The rest of this year promises to be very challenging for planners with wealthy clients. The federal exemptions on gift and estate taxes currently stand at $5.12 million, but they are scheduled to drop to $1 million in 2013 unless lawmakers act. In addition, President Obama's proposals for next year's budget would undermine many powerful wealth-transfer tax strategies. Planners need to be devising plans so that their clients can jump before an opportunity is lost.

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.

And that "not much" gives the IRS the chance to torpedo the plan by arguing that the step transaction doctrine applies. If the intervening step in which the first spouse gives assets to the other spouse can be ignored, then since the first spouse transferred $5.12 million to two trusts, a large gift tax is owed.

Hurdle No. 4: Is gift-splitting an option? Okay, your client reasons, I won't bother transferring assets to my spouse so I can avoid the step transaction risk. I'll just set up a trust and then transfer $10.24 million to that trust and have my spouse "gift- split." Gift-splitting is a gift-tax rule that permits one spouse to make a gift and both spouses to agree that the gift should be regarded as if it had been made one-half by each of them. Great tool - but there is a big catch.

If the spouse who did not make the actual transfer wants to elect gift-splitting, he or she cannot be a beneficiary of the trust. For most clients, given the amount of wealth being shifted to such an irrevocable trust, excluding both spouses as beneficiaries would be a gift transfer deal breaker. If either spouse never has access to such a large portion of wealth, the setup would simply not be acceptable.

Hurdle No. 5: There is a possibility that you might lose the client's business. Some planners might be concerned about retaining the assets under management if sophisticated trusts are created. Most of these trusts are formed in one of four states that have led the way in this type of planning: Alaska, Delaware, Nevada and South Dakota.

A trust company within the state is typically named as trustee. The trusts can be structured as a directed trust, which can reserve the power in a special fiduciary, called an investment trustee, to continue to designate the planner as investment manager.


Once all the hurdles have been cleared, this may well be the year of the gift. While practitioners should encourage clients to evaluate what might be a fleeting opportunity, they should also be cautious that all the obstacles to this planning have been cleared.

While clients may avoid many of these issues by making outright gifts or using simplistic trusts, those approaches provide less access to the assets given, offer less asset and divorce protection and, regrettably, are rarely going to be optimal.

Martin M. Shenkman, CPA, PFS, J.D., is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs, a free legal website.

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