When spouses have similar irrevocable trusts for each other’s benefit, they can be subject to the “reciprocal trust” doctrine. It prohibits tax avoidance through trusts that 1) are interrelated, and 2) place both grantors in the same economic position as if they’d each created trusts naming themselves as life beneficiaries.
What to do
To avoid unintended tax consequences, trusts should be designed to avoid the reciprocal trust doctrine. There are many ways to accomplish this, but essentially the goal is to vary factors related to each trust, such as the trust assets or terms, trustees, beneficiaries, or creation dates. This strategy will diminish the chances that the two trusts are deemed “substantially similar” by the IRS.
What not to do
Suppose that your and your spouse’s estates will trigger a substantial tax bill when you die. You transfer your assets to an irrevocable trust that provides your spouse with an income interest for life, access to principal at the trustee’s discretion, and a testamentary, special power of appointment to distribute the trust assets among your children.
Ordinarily, assets transferred to an irrevocable trust are removed from your taxable estate (though there may be gift tax implications). A short time later, your spouse establishes a trust with identical provisions, naming you as life beneficiary. This arrangement would violate the reciprocal trust doctrine, so the transfers would be undone by the IRS and the value of the assets you transferred would be included in your respective estates.
In this example, the intent to avoid estate tax is clear: Each spouse removes assets from his or her taxable estate but remains in essentially the same economic position by virtue of being named life beneficiary of the other spouse’s estate.
If you and your spouse have separate trusts, allow us to review them to ensure they don’t invoke the reciprocal trust doctrine. Contact me at SDitman@berdonllp.com or your Berdon advisor.
Scott T. Ditman, a tax partner and Chair, Personal Wealth Services at Berdon LLP, New York Accountants, advises high net worth individuals and family/owner-managed business clients on building, preserving, and transferring wealth, estate and income tax issues, and succession and financial planning.