PLR Finds Life Insurance Trusts Not Sufficiently Interrelated to be Reciprocal Trusts (CC 04-28)


Early in the endless cat-and-mouse battle between taxpayer and IRS, someone figured out a way to get around the predecessor of I.R.C. §2036(a), which, broadly, requires that property transferred by a taxpayer “by trust or otherwise” over which he has “retained for his life  . . . the possession or enjoyment of, or the right to the income from, the property” be included in the transferor’s gross estate.  For example, A creates a trust naming B as the income beneficiary of certain bonds. B also creates a trust, this one naming A the income beneficiary of certain bonds (perhaps the very same bonds; see United States v. Grace, infra).  Even better, suppose A and B also grant each other rights to withdraw trust property.  When A dies, his estate argues that neither trust is includible because he “did not have a power over a trust which he had created.”  Yet he certainly had a right to enjoy the trust property.

These facts are roughly those in Lehman v. Commissioner, 109 F.2d 99 (C. A. 2d Cir.), cert. denied, 310 U.S. 637  (1940).  The Second Circuit had little patience with the subterfuge: "The fact that the trusts were reciprocated or `crossed` is a trifle, quite lacking in practical or legal significance. . . . The law searches out the reality and is not concerned with the form." 109 F.2d, at 100. 

When the reciprocal trust doctrine reached the United States Supreme Court, it strongly reaffirmed the Second Circuit’s skepticism.  In United States v. Estate of Grace, 395 U.S. 316 (1969), a wealthy husband established a trust with his wife as income beneficiary, and then she established a trust with him as income beneficiary, with the very same corpus, under his direction. This allowed the Supreme Court to set out the legal standard for reciprocity:

[A]pplication of the 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 trusts naming themselves as life beneficiaries.

395 U.S. at 324. The inquiry is objective (thus, a court need not ask whether the second trust was intended as “consideration,” a quid pro quo, for the first), and need not require the finding of a tax avoidance motive.  The Court did not offer a definition of “interrelated”: it didn’t need to, since the facts were so clear: “It is undisputed that the two trusts are interrelated. They are substantially identical in terms and were created at approximately the same time. Indeed, they were part of a single transaction designed and carried out by decedent.  395 U.S. at 325.  Thus, presumably, whether trusts are interrelated will depend on the facts of each case. 

In theory, the “same economic position” criterion would seem more important, because it is the one that would seem to have §2036(a) consequences. If the trusts, interrelated or not, leave the parties in a different economic position than they would have occupied if they had named themselves beneficiaries, does this not at least raise the question whether the settlor relinquished enjoyment, etc., of the property?  If you’re searching out reality and disregarding form, shouldn’t that be the inquiry? 

Nonetheless, the Supreme Court stated the criteria conjunctively: the trusts must be interrelated and the parties must be in the same economic position. The Tax Court has followed this position.   PLR 200426008’s discussion of Tax Court precedent is worth quoting at length:

In Estate of Levy v. Commissioner, 52 T.C.M (P-H) P 83,453 (1983), a donor and his spouse created irrevocable trusts on the same date. Each spouse was named as trustee of the trust created by the other spouse. Each spouse transferred to the trust that spouse created 12.5 shares of stock in a closely-held corporation that the spouses controlled. The donor`s trust granted his spouse the power to appoint the income or the corpus of the donor`s trust at any time during the spouses` joint lives to any person or persons other than the spouse, her creditors, her estate, or the creditors of her estate. The spouse`s trust did not contain a similar provision but was substantially identical to the donor`s trust in all other respects.

One would think that the trusts’ being created at the same time, with spouses as each others’ trustees and the same property contributed to each would be enough to establish interrelatedness. However, as the PLR continues: “The Tax Court found that the spouse`s special power was valid under state law. The court concluded that the trusts were not interrelated and, consequently, not reciprocal.”  Thus, the Tax Court’s view appears to be that virtually any difference in the trust instruments—for example, a power of appointment given one settlor but not the other—is enough to destroy reciprocity.  And so, as the PLR continues, “[a]fter finding that the trusts in Levy were not interrelated, the Tax Court did not reach the second test.”  (One might wonder what result it would have reached if it did, since according to the PLR it takes the second test to be “whether or not the economic positions of the grantors have been altered by the creation of the trusts.”  That is very different from the Supreme Court’s “approximately the same economic position” language.)

PLR 200426008

Given Levy, the situation presented in PLR 200426008 (dated March 10, 2004, released June 25, 2004) would not seem to offer much difficulty.  A husband and wife proposed to execute irrevocable trust agreements creating Husband’s Trust and Wife’s Trust.  Each trust would contain a life policy on the respective settlor and cash.  Each spouse is the trustee of the other’s trust.

The trusts were identical in a number of respects:

·         Specified beneficiaries have the right to withdraw specified portions of each transfer to the trust for a limited time;

·         The settlor’s spouse will be deemed to be deceased and his/her descendants other than the settlor’s issue ineligible to exercise trust powers of be a beneficiary if there is a divorce, legal separation, or legal action for either;

·         While the settlor’s spouse is alive the trustee must distribute income to their first son and the spouse according to the usual ascertainable standards, the son coming first;

·         If the settlor survives the spouse, the trustee must continue to make distributions to the first son during the settlor’s life;

·         If the son predeceases the settlor, trust property in the settlor’s gross estate is held in a separate marital trust, income to the surviving spouse;

·         If the settlor’s spouse survives, non–marital trust property is to be distributed to spouse and son, son first, according to the usual standards;

·         If the son survives both settlers, the trust assets will be held for him throughout his life, income distributed as usual, principal to settlors’ living issue and deceased children with living issue upon the son’s death.

The trusts differed in several respects, however.

The husband’s trust:

·         Allows the wife to withdraw up to $5000 per calendar year with certain additions;

·         Grants the wife a power of appointment during the husband’s lifetime in favor of husband’s issue, their spouses, and any trusts created primarily for their benefit, but excluding the wife, her estate, and their creditors;

·         Provides for administration of the trust assets if the wife does not exercise the power of appointment;

·         Provides for payments to the wife from the marital trust, its disposition after her death, and its disposition if she does not exercise the power of appointment;

·         Provides for a continued right of withdrawal of non–marital trust property after the husband’s death;

·         Provides for a continued power of appointment over such property.

The wife’s trust:

·         Provides that the husband shall be a beneficiary of the trust no earlier than three years after her death and only so long as his net worth and compensation do not exceed certain thresholds, and distributions are limited to a maximum reduced by the husband’s income;

·         Sets out standards for determining whether the husband meets these eligibility standards.

Given all this, the IRS scarcely bothered to engage in analysis. It merely pointed out the differences between the trusts, concluded that they were not interrelated, and did not apply the second test. 


The letter ruling is straightforward, but one can question its bases. Specifically, one may ask whether interrelatedness is really the criterion the IRS and courts should be using for reciprocity if it is so easy to avoid as it was in Levy.  In Levy and in the letter ruling, there is no question that the trusts are interrelated in any ordinary sense.  In the letter ruling, they were established at the same time as part of a transaction to take care of the son and surviving spouse.  The fact that the trusts had different provisions to meet the different spouses’ needs should not make them less interrelated.  Indeed, the IRS’s recitation of differences between the trusts really highlights ways in which the spouses’ economic positions would differ from the positions they would have if they had appointed themselves beneficiaries of their own trusts—that is, it looks as if they are addressing themselves to the second criterion.

The moral for planners is that the reciprocal trust rules are easier to avoid than one might have thought, but that settlors should take care to ensure that they satisfy both of the Supreme Court’s criteria in Grace.  Differences in trust provisions should result in clear differences in the settlors’ resulting financial situation, taking the Supreme Court’s comment to heart that substance, not form, is the key.

Copyright © 2004, Advanced Planning Press, LLC. All Rights Reserved. 800-532-9955

Partial 1035 Exchanges (CC 04-27)

Background: The Conway Case

What happens if only a portion of an existing annuity contract is exchanged for a new contract, while the balance of the original contract is retained? This issue was dealt with in the Tax Court case of Conway v. Commissioner [111 T.C. No. 20 (1998)]. The relevant facts in the Conway case are relatively simple. The taxpayer purchased an annuity contract in 1992 for $195,600. Annuity installments were not to begin until the year 2029.  Two years later she decided to purchase a new second annuity contract from a different company, and requested the issuer of the first contract to withdraw $119,000 from that contract and send the net proceeds ($109,000, after the deduction of a $10,000 "surrender charge") directly to the issuer of the second contract, which thereupon issued the new $109,000 contract to the taxpayer.

Was this a qualified exchange transaction under §1035? In the Conway litigation the IRS deemed this to be stretching the exchange concept beyond reasonable limits. The Service basically argued that §1035 refers to an exchange of one contract for another contract involving the same insured, and the transaction here was not an exchange of the entire original contract, but rather, merely a withdrawal from the original contract which remained in effect. The fact that the amount withdrawn was sent directly to another insurance company for the purchase of a new annuity did not, the IRS argued, create a qualified exchange of contracts. The Tax Court disagreed.

Tax Court Rejects IRS Position

In the Conway case, the Tax Court ruled in favor of the taxpayer, referring to the specific language of section 1035 and the related regulations, and concluding simply that the IRS had not provided any authority to support its position that section 1035 "is limited to exchanges involving replacement of entire annuity contracts." The Court saw no reason from the legislative history of §1035 to limit its application as the IRS contended, nor did it see any undesirable tax advantage to be gained by a taxpayer from such a transaction.  In this connection the Court cites Greene v. Commissioner, 85 T.C. 1024 (1985), which sustained the application of §1035 in a case in which the taxpayer redeemed an annuity contract in full, received a check for the entire proceeds, and without obligation to do so, endorsed the check to apply the full amount for the purchase of a new annuity contract with a different company.  Thus, to the extent that the transaction in the Conway case might be deemed a dangerous precedent, potentially permitting avoidance of tax upon a partial withdrawal of cash value from an insurance or annuity contract, the Tax Court does not perceive a problem as long as the facts indicate that all of the funds were reinvested in a contract which would have qualified the end result for §1035 treatment if the entire original contract had been given up.

IRS Modifies Its Position Following Conway Decision

The IRS eventually announced acquiescence in the Tax Court’s decision in Conway, but with certain caveats [Action On Decision CC-1999-016, November 26, 1999]. This was followed in 2003 by Revenue Ruling 2003-76  [2003-33 IRB 1] specifically approving partial 1035 exchanges involving non-abusive fact patterns essentially the same as in the Conway case. However, simultaneously with the issuance of this ruling, an IRS notice was issued containing interim guidance on its treatment of such partial exchanges when used for avoidance of taxes under §72(e).

Revenue Ruling 2003-76 and Notice 2003-51

Revenue Ruling 2003-76

Revenue Ruling 2003-76, involved the following fact pattern (essentially identical to that of the Conway case):

·         A owns Contract B, an annuity contract issued by Company B.

·         A is the obligee under Contract B.

·         A contracts with Insurance Company C to issue Contract C, a new annuity contract.

·         A assigns 60 percent of the cash surrender value of Contract B to Company C to be used to purchase Contract C.

·         At no time during the transaction does A have access to the cash surrender value of Contract B that is transferred by Company B to Company C and used to purchase Contract C.

·         No consideration other than that part of the cash surrender value of Contract B that is transferred from Company B to Company C will be paid in this transaction.

·         The terms of Contract B are unchanged by this transaction, and Contract B is not treated as newly issued.

After completion of the transaction, A still owns original Contract B, reduced in value to reflect the cash surrender value transferred to Company C for Contract C. A also owns new Contract C. Because the funds were transferred by Company B directly to Company C, A had no access to the funds during the transaction other than in the form of annuity contracts. Therefore, the ruling concludes that the transfer of a portion of Contract B to Company C for new Contract C is a tax-free exchange under § 1035. The continued existence of Contract B with its reduced cash value does not affect the tax-free character of the exchange.

Under §1035(d), A’s basis in Contract B immediately before the exchange is allocated ratably between Contract B and Contract C based on the percentage of the cash value retained in Contract B and the percentage of the cash value transferred to purchase Contract C. A’s “investment in the contract” (for purposes of Code §72(e)) is allocated in the same manner.

The ruling concludes by expressing concern that some taxpayers may enter into a partial exchange of a portion of one annuity contract for a new annuity contract as a means of reducing or avoiding tax that would otherwise be imposed under § 72(e). In this connection reference is made to Notice 2003-51, published the same day as Rev. Rul. 2003-76.

IRS Notice 2003-51

Notice 2003-51 [2003-33 IRB 1] deals with potential abusive use of partial exchanges to avoid taxation under Code §72(e) on withdrawals from annuity contracts (including the possible 10 percent penalty tax on early withdrawals under §72(q)).

Treasury and the IRS are concerned that some taxpayers may enter into a transaction similar to the partial exchange transaction at issue in Conway (now specifically permitted as per Rev. Rul. 2003-76) to reduce or avoid the tax that would otherwise be imposed by §72(e)(2). For example, if a taxpayer withdraws $100 from an annuity contract with a cash surrender value of $200 and investment in the contract of $80, the entire $100 of the withdrawal would be included in income pursuant to §72(e)(2). However, if that same taxpayer assigned 50 percent of the cash surrender value of the annuity contract in a partial exchange, such that the cash surrender value of each contract after the exchange was $100 and the investment in each contract after the exchange was $40, and then surrendered either the existing annuity contract or the new annuity contract, under §72(e)(2) only $60 would be included in income and $40 would be excluded as a return of investment in the contract.

Section 72(e)(11) provides anti-abuse rules applicable to transactions governed by §72(e), and §72(e)(11)(B) grants the IRS broad authority to publish regulations as necessary "to prevent avoidance of the purposes of [§72(e)]." Treasury and the Service are considering whether to exercise the regulatory authority of § 72(e)(11) to address the transaction described above to assure that such transactions do not become a vehicle for avoiding the rules of § 72(e). In particular, they are considering regulations that would provide rules for determining when a partial exchange of an annuity contract followed by the surrender of, or distributions from, either the surviving annuity contract or the new annuity contract should be presumed to have been entered into for tax avoidance purposes. Specifically, it is suggested that surrenders or distributions that occur within 24 months of the date on which the partial exchange was completed would be presumed to have been entered into for tax avoidance purposes. However, taxpayers would be provided the opportunity to rebut such presumption by demonstrating that the surrender or withdrawal was not contemplated at the time the partial exchange was completed. Additionally, the presumption would not apply with respect to any surrender or distribution that is subject to one of the §72(q)(2) exemptions from the 10 percent early withdrawal (pre-age 59 1/2) penalty tax imposed by §72(q)(1). Other events, such as the safe harbors set forth in §1.121-3T(e), for divorce, loss of employment and other similar events, might also be treated as successfully rebutting any presumption.

Interim Guidance

Pending the publication of regulations, the Service, using general principles of tax law, will consider all the facts and circumstances to determine whether a partial exchange and a subsequent withdrawal from, or surrender of, either the surviving annuity contract or the new annuity contract within 24 months of the date on which the partial exchange was completed should be treated as an integrated transaction, and thus whether the two contracts should be viewed as a single contract to determine the tax treatment of a surrender or withdrawal under § 72(e). The Service cites Helvering v. LeGeirse, 312 U.S. 531 (1941), which concludes that, in substance, annuity contracts and the life insurance contracts purchased by the taxpayer were integrated contracts. However, if a taxpayer demonstrates that one of the conditions of § 72(q)(2), or any other similar life event, such as a divorce or the loss of employment, occurred between the partial exchange and the surrender or distribution, and that the surrender or distribution was not contemplated at the time of the partial exchange, the taxpayer will not be treated as having entered into the partial exchange and the surrender or distribution for tax avoidance purposes.

PLR Addresses Allocation of Basis in Partial 1035 Exchanges

Left open by Revenue Ruling 2003-76 was the question of how the taxpayer’s basis, in a partial 1035 exchange, should be allocated between the two resulting contracts.  The IRS addressed this question in PLR 11276302 (October 17, 2003), a case whose facts were essentially identical to those of Conway and the Revenue Ruling.

In a partial §1035 exchange, one contract is in effect split into two.  Before the exchange, the policyholder owned one annuity with a cash value of C.  after the exchange, he owns two contracts with cash values D and E, equaling C.  Intuitively, the policyholder’s basis in the contracts should be proportional to the cash values. 

The IRS adopts this perspective, suggesting that the original contract (Contract 1) should be considered as being divided into two contracts (Contracts 1A and 1B) just before the exchange.  The policyholder would continue to own Contract 1A, and 1B would be exchanged for a new Contract 2 with the same basis.  This theoretical division of the contract provides us with cash values with which we can calculate a proportional basis. 

The Service offers a complicated algebraic exposition of the way to calculate the basis, which can be paraphrased as follows. Suppose that the cash value of Contract 1 is $100 and its basis is $30, and the policyholder wishes to make a partial exchange of $40.  Then the cash values of Contracts 1A and 1B are $60 and $40 respectively.  (Surrender charges are ignored for the purpose of determining these cash values, even though they would result in a lesser amount being paid into the new contract.)  Then the bases of Contracts 1A and 1B can be determined by multiplying the proportion their cash values bear to that of Contract 1 by the basis of Contract 1. Thus, $60 is .6 of $100 and $40 is .4 of $100.  .6 x $30 = $18, and .4 x $30 - $12. Therefore, the basis of Contract 1A is $18, and that of Contract 1B, i.e. the new annuity that results from the partial exchange (Contract 2), is $12. 

The PLR concludes by noting that the IRS will scrutinize a surrender or withdrawal from either of the resulting contracts for up to 24 months, and that regulations concerning partial §1035 exchanges have yet to be implemented.

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