Spousal Lifetime Access Trusts
In 2016, every U.S. citizen and non-citizen resident is able to shelter $5,450,000 from the federal estate tax. As a result, with minimal planning spouses can effectively shelter $10,900,000 from the federal estate tax. However, clients with current or potential exposure to the federal estate tax should take steps to avoid the estate tax and its top tax rate of 40%.
In general, there are three primary ways to address a client’s exposure to the federal estate tax: (1) begin to move property out of the client’s taxable estate, (2) incorporate charitable planning techniques into the client’s estate plan, or (3) purchase life insurance in a manner that will not cause the death benefit to be includable in the insured’s gross estate and use the death benefit to pay the death taxes. The vast majority of the techniques that are available to address a client’s exposure to the federal estate tax will fall into one of these three categories, and often times an estate plan will involve a combination of planning techniques from each category.
With respect to the first category, in order to effectively remove an asset from the reach of the federal estate tax, the clients must irrevocably transfer the asset and, following the transfer, may not retain any interest in, or derive any continuing benefit from, the transferred asset. However, many clients may not be comfortable with the idea of shedding a significant portion of their net worth.
A Spousal Lifetime Access Trust or “SLAT” is one planning technique that can provide a client who has exposure to the federal estate tax with the best of both worlds: the client will begin to move property out of the client’s taxable estate, yet the client will retain an indirect benefit in the transferred assets through the client’s spouse. On its face, the SLAT is a deceptively simple technique whereby one spouse (the “Grantor”) will make a transfer to an irrevocable trust that will benefit the Grantor’s spouse for the spouse’s lifetime. The Trustee of the SLAT, who may also be the Spouse-Beneficiary, is authorized to make distributions of income and principal to the Spouse-Beneficiary. If the Grantor’s spouse is the Trustee of the SLAT, distributions to the spouse must be limited to his or her health, education, maintenance or support in order to avoid inclusion of the assets of the trust in the estate of the spouse at his or her subsequent death. Often times, the Grantor’s children and descendants will also be named as beneficiaries who are eligible to receive distributions from the trust during the lifetime of the spouse. The value of the assets transferred to the trust, after taking into account any applicable valuation discounts, will utilize a portion of the Grantor’s $5,450,000 exemption from the federal estate tax. However, when structured correctly, the assets of the trust, and all appreciation in the value of the transferred assets that occurs between the time of the transfer and the death of the Grantor, will be excluded from the taxable gross estates of both the Grantor and the spouse. Moreover, if the SLAT is structured as a generation-skipping trust that will benefit the Grantor’s descendants for multiple generations, the assets of the trust will be forever sheltered from the federal estate tax so long as the assets remain in the trust.
By funding the SLAT for the benefit of the Grantor’s spouse, the Grantor will have created a separate fund for the benefit of his or her family while retaining an indirect benefit in the transferred assets by reason of the Grantor’s relationship with his spouse. What is good for one spouse is typically good for the other. Notwithstanding this benefit to the Grantor, the property in the SLAT will not be subject to estate tax when either the Grantor or the Grantor’s spouse dies.
Despite its appearance of simplicity, care must be taken to ensure that the SLAT is structured correctly. For example, if two spouses create SLATs for the benefit of each other, care must be taken to avoid the implication of the “reciprocal trust doctrine,” which is triggered when as a part of a coordinated arrangement two taxpayers create identical trusts for the benefit of each other. If the trusts are not sufficiently different, the respective SLATs would be includable in the taxable gross estates of the spouses. In addition, the potential for divorce between the Grantor and the Grantor’s spouse should be considered. If the Grantor were to establish a SLAT and then become divorced, it is likely that the Grantor would not want the divorced spouse to continue to enjoy the benefit of the trust. One solution to this problem is to clearly define the term “spouse” to mean the Grantor’s spouse at the time of a proposed distribution. This would prevent the Trustee from making distributions to an ex-spouse and would even permit distributions to a future spouse upon the Grantor’s remarriage.
Finally, the possibility that the Grantor’s spouse might predecease the Grantor should be considered. Typically, a SLAT will provide that upon the death of the spouse the trust will divide into separate generation-skipping trusts for the benefit of the Grantor’s descendants. Because the Grantor will lose his or her indirect access to the trust assets upon the death of the Grantor’s spouse, the Grantor may be hesitant to fund a SLAT if there is a question concerning the health of the spouse. One solution to this problem is to give the spouse a “limited power of appointment” to appoint the assets of the SLAT to a separate trust for the benefit of the Grantor upon the death of the spouse. Caution must be taken to ensure that the spouse’s exercise of the limited power of appointment does not cause inclusion of the trust assets in the taxable gross estate of either spouse and that the assets of the trust continue to be safe from creditors.
Under the right circumstances, a SLAT can provide a client who has exposure to the federal estate tax with the best of both worlds: the Grantor will begin to move equity out of the Grantor’s taxable gross estate, yet the Grantor will retain an indirect benefit in the transferred assets through the Grantor’s spouse. Nonetheless, significant care must be taken to ensure that the SLAT is drafted correctly in order to avoid a variety of common pitfalls and traps for the unwary.