There are a host of specific technical issues that are critical to address this year; in the past these may have been perceived by planners as more theoretical than real. In the simplest terms, in many client families, a couple should each establish and fund a trust today that is similar to the typical bypass trust (also called a credit shelter trust or an applicable exclusion trust) that is contained in their wills.
One spouse could set up a trust and name his or her partner and descendants as beneficiaries. The spouse would do the same. Since financial planners will often be intimately involved in this process and since the assets under management may well be used to fund these trusts, planners should be at least conversant with some of the issues. There are several hurdles that have to be jumped over.
Hurdle No. 1: How much in terms of assets can or should a client transfer before 2013? In large part, that will turn on two important considerations.
The magnitude of the transfer should not be so great as to undermine the client's abilities to pay bills; if that were to happen, it could be characterized as a fraudulent conveyance and be susceptible to being set aside if the client is sued.
Another key consideration is the identity of the recipient of the transfer. For almost every situation, the transferee of this largesse should be an irrevocable trust. The trust could be a dynasty trust for all future descendants.
If so, that might inhibit how much the client is comfortable transferring, regardless of what the projections show. If a spouse is made a beneficiary of the trust, the couple might be comfortable transferring a greater proportion of their assets. Finally, even a transferor spouse may be a beneficiary of the trust; this may be permissible in a domestic asset protection trust formed in a state that has the appropriate law.
Hurdle No. 2: Does the reciprocal trust doctrine apply? A somewhat esoteric tax trap called the reciprocal trust doctrine has been on the back burner for most planners for a long time, but it's becoming a hotter topic this year. If spouses create similar reciprocal trusts, one for the other, then the net result may be no economic impact, nor any effect for tax purposes.
In prior years, there may have been no particular rush for spouses to create similar trusts. But now, many couples will be motivated to both make large gifts to use up some or all of the current gift exemption.
If a spouse gives $5.12 million to a trust for the benefit of his or her spouse and children, and the second spouse gives $5.12 million to a trust for the benefit of his or her spouse and children, the specter of the reciprocal trust doctrine is raised.
The IRS could "uncross" the two trusts and rule that each person is the grantor of the trust of which he or she is the beneficiary. This would result in each spouse's trust being taxed in his or her own estate, undermining all the well-intentioned planning.
There is no clear safe harbor as to what constitutes a sufficient difference between two trusts to avoid the reciprocal trust doctrine, so the best approach is to make the trusts as different as is practicable under the circumstances. The key concept is that the spouses should not be in the same economic position after the establishment of the two trusts.
Hurdle No. 3: Beware of the "step transaction" doctrine. For another couple, let's say all the marital assets are in one spouse's name. He or she wants to use up the $5.12 million exemption, and so does the other spouse. So the first spouse transfers the assets to his or her trust.
What can the second spouse do? That's easy - the first spouse can give the other spouse assets to fund the trust.
But if the first spouse transfers assets to the second spouse and the next day the second spouse gifts those assets to a trust he or she sets up, how different is that series of transactions from a sequence in which the first spouse simply transfers assets directly to the other spouse's trust? Not much.