Author: James G. Blase, CPA, JD, LLM, Blase & Associates, LLC, St. Louis, Missouri
Many clients are scrambling to implement significant gifting plans and trusts before changes are potentially made to the current estate, gift, and generation-skipping transfer (GST) tax laws by a new Congress and president. Regardless of the outcome of the election, planning will need to take place before 2026, when the current $11.58 million lifetime gift and GST tax exemptions are scheduled to sunset, potentially being reduced to their previous $5 million levels, adjusted for inflation. For many high net worth married couples, the goal is to double the amount of this current gift to up to $23.16 million.
The estate tax planning situation in 2020 is direr than it was in 2012, the last time there was an estate tax exemption sunset law. Regardless of the outcome of the November election, there is also a unique tax “grandfathering” situation.
Last Thanksgiving, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued final regulations under IR-2019-189, which clarified that individuals utilizing the current larger gift and GST tax exemption would be grandfathered if the law changed in the future. The Treasury and the IRS also clarified that individuals need to make gifts in excess of the future estate tax exemption amount if they want to receive any grandfathering. In other words, a lifetime gift of only $5 million will create no grandfathering if the individual dies after the exemption reverts to its previous amount, adjusted for inflation.
It is of course a simple matter for one spouse to establish an $11.58 million irrevocable spousal access trust (SAT) for the other spouse, and for that other spouse to establish an $11.58 million trust or trusts for the benefit of the children. But for many married couple clients, this plan is not satisfactory because it does not allow spousal access to the income or principal from the second trust. These couples then ask the next logical question: “Why can’t we each just establish a reciprocal SAT for the other spouse, with up to $11.58 million in trust assets each?”
The problem is that the U.S. Supreme Court ruled against these types of “reciprocal trust arrangements” in 1969 in Estate of Grace,1 holding that the trusts were includible in the spouses’ gross estates under Section 2036 of the Internal Revenue Code (Code). Although many creative estate planning attorneys have devised a variety of techniques for married couples to establish reciprocal trust arrangements without running afoul of the Supreme Court’s 1969 decision, many other estate planning attorneys view any type of lifetime reciprocal trust arrangement for their married couple clients as risky from a federal estate tax perspective. The attorney authors of one recent reciprocal trust doctrine article summarized the situation: “There’s no clearly defined line or safe harbor as to what constitutes a sufficient difference between two trusts to avoid the reciprocal trust doctrine.”2
If the clients are not enamored with the possibility that their reciprocal gifting plan may fail in the end, the next logical question that presents itself is whether the husband or wife may transfer up to $23.16 million in assets to a trust for the benefit of his or her spouse and descendants (assuming no previous use of the federal gift or GST tax exemption), and then have his or her spouse consent to gift-splitting on the couples’ federal gift tax returns for the calendar year, thus allowing the transfer to be treated as though each of the spouses made a gift of up to $11.58 million. If this plan were to work, the couple will have access to the trust assets as long as the “transferee spouse” is living.
Unfortunately, the short answer to this question is that the Code only allows spouses to gift-split on gifts made to persons other than the transferor’s spouse,3 and in general a gift by the transferor spouse to a trust that benefits both the other spouse and third parties is not a gift to “other than the transferor’s spouse.”4
The Double Spousal Access Trust
Enter the double spousal access trust, or DSAT. Here is an example of how the DSAT would operate, assuming the husband is the transferor spouse:
- Husband (H) transfers up to $23.16 million worth of assets to an irrevocable trust for the benefit of his wife and children (and grandchildren, if any).
- The couples’ children (and grandchildren, if any), but not the wife, are each granted an immediate Crummey withdrawal power over an equal percentage of the entire $23.16 million transfer.
- Thirty days after the transfer (and preferably still in 2020), each of the Crummey withdrawal rights lapse as to 5 percent of the then-current value of the trust.5
- Assuming the first lapse occurred in 2020, on January 31, 2021, the Crummey withdrawal powers each lapse as to another five percent.
- This same lapsing pattern continues on January 31 of each succeeding year, until the Crummey powers in up to $23.16 million worth of assets transferred to the DSAT no longer exist.
- During the entire period of the DSAT, income and principal will be available to both the wife and children (and grandchildren, if any) to the extent not subject to the unlapsed portion of the Crummey withdrawal powers. Thus, if it is assumed that the couple has ten children and grandchildren, after the first partial lapse of the Crummey withdrawal powers in thirty days, $11.58 million of the $10 million will be fully available for use by the wife as trustee, and on January 31, 2021, the second $11.58 million will be fully available to her. Of course, before the full lapse of all of the Crummey withdrawal powers, the remaining trust funds would also be available, though to the children (and grandchildren, if any) via the exercise of the unlapsed portions of their withdrawal powers.
- If this plan is implemented, the children (and adult grandchildren, if any) may wish to consider carrying additional umbrella liability insurance at least during their Crummey withdrawal right period because their Crummey withdrawal rights may be subject to the claims of potential future creditors.6
- Depending upon applicable state law, the Crummey withdrawal rights will most likely be considered separate property for marital or community property division purposes in the event any of the children or grandchildren should ever divorce.7 Notwithstanding this fact, if possible, the children and grandchildren should cover this issue with a premarital agreement if becoming engaged, or with a postmarital agreement if already married.
- If the above plan is implemented, the husband and wife would each be able to apply the balance of his or her $11.58 million lifetime gift and GST exemption to the DSAT, thus rendering the trust completely exempt from both estate and GST tax forever, or at least for the entire applicable rule against perpetuities period. Because the Crummey withdrawal powers in the hands of the children (and grandchildren, if any) would absorb the entire gift tax value of the $23.16 million transfer to the trust, the above-referenced limitations on gift-splitting, which would normally govern when the transferor’s spouse is a beneficiary of the trust, should not apply to transfers to a DSAT.8
- An obvious significant potential drawback to the DSAT approach is that, during the unlapsed portion of the Crummey withdrawal rights period, the children (and grandchildren, if any, including parents acting on behalf of minor grandchildren) will have the right to withdraw substantial assets from the trust. Likewise, creditors of the Crummey withdrawal power holders will have access to whatever the Crummey withdrawal power holders do. In most (but not all) states, the creditors’ access does not continue after the Crummey powers lapse pursuant to Code Section 2514(e). If this is a significant concern to the couple, the DSAT approach should either not be employed or be modified so that Crummey withdrawal rights are eliminated or limited in the case of any particular child or grandchild where a significant concern exists or arises. Note also that, as illustrated above, in many instances the Crummey withdrawal right period under a DSAT may only extend for a few years, which may reduce somewhat the couple’s concern that one or more of the Crummey withdrawal right holders will exercise his or her withdrawal power or have creditor or other issues. Maintaining a higher level of umbrella liability insurance for the Crummey power holders should also be considered, with the insurance continuing even after the withdrawal powers lapse in states that do not provide creditor protection for the trust assets at that point.
- Another potential disadvantage to the DSAT approach is that, if any of the children or grandchildren should die during the Crummey withdrawal right period, the unlapsed portion of that child’s Crummey withdrawal right will be subject to estate tax in that child’s estate. However, due to the largely anticipated federal estate tax exemption of $6 million or less beginning in 2026 (if not earlier), combined with the significant annual lapsing of the Crummey withdrawal powers in the hands of the children and grandchildren, for practical purposes, estate tax issues for the children and grandchildren may not be a significant concern in most instances, at least after a few years of the trust’s existence. Nevertheless, cheap term (or reducing term) life insurance on the lives of the children and grandchildren can normally be easily purchased to insure over any short-term risk.
- A final obvious potential disadvantage of putting all one’s eggs in a single DSAT basket occurs if the transferee spouse dies first, thus leaving the transferor spouse with none of the DSAT assets in which to live on. This concern can be alleviated by allowing the transferor spouse to borrow from the DSAT (for full value, of course) or by purchasing life insurance on the life of the transferee spouse. The divorce issue is the same as with any spousal access trust, just heightened as a result of the dollars involved.
- Of course, as is always the case when one spouse gifts assets to an irrevocable trust that benefits the other spouse in whole or in part, it is important that any assets being transferred by the transferor spouse be his or her independent assets, and not community property or jointly-owned assets. Also, to avoid the potential application of the step transaction doctrine, the gifted assets should not have been recently transferred into the independent name and ownership of the transferor spouse. A ninety-day waiting period would appear to be the recommended minimum time frame that the transferred assets should be in the independent name and ownership of the transferor spouse.
Additional Estate Tax Benefit of the DSAT
In addition to the significant nontax benefit of maintaining spousal access of up to $23.16 million worth of assets in the DSAT as opposed to only half of this amount, utilizing the DSAT eliminates any potential IRS estate tax inclusion argument based on the concept of “reciprocal trustees.” This argument is especially worrisome when the same or similar property is transferred by the husband and wife to each of two separate trusts.9 There is only one trust involved with a DSAT and therefore only one set of trustees. In contrast, two sets of trustees would be required if there were a second trust for the benefit of descendants only or if there were an attempt at a qualified reciprocal trust arrangement. If either or both of the latter forms of trust arrangements are utilized, cautious clients would need to consider utilizing outside trustees for the second trust to ward off any potential IRS reciprocal trustee attack.
Structuring SAT or DSAT as a Grantor Trust
To minimize both income and estate taxes, the SAT or DSAT should be structured as a complete grantor trust as to the transferor spouse during the transferor spouse’s lifetime. This step will not only avoid income taxes to the transferor spouse on any loan that he or she has with the trust, but it will also allow the SAT or DSAT to grow estate tax-free, unreduced by income taxes, while the transferor spouse’s gross estate is reduced each year by the income taxes attributable to the income of the trust.
The SAT or DSAT should also be structured so that the surviving spouse, if any, is taxed on all or part of the income of the trust under the third-party grantor trust rules and specifically under Code Section 678, which provides that a beneficiary of a trust is taxed on any trust income that beneficiary has the sole right to withdraw. This additional trust drafting technique will preserve all or most of the estate tax-free growth inside of the SAT or DSAT after the transferor spouse’s death while reducing the size of the surviving spouse’s taxable estate by the income taxes he or she pays each year on the trust income that is not withdrawn.
Note that the use of the Section 678 third-party grantor trust technique requires careful coordination with Code Section 2514, to ensure that the surviving spouse does not make a taxable gift when all or a portion of his or her income withdrawal rights lapse at the end of each year.
Note also that, in some situations, it may be advisable to not structure the trust as a grantor trust to shift income to children and grandchildren in lower income tax brackets. If the latter is the case, the trust must be carefully structured so as not to run afoul of the grantor trust rules (at least as to the ordinary income portion of the trust)—e.g., by restricting the ability of the trustee to apply all or a portion of the trust income to or for the benefit of the transferee spouse.
Use of the DSAT technique should be considered by any married couple who is contemplating making a gift of more than $11.58 million (or at least more than either spouse’s remaining lifetime gift tax exemption), either due to changes in tax laws after the election, or in light of the 2026 sunset provision in the existing law, but who is hesitant to do so without maintaining access to all or most of the gifted assets. As described above, the only significant potential disadvantage of the DSAT that cannot be easily solved (in addition to the fact that the couple may divorce or the transferee spouse may die prematurely) concerns the ability of the Crummey withdrawal power holders to withdraw significant trust funds, at least for a limited time. If the couple views this as a significant concern for their particular family, they should either not employ the DSAT device or, if the couple nevertheless still desires to utilize the DSAT, eliminate or limit Crummey withdrawal rights in the case of any particular child or grandchild in which there is a significant concern.
1United States v. Estate of Joseph P. Grace, 395 U.S. 316 (1969).
2Bruce D. Steiner & Martin M. Shenkman, Beware of the Reciprocal Trust Doctrine, Trusts & Estates 14, 17 (April 2012).
3I.R.C. § 2513(a)(1).
4This point was raised by the attorney authors of the article cited in footnote 2, and their proposed solution was to attempt to draft reciprocal trusts that did not run afoul of the Supreme Court’s decision in Grace. Steiner & Shenkman, supra note 2, at 14.
5Per Section 25.2514-3(c)(4) of the federal gift tax regulations:
Section 2514(e) provides that a lapse during any calendar year is considered as a release so as to be subject to the gift tax only to the extent that the property which could have been appointed by exercise of the lapsed power of appointment exceeds the greater of (i) $5,000, or (ii) 5 percent of the aggregate value, at the time of the lapse, of the assets out of which, or the proceeds of which, the exercise of the lapsed power could be satisfied. For example, if an individual has a noncumulative right to withdraw $10,000 a year from the principal of a trust fund, the failure to exercise this right of withdrawal in a particular year will not constitute a gift if the fund at the end of the year equals or exceeds $200,000. If, however, at the end of the particular year the fund should be worth only $100,000, the failure to exercise the power will be considered a gift to the extent of $5,000, the excess of $10,000 over 5 percent of a fund of $100,000. Where the failure to exercise a power, such as a right of withdrawal, occurs in more than a single year, the value of the taxable transfer will be determined separately for each year.
6Note that for beneficiaries who are residents of a domestic asset protection trust state, it may be possible to structure the Crummey withdrawal rights so that the lapsed portions will thereafter be protected from the withdrawal power holder’s creditors, at least outside of federal bankruptcy and its potential ten-year waiting period for transfers to a self-settled trust.
7Although in many states the income from separate property is considered marital or community property.
8Per Section 25.2513-1(b)4) of the federal gift tax regulations:
If one spouse transferred property in part to his spouse and in part to third parties, the consent is effective with
respect to the interest transferred to third parties only insofar as such interest is ascertainable at the time of the gift and hence severable from the interest transferred to his spouse. See § 25.2512-5 for the principles to be applied in the valuation of annuities, life estates, terms for years, remainders and reversions.
See also Section 2632-1(b)(2)(i) of the federal GST tax regulations:
An indirect skip is a transfer of property to a GST trust as defined in section 2632(c)(3)(B) provided that the transfer is subject to gift tax and does not qualify as a direct skip. In the case of an indirect skip made after December 31, 2000, to which section 2642(f) (relating to transfers subject to an estate tax inclusion period (ETIP)) does not apply, the transferor's unused GST exemption is automatically allocated to the property transferred (but not in excess of the fair market value of the property on the date of the transfer). The automatic allocation pursuant to this paragraph is effective whether or not a Form 709 is filed reporting the transfer, and is effective as of the date of the transfer to which it relates. An automatic allocation is irrevocable after the due date of the Form 709 for the calendar year in which the transfer is made.
9Estate of Bischoff v. Comm’r, 69 T.C. 32 (1977); Exchange Bank & Trust v. United States, 694 F.2d 1261 (Fed. Cir. 1982); contra Estate of Green v. United States, 68 F.3d 151 (6th Cir. 1995).