Irrevocable trusts are a fundamental legacy planning tool that serve various planning purposes, such as providing liquidity for estate expenses and financial security for the grantor’s family, including the lifetime support of a spouse (with the potential for indirect support of the grantor by his or her spouse). When spouses or other related parties (such as siblings) create trusts for each other, however, they must take extra care to avoid violation of the “reciprocal trust doctrine.” The doctrine can undo the legacy planning benefits of the irrevocable trusts by unwinding the trusts and causing inclusion of the trust assets in the donor’s estate, or by attributing gifts made by others to the grantor.
The reciprocal trust doctrine can unwind legacy planning that involves mutually beneficial trusts; however, a careful and deliberate approach can shield transfers against application of the doctrine.
In 2020, legacy planning for spouses and other related parties has focused largely on full use of their gift and estate tax exemptions due to the risk of prospective changes in the amounts of such exemptions. This type of planning often involves implementing mutually beneficial irrevocable trusts so that each party continues to have access to resources after the party gives assets away (e.g., spouses who each establish a spousal lifetime access trust (“SLAT”) for the benefit of the other spouse). However, such trusts can sometimes contravene the reciprocal trust doctrine, which applies to interrelated trusts that have substantially identical terms and are part of the same transaction or plan. The doctrine treats each party who creates a trust in such a transaction (a “grantor”) as having settled that trust for his or her own benefit, resulting in potential inclusion of the trust’s assets in a grantor’s estate at passing. Thus, a careful and deliberate approach is required to ensure the trusts’ terms differ to the degree required to avoid application of the doctrine.
Best Practices to Avoid Application of the Reciprocal Trust Doctrine
Mutually beneficial irrevocable trusts can be a powerful legacy planning strategy, so long as the trusts are structured to avoid the reciprocal trust doctrine. While the facts of each case are unique, best practices indicate that related grantors vary several factors among the respective trust agreements to reduce the risk of reciprocal trust treatment.
This material is intended for informational purposes only and should not be construed as legal or tax advice. It is not intended to replace the advice of a qualified attorney, tax advisor, or plan provider.