. The wife then executed a trust instrument that was virtually identical to that of decedent. At decedent’s death, the IRS determined that decedent and his wife had created “reciprocal trusts” and that the value of the trust created by the wife was includible in decedent’s gross estate. The decision was disputed. The Court formulated the following test to apply to situations where the trusts are “interrelated, and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.”4
So what would the consequences be? Uncross the transfer. “Uncrossing” the trusts would treat the taxpayer as the transferor of the trust for his or her benefit. The value of the trust property would be included in the transferor’s estate, and thus, subject to tax at his or her death. Taking the example from above with Chris and Jamie, when “uncrossing” is applied, Chris would be deemed the grantor of the trust created by Jamie for Chris’s benefit, and Jamie would be deemed the grantor of the trust created by Chris for Jamie’s benefit. In most cases, if you create an Irrevocable Trust for yourself, it is included in your taxable estate. By Uncrossing, the trusts are brought back into the taxable estate.
What are ways to avoid the application of the reciprocal trust doctrine to your irrevocable insurance trust or irrevocable gift trust? There is no one way to avoid the reciprocal trust doctrine’s application, and a skilled Will drafting attorney should be your guide. Each case will be unique given the facts and circumstances surrounding the family and the assets. Examples of some techniques our will drafting attorney’s have used include: adding children to one trust as permissible beneficiaries but not to the other, having different lifetime powers in each trust, having different trustees in each trust, having a special trustee in one trust but not in the other, having different funding for each trust, varying timing of document execution for each trust, adding power of appointment to one trust but not to the other, and many others. The reason we vary these different key features is that the trusts must not be mirror images of one another. They must contain differences so that your economic position before and after the gifts to the irrevocable trust is not the same. These drafting differences must be done correctly or the trust will be included in the grantor’s taxable estate, so consulting with an experienced estate planning lawyer is essential.
Throughout our website, klenklaw.com, you may find more information about Irrevocable Trusts, tax planning and many other estate planning tools. Our firm focuses exclusively in the area of estate planning, probate, and the litigation surrounding estate planning and probate including Will Contests and Will Challenges. If you need assistance in developing your Estate Plan please call one of our Estate Planning Lawyers for a free consultation. Estate Planning is all our Will drafting lawyers do!5
¹ This refers to an Irrevocable Trust designed specifically for removing Life Insurance from the grantor’s Federal Taxable Estate, commonly called an “ILIT”, or Irrevocable Life Insurance Trust. For example, if a person from Medford, Burlington County, New Jersey wished to remove a life insurance policy from his estate for Federal and New Jersey Estate Tax Purposes, he could form an Irrevocable Trust, which could purchase life insurance on his life.
² This refers to an Irrevocable Trust designed to hold assets other than Life Insurance to remove the asset from the taxable estate. For example, if a resident of Doylestown, Bucks County, Pennsylvania wished to remove his Pocono Mountain vacation home from his federal taxable estate and Pennsylvania Inheritance Taxable estate he could form an Irrevocable Trust and transfer the deed into this trust.
³ Lehman v. Comm’r, 109 F.2d 99 (2nd Cir.), cert. denied, 310 U.S. 637 (1940) (similar case involving brothers where the court found that the decedent’s gross estate included property of which the decedent had made a transfer to his brother, to extent that the decedent, at the date of his death, had the power to alter, amend, or revoke its enjoyment).
4 Grace, 395 U.S. at 324.
5 The Law Offices of Peter Klenk has Will drafting attorneys licensed in New York, Pennsylvania, New Jersey, Florida and Minnesota.