Reciprocal Trust Doctrine – What Does Interrelated Mean?

Take-Away: As many married couples are currently encouraged to adopt spousal lifetime access trusts (SLATs) in order to use their applicable excluion amounts before those exclusions are reduced, either by Congress, or in 2026 when the large exclusion amounts are scheduled to sunset, they need to be warned about the reciprocal trust doctrine, which can destroy the tax savings sought with the use of a SLAT.

Background: In the conventional SLAT setting, one spouse (call him Ward) creates an irrevocable trust for his spouse (call her June) using his applicable exemption amounts (for gifts and for the generations skipping transfer (GST) tax.) June contemporaneously creates a trust for Ward, also using her gift and GST exemptions. The income generated by these two irrevocable trusts will be available to both Ward and June so long as they remain married. As such, their lifestyles will not be altered much, if at all, by the two trusts, yet all of the transferred assets (and future asset appreciation) will be removed from both Ward and June’s taxable estates. In sum two SLATs, one created for each spouse by the other spouse, would seem to produce fantastic transfer tax results.

Reciprocal Trust Doctrine: Under the reciprocal trust doctrine, the IRS will recharacterize the two trusts and treat them as if each spouse created a trust for herself or himself. Consequently, at the death of one of the grantor-spouses, the trust created by the deceased  grantor’s spouse will be treated as a self-settled trust and included in the deceased spouse’s taxable estate under IRC 2036. Following the above example, on Ward’s death, the value of the trust that Ward created for his wife June will be included in Ward’s taxable estate under IRC 2036.

–Trusts Interrelated-  Grace Case: The U.S. Supreme Court acknowledged and approved of the reciprocal trust doctrine in United States v. Grace, 395 U.S. 316 (1969.) In that case spouses created irrevocable trusts two weeks apart. The trusts contained nearly identical terms; each spouse was named as the income beneficiary of the trust their spouse had created for their benefit. On the first spouse’s death the IRS asserted that the spouse’s trust should be included in the decedent’s taxable estate. The Supreme Court agreed with the IRS that the trusts were interrelated. The Court observed that the trusts had substantially identical terms and were created at the same time. Based on these observations, the Court concluded that there was enough to treat the created trust as being included in the grantor’s taxable estate.

-Grace Test: The Court created a ‘test’ as to whether the reciprocal trust doctrine applies: (i) the trusts must be interrelated; and (ii) the arrangement, to the extent of mutual value, leaves the grantors in the same economic position as they would have been in had they created the trusts for themselves, i.e. a self-settled trust, thus triggering application of IRC 2036.

Other Court Decisions With Respect to the Doctrine: While the Supreme Court in Grace provided a ‘test’ as to when the doctrine will be applied, it still left much uncertainty about what minimum facts had to exist for the trusts to be considered interrelated. The following court decisions have provided more insight, but still no clear answers.

– Levy Case: The case of Estate of Levy v. Commissioner, 62 Tax Court 32 1977 WL 3667 (1977) was a ‘big win’ for taxpayers. In Levy, the spouses created trusts on the same day and funded the trusts with an identical number of shares of stock in the same corporation. Each spouse was a life beneficiary and trustee of the trust their spouse created for their benefit. Both trusts named the spouses’ son as the sole remainder beneficiary. Despite all of these trust provisions which were identical, the Tax Court concluded that the two trusts were not interrelated. The Tax Court focused on the fact that in one trust the grantor gave to the beneficiary-spouse an inter vivos limited power of appointment, while in the other trust the beneficiary-spouse was not given a comparable limited power of appointment.

– Bischoff Case: The case of Estate of Bischoff v. Commissioner, 46 Tax Court Memo, 910 (1983) was a win for the IRS. In that case, neither spouse had any economic interest as a trust beneficiary. Rather, each spouse had created an identical irrevocable trust for their grandchildren. Each spouse named the other as trustee of the trust she and he had created. The Tax Court treated the trusts as if each spouse had named himself or herself as trustee, and therefore they had retained an IRC 2036(a)(2) right to designate the persons who would enjoy or possess the trust property, thus triggering estate inclusion of the value of the trust’s assets.

– Green Case: The case of Estate of Green v. United States, 68 F.2d 151, (6th Cir. 1995) was a taxpayer victory due to the absence of any retained economic benefit. There, each spouse created a trust for one granddaughter with their spouse named as trustee. The other spouse created an identical trust for another granddaughter with their spouse named as trustee. The court of appeals found that the couple’s powers as trustee did not constitute a retained economic benefit; accordingly, the reciprocal trust analysis did not apply.

IRS Private Letter Ruling: The latest indication of the IRS’s point of view on the doctrine is found in PLR 200426008. There, each spouse created an irrevocable life insurance trust in which they named their spouse as trustee. The trusts contained many identical provisions, but the trusts also differed in many respects, including: (i) the husband’s trust for his wife gave his wife several additional powers, including lifetime and testamentary powers of appointment; (ii) in the trust for the wife, the husband did not become a beneficiary unless he was living three years after wife’s death, and he had a right to distributions only if his net worth or income fell below specific dollar amounts. The IRS concluded that these differences were sufficient to concluded that the trusts were not interrelated.

Practical Considerations: If a married couple is seriously considering creating SLATs, then some pretty obviously planning steps should come to mind:

1. The trusts should be created at different times, so as to not appear to be part of one common plan;
2. The trusts should have different assets, although Levy suggests that this is not a critical distinction;
3. The trusts should not have identical provisions, such that the beneficial interests held by the spouses should be meaningfully different. Examples include:

– one spouse is a discretionary beneficiary, while the other spouse is a beneficiary subject to an ascertainable standard;

– one spouse is given a 5+5 power of withdrawal while the other does not have any power of withdrawal over the trust created for their benefit;

– one spouse is a discretionary beneficiary of trust income only, while the other trust permits discretionary distributions of income or principal;

– one trust vests the trustee with discretionary distribution powers and uses an independent trustee, while the other trust permits the beneficiary spouse to act as trustee, subject to a health, support, or maintenance distribution standard;

– as noted in the PLR, one spouse is given a limited testamentary power of appointment while the other spouse’s trust does not contain any power of appointment; or

-tie one spouse’s right to receive trust distributions to their income or to specified net worth ceilings, while the other spouse’s trust has no limitations that would preclude their right to receive distributions from their trust.

Conclusion: While there is some guidance provided by the court cases and the PLR as to when trusts will be considered to be interrelated, the test announced in Grace is still subjective. To be in the best situation to avoid application of the reciprocal trust doctrine, it would be best if one of the trusts does not provide for the other spouse at all, but that would seldom be acceptable to the spouses planning to use both of their available applicable exclusion amounts. The next best step would be to leave plenty of time between when the two SLATs are created, and if possible, use a different trustee for each, perhaps with an independent trustee for one SLAT. Finally, it appears that using different powers of appointment (lifetime v testamenary) or different classes of appointees would provide a distriction that would make the two trusts non-reciprocal.