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George F. Bearup, J.D. Senior Legal Trust Advisor

17-Jul-19

No Tax Between the SLATs

Take-Away: A spousal lifetime access trust, or SLAT, is a grantor trust for income tax reporting purposes. If each spouse creates a SLAT for their spouse, the settlor will continue to pay income taxes on the SLAT’s income. The fact that the SLATs are grantor trusts also means that the transfer of assets between the two SLATs will cause no gain or loss to be recognized for income tax reporting purposes. This is another positive attribute to the use of SLATs that might encourage a married couple to adopt non-reciprocal SLATs while the current federal gift tax exemption is temporarily very large. The married couple would still have access to all of the income the SLATs generate, yet upward to $22 million could be removed from their taxable estates.

Background: A grantor trust can result under several different Tax Code sections. [IRC 671 through IRC 679.]

  • Grantor Trust by Retained Powers: One common Tax Code section that is used to intentionally create a grantor trust is IRC 675. This Section requires the settlor to be treated as the owner of any portion of the trust in respect of which the settlor (or the settlor’s spouse) holds certain administrative powers.  The mere existence of some of these retained powers is sufficient to cause grantor trust Examples: (i) The settlor retains the power to deal for less than adequate and full consideration with the trust’s assets; or (ii) the settlor retains the power to borrow from the trust without adequate interest or collateral security.
  • Grantor Trust by Action: Actions (or omissions) taken by the settlor can also cause a trust to be treated as a grantor trust for income tax purposes. Example: The settlor directly or indirectly borrows principal or income from the trust but the settlor has not completely repaid the loan, including accrued interest, before the beginning of the next tax year of the trust. Due to the settlor’s outstanding and unpaid loan and interest, the trust will be classified and taxed as a grantor trust. This scenario is often used to toggle grantor trust status on and off from year to year, which turns on if the loan to the settlor is fully paid in full, or not, by the settlor at the end of the trust’s tax year.
  • Trust Disregarded: With a grantor trust the settlor is treated as the owner of the assets held in the trust and the grantor trust is disregarded as a separate tax entity. As a result, all trust income is taxed to the settlor. [Rev. Rul. 85-13, 19985-1 C.B. 184.] Thus, the grantor trust is effectively ignored and treated as the individual settlor of the trust.
  • Trust Income for Spouse: A grantor trust also exists when a trust is created for the settlor’s spouse. IRC 677(a) treats the settlor as the owner of any portion of a trust the income from which, without the approval or the consent of any adverse party, is, or in the discretion of the settlor, or the settlor’s spouse, or a non-adverse party, or both, may be distributed to the settlor or to the settlor’s spouse [Treas. Reg. 1.677(a)-1(b) (2) (i)]. Grantor trust treatment will also occur if the trust’s income is held or accumulated for future distribution to the settlor or to the settlor’s spouse. [Treas. Reg. 1.677(a)-1(b) (2) (ii).] By virtue of this Tax Code section, spousal lifetime access trusts, i.e. SLATs, are classified as grantor trusts, as usually the settlor’s spouse is named as the lifetime income beneficiary of the SLAT.

Intra-Spousal Transfers Treated as Gifts: The Tax Code also provides that no gain or loss will be recognized on the transfer of property from an individual to that individual’s spouse. [IRC 1041(a) (1).] With the transfer of appreciated assets between spouses, the transferred property will be treated as being acquired by the recipient spouse as a gift. Consequently, the income tax basis in the transferred asset held by the donee-spouse will be the adjusted basis of the donor-spouse, i.e. carryover income tax basis applies. [IRC 1041(b).]

SLAT Transactions: The tax rules summarized above result in the non-recognition of gains or losses in the transfer of assets to and from SLATs, or between SLATs, or by the spouses. Accordingly, these tax rules permit assets to move freely between SLATs without any income tax consequence. This non-tax treatment was confirmed in a recent private letter ruling. PLR 201927003, dated April 5, 2019, released July 5, 2019 (Index Number 1041.00-00.)

Example: Dan creates a grantor trust for Rosanne under IRC 675(4). IRC 675(4) (c) is the power of administration that is exercisable in a non-fiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity to reacquire trust corpus by substituting other property of equivalent value. This first trust created by Dan will be disregarded as a separate tax entity and Dan will be taxed on all the first trust’s income. Rosanne, Dan’s wife, creates and funds another, second trust for Dan. This second trust is also a grantor trust due to IRC 675(4), i.e. Rosanne retains a power of substitution. Rosanne is treated as the owner of the second trust’s assets. The second trust is disregarded as a separate tax entity and all income from the second trust is taxed to Rosanne. [Rev. Rul. 85-13.] Dan sells limited partnership interests that he owns to the second trust. In addition, the trustee of the first trust created by Dan sells its limited partnership interests to the second trust established for Rosanne. Because the first trust is a grantor trust, the limited partnership interests sold by the first trust will be treated for federal tax purposes as being sold by Dan. In addition, because the second trust is also a grantor trust, assets purchased from both Dan and the first trust will be treated for income tax purposes as purchased by Rosanne. The results of these sales of limited partnership units to the second trust are summarized as follows:

  • Dan will recognize no gain or loss on the sale by Dan of his interest in the limited partnership to the second
  • Dan will recognize no gain or loss on the sale by the first trust of its limited partnership interests to the second trust, for the same reasons.
  • The income tax basis of the limited partnership interest acquired from Dan by the second trust will be the same as the adjusted income tax basis in the limited partnership while it was owned by Dan.
  • The income tax basis of the limited partnership interest acquired from the first trust by the second trust [grantor trust to grantor trust ]will be the same as the adjusted income tax basis in the limited partnership interest held by the first

These non-tax results are caused by: IRC 677 (grantor trust when spouse is beneficiary) IRC 1041 (a)(1) and (b)(1) (carryover basis in transfers between spouses) and Revenue Ruling 85-13 (grantor trust is ignored and treated as its settlor.)

SLAT Limitation: If there is a big downside to creating a grantor trust like a SLAT for a spouse’s benefit.  That is when, if ever, the spouses subsequently divorce. In the event of a divorce between spouses,  the trust remains a grantor trust for income tax reporting purposes. In the above example, if Dan and Rosanne later divorce, Dan will continue to be responsible for the income tax liability on the second trust of which Rosanne remains the income beneficiary. This was not so much of a problem in the past because IRC 682 “trumped” most of the grantor trust rules and shifted the income tax responsibility to the spouse who is the income beneficiary of that otherwise grantor trust. However, the Tax Cuts and Jobs Act of 2017 repealed IRC 682. This problem, if the  spouses later divorce, is why most SLATs are drafted using a floating spouse concept as the designated income beneficiary. This means that rather than describe “Rosanne” as the first trust’s income beneficiary created by Dan, the beneficiary of the first trust is described by Dan as “the person to whom I am legally married;” Dan will continue to be legally responsible for the taxes on the first trust’s income, but Rosanne will no longer be the income beneficiary after their divorce. Unfortunately, the IRS’s position is that the grantor trust classification does not end just because Dan and Rosanne later divorce and cease to be married- the fact that they were married at the time the trust was created is the operative fact that causes the grantor trust classification.

Conclusion: There is also the danger of triggering the reciprocal trust doctrine if mirror-image SLATs are created by the spouses for each other. If, however, that doctrine can be avoided through careful drafting and funding, i.e. non-mirror image trusts, created at different times, with different assets, the opportunity to move assets back and forth between spouses and their grantor trusts provides additional flexibility for lifetime income tax planning purposes without exposing the trusts’ assets to federal estate taxation.