Estate planning attorneys utilize a number of different estate planning techniques to accomplish the goals of their clients and sometimes to minimize transfer taxes. One common estate planning technique is the transfer of assets into an irrevocable trust in a manner designed to remove the assets from the estate of the person establishing the trust (referred to as the “trustor” or “settlor” of the trust.)
The Reciprocal Trust Doctrine
The Internal Revenue Service (IRS) has historically attacked estate plans and trusts that remove assets from an estate. The IRS may scrutinize such a trust, applying a principle they call “substance over form.” In practice this means that the IRS will look at the totality of the facts and circumstances surrounding the creation of the estate plan to determine the real purpose of the trust and to determine whether the trust assets were effectively removed from the settlor’s estate.
A 1969 U.S. Supreme Court case, U.S. v. Estate of Grace, recognized the “reciprocal trust doctrine,” as an example of “substance over form” analysis. Separate trusts for husbands and wives are frequently set up simultaneously for estate planning purposes. The Court held that, where such trusts are interrelated and “the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as if they had created trusts naming them as life beneficiaries” (i.e., the settlers continue to enjoy the use and benefit of the assets during their respective lifetimes), the trusts and the assets within the trusts may be included in the settlor’s estate.
Illustration of the Application of the Reciprocal Trust Doctrine
To illustrate the application of the reciprocal trust doctrine, consider the following example: Husband and Wife visit an estate planning attorney and decide to create an irrevocable life insurance trust (ILIT) to own a life insurance policy on the life of Husband, intending to exclude the death benefit on the policy from Husband’s taxable estate. Their attorney prepares the ILIT for Husband’s signature as the settlor of the ILIT, and Wife’s signature as the trustee of the ILIT. Husband’s ILIT names Wife as the primary beneficiary of the ILIT during her lifetime, with their children as secondary beneficiaries after Wife dies.
Husband and Wife decide that they would like to acquire a life insurance policy on the life of Wife, but do not want to incur the additional attorney’s fee in having an ILIT created for the policy on the life of Wife. They decide that since the ILIT their attorney prepared contains the exact dispositive arrangement they have agreed upon, they will simply copy Husband’s ILIT, transposing the names of Husband and Wife, so that Wife will be the settlor of the ILIT and Husband will be the trustee of Wife’s ILIT.
Husband and Wife have just inadvertently triggered the reciprocal trust doctrine. The doctrine is invoked because the two ILIT’s have identical provisions. When each spouse dies, the assets in each trust will be includible in the deceased spouse’s estate, thereby defeating the primary purpose of establishing the ILIT’s in the first place. Husband and Wife’s attempt to save on attorney’s fees may ultimately cost them more in estate taxes.
When scrutinizing reciprocal trusts, the courts and the IRS have focused on the factors stated in the Estate of Grace opinion, such as whether the provisions and rights granted each spouse under their respective ILIT’s are the same or whether any retained economic benefits are too broad, rising to the level of a life estate. Where the provisions of each ILIT are different, the exclusion of the life insurance benefits from the estate has been upheld. The Grace Court made clear, however, that the intention of the parties was irrelevant. Trusts must be examined based on the provisions contained within the trust document, not what the parties intended.
Private Letter Ruling
In response to inquiries by taxpayers, the IRS may issue a “private letter ruling” (PLR), which is directed only to the taxpayer who requested it and may not be used or cited as precedent. PLRs can, however, give some insight into the reasoning and policies of the IRS on an issue. In a PLR dated March 10, 2004, the IRS ruled that ILIT’s created for a couple were not “interrelated” because they contained different provisions (e.g., in one ILIT there was a power of appointment that did not exist in the other ILIT). Hence the IRS was of the opinion that the reciprocal trust doctrine did not apply and the assets in the ILIT were not includable in the estate of either spouse. The IRS reached this opinion after carefully scrutinizing the language and provisions of both ILITs.