Random Thoughts on SLATs

Take-Away: If a spousal lifetime access trust is considered by spouses, there are several traps to avoid when the trust is drafted and when the trust is funded.

Background: As married couples begin to ask their advisors about the possibility of adopting a spousal lifetime access trust (SLAT) there are several traps to be considered at when drafting or funding the SLAT. Some of the more important considerations follow:

Avoid Retained Powers of Appointment: Since many SLATs are ‘pitched’ to the married couple as removing an appreciating asset from their taxable estates while they can continue to have indirect access to the SLAT’s income (through the beneficiary-spouse) several thoughts come to mind. First, communications with married couples should avoid any reference to the settlor’s ‘indirect access’ benefit to the SLAT’s income. This wording suggests an illusory aspect to the assets presumably irrevocably transferred by the settlor to the trust which the IRS can discover in litigation. Second, indirect access references in correspondence with the settlor, or with the settlor’s other advisors, might expose the irrevocable trust assets to claims of creditors- the goal is to avoid the implication of an implied understanding, or a claim that the SLAT created by the settlor is actually a self-settled trust and thus subject to creditor claims. Third, the settlor should not hold a power of appointment over the trust, nor act as a trustee with the power to distribute trust income or principal. At most, if the settlor wants to remain involved in the administration of the SLAT, he/she can name themselves as a trust director over trust investments, but not act as a trustee or co-trustee. It is possible to structure a trust as a qualified dispositions in trust, aka asset protection trust, in which the settlor would shield the assets from future creditor claims (but that’s for another missive.)

Avoid a Grantor Trust Classification: Since the settlor’s spouse is the beneficiary of the trust, the trust is within the classification as a grantor trust for income tax reporting purposes. [IRC 677.] The trust remains a grantor trust even after the beneficiary-spouse’s death, which will cause the settlor-spouse to continue to be liable for the trust’s income tax liability when the settlor will no longer have ‘indirect access’ to the trust’s income (through his/her spouse.) The trust remains classified as a grantor trust even if the spouses later divorce. The way around the grantor trust problem is to draft the trust instrument so that another person with an adverse interest in the trust (to the beneficiary-spouse), like a child who holds a remainder interest in the trust, must consent to distributions to the beneficiary-spouse. If that ‘adverse interest’ consent is required, then the trust will not be classified as a grantor trust. the beneficiary-spouse should not possess the right to trust income, if possible.

Anticipate a Future Divorce: As just noted, even if the settlor and the spouse later divorce, the trust remains classified as a grantor trust for income tax purposes. For the settlor to avoid having to pay income taxes on a trust of which his/her former spouse is the beneficiary, consider: (i) make income distributions discretionary, or shift from a right to income to a discretionary trust in the event of divorce; or (ii) provide that the spouse ceases to be a beneficiary of the trust if there is a divorce; or (iii) use a ‘floating spouse’ description rather than name the spouse as the trust’s income beneficiary, e.g., the trustee shall pay income to the person to whom I am legally married at the time of distribution. The first two suggestions will avoid the ignominy of paying a former spouse’s income tax liability. The last suggestion would enable the settlor’s ‘new’ spouse to step into the shoes of their former spouse as beneficiary of the trust.

Beware Reciprocal Trust Doctrine: This doctrine was announced in U.S. v Grace, by the U.S. Supreme Court. The import of this doctrine is that where settlors possess beneficial interests in two trusts that are substantially similar, such as mirror image trusts where the husband’s trust created for his wife looks just like the trust that the trust the wife created for her husband, those interests will be treated as if they were self-settled trusts, and the value of the assets of which will be included in the settlor’s taxable estate. [IRC 2036(a)(1).] If the spouses are contemplating the creation a trust for each other, the trust instruments should be made as different as possible, e.g.,: (i) make beneficial interests of the spouses substantially different; (ii) grant one spouse a limited power of appointment but not the other; (iii) delay the beneficial interest of one spouse in the other’s trust; (iv) settle the trusts in different states, e.g., Michigan and Delaware;  (v) settle each trust in a different tax year.

Beware the Step-Transaction Doctrine: If the assets that are to be used to fund both SLATs are held in the name of one spouse, a transfer from the owner to his/her spouse to enable the spouse to fund their SLAT can be claimed by the IRS, which would consume the donor-spouse’s applicable exemption amount. In Smaldino v Commission, the Tax Court held that the husband’s transfers, through his revocable trust, to his wife, of interests in an LLC, which the wife assigned the next day to an irrevocable trust that the husband had previously funded (exhausting his own applicable exemption amount) were treated as additional, taxable, transfers by the husband to the irrevocable trust. The result was the imposition of significant gift taxes imposed on the husband. Thus, if one spouse needs to transfer assets to the other spouse to enable the other spouse to make taxable gifts using his/her available applicable exemption amount, there should be significant amount of time that passes between the gift to the one spouse, the later the gift by the donee-spouse to the SLAT created for the other. Better yet, if the nature of the gifted assets changes between the gift between the spouses and the donee’s funding of the SLAT, that is even better.

Use Different Assets: As part of the effort to avoid the risk of the IRS asserting the application of the reciprocal trust doctrine, the trusts should be funded using different assets. To start with, the trusts should not be funded from joint account. If there are insufficient assets available to fully fund both SLATs, consider funding one SLAT with a secured promissory note from the settlor-spouse.

Avoid ‘Back-Door’ Access to the Trust: One of the big concerns of heavily funding a SLAT is that the beneficiary-spouse dies, the SLAT continues, the settlor spouse is still having to pay income taxes on the SLAT’s income, yet the settlor no longer has indirect access to the SLAT’s income since his/her spouse died. There have been several articles how the settlor could be ‘added back’ to the SLAT as a beneficiary, in effect replacing their deceased spouse as a beneficiary. Some ‘suggestions’ that have been floated include: (i) give the beneficiary-spouse a limited testamentary power of appointment to appoint assets, either outright but more likely in a continuing trust, for the benefit of a class among which the settlor would qualify, e.g., the class of potential appointees consists of descendants of John Smith, when the settlor was a grandson of John Smith; or (ii) give a trust director the authority to add trust beneficiaries, again using a vague description of a class of potential beneficiaries which includes the SLAT’s settlor. Obviously, with either of these approaches that might bring the settlor back into the SLAT that he/she created as a potential beneficiary carries the feeling that there might be some prearrangement to bring the settlor in through the back-door into the SLAT. Perhaps a cleaner way to proceed, if the goal is to give the SALT’s settlor access to the trust’s income is to give the trustee the authority to loan income producing assets to the settlor. Or, since most SLATs are classified as grantor trusts, the settlor could purchase income producing assets from the SLAT that he/she created in exchange for a promissory note, or substitute assets of equivalent value for the income producing assets held in the SLAT.

Conclusion: SLATs make a lot of sense to remove assets and their appreciation from a taxable estate. You just have to be careful to avoid all of the ‘traps’ along the way.