Take-Away: The benefits and limitations of a conventional spousal lifetime access trust, or SLAT, are fairly straightforward. However, SLATs can also be structured differently to accomplish different tax or creditor protection objectives. As such, a variety of form SLATs should be considered to best achieve the settlor’s objectives.

Background: A spousal lifetime access trust (a SLAT) is currently a popular estate planning strategy for many married couples. A SLAT results in a taxable gift that is made by the settlor-spouse to an irrevocable trust that is established for the benefit of the settlor’s spouse, and perhaps other family members. No marital deduction is claimed by the settlor for his/her transfer; instead, the transfer is reported as a taxable gift on a Form 709 Federal Gift Tax Return. The benefits that arise from a SLAT include:

  • Creditor Protection: The assets held in the SLAT are protected against creditor claims against the settlor-spouse and the beneficiary-spouse if the SLAT contains a comprehensive spendthrift provision;
  • No Gift Tax When the SLAT is Funded: The settlor’s taxable gift to the SLAT is sheltered by the settlor’s currently large federal gift tax applicable exemption amount;
  • Settlor Indirectly Benefits from the SLAT’s Assets: The settlor-spouse can indirectly benefit from the SLAT’s income and principal, since the settlor’s spouse is the (or one of the) lifetime beneficiaries of the SLAT; and
  • No Federal Estate Tax: The SLAT’s assets (and any future appreciation of its assets) escape federal estate taxation on the beneficiary-spouse’s death as well as the settlor-spouse’s death. The SLAT could also be structured as a dynasty trust that would avoid federal estate and generations skipping transfer taxes for multiple generations.
  • Use GST Tax Exemption: If a dynasty-type of SLAT is contemplated, the settlor-spouse can assign his/her generation skipping transfer tax (GSTT) exemption to the transfer. Unlike the settlor’s unused applicable exclusion amount that can be ported to their surviving spouse, a deceased spouse’s unused GSTT exemption cannot be ported. Consequently, in the absence of portability, it is better for the spouses to use their available GSTT exemption to shelter lifetime gifts, such as to a long-duration SLAT.

Often these conventional lifetime SLATs are called a completed gift SLAT due to the settlor’s desire to fully use his/her then available federal transfer tax applicable exclusion amount (and/or his/her GSTT exemption amount) to shelter a lifetime gift from taxation before its 2026 sunset when the federal transfer tax applicable exclusion amount and GSTT exclusion amount are scheduled to be cut in half.

SLAT Limitations: There are some limitations associated with a completed gift SLAT that must be addressed in the design of the SLAT. A short summary of those  SLAT limitations follow:

  • The Couple Divorce: A completed gift SLAT is a grantor trust for income tax reporting purposes. This does not pose much of a problem while the beneficiary-spouse is alive and married to the settlor, since any distributions from the SLAT to the beneficiary-spouse will be reported on the spouses’ Form 1040 income tax return for the year. The problem arises when the spouses divorce. The SLAT will continue to be taxed as a grantor trust as to its settlor even though the spouses are no longer married. [IRC 677.] The risk of a future divorce can be mitigated to some degree with the use of a floating spouse provision in the SLAT instrument, where the beneficiary-spouse is not expressly named in the trust instrument; rather, the trust beneficiary who is entitled to distributions from the SLAT is described as “the person to whom the trust settlor is married.” If there is a future divorce, the settlor’s former spouse will no longer fit within that definition as the SLAT’s beneficiary.

    However, the floating spouse provision does not eliminate the fact that the SLAT remains a grantor trust and its settlor will continue to be taxed on the SLAT’s income but no longer with a spouse as the trust’s beneficiary who can provide to the settlor indirect access to the trust’s income to pay the continuing income tax liability; the settlor will continue pay the SLAT’s income tax burden without access to any trust funds to pay the income tax liability.

  • Grantor Trust Income Tax Burden: As noted, the income tax burden problem as a grantor trust continues even when the beneficiary-spouse dies. Since the deceased spouse is no longer a SLAT beneficiary, the settlor-spouse loses indirect access to the SLAT’s income or principal. This problem can be mitigated to some extent by giving the SLAT’s trustee the authority to, from time to time, make distributions to the settlor-spouse to enable the settlor to pay their income tax liability associated with the grantor trust. However, reimbursement of the settlor’s income tax liability by the SLAT’s trustee cannot be a regular or annual occurrence, otherwise the IRS will claim that there was a pre-arrangement between the settlor and the SLAT’s trustee to always reimburse the settlor, which will lead to inclusion in the settlor’s  gross estate the value of the SLAT’s asset under IRC 2036.

    Presumably the SLAT trustee could also loan SLAT assets to enable the settlor to pay the income tax liability associated with the SLAT if the settlor faces a genuine financial crisis, if the power to make loans is expressed in the trust instrument.

    Or, if the settlor retained the power to substitute assets of equivalent value with the SLAT’s assets, then the settlor could purchase the SLAT’s income producing assets in exchange for an interest-only, balloon note, to reduce the SLAT’s annual income amount.

  • Settlor’s Loss of Indirect Access: One of the prominent benefits of the SLAT is that the settlor-spouse can use his/her large applicable exemption amount while it exists, yet continue to have indirect access to his/her gifted assets through the SLAT trustee’s income and/or principal distributions to the beneficiary-spouse. When the beneficiary-spouse dies, that indirect access to the trust’s income and principal enjoyed by the settlor-spouse comes to an end.

    Recently a couple of states [North Carolina and Florida] have amended their state trust statutes to enable the settlor-spouse to name himself/herself as a successor beneficiary to the SLAT that they create. Michigan’s Estate Planning and Probate Council is currently studying similar legislation for Michigan. These statutory amendments prohibit such a ‘continuing’ SLAT for the settlor’s successor lifetime benefit as being classified as a self-settled trust, which thus maintains the trust’s creditor-protection features. Less clear is whether the IRS will look at the SLAT with its settlor as-continuing-trust-successor-beneficiary along the same lines as state property law protection purposes for federal transfer tax purposes, or whether the IRS will try to include the value of the SLAT’s assets in the settlor’s gross estate on death under IRC 2036-2038, i.e. a lifetime transfer with a retained interest in the transferred assets and the income generated by those transferred assets.

  • Reciprocal Trust Doctrine: The last drawback to the use of a completed gift SLAT is when each spouse creates and funds a SLAT for the other. If the two SLATs are close to ‘mirror images’ of each other, the IRS will ‘uncross’ the two SLATs, and treat each as a self-settled trust created for himself or herself, the result of which is that the value of the created SLAT’s assets will be included in the settlor-spouse’s taxable estate at death. It is fairly easy to avoid application of the reciprocal trust doctrine by using different trust terms, different trustees, different assets, and perhaps create the two SLATs in different tax years when the settlors’ taxable gifts to the SLATs are reported to the IRS on Form 709.

Non-grantor SLATs: As noted earlier, a conventional or completed gift SLAT is a grantor trust where the trust’s taxable income is reported on the settlor’ personal income tax return; IRC 677 taxes the settlor if the settlor’s spouse is a beneficiary of the trust. One option, not used very frequently, is that the SLAT can be designed so that the settlor is not taxed on the SLAT’s income. This is accomplished by requiring any adverse party, e.g. a trust beneficiary other than the settlor’s spouse, to consent or approve any distributions  to be made from the SLAT by its trustee. For example, if a SLAT was set up for the lifetime benefit of the settlor’s spouse and his/her descendants, all distributions from the SLAT by the trustee would require the written consent of one of the settlor’s children. This required consent by a person with an adverse interest in the trust would cause the SLAT to not be taxed as a grantor trust.

  • State Income Tax Savings: A non-grantor SLAT is sometimes used to avoid state income taxes by structuring the SLAT instrument around the state’s income tax rules that apply based on the settlor’s residence, the trustee’s residence, the place of the trust’s administration, and in rare cases the residency of the trust’s beneficiaries. A non-grantor SLAT can thus be used in situations to possibly save state income taxes when income is to be accumulated in the trust, potentially save estate taxes on the beneficiary-spouse’s death, provide some creditor and divorce protection, while still giving the SLAT’s settlor indirect access to the SLAT’s assets through periodic distributions to the settlor’s spouse while he/she is alive.

Incomplete SLATs: If the settlor-spouse wishes to be assured that he/she will possess the ability to benefit from the SLAT that he/she creates and funds, fearing a future divorce or the beneficiary-spouse’s sudden death, then the SLAT can be structured as an incomplete gift by the settlor. Usually this is accomplished by the settlor-spouse retaining a lifetime and testamentary power to appoint the SLAT’s income or principal to anyone other than the settlor, the settlor’s estate, or the creditors of the settlor or the settlor’s estate, i.e. a limited or special power of appointment. The settlor-spouse also can retain a power to veto any distributions from the SLAT. Due to these retained powers by the settlor-spouse, his/her transfer to the SLAT is not a completed transfer for federal gift tax purposes.

  • Estate Inclusion: The obvious ‘downside’ to the incomplete SLAT is that the value of the SLAT’s assets (and future appreciation of those transferred assets) will be included in the settlor’s gross estate for federal estate tax purposes. [IRC 2033.]
  • Tax Basis Adjustment: However, there will be a corresponding income tax basis adjustment to the SLAT’s assets on the settlor-spouse’s death, due to the estate inclusion of the SLAT asset values in the settlor-spouse’s taxable estate. [IRC 1014.]

Hybrid SLATs: When the settlor-spouse wants to preserve the ability to benefit from the SLAT that he/she creates in the event that there is a future divorce, or the beneficiary-spouse dies ‘prematurely’, a SLAT can have its situs in a jurisdiction with a favorable domestic asset protection trust (DAPT) statute. Sometimes this type of SLAT is called a hybrid SLAT.  The belief is that a hybrid SLAT can increase the likelihood that the trust’s assets will be protected from creditor claims, due to the provisions of the state’s DAPT statute. Practically speaking, the hybrid SLAT is like a conventional DAPT except that the settlor is not a beneficiary of the trust, but he/she can be added as a beneficiary at a later date. Thus, for example, a trust is established to benefit the settlor’s spouse and his/her descendants, but not for the settlor’s own benefit. By not including the settlor as a beneficiary of the trust, a hybrid SLAT is by definition a third-party created trust, not a self-settled trust, and thus it initially avoids the risk and scrutiny normally associated with a DAPT. Like the conventional SLAT, the settlor will have indirect access to the DAPT-trust’s assets and income through his/her beneficiary-spouse. If the settlor later needs to become a discretionary beneficiary of the hybrid SLAT, the trust instrument provide that a trust director/protector can add additional beneficiaries to the trust, including the settlor, e.g. from a defined class within which the settlor would qualify- “the trustee may add as a beneficiary to this trust any lineal descendant of John Smith.”

‘SLAT’ Converts Later to DAPT:  If the settlor is later added to the class of discretionary trust beneficiaries, then the hybrid SLAT becomes instead a normal DAPT rather than a SLAT. Psychologically speaking, simply knowing that the settlor can be added, if necessary, especially if he/she can indirectly influence being added as a beneficiary at a later date, can make the settlor feel much more comfortable about transferring a larger amount of assets to the irrevocable trust for their spouse and descendants.

  • Choice of Jurisdiction: Some states have far more flexible DAPT statutes that should probably be considered if a hybrid SLAT is being considered. Trust ‘haven’ states like South Dakota or Nevada have statutes that are intended to attract DAPT business, so they might be candidates for this type of trust, moreso than other states that have DAPT statutes but with other limitations or constraints that have to be factored into the decision where to locate the hybrid SLAT.
  • Caution: The hybrid SLAT-DAPT cannot be set-up as a non-grantor trust, so that if state income tax avoidance is a key objective to creating the trust, a different trust alternative must be used.

Conclusion: While most of us are familiar with a completed gift SLAT, there may be occasions when a different variety of SLAT should be considered, depending upon the goals of each settlor.