Married persons sometimes want to set up two TOLIs: one created by the husband for the benefit of his wife and their children, and another created by the wife for the benefit of her husband and their children. If you want to set up this type of arrangement, steps must be taken to avoid the reciprocal trust doctrine, which can result in both TOLIs being included in the insured’s estate.
For example, there was a case where a decedent (i.e. person who died) transferred assets to his wife over the course of 23 years. The decedent then set up a TOLI for his wife, with the remainder going to their children. Then, the husband directed his wife to create a very similar TOLI for his benefit, with the remainder going to their children. In finding that the TOLI was includable in the decedent’s estate, the United States Supreme Court held
[T]he 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.
U.S. v. Estate of Grace, 395 U.S. 316, 324 (1969)
When this situation arises, the IRS will simply uncross the TOLIs by finding a “quid pro quo,” thus, treating each spouse as if they created a TOLI and included the insurance policy proceeds in each spouse’s estate.
For these reasons, the reciprocal trust doctrine significantly limits the use of such an arrangement due to the uncertain tax treatment. If such TOLIs are desired (despite its potential risks), the terms of property distribution should be as different as possible, the TOLIs should be set up at different times, and at one TOLI should not economically benefit the other spouse.
NOTE: This does not apply in situations where the settlor does not benefit from the trust. For example, you can create two trusts for the benefit of your children, which thereby allows each spouse to be the trustee of the other spouse’s trust.
