Beware of the ‘Reciprocal Trust’ Doctrine

If you and your spouse have similar irrevocable trusts that benefit each other, it is important to know that the trusts might be subject to the ‘reciprocal trust’ doctrine. In short, the doctrine prohibits tax avoidance through trusts that are interrelated and place both spouses in the same economic position as if they had each created trusts naming themselves as life beneficiaries.

Avoid This Scenario
For example, both your estates will trigger a substantial tax bill when you die. So, 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). However, what if two weeks later, your spouse establishes a trust with a comparable amount of assets and identical provisions, naming you as life beneficiary? This arrangement would violate the reciprocal trust doctrine, so for tax purposes 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 their taxable estate but remains in essentially the same economic position by virtue of being named life beneficiary of the other spouse’s estate.

Create Two Substantially Different Trusts
There are many ways to design trusts to avoid the reciprocal trust doctrine, but essentially, the goal is to vary factors related to each trust, such as the trust assets, terms, trustees, beneficiaries, or creation dates, so that the two trusts are not deemed ‘substantially similar’ by the IRS. Contact us to learn more.

Related Articles

Talk with the pros

Our CPAs and advisors are a great resource if you’re ready to learn even more.