Reciprocal Trust Doctrine: Can A Couple Establish Two ILITS, One For Each Other?

Situation – With the sunset of the high estate tax exemption just around the corner even moderately wealthy couples are increasingly worried about potential Federal Estate Taxes. To keep the life insurance proceeds outside their estate we usually suggest that life insurance be owned by an irrevocable life insurance trust (ILIT). We often find that moderately wealthy couples want to include provisions in their ILITs that make the trust assets “accessible” while removing the policy proceeds from their estates – so called Spousal Limited Access Trusts or SLATs.

Arguably it’s possible to give the noninsured spouse a limited beneficial interest and the children the ultimate remainder beneficiaries, while still excluding the policy from the couple’s estate. However, the law regarding the use of SLATs is still developing. Clients must consider the tax risks along with what should happen in the event of divorce or premature death of the noninsured spouse when establishing SLATs. Furthermore, a question that inevitably comes up is, “If one spouse can do this, can both spouses create trusts with substantially similar provisions?” Specifically, can the wife and children be the beneficiaries of a trust with the husband as the insured, while the husband and the children are the beneficiaries of a trust with the wife as the insured? This Counselor’s Corner sheds light on this question.

Details and Outcome – When two trusts are interrelated and leave the grantor spouses in about the same economic position as if they had made themselves life beneficiaries of the trust they created, the IRS switches the grantors so that each grantor is regarded as creating the trust under which s/he retained a life interest for himself, resulting in inclusion of the trust in
each grantor’s estate. This theory is known as the reciprocal trust doctrine.

Early History of the Doctrine. The reciprocal trust doctrine was developed over the years as a result of IRS challenges and subsequent court cases. Since it developed from several different factual situations and is not defined in any statute, it is an unsettled area that depends upon the facts and circumstances of each case. A review of some of the major cases is helpful to better understand how the doctrine has been applied.

The 1940 case, Lehman v. Commissioner,1 is the first one reported on the subject. It involved two brothers who established trusts for the benefit of each other and the other’s children. The court stated that three circumstances were present that made the trusts reciprocal and, therefore, would not avoid estate tax. Those three circumstances were:

• Quid pro quo consideration accurred between the individuals involved (each trust was created as a quid pro quo for the other)

• The individuals were in the same economic position before and after the establishment of the trusts.

• The trust provisions were interrelated, meaning similar in terms.