Spousal Lifetime Access Trusts: A Planning Tool for Uncertain Times

Take-Away Message: Married couples should strongly consider adopting spousal lifetime access trusts at this time as a ‘hedged’ planning strategy while they await possible change in the federal transfer tax laws.

Context: Over the past couple of months I must have read over 15 articles in estate planning journals that address the question what to advise clients while we all await the promised tax reform from a Republican controlled Congress. Almost each of those articles that I read noted that adopting a ‘a wait and see’ attitude is probably a mistake by our clients, either due to the loss of the shift of asset appreciation to the next generation while we wait, or due to the reality that any estate (or gift) tax reform will be phased in over a ten year period caused by the Senate’s ‘budget reconciliation’ process, which means that estate taxes are not going to disappear all at one time. Each article emphasized that if clients are in the process of estate planning, they should not stop to wait to see what Congress produces in the way of ‘tax reform.’ One strategy that married couples should strongly consider during this uncertain time is the adoption of a Spousal Lifetime Access Trust, or SLAT.

SLAT Definition: As the name suggests, a spousal lifetime access trust is an irrevocable trust that established for a spouse’s lifetime benefit. Another way to look at a SLAT is that it is a lifetime credit shelter or bypass trust that is used to save estate taxes on the death of one spouse. Many wealthy clients are already familiar with credit shelter or A-B Trusts from prior visits to their estate planning attorney.

Several Tax Benefits Come With a SLAT: Consider a situation where married clients own an estate worth $10.0 million. The couple is uncertain as to what Congress will do with the federal estate and GST taxes. They also remember back to 2012 when the estate planning-world thought we were going back to a $1.0 million federal estate and gift tax exemption (down from $3.0+ million for each) leaving estates subject to possible federal estate taxation at 35% rates. The planning steps are easy to understand. Each spouse creates an irrevocable trust for the lifetime benefit of their spouse. Each spouse transfers $5.0+ million of assets into the trust that they establish for their spouse’s lifetime benefit. Depending on the nature of the asset transferred, it is possible to exploit valuation discounts when assets are transferred into the SLATs with the goal of staying below $5.0+ million in the transferor-spouse’s federal gift tax exemption.

Gift Tax: Rather than applying their unlimited federal gift tax marital deduction to shield the transfer of assets to the trust, each spouse instead uses his/her available federal gift tax exemption [currently $5.45 million each.] Thus, there will be no gift tax actually paid on the transfer of assets to the irrevocable trust, but there will be a use of the transferring spouse’s currently available federal gift tax exemption.
GST Tax: If the spouses like the thought of long-running trusts, e.g. a dynasty trust that runs for the benefit of their children and grandchildren after their spouse’s death, then the transferor-spouse will also elect to apply to the initial transfer of assets into the trust that spouse’s available GST exemption [also currently $5.45 million.] As a result, if assets are subsequently transferred decades later to the spouses’ grandchildren, no GST tax will be imposed on the distributions from the dynasty-SLATs to the grandchildren.
Estate Tax: Because the transferred assets are removed from the transferor-spouse’s estate, the value of those transferred assets will not be taxed in the transferor-spouse’s estate for federal estate tax purposes. And like a conventional credit shelter trust, the value of the transferred assets will also not be included in the beneficiary-spouse’s taxable estate on his/her death. Thus, all post-transfer appreciation of the transferred assets will escape estate taxation on the deaths of both spouses, and if a dynasty–SLAT is to continue during the lifetime of the couple’s children who are the trust’s remainder beneficiaries, no estate tax erosion will occur on the children’s deaths either.
Capital Gains Tax: This might either result in either a ‘good news’ or ‘bad news’ point of view. If Congress replaces the current federal estate tax with a capital gains tax imposed at death, then using a SLAT is a ‘good news’ strategy since all built-in capital gains in the transferred assets will not be owned by the deceased spouse, and thus there will be no capital gain tax liability imposed on the death of the beneficiary spouse. Conversely, if Congress decides to stick with some type of federal estate tax, then the transferred assets, will not be ‘owned’ by the beneficiary spouse at their death, and thus there will be no step-up in the SLAT asset’s income tax basis on the beneficiary-spouse’s death. [More on this below.]
Use It Or Lose It: A lot of married couples created SLATs in 2012 out of a fear that the fairly large federal estate and GST tax exemptions were going to disappear with the new year when existing tax exemptions sunset via Congressional inaction. While that ‘cliff’ never ultimately appeared, there is still a concern among many taxpayers that they may never see such large transfer tax exemptions during their lifetimes. Consequently those folks are motivated to use their large federal transfer tax exemptions [gift; estate; GST] now for fear of losing them with a change in the make-up of Congress or the ever-present need by the government to generate revenues.

Cash-flow Preserved: If each spouse is the beneficiary of the SLAT established for their benefit by their spouse, then all of the income that is generated by these two trusts will still be available to the spouses. In short, just like if the spouses continued to own the assets outright and were thus able to access the income their assets generate, they will still have access to the same income even if the underlying asset that generates the income is now owned by a SLAT. Distributions of income from the two trusts are simply reported by the spouses on their personal Form 1040; while the two SLATs will have to file an income tax return, it will be informational only, as all distributions to the lifetime beneficiary of the irrevocable trust are deductible by the trustee. More technically, each trust is structured to function as a grantor trust for income tax reporting purposes, which causes the grantor-settlor-spouse of the SLAT to continue to be liable for the income tax liability associated with the income generated by the trust created by them for their spouse, and subsequently their children or grandchildren.

Non-Tax Benefits:

Control: The SLAT can be set up so that the spouse is the trustee of the trust for their own benefit. In order to avoid federal estate taxation upon the beneficiary-spouse’s death, the distribution of principal to the spouse-beneficiary needs to be limited to an ascertainable standard, e.g. “health, education, maintenance and support.”
Asset Protection: It is possible that those assets held in the name of the SLAT will avoid exposure to the beneficiary-spouse’s creditors. But as I noted in a summary last week, if the spouse acts as the sole trustee of the SLAT established for their own benefit, the trust’s assets might still be exposed to a bankruptcy trustee even if there is a spendthrift clause in the trust, if the ascertainable standard is ignored. But conventional creditors should continue to be frustrated from accessing the SLAT’s assets if there is a spendthrift clause in the SLAT and the spouse sticks to the ascertainable standard.
Asset Management: If the beneficiary spouse is not particularly sophisticated in asset management, or there is a fear of subsequent dementia, ‘wrapping’ the assets in the SLAT with a professional trustee, or a successor trustee named, will help to maintain the continuity of asset management while also protecting the spouse from future disabilities or vulnerabilities and perhaps avoid the need for a future conservatorship proceeding for that beneficiary.

Drawbacks to A SLAT: Like any estate planning device, there are always some risks to consider, but also risks that might be mitigated with some more sophisticated trust provisions. Some of the common concerns and responses to those concerns follow.

Divorce: If the spouses subsequently divorce, what happens? Either the trust can continue to benefit the former spouse, in lieu of an alimony award, or the trust can be drafted in a way which causes the former spouse to lose all beneficial rights in the SLAT. If the trust is drafted to ‘pay all income to the settlor’s current spouse,’ upon the divorce being final, that entitlement to the income will ceases to exist. If the settlor remains unmarried post-divorce then the SLAT will essentially become an accumulation trust. If the settlor remarries, then a new individual will satisfy the ‘current spouse’ definition and be entitled to receive all income. Note that if the SLAT continues to benefit the former spouse post-divorce, the grantor spouse will probably release their retained rights in the trust so that the SLAT is no longer taxed as a grantor trust for income tax reporting purposes; this release will force the income tax liability back onto the SLAT, and thus onto the former spouse who continues to receive all income from the trust.
Grantor Dies First- Income Tax Burden: If the spouse who creates the SLAT dies first, then the trust will cease to be a grantor trust for income tax reporting purposes. This then shifts the income tax burden to the SLAT and/or to the surviving spouse. But the spouses, while married, were already paying the income taxes on the trust’s income, so there is not much of a change in circumstances.
Grantor Dies Second- Loss of Access to Income: Access to all of the income the two SLATs generate will change on the death of the beneficiary spouse. At that time usually the children step into the shoes of their deceased parent as the next-in-line income beneficiaries. As such the settlor spouse who created the SLAT will lose indirect access to the income that SLAT generated and paid to their spouse while alive. While the settlor spouse may not have need for the SLAT’s income, that may not always be the case. To address this ‘I still need the income from my late spouse’s SLAT’ situation, it is possible to give to a third party what is called a naked power of appointment, which if exercised could add the settlor-spouse back as a potential SLAT beneficiary. Example: I create a SLAT for my wife’s lifetime benefit. My children are the trust beneficiaries after my wife’s death. I also give to my brother a power to add beneficiaries to the SLAT at any time (before or after my wife’s death), but those beneficiaries who can be added to the trust must be ‘descendants of the settlor’s grandparents.’ This naked power given to my brother could enable him to amend the trust to add me (a descendant of the settlor’s grandparents) as a potential beneficiary to receive income from the trust along with my children. Alternatively, a far less useful provision would be to give the SLAT trustee the authority to make unsecured loans to me using SLAT assets.
Basis: As noted above, if the current estate tax laws continue into the future, then there will be a loss of basis step-up to the SLAT’s assets on the death of the beneficiary spouse. This could prove to be an expensive loss to the trust and its beneficiaries. It is possible, albeit risky, to give a trust protector, or a naked power of appointment holder, the ability to confer on the spouse who is the SLAT lifetime beneficiary, by trust amendment, the ability to appointment SLAT assets on the spouse’s death to creditors of the deceased lifetime beneficiary’s estate. This ability through trust amendment to give to the lifetime beneficiary a testamentary power of appointment to use trust assets to pay the deceased beneficiary’s creditors would cause estate tax inclusion of the SLAT’s assets in the deceased spouse’s estate, which is admittedly a bad thing, but along with it comes a basis step-up in the SLAT’s assets, presumably a good thing which prompted the trust amendment in the first place. Because of this trade-off, i.e. estate tax inclusion vs basis step-up, probably the power of appointment conferred on the SLAT spouse-beneficiary will be written as a ‘word formula’ to minimize the exposure to federal estate taxes on the spouse’s death, or limited to only consume whatever amount of federal estate tax exemption the beneficiary-spouse has available at death, so that there will be no federal estate tax liability actually paid yet some SLAT assets will enjoy a full basis step-up by virtue of the presence of the word-limited general testamentary power of appointment to pay the deceased beneficiary’s credits at death.

Reciprocal Trust Doctrine: Probably the biggest drawback to spouses creating SLATs for each other is the IRS’s attack on them using the judicially created reciprocal trust doctrine. In its most basic form, if two mirror image trusts are created at the same time, i.e.me for my spouse, my spouse for me, the IRS will un-cross those two trusts, and treat them as if I created an irrevocable trust for my own benefit, and my spouse created an irrevocable trust for her own benefit. The result is that upon my death, the IRS will nonetheless include the value of the assets in the SLAT established for my lifetime benefit in my taxable estate under IRC 2036 and 2038, and the same for my wife, such that there will be no estate tax savings using reciprocal trusts. But there are limits to how far this judicial doctrine can be applied. Most often it is applied when trusts are truly mirror images of each other. Consequently, the more that the two SLATs do not look alike, the less likely it is the IRS will be successful in a challenge to the SLATS asserting the reciprocal trust doctrine. Examples of how the two SLATs can look, or be administered differently, so as to defeat the reciprocal trust doctrine follow:

Timing: Create the SLATs at different times, so that it is hard to mirror a nonexistent trust. Since a reportable gift is used to fund the SLATs, create and fund one SLAT in one calendar year, then create and fund the second SLAT in another calendar year. The gifts, and thus the SLATs, will be reported in two separate calendar years.
Assets: Rather than create 50% tenant in common interests in assets and then transfer those separate but identical 50% tenant in common interests to the two SLATs, it would be better to transfer different assets to the separate SLATs, so that the assets held in each SLAT are not mirror images of one another. Example: refrain from transferring a 50% tenant in common interest in the spouses’ home to their respective SLATs.
Income: Rather than each SLAT granting to the beneficiary-spouse the right to all income, it helps to defeat the reciprocal trust doctrine, if one spouse was given the right to all income from their SLAT, where the other spouse is only given a right to request income, although that may not be too comfortable to the spouse who is only entitled to ask for an income distribution from the trustee. Alternatively, one spouse could be given the right to all income from their SLAT, while the other SLAT contains an income spray provision, where income may be sprayed among the spouse-beneficiary and the couple’s children, with a priority given to the spouse’s needs first. A variation to make the SLATs look disparate would be to give one spouse the right to receive all income, and give to the other spouse a 3% annual unitrust withdrawal right over their SLAT, which withdrawal carries out income from the trust- much the same as all income, but arguably in a bleak year a unitrust withdrawal right could put more assets in the spouse-beneficiary’s hands..
Other Features: Yet other trust provisions have been used in the past to defeat the imposition of the reciprocal trust doctrine. (i) One spouse could act as sole trustee of their SLAT, while the other spouse acts as co-trustee with an independent trustee over their SLAT; (ii) one spouse could be given a limited power of appointment over their SLAT (lifetime or testamentary) where such a power of appointment does not exist in the other spouse’s SLAT; or (iii) one spouse could be given the power to sell assets held in their SLAT while the other spouse must first obtain the consent of a Trust Protector before that spouse could compel the sale of SLAT assets.

Conclusion: To summarize, if two SLATs are created by spouses fairly close in time (but not too close) they can remove close to $11 million in assets from their taxable estates without paying any tax, while still enjoying the income from those transferred assets for their lifetimes. Thus, their lifestyle is not cramped since the cash flow after the transfers is still available to them. If dynasty SLATs are created, then their children will pay no federal estate tax, and their grandchildren will pay no generation skipping transfer tax on future distributions. The primarily drawback is the loss of a basis step-up in the transferred assets if the existing laws remain in place, but some creative drafting of the SLATs using a naked power holder or a Trust Protector might nonetheless gain a basis step-up for some SLAT assets on the death of the spouse. Thus, while it is tempting to wait-and-see what Congress does with the federal transfer tax laws, it is possible for a married couple to proceed at this time with SLATs to exploit the current favorable federal transfer tax exemptions while still maintaining the same lifestyle through their access to the SLATs’ income.