Journal of Financial Planning: December 2011
Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.
Happily married couples looking for an innovative way to use their increased gift-tax exemption without diminishing their combined cash flow should consider the Spousal Lifetime Access Trust (SLAT). A SLAT is an irrevocable trust created by a married person for the benefit of his or her spouse. Usually, the spouse is granted a life estate, followed by further retention in trust of the principal for the benefit of the married couples’ children.
In order to avoid inclusion of the assets of the SLAT in the gross estate of the spouse/beneficiary under IRC Section 2036, only separate property of the grantor may be used to fund the SLAT. In a community property state, the community should be bifurcated into equal shares of separate property, and the grantor should transfer his or her share of the separate property to the SLAT. In order to avoid making the bifurcation illusory, the non-grantor spouse should be careful to maintain the separate property nature of his or her share and not convert it back into community property.
Also, to avoid inclusion of the assets of the SLAT in the gross estate of the grantor under IRC Section 2036, the grantor should not serve as trustee. The grantor’s spouse could serve as trustee if his or her distributive powers are limited by an ascertainable standard. Many estate planners recommend that an independent third party serve as trustee or at least as a co-trustee. Moreover, the SLAT must prohibit distributions to the grantor’s spouse in discharge of the grantor’s legal obligation of support.
For example, assume a married couple with a significant estate understands that using the gift-tax exemptions by transferring income-producing real estate to irrevocable trusts for the children would be a prudent estate planning step, but are reluctant to give up the income it generates “just in case” it might be needed in the future. The husband could establish a SLAT for the wife, with remainder passing to the children and grandchildren. Alternatively, the SLAT could be structured as a “family pot” in which distributions may be made to the wife, children, and grandchildren. In either case, the SLAT must prohibit any distributions in discharge of the husband’s legal obligation to support any beneficiary.
If possible, real property transferred to the SLAT would take the form of either undivided interests or non-voting, non-controlling interest in a limited liability company or limited partnership owning the real property. The value of such transfers would reflect valuation adjustments for lack of marketability and lack of control.
On a timely filed gift-tax return (form 709), the husband would allocate his $5 million generation-skipping transfer tax exemption to the transfer. The SLAT would provide multiple generations of beneficiaries protection from creditors, ex-spouses, and bankruptcy.
Could the wife establish a similar SLAT for the husband and/or their issue and transfer $5 million of her separate property to that trust? Unfortunately, the answer is unclear in view of possible application of the reciprocal trust doctrine.
Reciprocal Trust Doctrine
The reciprocal trust doctrine (also sometimes referred to as the cross trust doctrine) was articulated in Lehman v. Comm’r, 109 F.2d 99 (2nd Cir 1940), in which the decedent transferred certain stocks and bonds into trust for his brother in consideration of his brother’s transfer of substantially identical stocks and bonds into trust for the decedent. Each trust provided that the trustee was to pay the income to the other brother for life, with remainder to that brother’s issue. The Internal Revenue Service (IRS) “uncrossed” the trusts, finding that each trust was the quid pro quo for the other, and treated the decedent as the settlor of the trust created by his brother, thereby including the trust in the decedent’s gross estate under the predecessor to IRC §2036(a)(1) (retained life estates).
Lehman was amplified in U.S. v. Estate of Grace, 395 U.S. 316 (1969). In Grace, the decedent transferred substantial assets to his wife during a 23-year period. The decedent then established an irrevocable trust for his wife, with remainder to their issue. Two weeks later, at the husband’s request, his wife established a substantially identical trust for his benefit, with remainder to issue. In finding that the wife’s trust was includible in the husband’s estate, the Supreme Court held that:
Application of the reciprocal trust doctrine is not dependent upon a finding that each trust was created as a quid pro quo for the other. Such a “consideration” requirement necessarily involves a difficult inquiry into the subjective intent of the Settlors. Nor do we think it necessary to prove the existence of a tax-avoidance motive. … Rather, we hold that application of 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 the trusts naming themselves as life beneficiaries.
The IRS has succeeded in applying the reciprocal trust doctrine even in situations in which the settlors did not retain beneficial interests in the trusts they created. In Estate of Bischoff v. Comm’r, 69 T.C. 32 (1977), each settlor (grandparent) created four discretionary trusts—one for each grandchild—and named the other grandparent as trustee. The Tax Court uncrossed the trusts on the basis that the trustee’s discretionary powers over income left the settlors “in approximately the same economic position.” As a result of uncrossing the trusts, each settlor was deemed to have retained the power to designate the persons to whom income was distributable, and the trusts were includible in their respective gross estates under IRC §2036(a)(2).
The Sixth Circuit refused to follow Bischoff in Estate of Green v. U.S., 68 F.3d 151 (6th Cir. 1995), where the IRS sought to apply the reciprocal trust doctrine for purposes of applying IRC 2036(a)(2). In Green, the decedent and his wife each created separate trusts for their two grandchildren. For one grandchild, the decedent was the settlor and his wife was the trustee. For the other grandchild, the decedent was the trustee and his wife was the settlor. Even though the settlor and his wife did not possess beneficial interests in the two trusts, the IRS sought to uncross the trusts based on reciprocal fiduciary powers. If each settlor was the trustee of the trust he or she had created, the trustee’s discretionary powers over distributions of income and principal would have resulted in inclusion of the trust’s corpus in the gross estate of the settlor under IRC §2036(a)(2). The Sixth Circuit rejected the Bischoff analysis on the grounds that the “same economic position” test in Grace required the settlor to retain a beneficial interest and that mere control of beneficial interests as trustee was not sufficient.
The reciprocal trust doctrine will be relevant if both spouses create SLATs. In a private letter ruling from the IRS (9643013), a husband and wife created irrevocable trusts in which the husband’s trust named the wife as trustee and the children as beneficiaries and the wife’s trust named the husband as trustee and the husband and children as beneficiaries. Each trust vested distributive discretion in an independent trustee. In this factual situation, the IRS held that the reciprocal trust doctrine did not apply.
Could the reciprocal trust doctrine be avoided if the SLAT created by the husband provided that income was payable to the wife for her lifetime, while the trust established by the wife provided that the income could be sprinkled among the husband and their issue? Would this be sufficient to avoid leaving the couple “in approximately the same economic position”? Your author has discovered no guidance in the case law concerning how much the beneficial interests in SLATs must differ in order to avoid being uncrossed. Even if the husband created a trust for the benefit of his wife, while his wife created a trust for the benefit of their issue as in PLR 9643013 above, the IRS could cite Bischoff to attempt to uncross the trusts based on their retained powers as trustees.
Whether Green’s distinction between retained beneficial interests and retained administrative powers will be upheld is a matter for future decisions. In the interim, estate planners should proceed with caution whenever both husband and wife propose to create SLATs and name one another as trustees or beneficiaries. Prudence dictates that only one spouse should create a SLAT. Even so, a SLAT is a useful technique for the happily married couple.