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

October 4, 2023

SLAT Risks

Take-Away: While a spousal lifetime access trust may make sense for many wealthy married couples, they do present some risks in how they are administered, how they are drafted, and the ever-present danger of a future divorce.

Background: As 2026 comes closer with the scheduled drop in an individual’s federal transfer tax applicable exemption amount, more married couples are going to seriously consider adopting spousal lifetime access trusts, or SLATs, to use their large applicable exemption amounts while they still exist. In their rush to adopt SLATs, married couples need to keep in mind that a SLAT comes with some serious risks in how it is drafted, administered, or if the married couple later divorce.. These three risks are addressed in the following paragraphs.

  • Estate Inclusion Due to Implied Agreement: IRC 2036(a) links estate inclusion to an individual’s relationship with previously transferred property, rather than mere legal ownership. Specifically, this Tax Code section provides that a decedent’s estate includes any property that was previously transferred by the decedent by gift but over which the decedent still retained either: (i) the possession or enjoyment of, or the right to income from the property, or (ii) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. A SLAT typically excludes the donor-settlor  as an initial beneficiary while limiting the donor’s discretion over the trust’s distributions. However, that is not the whole story, since the ‘pitch’ that often sells a SLAT is that while the asset is removed from the donor-settlor’s taxable estate, the donor-settlor continues to have indirect access to the gifted asset’s income stream. The danger is that indirect access may be viewed as an implied understanding that assures such access. How a SLAT is administered could cause the SLAT’s assets to be included in the donor-settlor’s taxable estate.

IRC2036(a)(1):  IRC 2036(a)(1) can cause estate inclusion for the donor-settlor based on an understanding-whether express or implied- that the donor-settlor will retain the use or enjoyment of the trust property or its income. Proof of the absence of this implied understanding falls on the donor-settlor, especially when the transfer involves an intrafamily arrangement.

  •  Treasury Regulations provide: “An interest or right is treated as having been retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred.” [Regulation 20.2036-1(c)(1)(i).]
  • Several  ‘bad facts’ Tax Court cases exist where an implied retained interest by the donor-spouse was found when the donor failed to retain sufficient liquid assets outside the trust to pay for ongoing personal expenses, leading to the conclusion that there was an implied understanding that access to the trust’s income or assets will be available to sustain the donor’s lifestyle. See Strangi v. Commissioner, 85 Tax Court Memo 1331 (2003). In Strangi, the decedent’s estate argued that  the donor kept ‘liquifiable’ assets outside of the trust sufficient to satisfy his personal expenses without having to rely on the trust’s income or assets. The Tax Court found that it would be unreasonable to assume that the decedent would sell his remaining illiquid assets solely for that purpose. Keeping liquid assets outside the SLAT can negate the claim that the donor continues to rely on the SLAT’s income.
  • If a married couple transfer almost all of their assets to SLATs, leading to them rely upon the SLATs to support their post-transfer lifestyles, it is possible that the IRS and Tax Court could find an implied understanding that distributions will be made to or for the benefit of the donor-settlor. It would be best for the donor-settlor to retain enough assets ‘outside’ of the SLAT so that the IRS cannot argue that there was an implied understanding that the SLATs will always be available to support the donor’s lifestyle.
  • If the income from the two SLATs is deposited into a single joint account owned by both spouses, will that deposit be interpreted by the IRS that the income from the other spouse’s SLAT indirectly benefited the donor-settlor? The income distributed from each SLAT should be maintained in separate accounts.
  • If the SLAT is drafted where the trustee is given the discretion to reimburse the donor-settlor for the SLAT’s income taxes, will such a distribution suggest an implied agreement? This provision might be dropped from the SLAT even though it is permitted under Revenue Ruling 2004-64.
  • Another way to avoid estate inclusion arising from an implied agreement claim is for there to be a meaningful change in the donor-settlor’s relationship with the transferred property. If identical distributions flow to the spouses from their respective SLATs the IRS may find an implied agreement. Estate of Maxwell v Commissioner,  3 F.3d 591 (2nd Cir. 1993). In another case, where a husband acting on behalf of his wife (the disabled SLAT beneficiary) requested distributions from her SLAT due to a change in ‘his’ financial circumstances led another court to find that there was a pre-existing arrangement  between the donor-settlor and the SLAT trustee, where the court found that “a pretended transfer to a wife, with the retention of a life estate by the husband so apparent from the facts, as here, is the archetypal situation reached by subdivision (1) of Section 2036(a).” Estate of McCabe v U.S. 475 F.2d 1142 (1973.)

Take-Away: While estate planning attorneys set up the SLATs, seldom are they involved in the continuing administration of the SLATs, which is where the actual facts might lead the IRS to conclude that an implied agreement existed. It is best for the donor-settlor to retain enough assets outside of the SLATs on which the donor-settlor can support himself. In addition, the SLAT should be administered to avoid facts where it appears that the donor-settlor is spending the income generated by the other spouse’s SLAT. Since the attorney’s correspondence with his/her clients might be discovered by the IRS in litigation, it would also be wise to avoid communications that ‘sell’ the SLAT emphasizing the indirect access to income to the SLAT settlor. Key will be the ability of the settlor {or more accurately his/her estate} to show that he/she never counted on, relied upon, or expected the income from the trust that they funded.

  • Reciprocal Trust Doctrine: The creation of two SLATs at approximately the same time that leaves each spouse with beneficial access to assets that are substantially similar to those that were transferred away can trigger the IRS’s reciprocal trust doctrine, leading to IRC 2036(a)(1) estate inclusion.

Interrelated Trusts: This doctrine applies to interrelated trusts that ‘to the extent of mutual values leaves the grantors in approximately the same economic position as they would have been in had they created the trust naming themselves as life beneficiaries.” U.S v. Grace Estate, 395 U.S. 316 (1969). 

  •  In the determination of whether the two irrevocable trusts are interrelated, courts have looked to similarities in the trusts’ terms, assets, trustees, beneficiaries, funding dates, and involvement in a prearranged plan. Estate of Levy v. Commissioner, 46 Tax Court Memo, 910 (1983)
  • If the two SLATs are interrelated, the IRS will uncross them, which means that each donor-settlor is treated as the creator of the trust for such donor-settlor’s own benefit, to determine his/her own resulting economic position.
  • The interrelationship can happen when both SLATs make reciprocal distributions such that the married couple retain substantial the same access to the trust assets that they had before the trusts were funded. Estate of Wells v. Commissioner, 42 Tax Court Memo, 1305 (1981).
  • In order to avoid application of the reciprocal trust doctrine when the two spouses each create an irrevocable trust, the two SLATs should include a wide array of differences, but those differences must significantly impact the spouses’ respective beneficial interests. Estate of Levy, Supra. For example, the two SLATs might be funded in different calendar years, and thus reported on different gift tax returns. Different assets should be transferred to the two SLATs. One spouse might hold a testamentary power of appointment over the SLAT’s assets, while the other spouse would not hold such a power of appointment. Different trustees, different rights, e.g., one spouse is a discretionary beneficiary where the other possesses the right to all income. Or, one spouse may hold a 5+5 withdrawal power but not the other.

Take-Away: The more the two SLAT instruments are different in their terms and, more importantly, in the beneficial interests that each spouse holds in the SLAT that is created for their benefit, the easier it will be to avoid the reciprocal trust doctrine. The same terms, but just different trustees, may not be enough to avoid the IRS asserting the doctrine. Different times they are created and funded, with different assets, using different trustees, providing different beneficial rights, all should be sufficient to avoid the doctrine.

  • Divorce of Spouses: The perceived transfer tax benefits that result from funding a SLAT often outweighs the immediate income tax consequences. The donor-settlor of a SLAT is generally treated as the owner for income tax purposes of a trust whose “income without the approval or consent of any adverse party is or, in the discretion of the grantor or a nonadverse party, or both” may be distributed or accumulated for future distribution to the donor-settlor’s spouse. [IRC 677(a).] Under the so-called spousal unity rule, the donor-settlor is treated as if he/she holds any power or interest held y an individual who was the donor-settlor’s spouse at the time of the creation of such power or interest. [IRC 672(e)(1)(a).] What these rules mean is that: (i) a SLAT created for one’s spouse is taxed as a grantor trust, unless someone with an adverse interest to the spouse-beneficiary must consent to distributions to the spouse-beneficiary, e.g., a child who holds a remainder interest in the SLAT; and (ii) the identity of the donor-settlor’s spouse is determined at the time the SLAT is created and remains fixed, even if the couple later divorce. Consequently, the donor-settlor will remain liable to all income taxes attributable to the SLAT after divorce if the ex-spouse continues to be a SLAT beneficiary, and possibly even if the ex-spouse ceases to be a beneficiary depending on the terms of the SLAT.
  •  In the past this continuing tax liability was not a problem because old IRC 682 shifted the income tax burden to the spouse-beneficiary. But the 2017 Tax Act repealed IRC 682.
  • As noted above, the SLAT can be created as a non-grantor trust if someone with an adverse interest to the spouse must consent to the distribution. Thus, the SLAT could intentionally be structured as a non-grantor trust, but using a the consent of an adverse interest is often rejected by the spouses. Note that an independent trustee is not considered to hold an adverse interest in the trust.
  • It could be possible to structure a SLAT as a grantor trust but using an adverse party consent. For example, the donor-spouse could retain a right to substitute assets of equivalent value, which also makes the trust a grantor trust. The difference is that the right to substitute can be ‘toggled on-or-off’ either by a trust director or by a release of the donor-settlor. Thus, as long as the parties are happily married the trust would be classified as a grantor trust if that is beneficial to the married couple’s estate planning objectives. If the spouses later divorce, then the grantor trust classification could be ‘toggled off’ by the settlor if he/she needs access to more income and no longer can afford to continue to pay the SLAT’s income tax liability.
  • As we have covered in the past, another way to avoid the ex-spouse continuing to be a trust beneficiary in the event of a divorce is that rather than name the spouse as a trust beneficiary, the trust uses a floating spouse definition for the beneficiary, e.g., “the individual to whom I am married at any point in time.” Or, the SLAT instrument could in the event of divorce “treat the spouse beneficiary as having predeceased me for all purposes in the event of a divorce, regardless of who files for divorce.” This latter provision would remove the former spouse as trustee or trust director of the SLAT.
  • Since the classification of the SLAT as a grantor trust occurs when the trust is created, and it does not disappear when the couple later divorce, perhaps the spouses will need to enter into a postnuptial agreement at the time that the SLAT (or SLATs) are funded that provides that the assets held in the SLAT(s) will be treated by them as marital assets at the time of their divorce or action for separate maintenance.
  • Or, the parties’ divorce settlement agreement might, through difficult negotiation,  require the beneficiary spouse to reimburse his/her former spouse for any income tax burdens that the  donor-spouse continues to face even the divorce since the SLAT retains its grantor trust classification for income tax reporting purposes.

Take-Away: If divorce is a real concern (assuming the spouses are willing to disclose that fact) then a SLAT should not be considered (nor a QTIP trust for that matter.) The SLAT can be structured as a non-grantor trust using an adverse party’s consent for distributions to the spouse-beneficiary, this may be a difficult provision to persuade ‘happily married’ individuals to include in a SLAT, or both parties’ SLAT’s.

 

Conclusion: A SLAT may make a lot of sense for wealthy married couples who may have taxable estates come 2026, but not so much wealth that they can live without the income generated by the gifted assets. Then again, the spouses must confront the possibility of a divorce and the implications of a SLAT always being classified as a grantor trust. And even if the spouses remain happily married and divorce is not a realistic concern, they must still realize that the value of the transferred assets may nonetheless be included in the donor-settlor’s taxable estate if the SLAT is administered in such a way that the IRS may find an implied understanding that he/she will continue to have access to the SLAT’s income to support their lifestyle. So with the transfer tax rewards of a SLAT come some income tax risks and possibly stealth transfer tax risks. Counsel clients wisely when discussing the pros and cons of a SLAT.