A popular estate planning tool right now is the use of spousal lifetime access trusts (SLATs).
This is because the current estate tax exemption amount (i.e., the amount which individuals can gift to others free of gift or estate tax) is currently the highest it has ever been. The Tax Cuts and Jobs Act of 2017 increased the federal estate and gift exemption from an inflation-adjusted $5 million per person to $10 million per person. For 2020, each person can gift $11.58 million ($23.16 million per couple) during life or at death without being subject to gift or estate tax, but this provision is scheduled to expire by the end of 2025 with the exemption reverting to $5 million per person, adjusted for inflation. It may be reduced sooner by Congress.
The IRS has stated that any exemption used under the increased exemption amounts will not be "clawed back." So, if taxpayers use the higher exemption amount now, they will not be penalized at a later date. If they fail to use the exemption, they could lose it going forward when exemption amounts go down. It is important to note that, depending on where the exemption ends up after reduction, individuals will not start to use up the higher exemption amount until they have first made gifts totaling $3.5 million or even up to $6 million dollars.
In light of the pending reduction in the exemption, many individuals with federally taxable estates are seriously considering reducing their taxable estates by making lifetime gifts before the exemption amount is reduced. An effective estate-planning strategy for accomplishing this involves setting up an irrevocable trust. For a trust to be irrevocable, the grantor will give up all ownership of the trust's assets. This presents the age-old dilemma for many individuals who want to use the exemption before it goes away but want to retain access to the assets for their family or other beneficiaries if they need the assets in the future.
This is where the SLAT is useful. A SLAT is a gift from one spouse (the donor spouse) to an irrevocable trust for the benefit of the other spouse (the beneficiary spouse) and possibly their children or grandchildren. The beneficiary spouse may receive trust distributions, but ideally the trust assets would be assets of last resort. A SLAT allows married couples to utilize the federal lifetime gift and estate tax exclusion of the donor spouse while providing access to the beneficiary spouse.
Although each spouse may fund a SLAT for the other spouse, it is very important that the trusts are substantially different from each other. Similar trusts may be deemed "reciprocal trusts" by the IRS and able to be included in each donor spouse's estate, where they would be subject to estate tax.
Because a SLAT is funded with a gift made during the spouse's lifetime, future appreciation of trust assets will be shielded from transfer taxes and the assets will receive limited protection from claims by the beneficiaries' creditors.
SLATs are generally "grantor trusts," which means that income generated by the trust is taxable to the donor spouse instead of the trust. This allows the donor spouse to make nontaxable "gifts" to the trust by paying the income tax owed. A SLAT can also be a non-grantor trust, so that all income is taxed to the trust itself. But this is very difficult to accomplish during the beneficiary spouse's life. If a SLAT is a non-grantor trust, this may enable the trust to avoid state income taxes if located in a state where income tax does not apply to trusts.
To ensure the trust assets do not become part of the donor spouse's taxable estate, the donor spouse cannot act as trustee. The beneficiary spouse may serve as trustee, but only if distributions are limited to an ascertainable standard (e.g., beneficiary spouse's health, education, maintenance or support). If the donor spouse wants more flexibility in the trust for distributions to the beneficiary spouse, an independent trustee may be able to provide flexibility.
Another important requirement is to fund the trust with the donor spouse's separate property. If the donor spouse uses marital or community property, there is a risk that the trust assets will be included in the other spouse's estate. Also, if there is any chance that the donor spouse is under threat of litigation or bankruptcy, the donor spouse should be careful when transferring assets to the trust to avoid the appearance of fraudulent transfers.
If a couple divorces, the beneficiary spouse may continue to benefit from the arrangement. These and other risks should be discussed with an attorney before creating and funding a SLAT.
SLATS are not always the right tool for using exemption before the expected reduction. But with careful planning for gift, estate and income taxes, they can be a great solution for many.
Grassi is a member of McDonald Hopkins LLC.
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December 19, 2020 at 04:00PM
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Tax Tips: Planning to use your estate and gift tax exemption? Consider the SLAT - Crain's Cleveland Business
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