186 / What is the reciprocal trust doctrine, and how does it affect life insurance trusts?

Assume there are two insureds, A and B, each of whom wishes to create funded life insurance trusts for the same beneficiaries, with each retaining certain life interests in the property transferred. Each realizes that the retention of such interests will cause the value of the property each transfers to be included in his or her gross estate ( Q 182, Q 183). They reason that if they give these interests to the other, there should be no basis for includability of the trust assets in their own estates, assuming the trusts are irrevocable.

The reciprocal trust doctrine, developed by the courts, prevents this estate tax result. If the parties were to go ahead with their plan, the doctrine would be applied so as to “uncross” the trusts. For estate tax purposes, A would be treated as grantor of the trusts in form created by B, and vice versa. The doctrine is applied when trusts are interrelated and the arrangement, to the extent of mutual value, leaves the grantors in approximately the same economic position in which they would have been had each retained life interests in the trusts the grantor in form created. There is no need to find that the trusts were exchanged in “payment” for each other, nor that there was a specific “tax avoidance” motive involved in their creation.¹ The U.S. Court of Appeals for the Sixth Circuit and the Tax Court, in split decisions, have held that application of the reciprocal trust doctrine does not require that the grantors have crossed economic interests in the trusts they have created.² The U.S. Court of Appeals for the Federal Circuit appears to concur with the Tax Court in this view. The reciprocal trust doctrine also has been applied to uncross transfers of assets in custodianship under the Uniform Gifts to Minors Act.³

A letter ruling uncrossed reciprocal discretionary distribution rights given to trustees where each trustee was given a discretionary power to make distributions to the other trustee. Consequently, the decedent in this letter ruling was treated as holding a general power to appoint trust corpus to himself and the corpus was included in his estate.⁴