The Go-To Estate Planning Strategy for Married Couples in the Know
Estate planning has become especially difficult for affluent families in 2021. Many are concerned that the generous $11.7 M exemption from gift and inheritance tax will go away.
This could happen because per the Tax Cut & Jobs Act (TCJA), the exemption will be reduced in half in 2026 and Congress could make further changes.
The risk of not making a substantial gift prior to the exemption decrease is that a beneficiary could pay substantially more in taxes., But many people also would like to retain control and access while at the same time making a gift while using their exemption.
A potential solution is the creation of a Spousal Lifetime Access Trust (SLAT).
What is a Spousal Lifetime Access Trust (SLAT)?
A SLAT is an irrevocable trust created by a grantor spouse for the benefit of a beneficiary spouse during his/her lifetime.
The trustee of such a trust can make distributions to the beneficiary spouse on a purely discretionary basis, or subject to an ascertainable standard of health, education, maintenance, and support (HEMS).
Since the grantor and beneficiary spouse are married, the grantor spouse will have indirect access to the funds. The gift to the SLAT will be covered by the grantor’s applicable exclusion amount, removing all the assets in the trust (and the growth thereof) outside of the grantor’s and beneficiary spouse’s estates.
Generally, the remainder beneficiaries will be the children, charity, or combination thereof. Often the beneficiary spouse is given a special power of appointment, in which he/she can decide until time of death in their last will and testament which beneficiaries will receive the remainder of the trust and in what proportions.
This is how a SLAT Works
Susan Dao (age 55) transfers her commercial building worth $11 M into a trust for the benefit of her wife, Linda Yee (age 50), with the remainder going to their three children.
During Linda's life, the trustee can make distributions to her, subject to HEMS. Because Linda can receive distributions, Susan can in theory have indirect access to the assets. At Linda's death, she can leave the remainder to the children in any proportion she so chooses by designating this special power of appointment in her last will and testament. If she fails to exercise this power, then it will be left equally to their three children.
When Susan made the gift to the trust, she filed a gift tax return using her $11 M applicable exclusion amount. When Linda died 35 years later, the value of the trust was $35M, which was completely outside of both Susuan's and Linda's estate.
Consider a Two-Trust Strategy
Many clients may want to investigate a two-trust strategy, where each spouse creates a SLAT for the other spouse. But due to the distinct possibility that the estate tax exemption will be reduced and that the use of the current exemption is a “use it or lose it” proposition, the first spouse’s exemption should be funded to the full amount of the exemption ($11.7 M in 2021) before the second spouse funds his/her trust.
In addition, two identical trusts should not be created to avoid the reciprocal trust doctrine. The reciprocal trust doctrine is a judicial concept that applies to donors who have made interrelated transfers to trusts that effectively leaves them in the same position economically as they would have been, had no transfers occurred. In such instances, the doctrine unwinds those transfers, potentially resulting in the exclusion of the transferred assets in the donor’s estate.
To avoid the reciprocal trust doctrine the trusts must be different from each other.
A Two-Trust Strategy Alternative
An option to the two-trust strategy is to fund a single trust with discountable assets. This would allow the trust to be funded with substantially more than the $11.7 M exemption, while at the same time avoid the possibility that a court could invalidate the strategy, based on the reciprocal trust doctrine.
Here’s an example. Harlan Moore transfers $20 M into a family LLC, with a 1% managing member interest and a 99% limited non-managing member interest. He then transfers a non-managing interest of $11.7 M into a SLAT for the benefit of his wife, Jo. The $11.7 M valuation was determined by a qualified appraiser, but due to discounts actually represented $15 M of assets. This in effect supercharges the SLAT.
Divorce Effect on SLAT
Upon divorce, the donor’s indirect access to the SLAT will end. There are, however, steps that can be included when creating a SLAT to account for the possibility of divorce. For example, a floating spouse provision can be added, which defines a spouse as the person to whom I am married to from time to time, as opposed to a specific individual. In this way a later marriage could re-establish the original concept of indirect access lost upon divorce.
As an alternative, the spouse’s discretionary beneficiary status would terminate upon divorce of the beneficiary spouse. These actions do nothing to keeping the grantor’s access to the trust funds upon divorce. A solution would be to give the power to a trust protector to add a descendent of the grantor’s grandmother as a potential beneficiary of the SLAT. This would allow the grantor to be a future beneficiary if need be. If this option is chosen, it is also best that the trust be transferred to a Domestic Asset Protection Trust (DAPT) jurisdiction (like South Dakota) to avoid estate tax inclusion. There are numerous tax and creditor protection issues, but it gives many clients comfort in case their entire estate and financial plan goes awry upon divorce.
Minimize SLAT Risk
There is a significant mortality risk in SLAT planning if the donor’s spouse dies before the donor. In that case, the donor would lose all indirect access to the SLAT. Life insurance strategies should be employed to minimize this risk.
An example will illustrate how this would be accomplished. Scott and Geoffrey are a married couple in their late 40’s, with a combined net worth of $60 M, mostly acquired from Scott’s work as a renowned writer of romantic novels. Geoffrey does not earn any additional income but spends most of his free time accompanying Scott on business trips after his books are released. Scott and Geoffrey want to create non-reciprocal SLATs for each other and fund them with their remaining exemption amounts. Geoffrey is concerned about losing the indirect access of the SLAT he created for Scott. Scott creates an Irrevocable Life Insurance Trust (ILIT) where Geoffrey is a discretionary beneficiary. The ILIT’s only asset will be a life insurance policy on Scott’s life. At the death of Geoffrey, the remainder in the trust will be used for estate liquidity purposes. Geoffrey will then have sufficient income, regardless of who dies first.
A SLAT can also be used to own a life insurance policy, as opposed to using an ILIT with traditional Crummey powers. This could allow the full use of the enhanced exemption and give the beneficiary spouse access to capital at the death of the grantor spouse.
A Well-Planned SLAT Could be the Solution
SLATs offer clients the opportunity to find a silver lining in the current uncertainty of the permanency of the high gift and estate tax exemptions. A properly designed SLAT can be an excellent receptacle for deployment of expiring federal tax exemptions, as it allows a family to continue to benefit from the assets while meeting the donor’s overall objectives.
This content is prepared solely to provide general information to our clients and community.
This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.