The Reciprocal Trust Doctrine it Matters and What You Can Do to Avoid It

“Having your cake and eating too” is an infamous phrase within the estate planning community which relates to the concept of giving property away (for estate tax purposes) but retaining its use and enjoyment.  At the end of this year, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 will expire; and as a result, Georgia residents and people across the United States are scrambling to take advantage of what may very well be a “once-in-a-lifetime” $5 million per person gift tax exemption.

In determining how to best utilize their $5 million exemption, a popular trend is for a married couple to each gift property to a separate trust for the benefit of their spouse and their children.  The result is that each spouse can remove significant amounts of property from their estate while retaining the benefit of the property gifted by their spouse.

The administration and set-up expense is considerable as this technique requires two separate trusts.  In addition, the trusts must be carefully crafted by estate planning experts to avoid the Doctrine of “Reciprocal Trusts”.  While burdensome to create, if executed properly, this two trust system can provide the long lost desire of “having your cake and eating it too”.


In Trust We Trust

The current $5,000,000 gift tax exemption applies to gifts made during the donor’s lifetime.  Estate taxes, or taxes paid on your estate after you pass away, do not include the value of items given tax free as gifts.[1]  Therefore anything given away during your lifetime that counts towards your gift tax exemption should NOT count towards your estate tax.

One of the hallmarks of a gift is that the donor loses all rights to the property when the gift is accepted.  While most people think of gifts as presents or property given directly to an individual, you can also make a gift to a trust.  Doing so may make your gift last longer because generally the beneficiary cannot spend the gift all at once.  Therefore large gifts typically are structured around trusts.

It is very common for husbands and wives to make trusts for each other.  Generally this does not cause a problem for gift tax or estate tax purposes.  However, recently courts have stepped up enforcement of the “reciprocal trust doctrine.”  If the court finds your trust violates this rule, you may be on the hook for estate or gift taxes after all.


The Reciprocal Trust Doctrine (In a Nutshell)

The essence of the RTD is reciprocity.  The IRS believes if you and someone close to you make trusts that are very similar, and each trust names the other person as a trustee or beneficiary, then basically each person ends up in the same position they were in before making the trust.  The logic goes that if you are basically in the same position before making the gift, then you should be taxed on items that were “not gifted.”


How to Avoid the RTD

Bruce Steiner and Martin Shenkman, two prominent New England attorneys, offer some great advice on how to avoid the RTD.[2]

1. Embrace Inequity

If the RTD is premised on each person being in roughly the same position before and after the gift is made, you can try to avoid the RTD by making the benefits unequal.  Make sure that the trusts are not “mirror images” of each other that simply switch out the named beneficiary or trustee for the other spouse.  It is very important after both trusts are created that one person will get more than the other.  While this may hurt feelings if reciprocity was expected, explaining why things have to be unequal can help.

2. Shake Up Your Trustee Selection

Avoid having your spouse act as the trustee or co-trustee of any trust you set up, if you expect your spouse to make you the trustee of their trust.  If there is no way around each spouse acting as trustee for the other spouse’s trust, try to have a neutral co-trustee administer the trust along with your spouse.

3. Insert a Marital Deduction Savings Clause

For insurance trusts, put a martial deduction savings clause in one trust but not in the other trust.  These provisions allow a portion or the entirety of life insurance proceeds from the death of a spouse may be paid to the other spouse, or be placed into another special trust.  This is a very specific example of using unequal property distributions to avoid the RTD.

4. Space Out Your Trust Creation

Time is running out to claim your $5 million lifetime gift tax exemption, but if you and your spouse act now you may still pull it off.  The trick is not to establish both trusts in the same day, or even the same week or month if possible.  This is meant to avoid the “step transaction doctrine,” which is IRS speak for “you planned each separate transaction to avoid taxes, but we will count two (or more) transactions as a single transaction.  Also, if you need to transfer assets to your spouse so they can fully fund their trust (a typically tax free event)[3] be sure to allow enough time to avoid another way the IRS could argue the whole thing was a “step transaction.”


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