Insurance Trusts and the Reciprocal Doctrine
| Publication year | 1991 |
| Pages | 2067 |
| Citation | Vol. 10 No. 1991 Pg. 2067 |
1991, October, Pg. 2067. Insurance Trusts and the Reciprocal Doctrine
The unified credit against federal estate and gift taxes pla-teaued in 1987. Consequently, the number of families with potentially taxable estates is increasing. Because of this and the repeal of Internal Revenue Code ("Code") § 2036(c), use of irrevocable life insurance trusts for addressing estate tax liability may become even more common. However, a little-known rule---the "reciprocal trust doctrine"---impacts the planning of these trusts for married couples. This article describes the elements and application of the reciprocal trust doctrine.
The reciprocal trust doctrine ("doctrine") undergirds the literal provisions of the Code. It is a court-established rule providing that the taxability of a trust corpus depends on the nature and operative effect of the trust transfer.(fn1) The doctrine does not, itself, impose a tax. The incidence of taxation depends on the operation of a particular applicable Code section, once the form of a trust transfer is disregarded and the objective effects of the transfer are determined.(fn2)
The effect of applying this doctrine is to prevent "circumvention of federal estate tax by use of schemes which do not significantly alter lifetime beneficial enjoyment of property supposedly transferred by a decedent."(fn3) Its origin lies in the 1940 case of Lehman v. Commissioner(fn4) in which two brothers transferred securities of equal value into irrevocable trusts. Each grantor provided that his brother was to have all the income and certain rights of withdrawal. Each also provided that on the death of his brother, the remaining trust estate was to go to his brother's children. When one of the brothers died, it was held that the assets in the trust that had been established by the surviving brother (for the benefit of the deceased) were, in substance, a transfer by the deceased brother with a retained life estate. Thus, the property was deemed part of the dead brother's taxable estate.
The reciprocal trust doctrine remains strong today. No effort has been made to codify it by statute or regulation, and no significant changes have occurred since 1969 in its effect or the elements required to invoke it.
A flurry of cases following Lehman developed two tests for determining if the doctrine should be invoked. Several opinions found the doctrine applicable based on the presence of an element of consideration, requiring a determination that there was a bargain and sale element involved in the establishment of the trusts. This first test led to an inquiry into the intent of the parties, in many cases decades after the death of the principals.
The second test is based on a line of cases which disregard intent. These cases looked to objective evidence to determine whether trusts were reciprocal. This second line of cases became the current law.(fn5) First announced in U.S. v. Grace, the elements of the test for judging whether a trust arrangement is reciprocal are as follows:
1. The trusts must be interrelated. Commonly, courts will look at the terms of the trust documents, the timing of transfers into the respective trusts, the value of property transferred into the trusts and the relationship to the parties.
2. The arrangement, to the extent of mutual value, must leave the settlors in approximately the same economical position as they would have been in had they created trusts naming themselves as life beneficiaries.(fn6)
In cases where, instead of creating life estates for each other, the settlors have granted each other reciprocal powers of management or appointment, this crossing of powers has been found sufficient to invoke the doctrine. A retained economic interest is not a required element. This is the case as long as the power exercisable by the trustee would result in the includability of the assets subject to that power if the settlor were to transfer the assets into a trust under his or her own trusteeship, retaining...
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