Journal of Financial Planning: December 2012
Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.
Since this column is scheduled to run in December, it seems only appropriate to focus on gift giving and helping others. As best-selling author Karen E. Quinones Miller observes, reciprocity—the ability to help others who have helped you—is viewed by most of us as a virtue. At the risk of suggesting that the Internal Revenue Service is the Grinch Who Stole Christmas, it is important for those of us in the estate planning world to understand that the IRS has a very different take on reciprocity!
What is commonly known as the reciprocal trust doctrine (also sometimes referred to as the cross trust doctrine) was first articulated by the Service in Lehman v. Comm’r, 109 F2d 99 (2nd Cir 1940), where two brothers created irrevocable trusts for each other. Each trust provided that the trustee was to pay the income to the other brother for life, with remainder to that brother’s issue. Each brother transferred substantially identical stocks and bonds into the trust for the other brother. When the first brother died, the IRS “uncrossed” the trusts, finding that each trust was the quid pro quo for the other. As a result, the deceased brother was treated as if he had created the trust for his benefit, with the result that the trust was includable in his gross estate under the predecessor to IRC §2036(a)(1), which includes property transferred with a retained life estate.
The Supreme Court Weighs In
The reciprocal trust doctrine was amplified in U.S. v. Estate of Grace, 395 US 316 (1969). In Grace the husband had transferred substantial assets to his wife during a 23-year period. He then established an irrevocable trust for his wife, with remainder to their issue. Two weeks later, at the husband’s request, his wife established a substantially identical trust for his benefit, with remainder to issue. In finding that the wife’s trust was includible in the husband’s estate, the Supreme Court held 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. ... 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 the trusts naming themselves as life beneficiaries.
When the reciprocal trust doctrine applies, Rev. Rul. 74-533, 1974-2 Cum. Bul. 293, explains the tax consequences. The facts were quite simple. In 1960, husband and wife created irrevocable trusts that the Service found to be reciprocal. Husband transferred $400,000 to the trust he created and paid $80,000 of gift tax. Wife transferred $300,000 to the trust she created and paid $70,000 of gift tax. Husband and wife both died within a few months of each other in 1971, at which time the trust created by husband was worth $600,000, and the trust created by wife was worth $500,000. Pursuant to Grace the estates of husband and wife included in each decedent’s gross estate the principal of the trust created by the other spouse to the extent of the mutual value of the reciprocal transfer.
The gross estate of the husband included the full value, $500,000, of the principal of wife’s trust as of the date of death of husband, since the principal of wife’s trust was initially smaller than that of husband’s trust. Three-fourths of the value of the principal of husband’s trust, as of the date of death of wife, was included in her gross estate, since the value of the principal of husband’s trust was greater than that of wife’s trust at the time of the original transfer.
The amount includible, $450,000, was determined by multiplying the value of the principal of husband’s trust at the death of wife by the ratio of the original value of the principal of the smaller wife’s trust to that of the larger husband’s trust. Because wife’s trust was fully includible in husband’s gross estate, his estate was entitled to a credit for the full amount of gift taxes paid by the wife. Similarly, the wife’s estate was entitled to a credit for three-fourths of the gift taxes paid by husband.
The IRS has succeeded in applying the reciprocal trust doctrine even though the settlors did not retain a beneficial interest in the trusts that they created.
In Estate of Bischoff v. Comm’r, 69 T.C. 32 (1977), the settlors created trusts for four grandchildren. Each settlor created four discretionary trusts, one for each grandchild, and named the other grandparent as trustee. The Tax Court uncrossed the trusts on the basis that the trustee’s discretionary powers over income left the settlors “in approximately the same economic position.” As a result of uncrossing the trusts, each settlor was deemed to have retained the power to designate the persons to whom income was distributable and the trusts were includible in their respective gross estates under IRC §2036(a)(2).
However, the Sixth Circuit refused to follow Bischoff in Estate of Green v. U.S., 68 F.3d 151 (6th Cir. 1995), where the IRS sought to apply the reciprocal trust doctrine for purposes of applying IRC 2036(a)(2). In Green, the decedent and his wife each created separate trusts for their two grandchildren. For one grandchild, the decedent was the settlor and his wife was the trustee. For the other grandchild, the decedent was the trustee and his wife was the settlor. Even though the settlor and his wife did not possess beneficial interests in the two trusts, the IRS sought to uncross the trusts based on reciprocal fiduciary powers. If each settlor was the trustee of the trust he or she had created, the trustee’s discretionary powers over distributions of income and principal would have resulted in inclusion of the trust’s corpus in the gross estate of the settlor under IRC §2036(a)(2).
The Sixth Circuit rejected the Bischoff analysis on the grounds that the “same economic position” test in Grace required the settlor to retain a beneficial interest and that mere control of beneficial interests as trustee was not sufficient.
Applying the Situation to Married Clients
The reciprocal trust doctrine will be relevant in situations in which a husband and wife create identical cross trusts, with each trust owning insurance on the life of the settlor and the other spouse being the income beneficiary. Some assurance is provided by PLR 9643013, in which husband and wife created irrevocable trusts. The husband’s trust named the wife as trustee and the children as beneficiaries, and the wife’s trust named the husband as trustee and the husband and children as beneficiaries. Each trust vested distributive discretion in an independent trustee. In this fact situation, the Service held that the reciprocal trust doctrine did not apply.
What if the trust established by the husband provided that income was payable to the wife for her lifetime, while the trust established by the wife provided that the income could be sprinkled among the husband and issue? It is not possible to say whether this would be sufficient because the author has discovered no guidance in the case law concerning how much the beneficial interests in husband/wife trusts must differ to avoid being uncrossed.
The beneficial interests would clearly not be reciprocal if the husband created a trust for the benefit of his wife, while the wife created a trust for the benefit of their issue as in PLR 9643013 above. Nevertheless, the Service could cite Bischoff to attempt to uncross the trusts based on the spouses’ retained powers as trustees.
Whether Green’s distinction between retained beneficial interests and retained administrative powers will be upheld is a matter for future decisions. In the interim, estate planners should proceed with caution whenever both husband and wife are considering irrevocable trusts which name one another as trustees or beneficiaries.