Married clients often identify identical goals for both of their estate plans. The most obvious is to provide fully for the surviving spouse during his or her remaining life. With this in mind, married individuals’ revocable trusts often mirror each other as to how they provide for the surviving spouse and as to what happens when both spouses die. While this is a form of reciprocal planning, it does work to avoid probate (if all assets are titled in the married couple’s revocable trusts) and can effectively save some estate taxes by using a “bypass trust” at the death of the first spouse.
When clients express the intention to remove assets from their taxable estates, in order to avoid significant estate taxes at the death of both spouses, more comprehensive planning is warranted. Often, such planning will involve a variety of irrevocable trusts that function to remove control over the assets and effectively remove them from both spouse’s taxable estates and therefore not subject to estate tax at either spouse’s death. However, because a major goal is providing for the surviving spouse at the death of the first spouse, provisions are typically inserted in these types of irrevocable trusts to provide income and access to principal of the trust for the benefit of the surviving spouse. For example, Spouse A creates an irrevocable trust for the benefit of Spouse B and transfers $5 million dollars into this irrevocable trust. Likewise, Spouse B creates an irrevocable trust for the benefit of Spouse A and also transfers 5 million dollars into this irrevocable trust. These trusts are sometimes referred to as “Spousal Lifetime Access Trusts” or “SLATs”. Both spouses expect that the assets in both irrevocable trusts will not be subject to estate tax at either death, and want the surviving spouse to have access to (and maybe control) over the assets in both irrevocable trusts at the death of the first spouse. On its face, the concept is not complex, but this type of planning must be done carefully in order to achieve the main goal of removing the assets from both spouse’s taxable estates. Moreover, this type of planning has come under heavy scrutiny.
In 1969, The Supreme Court decided the case of United States v. Grace Estate, 395 U.S. 316. In that case, Mr. and Mrs. Grace set up reciprocal trusts for one another in which each created an irrevocable trust for the benefit of the other, deposited the identical amount of assets into it and each trust had what appeared to be the identical terms except the Grantors and Beneficiaries were reversed. (Mr. Grace was the Grantor of the trust where Mrs. Grace was the Beneficiary and Mrs. Grace was the Grantor of the trust where Mr. Grace was the Beneficiary). Upon their deaths, controversy arose as to the inclusion of the Trust funds in the gross estate of each individual for estate tax purposes. The Supreme Court held that “the reciprocal trust doctrine requires only that the trusts be interrelated, and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.” United States v. Grace Estate, 395 U.S. 316, 324 (U.S. 1969).
The importance of this case is to highlight the pitfalls of reciprocal trust planning. When utilizing this technique, the reciprocal trusts must not resemble each other. There are key differences, whether it’s different terms, different beneficiaries, different trustees, or different asset totals. These differences must be present in order for the trust planning to be effective in eliminating these assets from the taxable estates of both spouses. Sloppy or mindless planning from boilerplate language will cause troubled results as it did for Mr. and Mrs. Grace. It is imperative to understand that spouses can utilize many techniques to plan equally for each other. Trusts seeking to produce mostly reciprocal results are one of those techniques. The key is to understand that the same result can be produced from different means and that is how you avoid the reciprocal trust pitfall. Please review your estate plan to make sure you aren’t left looking in the mirror at a failed plan.
– Gary Altman, Esq. and Adam Abramowitz, Esq.