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Planning to Avoid Application of the Reciprocal Trust Doctrine

This article appeared in the December 2012 edition of the Nassau Lawyer

With the “fiscal cliff” looming on the near horizon, practitioners are wary of the overwhelming possibility that the estate tax exemption and lifetime gift tax exemption will be dramatically reduced for the year 2013 and beyond. As a prudent and prophylactic planning measure, estate planners are using Spousal Lifetime Access Trusts (SLATs) to take advantage of the current $10,240,000 lifetime gift tax exemption for married couples.

The SLATs solve two issues: they allow the spouses to gift assets in the current favorable regulatory climate while retaining indirect control over the assets to fund their golden years or use in case exigent circumstances arise. For many wealthy couples, however, a SLAT formed by both spouses for the benefit of each other proves to be the most advantageous solution for tax purposes. While mutual SLATs allow for gifting the maximum amount of assets, they are also ripe targets for I.R.S. scrutiny due to a heretofore obscure offshoot of the substance-over-form principle called the Reciprocal Trust Doctrine (RTD).[1]

Though federal case law regarding the RTD began as early as 1940,[2] its development in the years since has been scant,[3] leaving estate planners with little guidance in structuring mutual trusts to avoid the RTD. The Supreme Court decision sanctioning the use of the RTD by the I.R.S.[4] and a handful of subsequent cases provide only a nebulous framework in which to operate, but fortunately, some of the rulings were decidedly taxpayer-friendly. Below, I apply those rulings and draw from expert commentary to list several methods a planner may use to best ensure that any attempt by the I.R.S. to apply the RTD is unsuccessful.

Differentiate the funding of each trust in terms of both asset nature and asset value. The standard set by the Supreme Court in Estate of Grace, which is still good law, is an “interrelatedness” test that examines whether the mutual trust arrangement “leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.”[5] To best avoid the application of this standard, planners should fund each SLAT with a variety of assets,[6] and the total value of the principal in each SLAT should be substantially different. While the dearth of authority precludes the prescription of a concrete percentage difference between the values of each trust, I feel uncomfortable in my own practice suggesting a gap of any less than 20%.

Designate independent trustees for each trust. The RTD can also apply if the trustees are reciprocal, even if the trusts themselves are not, provided that there is a “basis for taxation” of the grantors due to a retained economic interest when the trusts are “uncrossed” by the RTD.[7] The way to guarantee avoidance of this problem is by designating an independent trustee, preferably an institution, over whom the grantor and beneficiaries cannot exert any influence. If the client is not amenable to the designation of an institutional trustee for financial or other reasons, a trusted friend or distant relative is a much better alternative than a sibling, child, or other close relative.

Vary the powers available to trustees and beneficiaries in each trust. In one particularly favorable case for taxpayers, the Tax Court held that two otherwise identical spousal trusts were not reciprocal because one of the trusts had an inter vivos special limited power of appointment.[8] To be safe, practitioners should vary as many powers as possible among each trust, considering many avenues are available to do so. Among the options to add contrast to the trusts are distinguishing trustee removal powers, termination dates, powers of appointment, standards of distribution (e.g. health, education, maintenance, and support) and powers of distribution (e.g. a “five and five” power).[9]

Separate the creation of each trust by as much time as practically possible. One of the main areas of analysis in each federal court case regarding the RTD has been the time frame within which the trusts were created.[10] Current circumstances may make a large separation impracticable, but a difference of as few as 15 days between the establishment of each trust may have an effect in the event of litigation.[11]

In spite of the lack of authority available to practitioners to guide them, the foregoing measures allow estate planners to shield their clients as much as possible from I.R.S. and Tax Court scrutiny when structuring gifts for 2012. I have little doubt that in the coming years, subsequent decisions will serve as guideposts to forming more certain planning techniques, which will prove quite useful if another golden gifting opportunity presents itself.



[1] The Supreme Court first gave its imprimatur to “substance over form” in Gregory v. Helvering, 293 U.S. 465 (1935).
[2] Lehman v. C.I.R., 109 F.2d 99 (2nd Cir. 1940).
[3] See, e.g., Elena Marty-Nelson, “Taxing Reciprocal Trusts: Chartering A Doctrine’s Fall from Grace,” 75 N.C. L. Rev. 1781, 1786-1787 (1997).
[4] U.S. v. Estate of Grace, 395 U.S. 316 (1969).
[5] Estate of Grace, 395 U.S. at 324.
[6] In both Estate of Grace and Estate of Bischoff v. C.I.R., 69 T.C. 32 (1977), it was problematic for the taxpayer that both trusts contained the same securities in the same or only slightly different amounts.
[7] Estate of Bischoff, 69 T.C. at 46, n. 16.
[8] Estate of Levy v. C.I.R., 46 T.C.M. (CCH) 910, 911 (1983).
[9] Jed C. Albert, Planning for 2012 and Beyond: Issues Raised by 2012 Exemptions, Estate Planning Council of Nassau County (September 20, 2012).
[10] See, e.g., Estate of Grace, 395 U.S. at 318-319.
[11] Bruce D. Steiner & Martin M. Shenkman, Beware of the Reciprocal Trust Doctrine, Trusts & Estates, April 2012, at 17.
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