Originally published in October 2016
Copyright © 2016 Knox McLaughlin Gornall & Sennett, P.C.
A spousal lifetime access trust (“SLAT”) can be an effective estate planning tool for a wealthy married couple who wishes to reduce estate taxes, to protect their assets from creditors, or both. Generally, a SLAT is an irrevocable trust that one spouse establishes for the benefit of the other spouse. If properly structured, the assets in a SLAT are not taxable in either spouse’s estate and are not available to either spouse’s creditors. At the same time, the beneficiary-spouse may receive distributions of income and/or principal from the SLAT and thus will benefit from the gifted assets.
To better understand the federal estate tax benefits of a SLAT, a brief summary of the federal gift and estate tax scheme may be helpful. The federal government currently imposes a gift tax on lifetime gifts and an estate tax on transfers at death. A properly-structured estate plan can reduce these taxes by taking full advantage of the available tax exemptions, specifically the gift and estate tax “unified credit.” The unified credit permits every individual to transfer a specified amount of assets (an “exemption”) tax-free either during lifetime or at death. For estates of decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026, the new tax law doubles the base estate and gift tax exemption amount from $5 million to $10 million. (Code Sec. 2010(c)(3), as amended by Act Sec. 11061(a))
The $10 million amount is indexed for inflation occurring after 2011 and is expected to be approximately $11 million in 2018 ($22 million per married couple). The language in the Act does not mention generation-skipping transfers, but because the generation-skipping transfer tax exemption amount is based on the basic exclusion amount, generation-skipping transfers will also see an increased exclusion amount.) (The excerpt if from RIA Checkpoint dated 12/28/2017 The gift and estate tax rate is 40%.
The sections that follow will explain how a properly drafted SLAT can protect assets from estate taxes and creditor exposure.
Suppose, for example, that a married couple, Husband and Wife, owns and runs a family business. The business has been doing very well, and Husband and Wife anticipate that the value of the business will appreciate substantially over time. Husband and Wife want to minimize the impact of estate taxes and implement a tax-efficient strategy to pass wealth to their children and grandchildren. The couple also wants to ensure that their assets are protected from their creditors and their children’s creditors. At the same time, the life expectancy of both Husband and Wife is at least 20 to 30 years. The couple wishes to maintain some control over and access to their assets for themselves, and they want to ensure that they will have enough income to live comfortably for the remainder of their lives.
For simplicity’s sake, assume the following:
If Husband retains ownership of his one-half of the family business, and does nothing to transfer the business while alive, he will certainly maintain access to the asset and its income, as well as control over the business. However, Husband’s one-half interest in the family business is vulnerable to attack by his creditors (or Husband and Wife’s joint creditors). In addition, upon Husband’s death, one-half of the value of the family business at his date of death will be included in his estate and potentially exposed to estate taxes. If Husband’s one-half of the family business passes to Wife, it will not be subject to estate taxes at Husband’s death due to the marital deduction, but it will be included in Wife’s estate and subject to estate taxes at the time of Wife's death. There will be fewer assets left at the end of the day for their children and grandchildren.
Suppose, instead, that while both spouses are alive, Husband transfers his one-half interest in the family business to a trust for Wife’s benefit. This trust is known as a “Spousal Lifetime Access Trust” or a “SLAT.” Note that whether it is an interest in a family business or a different asset, any asset transferred by Husband to the SLAT must be Husband’s separate property. In other words, the asset must be in Husband’s name alone.
The transfer of Husband’s one-half interest in the family business removes that asset from both Husband’s estate and Wife’s estate and therefore shields the asset from estate taxes. The business can grow over the years without exposure to any additional estate or gift taxes on that growth. In addition, if the SLAT is drafted properly, the asset should be protected from both Husband and Wife’s creditors, as well as the creditors of their descendants. The estate tax savings and creditor protection provisions of the trust are discussed further below.
At the same time, the structure of the SLAT allows Wife to benefit from the wealth of the family business and to maintain some level of control over the trust assets, also explained below.
Note that other types of assets may be transferred to a SLAT. However, as discussed above, a SLAT is most effective for assets with substantial growth potential over the donor’s lifetime. In addition, Husband and Wife’s attorney may suggest other techniques for transferring an asset, including ownership in a family business, to the SLAT. A common technique is for the donor to sell an asset to a SLAT in exchange for a promissory note bearing adequate interest. Ideally the asset in the SLAT would outperform the note interest rate, leading to transfer tax savings.
A SLAT is an irrevocable trust established by one spouse (the “Settlor” or “Grantor”) during his or her lifetime for the benefit of his or her spouse. Using the above example, assume that Husband will establish a SLAT for the benefit of Wife.
First recall that Husband must transfer his separate property to the SLAT. This can be done by splitting assets and titling assets in separate accounts for Husband and Wife, before Husband makes the transfer. Husband cannot transfer a portion of property that he owns jointly with Wife as tenants by the entireties. If a joint asset is transferred to the SLAT, the trust assets could be included in Wife’s taxable estate at death under Internal Revenue Code Section 2036.
Wife will be the primary beneficiary of the SLAT during her lifetime. Husband may also name children, grandchildren and spouses of descendants as beneficiaries. Wife will typically be named as individual Trustee of the SLAT. In certain circumstances, Husband may name an independent third party to serve as co-Trustee with Wife. Income distributions from the family business will be made to the SLAT and other shareholders on a pro-rata basis in accordance with the operation of the family business. (In our example, SLAT will own 50% of the company, and therefore, will receive 50% of the income distributions.).
Wife, as Trustee, may in turn distribute income (and principal) from the SLAT to herself, as beneficiary, for her health, education, support and maintenance. Wife should have a separate account to receive trust distributions and should ensure that no SLAT distributions are made to a joint account with Husband. If SLAT distributions are made to a joint account, Husband could face estate tax exposure under Code Section 2036. However, Wife may use the SLAT distributions for the joint benefit of the couple or may utilize the unlimited marital deduction to make gifts from her accounts to Husband free of gift tax.
The SLAT will be a “grantor trust” for federal income tax purposes during the joint lifetimes of Husband and Wife, so all trust income will be taxed to Husband, as the Settlor, during his lifetime. This enables the trust assets to grow for the benefit of the beneficiaries without paying federal income tax. Husband is effectively making a tax-free gift to the trust. On the death of Husband and Wife, all SLAT assets will be held in separate trusts for the lifetimes of Husband and Wife’s children and/or descendants, if so directed by the SLAT terms.
As discussed above, SLAT assets will not be considered part of the federal estates of Husband or Wife and therefore will not be subject to federal estate tax upon their deaths. However, certain precautions in the drafting and administration of a SLAT must be taken to avoid federal estate tax inclusion, including the following:
Note that Husband’s transfer to the SLAT will be deemed a gift for federal gift tax purposes at the time it is made. Husband must obtain a valuation of his interest in the family business and file a gift tax return indicating the value of the gift to the SLAT for the year in which the gift was made. If Husband has a sufficient amount of available gift tax exemption, Husband will not owe gift tax. If Husband does not have enough available exemption, he will pay gift tax on the transfer in excess of his federal gift tax exemption.
The value of Husband’s transfer to the SLAT for gift tax purposes is determined as of the date of the transfer (i.e., today). Husband will pay gift tax (or use up part of his gift tax exemption) on the value of his one-half interest in the business on the date of transfer. Presumably, this value will be significantly less than the value of Husband’s interest would have been on his date of death. Any future appreciation in the family business is contained in the SLAT and remains outside of Husband’s estate and outside of Wife’s estate. If Husband had held on to the business, his estate or Wife’s estate would pay estate tax (or use estate tax exemption) on the appreciated value of one-half of the business at his death or Wife’s death, depending on who dies second and the amount of exemption available at that time. By transferring Husband’s interest in the business now, Husband and Wife’s estates in theory will pay less in total transfer taxes than their estates would have paid if Husband owned his one-half of the business at death.
In addition to its estate tax benefits, the SLAT should be an effective asset protection tool for Wife and for Husband and Wife’s children and descendants. The SLAT creates a substantial barrier between the SLAT beneficiaries and their creditors. The SLAT will contain a provision known as a “spendthrift” provision. A spendthrift provision stipulates that a trust beneficiary cannot sell, pledge, or encumber a beneficial interest, and a creditor cannot attach a beneficiary’s interest. A spendthrift provision should be effective to prevent the creditors of Wife or any other beneficiary from recovering from the beneficiary’s interest in the trust, subject to state law. A SLAT that permits only discretionary distributions, such as support or medical or educational expenses, rather than mandatory distributions, will likely provide additional asset protection.
The SLAT should also protect the assets Husband gifted to the trust from the reach of Husband’s creditors. To ensure protection from Husband’s creditors, the SLAT should be carefully drafted and administered so that Husband does not retain any ownership interests in the SLAT that would cause the SLAT to be considered his property.
Husband and Wife should be mindful, however, that the SLAT’s asset-protection barrier is not bulletproof. Creditor rights are governed by state law. Some states may allow certain groups of creditors to reach the trust assets regardless of the trust’s protective provisions, including the spendthrift provision. Although the SLAT may not provide complete protection against all creditors in all circumstances, it remains an extremely effective asset-protection tool interposing a substantial barrier against creditors.
As time passes, if Husband and Wife maintain a significant level of assets and wish to do more planning to reduce estate tax liability and creditor exposure, they should consult with their estate planning attorney. There may be the opportunity for Wife to establish a SLAT for Husband’s benefit. However, if Wife establishes a SLAT, she should be aware of the application of the “Reciprocal Trust Doctrine,” discussed below.
Under the Reciprocal Trust Doctrine, if Husband and Wife create two identical or substantially similar SLATs for the benefit of each other, the SLATs may be ignored for federal tax purposes. The Internal Revenue Service (IRS) considers identical or substantially similar SLATs to be “reciprocal:” All of the assets in the SLAT created by a wife for the benefit of her husband will be deemed a part of the wife’s estate, and all of the assets in the SLAT created by a husband for the benefit of his wife will be deemed a part of the husband’s estate. The Reciprocal Trust Doctrine will subject both SLATs to estate tax in the wife’s and husband’s estates under one or more of the retained power provisions (Code Sections 2036‑2038).
In order to avoid the application of the Reciprocal Trust Doctrine, Husband and Wife must understand that regardless of how satisfied they are with the existing SLAT, the SLAT cannot simply be duplicated, even if doing so saves legal fees. Husband and Wife’s needs are unique. Each spouse should individually consider whom he or she wants to benefit in his or her estate plan and how each spouse wishes to accomplish his or her estate planning goals.
If Husband and Wife want to establish a second SLAT, they and their estate planning lawyer should consider the following:
The decision to apply the Reciprocal Trust Doctrine ultimately lies with a court. There are currently no “safe harbor” statutory or regulatory rules to ensure that the Reciprocal Trust Doctrine will not apply to two SLATs. SLATs should be carefully considered and drafted to truly reflect the individual wishes of each grantor.
In addition to the federal estate tax, 14 states and the District of Columbia currently impose a separate state estate tax. The 14 states are: Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Vermont and Washington. Only one (1) of these states, Connecticut, has its own state gift tax.
Exemption amounts under the state estate taxes vary, ranging from the federal estate tax exemption amount ($10,000,000, indexed for inflation) to $675,000. For example, as of January 1, 2018, New York’s estate tax exemption is $5,250,000.
In these 14 states, SLATs have an added benefit of planning for the avoidance of state estate taxes. By funding a SLAT during lifetime, a client can transfer assets in excess of the state estate tax exemption to the SLAT and avoid state estate tax exposure on these assets at death. Other than Connecticut, the states that impose a state estate tax do not have a state gift tax, so the lifetime transfer of assets does not use up any of the client’s state estate tax exemption available at death.
The death of the beneficiary-spouse will typically eliminate the grantor’s indirect access to the SLAT’s assets. One option to address this concern might be to grant the beneficiary-spouse a limited power of appointment over SLAT assets that could be exercised in favor of the grantor. However, there are concerns that giving the beneficiary-spouse a limited power of appointment to appoint the SLAT assets back to the grantor-spouse could cause estate tax or creditor protection issues.
According to Steve Akers of Bessemer Trust, a beneficiary-spouse could have a limited power of appointment to appoint the SLAT assets back to a trust for the grantor-spouse as long as certain precautions are taken. The IRS might argue that Section 2036 or Section 2038 could apply in the grantor-spouse’s estate if the IRS could establish the existence of an implied agreement that the beneficiary-spouse would leave the gifted assets back into a trust for the benefit of the grantor-spouse. As long as there was no pre-arrangement between the spouse, exercising the power of appointment in the beneficiary-spouse’s will to include the grantor-spouse as a discretionary beneficiary should not cause inclusion in the grantor-spouse’s estate under Section 2036(a)(1). However, even if there was no pre-arrangement between the spouses, if the beneficiary-spouse exercises the power of appointment in favor of the grantor-spouse, the grantor-spouse’s creditors may be able to reach the trust assets, unless the trust is created in a self-settled jurisdiction.
Akers suggests structuring the transfer to remove inferences of any implied agreement or pre-arrangement, including the following techniques:
To fully understand why granting a beneficiary-spouse a power of appointment in favor of the grantor-spouse raises estate tax concerns, it is helpful to look at the Code. Under Section 2036(a) of the Code, property transferred by the grantor while living is included in his gross estate at death if the transfer was not a bona fide sale for adequate and full consideration and the grantor retained for life either of the following interests:
To trigger the application of Section 2036(a), there must be a retained right by the grantor to the income of a trust or an understanding that the income would be received by the grantor. To determine whether such an understanding exists, the courts look at all of the relevant facts. Although showing an express agreement is fairly straightforward, an implied agreement generally must be demonstrated indirectly.
Courts have considered several factors as evidence of an implied agreement between the grantor and trustee that the grantor will receive trust income. Note these factors apply to the situation where a grantor explicitly retains the right to receive discretionary distributions from the trust he or she created. Although the grantor of a SLAT would not retain any explicit right to receive discretionary distributions from the SLAT, and although this section discusses an implied agreement between grantor and spouse, these factors may nonetheless be instructive. The factors considered by courts include the following:
Thus, it is possible to give the beneficiary-spouse a limited power of appointment to appoint SLAT assets in favor of the grantor-spouse, but estate planners should carefully consider all of the circumstances of the transaction to ensure that no unintended tax consequences result.
The SLAT will be a “grantor trust” for federal income tax purposes, so any income earned by the SLAT will be taxed on the grantor’s income tax return. Some clients may want the SLAT to reimburse the grantor for the extra income taxes attributable to the trust. However, there are potential adverse or unintended consequences if the SLAT permits the Trustee to reimburse the grantor for income taxes attributable to the SLAT and paid by the grantor.
In Revenue Ruling 2004-64, the IRS addressed whether either a mandatory or discretionary reimbursement clause would (i) be considered a gift from the grantor to the beneficiaries or (ii) cause trust assets to be included in the grantor’s estate under Section 2036 of the Internal Revenue Code.
Revenue Ruling 2004-64 provided as follows:
It is important to note that Revenue Ruling 2004-64 dealt with a trust instrument which only granted the discretionary reimbursement power to a trustee who was not related or subordinate to the grantor of the trust. The ruling does not address the issue of when reimbursement is discretionary and the trustee is related or subordinate to the grantor. Some commentators believe that the IRS might argue that an implied agreement to reimburse might exist in such a situation and would cause estate inclusion under Section 2036. Other commentators point out that since gross estate inclusion normally does not hinge on the relationship between the trustee and the grantor, it is unlikely that the IRS would maintain this presumption.
Originally published in October 2016
Copyright © 2016 Knox McLaughlin Gornall & Sennett, P.C.