Reciprocal Trust Doctrine: Beware!
The Reciprocal Trust Doctrine is an IRS rule that prevents tax payers from gaming the system. Take, for example, the following hypotheticals:
Two spouses each make an ILIT (Irrevocable Life Insurance Trust) benefitting the other. They each purchase insurance policies worth $1 million with the other as a beneficiary. The life insurance policies are kept out of their respective estates and the other spouse benefits accordingly.
Two spouses each form a SLAT (Spousal Lifetime Access Trust) benefitting the other. They each form a trust with the other spouse as beneficiary and deposit $1 million into the respective trusts. This removes $1 million from each of their estates and allows them each to benefit in the same amount.
Two brothers each have a child. Brother A gifts to his child and Brother B's child $15,000 – the maximum annual gift exclusion. Brother B does the same. Each child thereby receives $30,000, and nobody needs to pay taxes on the gifted amounts.
Each person was able to double dip into the tax exclusions to their benefit. It would seem that nobody broke any rules to do so, except for the Reciprocal Trust Doctrine.
What is the Reciprocal Trust Doctrine?
The Reciprocal Trust Doctrine is a doctrine created by the Courts in 1969 in United States v. Estate of Grace. It developed a theory wherein the IRS would look to the substance of a transaction over its form. This was done:
“[T]o prevent taxpayers from transferring similar property in trust to each other as life tenants, thus removing the property from the settlor's estate and avoiding estate taxes, while receiving identical property for their lifetime enjoyment that would likewise not be included in their estate.”
The Court developed a two part test. First, look to see if the parties involved end up in the relative same position as they did pre-transaction. If they are, then second, determine whether the trusts are interrelated. It matters not whether there was intent to do a quid pro quo, only that the two elements had been met.
How does one tell if trusts are interrelated?
There is no set test as to whether two trusts are interrelated. The courts, instead, look to several different factors. Two more recent cases, the Estate of Levy v. Commissioner of Internal Revenue, and the Estate of Shuler v. Commissioner of Internal Revenue are instructive. The cases identify the following relevant factors:
If the trusts were created at approximately the same time or on about the same date.
If the trusts were created with identical terms.
Whether the trusts have the same trustees.
Whether the primary beneficiaries are related to the grantors.
If the trusts traded equal shares of stock.
If the stocks traded stock of identical type.
Whether the trusts were apparently made pursuant to a prearranged plan.
These are in addition to any other factors that creative minds have argued to be relevant.
Takeaway
There is a lot of flexibility in estate planning. Intelligent minds have a lot of room to take advantage of some creative strategies. But one can push the envelope too far. The Reciprocal Trust Doctrine is an example of this – the IRS putting a stop people gaming the system. Strategic trust drafting can hopefully avoid some of the pitfalls of the Reciprocal Trust Doctrine, but there are no guarantees. If you have questions as to whether your current estate plan complies with the Reciprocal Trust Doctrine, contact Signature Law for a free consultation.