September 18, 2020

The scheduled 50 percent reduction in the $11.58 million federal transfer tax exemption in 2026, and the potential for an earlier decrease depending on the results of the upcoming elections, has many clients looking for ways to utilize their exemptions by lifetime gifting. Traditionally, this gifting would take the form of gifts to children, grandchildren, or trusts for their benefit. However, many clients are reluctant to give up access to a significant amount of funds. Or, clients may be reluctant to give their children or grandchildren immediate access to the assets transferred.

For married clients reluctant to make gifts directly to their children, a "spousal lifetime access trust," or "SLAT," can be an ideal solution. A SLAT is an irrevocable trust created by one spouse (referred to as the "grantor spouse") for the current benefit of the other spouse (referred to as the "beneficiary spouse"), typically with the remainder interest in the trust passing to the grantor's children upon the death of the beneficiary spouse. The phrase "spousal lifetime access" reflects what for many clients is the chief advantage of a SLAT, namely that the beneficiary spouse can receive distributions from the SLAT. Thus, for example, if the couple's financial situation deteriorates after a gift is made, distributions can be made to the beneficiary spouse from the SLAT.

If properly structured, for estate tax purposes the assets of a SLAT will not be includible in the estate of either the grantor spouse or the beneficiary spouse upon death. Gifts from the grantor spouse to the SLAT are considered "taxable gifts," meaning that the grantor spouse must typically use a portion of his or her lifetime transfer tax exemption to shelter gifts to the SLAT from the payment of gift tax, and must report the transaction on a federal gift tax return. However, making gifts to a SLAT can nevertheless result in net transfer tax savings, as any appreciation on the transferred assets between the date of the transfer and the date of death escapes estate taxation at death. Furthermore, if generation-skipping transfer tax exemption is allocated to a SLAT, it can be structured to create "dynasty" trusts for children and grandchildren upon the death of the beneficiary spouse, with the trust assets then not being includible in their estates for their estate tax purposes.

For income tax purposes, a SLAT is treated as a "grantor trust." In other words, all items of income, deduction, and credit are attributed to the grantor of the trust, rather than to the trust itself. This makes a SLAT a form of "intentionally defective grantor trust," or "IDGT," as notwithstanding its income tax treatment, a properly drafted SLAT is not includible in the grantor's estate for estate tax purposes. The term "defective" is something of a misnomer, as grantor trust treatment can be quite beneficial. Under Revenue Ruling 2004-64, the grantor's payment of the income tax liability of a grantor trust (such as a SLAT) is not considered a taxable gift. This represents a kind of estate planning miracle, as it effectively allows the grantor to make transfers to the trust without using any transfer tax exemption.

Like any strategy involving an irrevocable trust, a SLAT should not be entered into without careful consideration. An irrevocable trust such as a SLAT is a real legal entity and transferring assets to it has real consequences. First, remainder beneficiaries of a SLAT have certain rights, such as the right to be notified upon the creation of the trust and the right to receive accountings (although, by strategically structuring powers of appointment and designated representatives, the grantor of a SLAT can to some extent the flow of information to remainder beneficiaries). Second, if the beneficiary spouse dies, the assets of the SLAT would generally pass to the remainder beneficiaries (e.g., the couple's children), even if the grantor is still living. Therefore, it is not advisable to fund a SLAT to such an extent that the grantor would become destitute in the event of the death of the beneficiary spouse. Third, as with any planning for married couples, potential divorce is a major concern. Since a SLAT is irrevocable, the impacts of divorce must be discussed when the trust is created. Finally, assets in a SLAT do not receive a "step-up" in cost basis at death, so consideration should be given to the basis of assets transferred.

Despite the foregoing concerns, SLATs remain one of the most powerful estate tax planning tools available. This is especially true for clients who are "wealthy" but not "ultra-wealthy" (i.e., clients who would be hesitant to transfer multiple millions of dollars to their children and lose all access to those funds). For this reason, interest in SLATs is only likely to increase as the planned reduction of the federal transfer tax exemption looms larger.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.