Throughout 2020, as many tax attorneys and their clients continuously worried about potential changes in federal transfer tax laws that could result with an administration change, numerous articles were published and webinars held regarding spousal lifetime access trusts (SLATs) and the interplay of SLATs and the reciprocal trust doctrine. With the likelihood that the Biden administration will seek to rollback the exemption amounts for the estate, gift and GST tax as provided under the 2017 Tax Cuts and Jobs Act, it is important to keep in mind that an analysis of the reciprocal trust doctrine should also be on the checklist when creating irrevocable life insurance trusts (ILITs) for spouses.
What is the Reciprocal Trust Doctrine?
In summary, the reciprocal trust doctrine is a judicially created principle that acts to deter estate planning where two trusts are created with terms that allow spouses to retain beneficial enjoyment of assets while excluding many if not all of those assets from their gross estates for estate tax purposes.
The key Supreme Court decision on the reciprocal trust doctrine is U.S. v. Estate of Grace. In that case, the Court created two requirements for interpreting the validity of trusts that might run afoul of the reciprocal trust doctrine. For the doctrine to apply, the trusts created must be interrelated, and the arrangement must leave the two grantors in approximately the same position as if they had just created the trusts and named themselves as beneficiaries. The Court ordered the trusts at issue in Estate of Grace uncrossed because they contained almost identical terms, were created very close in time to one another (15 days), were part of a single transaction, and left the parties in the same economic position they would have been in otherwise.
The Tax Court added to the reciprocal trust doctrine in Estate of Bischoff. There the Court, citing Estate of Grace, found that where a husband and wife created two trusts, each naming the other spouse as trustee and their grandchildren as beneficiaries, the trusts should be uncrossed. The key element of interrelatedness was the fact that the husband and wife were given the discretionary right to make income and principal distributions. This power was enough to cause inclusion after the trusts were uncrossed.
Another important case in the reciprocal trust doctrine landscape is Estate of Levy. The court concluded that where a special power of appointment was used in one trust, but not the other, the trusts were not interrelated and therefore not to be uncrossed. It should be noted that the trusts in question had the spouses as trustees of one another’s trusts, and their son as the beneficiary. The spouses were not the beneficiaries of the trusts. And, the court did not specifically address whether the reciprocal trust doctrine applied. The resolution of the case was based on the IRS’s stipulation that they would not apply the reciprocal trust doctrine if the special power of appointment was used.
Does the Reciprocal Trust Doctrine Apply to ILITs?
Moving now to the IRS’s application of the reciprocal trust doctrine to ILITs in particular, Zaritsky & Leimberg have noted that while ILITs are not exempt from the reciprocal trust doctrine, there are not many cases or rulings applying the reciprocal trust doctrine to ILITs, and the rule rarely applies to them. One of the few rulings on this issue, PLR 200426008, provides that the reciprocal trust doctrine was not applicable where the two ILITs at issue had a few important differences. One key difference was the fact that the wife’s trust made the husband a beneficiary only if his net worth fell below a certain amount after the wife had been deceased for two years. This was a substantial difference in the terms of the trusts, as opposed to other more minor differences that were also present. The result in PLR 200426008 is consistent with the general notion held by commenters that “there are several difficulties in applying the reciprocal trust doctrine more broadly to life insurance trusts.”
Bearing the above in mind, it is important to note that while there may be some difficulties in applying the reciprocal trust doctrine to ILITs, “life insurance trusts are not immune from the reach of the reciprocal trust doctrine.” Specifically, “if a husband and wife create reciprocal life insurance trusts and each serve as the trustee for the trust of the other, the IRS may (but has not yet done so), seek to impute to the first deceased insured the incidents of ownership held by the surviving spouse over the policy on the insured’s life.” For ILITs, then, the best way to draft a trust that will not invite reciprocal trust doctrine scrutiny is adding differences in the trusts that bypass the interrelatedness prong of the reciprocal trust doctrine:
“The safest approach to avoiding even an argument of reciprocal trusts is to create two trusts that give the spouses distinctly different interests. While one spouse may be trustee of the other’s trust, there should be an independent trustee of at least one trust while both spouses are alive. Furthermore, the beneficiaries of the two trusts should be somewhat different. Perhaps, for example, one trust could give the surviving spouse a mandatory income interest and right to invade principal subject to an ascertainable standard, while the other could create a sprinkling trust in favor of the surviving spouse and descendants.”
In terms of clear and concise safe harbors for differences that can be inserted into the terms of two ILITs to avoid the reciprocal trust doctrine, there does not appear to be straightforward guidance from the IRS or the Courts. That being said, one heavily cited secondary source provides a number of suggestions on terms one might include in ILITs that could provide protection from the “interrelatedness” prong of Estate of Grace:
a. Draft the trust pursuant to different plans
b. Avoid putting husband and wife in the same economic position after the trusts are established
c. Use different distribution standards in each trust
d. Use different trustees or co-trustees
e. Give one spouse a noncumulative “5 and 5” power, but not the other
f. Give one spouse a special power of appointment, but not the other
g. Give one spouse a broad power of appointment, and the other a narrower power of appointment
h. Give one spouse a power of appointment exercisable during life and by will, and the other a power of appointment only by will
i. For insurance trusts, include a marital deduction savings clause in one, and not the other
j. Create different vesting provisions for each trust
k. Give beneficiaries varying degrees of control instead of mandating distributions
l. Vary the beneficiaries
m. Create the trusts at different times (15 months)
n. Contribute different assets to each trust (by value or nature)
What should Practitioners when recommending the use of ILITs for spouses?
In summary, there is no exemption from the reciprocal trust doctrine for ILITs. However, there are drafting techniques one can use to become more comfortable that the reciprocal trust doctrine will not pose a problem for a pair of spousal ILITs. Additionally, as a generality it seems that the service is somewhat less inclined to apply the reciprocal trust doctrine to ILITs, though it is not totally unheard of. The prudent way forward seems to be understanding the prongs of the reciprocal trust doctrine and drafting ILITs that steer clear of those prongs by adding language or varying the terms of the trusts as needed.
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