CSG Law Alert: "Mirror, Mirror" - Not for All
A carefully constructed trust is the cornerstone of mindful legacy planning that can protect assets from many risks and minimize tax burdens. Married clients commonly create two trusts that mirror each other for the benefit of the other spouse and their descendants funded by lifetime gifts between the two spouses. By creating these mirror trusts, married clients reduce their tax burden by removing assets from their taxable estate thereby shielding the trust assets from estate tax.
However, drafters beware! As the old saying goes, “all that glitters, isn’t gold,” and drafters of these types of trusts should familiarize themselves with the risks associated with this type of estate planning to avoid running afoul of the “reciprocal trust doctrine,” which can unravel a client’s carefully laid estate plans and result in large, unintended estate tax consequences.
Why would an individual make a lifetime gift to a trust?
Clients seek to make lifetime gifts to a trust for many reasons. Minimizing estate tax is one major benefit of making a lifetime gift to a trust. Once assets are contributed into the trust, they grow free of estate tax if the donor of the gifted assets generally has no control over or beneficial interest in the trust. Depending on the terms of the trust and how the gifts to the trust were reported to the Internal Revenue Service, assets in the trust may also be excluded from a beneficiary’s taxable estate and can therefore pass down generation to generation without any estate taxes. Because the lifetime federal gift and estate tax exemption is currently $12.06 million for individuals ($24.12 million for married couples), clients can easily gift assets into a trust and lock in the current generous lifetime exemption.1
What is the reciprocal trust doctrine?
Reciprocal trusts are created when two parties’ separate trusts contain identical mirror terms in the trust instrument and name each spouse as a beneficiary of the other’s trust. The court, however, may consider a mirror trust a tool to circumvent paying estate taxes, which is where the reciprocal trust doctrine comes into play.
Reciprocal trusts do not only apply to married couples. In fact, the first case that gave rise to the reciprocal trust doctrine involved two brothers who created two mirror trusts to benefit each other.2 The trusts’ identical terms granted each brother an income interest, the right to withdraw $150,000, and provided that the remainder of the trusts would go to the grantor-brother’s descendants.3 As a result, the U.S. Court of Appeals for the Second Circuit uncrossed the trusts when the first brother died and held that the money the deceased brother could withdraw from the trusts ($150,000) be included in his taxable estate.4
What exactly was the problem with the Lehmann brothers’ trusts?
Mirror trusts represent a reciprocal arrangement between two parties who make interrelated trusts in which each party becomes the beneficiary of the other party’s trust. The two mirror trusts in Lehmann functioned like a payment to the other, set up for their own individual benefit, which undermines the purpose of a completed gift to a trust.
Parties’ intentions do not matter for the purpose of determining whether two reciprocal trusts have breached the reciprocal trust doctrine. The leading case concerning the reciprocal trust doctrine, United States v. Grace5, resolved this question. In this case, two spouses established mirror trusts for the benefit of the other within two weeks of each other. Here, the Supreme Court addressed the question of whether the parties’ motive factored into whether the doctrine applied and held that it does not. The Supreme Court held that the doctrine only applies in situations where two interrelated trusts “leave[…] the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.”6
While there is no bright line rule to avoid the resulting tax consequences the Lehmann brothers and the Grace spouses faced, Grace articulated two essential principles to consider in whether the reciprocal trust doctrine applies to interconnected, mirror trusts: (i) the interrelatedness between the two trusts, and (ii) whether the parties establishing the trusts have maintained the same economic position by retaining a “mutual economic value.”7 These two standards still apply today.
What happens when courts apply the reciprocal trust doctrine?
When the terms of two interrelated trusts result in leaving the parties in the same economic position that they would have otherwise been in had they not engaged in the transaction, a court will “uncross” the trusts. This means that the assets that were removed from an individual’s taxable estate for the purposes of funding the trust will now be included in their taxable estate when they die. Uncrossing the two reciprocal trusts could pose disastrous tax consequences for a client. Therefore, it is critical that interconnected, mirror trusts be prepared with this in mind.
How can drafters avoid triggering the reciprocal trust doctrine?
Navigating the reciprocal trust doctrine can be tricky. In some cases, courts have found that naming the other spouse as trustee was enough to trigger the reciprocal trust doctrine.8
Although no hard and fast rule exists that triggers the reciprocal trust doctrine, prudent drafters can draft language around it by making the trusts as different as reasonably possible. A few ways to accomplish this include:
- Changing the trustees between the two trusts;
- Varying the beneficiaries of the two trusts;
- Providing for different powers of appointment within the two trusts;
- Providing for different trustee removal powers between the two trusts;
- Signing and funding the two trusts at different times, preferably during different tax years to provide enough variation between gift tax returns;
- Contributing different types of assets or different amounts to the trusts; and/or
- Altering distribution standards.
No single suggestion guarantees that the reciprocal trust doctrine will be avoided. Depending on a client’s needs and circumstances, drafters should use a variety of techniques to sufficiently vary the terms of the trusts between two parties. Otherwise, “mirror, mirror” – it could be your estate plan’s downfall.
If you have any questions about mirror trusts or would like to discuss your personal situation, please contact your CSG Law attorney or Michelle Bergeron Spell, Trusts & Estates Practice Group Leader.
1 The federal gift and estate tax exemption is due to sunset in 2026.
2 Lehman v. Comm’r, 109 F.2d 99 (2d Cir. 1940).
3 Id. at 100.
4 Id.
5 United States v. Grace, 395 U.S. 316 (1969)
6 Id. at 324.
7 Id.
8 See Estate of Bischoff v. Comm’r, 69 T.C. 32 (1977).
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