As we continue to march toward the potential sunset of the Tax Cuts & Jobs Act, with the corresponding implications that such sunset will essentially cut the estate tax exemption, gift tax exemption, and generation-skipping transfer tax exemption in half on January 1, 2026 without government intervention, the discussion of the “reciprocal trust doctrine” as it relates to advanced estate planning transactions has become much more commonplace in the private wealth planning area. In general, the reciprocal trust doctrine is a rule that attempts to prevent certain tax avoidance through the structuring of trusts that are interrelated and ultimately place the trust’s beneficiaries in similar economic positions. This doctrine, which first surfaced in 1940 in the Second Circuit court case of Lehman v. Commissioner,[1] generally held that when multiple trusts have overlapping beneficiaries and donors, such trust can essentially be unwound by the IRS and ultimately cause significant tax consequences to the taxpayers involved in such estate planning transactions.
The Origins of the Reciprocal Trust Doctrine
The 1940 ruling within Lehman v. Commissioner set the stage for the application or threat of application due to the Court’s displeasure with two brothers creating trusts for each other, and their respective children and descendants upon their passing, where each brother thereafter gifted their equal shares in stocks and bond to the trust for the other brother. The Court noted the brothers’ transactions as a “trifle” and “quite lacking in “practical or legal significance” applying a law very similar to today’s Internal Revenue Code section 2028 in uncrossing such trusts upon the death of one brother: “While section 302(d) speaks of a decedent having made a transfer of property with enjoyment subject to change by exercise of power to alter, amend or revoke in the decedent, it clearly covers a case where the decedent by paying a quid pro quo has caused another to make a transfer of property with enjoyment subject to change by exercise of such power by the decedent.”[2] The end result was that the court treated each brother as the creator of the trust that was created for the brother, which ultimately pulled back the assets into their own estate for estate tax purposes: “A person who furnishes the consideration for the creation of a trust is the settlor, even though in form the trust is created by another.”[3]
The Impact of Estate of Grace and Estate of Levy on the Reciprocal Trust Doctrine
While Lehman v. Commissioner is the origin of the reciprocal trust doctrine, the most well-known case is U.S. v. Estate of Grace[4]—commonly referred to as “Estate of Grace”— which provided clarity to courts whose rulings were inconsistent for almost two decades. In such case before the United States Supreme Court, the taxpayer has created a trust for the benefit of his wife during her life and, upon her death, provided the wife a power of appointment to appoint the remaining assets to amongst the husband and their children. Shortly thereafter—fifteen days to be exact—the wife created a trust that Justice Thurgood Marshall described as “virtually identical”[5] for the husband’s benefit: “[W]e hold that application of the reciprocal trust doctrine is not dependent upon a finding that each trust was created as a quid pro quo for the other. Such a “consideration” requirement necessarily involves a difficult inquiry into the subjective intent of the settlors. Nor do we think it necessary to prove the existence of a tax avoidance motive… standards of this sort, which rely on subjective factors, are rarely workable under the federal estate tax laws. Rather, we hold that application of the reciprocal trust doctrine requires only that the trusts be 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.”[6]
Similar to Lehman v. Commissioner, the U.S. Supreme Court also “uncrossed” such trusts created by husband and wife pursuant to then Section 811(c)(1)(b) of the Internal Revenue Code which has been recodified as what we current know today as Section 2036.
Many taxpayers may find such court rulings to be quite unfair. Specifically, if our elected officials and the Internal Revenue Code provide taxpayers with estate, gift, and generation-skipping transfer tax exemptions that enable taxpayers to shelter the transfer of their assets either during life or upon death from wealth transfer taxes, why should the courts—with all due respect to Justice Thurgood Marshall—prevent taxpayers from using such exemption amounts to provide for their closest loved ones. In doing so, such courts and the reciprocal trust doctrine goes against one of the most famous tax quotes of all time by Judge Learned Hand in Helvering v. Gregory: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury… There is not even a patriotic duty to increase one’s taxes.”[7] Fortunately, for such taxpayers finding the reciprocal trust doctrine to be inherently unfair, the Estate of Levy v. Commissioner[8]—commonly referred to as “Estate of Levy”— perhaps scales back the application of such doctrine.
Within the Estate of Levy, a husband and wife created trusts for each other on the same day, with the same exact assets, and were essentially identical except for one provision; the trust for the benefit of the wife gave her a power of appointment over income and principal of the trust, whereas the trust for the benefit of the husband did not contain such provision. The Court found the “power of appointment had objective value which cannot be ignored,”[9] and thus, ruled in favor of the taxpayer and did not apply the reciprocal trust doctrine.
Reciprocal Trust Doctrine Implications for Estate Planning
While Lehman, Grace, and Levy are the most discussed cases on the reciprocal trust doctrine, there are other cases and IRS private letter rulings on the topic as well. Therefore, its application is still alive and well where the reciprocal trust doctrine still has significant implications for estate planning. The most notable impact is that it potentially prevents taxpayers from evading estate taxes by creating trusts that would otherwise seem independent. While creating a trust for estate planning purposes is a legitimate way to minimize estate taxes, the reciprocal trust doctrine espouses that taxpayers cannot use two separate, yet essentially identical, trusts to skirt those taxes.
For estate planning attorneys, such doctrine underscores the need for careful consideration when structuring trusts. If two trusts are created for similar purposes, with reciprocal benefits and powers, the IRS may challenge their validity under the reciprocal trust doctrine. As a result, practitioners must be cautious in structuring trusts that involve mutual or reciprocal arrangements between parties.
The Reciprocal Trust Doctrine Today
The reciprocal trust doctrine continues to be an important consideration in modern estate planning. It is particularly relevant when dealing with high-net-worth individuals who are looking to minimize estate tax exposure through complex trust structures. In light of the growing sophistication of estate planning strategies, it remains crucial for individuals and their advisors to be aware of the potential consequences of creating reciprocal trusts.
In practice, estate planners have found ways to structure trusts in a manner that avoids triggering the reciprocal trust doctrine. For instance, rather than creating identical trusts for each spouse, it may be advisable to introduce significant differences in the terms of the trusts, such as varying beneficiaries, powers of appointment, or trusteeship. Such distinctions can better ensure that the trusts are distinct in substance, preventing them from being uncrossed by the IRS. Regardless, it is highly recommended that taxpayers work with reputable tax and legal counsel when exploring such advanced estate planning transactions.
Read the full article here