January232023
The “Reciprocal Trust” Doctrine Can Wreak Havoc on Your Estate
T&E Chat
Kevin Wong, Principal, Citrin Cooperman Advisors LLC / Berdon Advisors LLC
01.23.23 | T&E Chat
Consider this scenario: You and your spouse have pooled your finances and share everything equally. As part of your estate plan, both of you decide you want to move assets out of your estate but still enjoy the benefit of owning the asset. You want to continue the practice of sharing everything equally. You both decide to set up separate but identical irrevocable trusts while naming the spouse as the income beneficiary.
While these two trusts may sound reasonable to you and accomplish your goals of sharing things equally, they may not accomplish your goal of removing assets from your estate. Even though your intentions are good, this could violate the “reciprocal trust” doctrine and pull the assets back into your respective estates. If the assets had significantly appreciated since your transfer to the trusts, this could lead to substantial taxes upon your death, as you may have thought the assets were already out of your estate.
What is the “reciprocal trust” doctrine?
Ordinarily, when assets are transferred into an irrevocable trust, the assets would be removed from your taxable estate. However, there may be some situations where the assets may be pulled back into your estate. One of these is when the reciprocal trust doctrine is violated. The reciprocal trust doctrine was developed to counter tax avoidance when two parties create trusts for each other’s benefit and lifetime enjoyment while leaving each of them in the same economic position as if the trusts were never created. Thus, if the reciprocal trust doctrine is violated, the transfers would be undone by the IRS for estate tax purposes and includable in your respective estates. If you and your spouse want to create identical trusts for each other’s benefit and lifetime enjoyment while avoiding the estate tax, think again. The doctrine doesn’t just affect spouses but other parties as well, such as when siblings create trusts for each other and their descendants.
Avoiding the doctrine
The trusts need to be substantially different to avoid the application of the reciprocal trust doctrine, and there are several ways to properly design the trusts to make them substantially different. The following are some of the ways the trusts can be made substantially different for purposes of the reciprocal trust doctrine:
- Trust assets transferred to each trust should be substantially different. Consider setting up one trust with the primary residence and other real estate assets and another with financial assets such as securities and bonds.
- Different trustees and fiduciaries can direct different amounts of distributions or make different investments.
- Different beneficiaries in each trust. Consider a trust with the spouse as the income beneficiary and the descendants as contingent beneficiaries and another with the spouse and children as income beneficiaries and other descendants as contingent beneficiaries.
- Timing the transfer of assets. Transfers close together may be construed as interrelated, whereas transfers made far apart provide a stronger argument that the transfers are not related.
- Varying trust terms such as powers of appointment, distributions, and withdrawal rights.
Conclusion
Taxpayers and their advisors should take proper precautions to avoid the reciprocal trust doctrine when creating trusts. Failure to do so can become a very costly mistake.
Questions? I can be reached at 212.331.7441 | kewong@berdon.com or contact your Berdon advisor
Kevin Wong is a Tax Principal in the Personal Wealth Services Group of Berdon with over ten years of professional experience. He works closely with high net worth individuals on matters involving their personal income tax, family businesses, fiduciary, and gift and estate taxes.