This article discusses the use of the spousal lifetime access trust (the “SLAT”) to possibly address these two competing objectives mentioned above.

There are three key aspects to the SLAT, as follows:

1. A spouse will transfer certain assets to the SLAT. This transfer will be treated as a gift of these assets and the removal of these assets from the transferring spouse’s taxable estate. Generally, the most effective assets to transfer to the SLAT are assets that are expected in the future to appreciate in value and/or generate significant income because “post-transfer appreciation” and “post-transfer income” also then can be removed from the transferring spouse’s taxable estate. The SLAT will be more effective the greater the aggregate estate tax “savings” from the removal of the transferred assets, “post-transfer appreciation”, and “post-transfer income” from the transferring spouse’s taxable estate relative to the aggregate gift tax liability (or utilization of gift tax liability exemptions) from the transfer of the transferred assets. In essence, from an “estate tax/gift tax” perspective, the SLAT is only effective to the extent that its estate tax “savings” exceed its gift tax “costs”.
2. The other spouse (the “non-transferring spouse”) will be the beneficiary of the SLAT and be able to receive distributions of income and principal from the SLAT. As such, the non-transferring spouse has “spousal lifetime access” over the income and principal of the SLAT. The SLAT should be excluded from the taxable estate of the non-transferring spouse (subject to the comment below). In addition, while care must be taken to keep the assets of the SLAT removed from the taxable estate of the transferring spouse, through the non-transferring spouse’s use of the income and principal distributed from the SLAT, the transferring spouse may be able to indirectly also benefit from the SLAT. Thus, the SLAT possibly can offer the transferring spouse the two objectives of reduced estate tax liability on death and retained income and principal (indirectly) during life.
3. On the death of the non-transferring spouse, the SLAT will terminate. The remaining assets of the SLAT will transfer to the intended remainder beneficiaries under the SLAT (most commonly, descendants of the spouses, other family members, and/or charities).

These three key aspects of the SLAT can be evidenced in the following example:

Michael owns a real estate property, which currently has a fair market value of $1,000,000 and produces a net income of $100,000 per year. Michael has a projected life expectancy of 10 years, at which time it has been estimated that the real estate property would have a fair market value of $2,000,000. Based on all of Michael’s assets, the real estate property will be subject to certain estate taxation on Michael’s death. It is important to remember that even if a person is within the current exemption from Federal estate tax liability ($13,990,000), such person may not be within the current exemption from applicable state estate tax liability (for example, only $4,000,000 in Illinois). If Michael takes no action, it can be estimated that his continued ownership of the real estate property would result in estate tax liability of approximately $1,500,000 in 10 years on his death (based on $2,000,000 of real estate property and $1,000,000 of aggregate net income). Instead, Michael decides to create a SLAT and transfer the real estate property to the SLAT. The SLAT provides for (a) income and principal of the SLAT to be distributable to Michael’s wife, Susan, and (b) on the death of Susan, the SLAT will terminate, and the remaining assets of the SLAT will transfer to the descendants of Michael and Susan. The transfer of the real estate property to the SLAT will be treated as a gift of $1,000,000 (the current fair market value of the real estate property), but will remove the real estate property, its “post-transfer appreciation”, and its “post-transfer income” from Michael’s taxable estate. Given “gift tax/estate tax” integration, and comparing “apples to apples”, the transfer of the real estate property to the SLAT will “cost” Michael approximately $500,000 of estate tax liability (the estate tax “cost” of utilizing a gift tax exemption to avoid gift tax liability and thereby having a lower estate tax exemption to utilize on death) – a “savings” in estate tax liability of approximately $1,000,000 compared to the above-described consequences if Michael took no action. This significant estate tax liability “savings” (and, in addition, the real estate property should be excluded from the taxable estate of Susan (subject to the comment below)) can be achieved even while Susan definitely directly during her lifetime and Michael possibly indirectly during his lifetime are benefitting from the income and principal of the SLAT.

The above discussion focuses on the “reduced estate tax liability/retained income and principal” benefits of the SLAT.

One other possible benefit from the SLAT is asset protection. Based on the specific facts and circumstances in each situation (including based on the “SLAT trustee” issue described below), it could be argued that the assets of the SLAT should not be subject to claims of creditors of the transferring spouse or the non-transferring spouse. This argument would only apply to assets that continue to be owned by the SLAT, and not to the income and principal distributed out of the SLAT.

SLAT Drawbacks

While the SLAT can offer many benefits, it also has various drawbacks. First, the ability of the transferring spouse to indirectly benefit from the SLAT will depend on cooperation from the non transferring spouse. One problem is if the transferring spouse and the non-transferring spouse divorce or otherwise have marital problems, such that the non-transferring spouse thereby would no longer want to cooperate with the transferring spouse. A second problem is if the non-transferring spouse dies before the transferring spouse and then the SLAT terminates and distributes its remaining assets to the remainder beneficiaries under the SLAT. Each of these problems can cause the transferring spouse to no longer indirectly benefit from the SLAT.

Second, the SLAT may not be favorable from an income tax perspective. If the transferring spouse does not transfer assets to the SLAT, but instead continues to hold them until death, the transferring spouse’s beneficiaries will receive a “stepped-up” tax basis in those assets on the transferring spouse’s death and thereby generally be subject to a lower income tax liability when those assets are ultimately sold. On the other hand, if the transferring spouse transfers assets to the SLAT, the transfer of those assets will be treated as a gift for tax purposes, resulting in a “carryover” tax basis in those assets and thereby generally a higher income tax liability when those assets are ultimately sold.

Third, while the transferring spouse can indirectly benefit from the income and principal from the assets of the SLAT, the transferring spouse will not be able to retain “management control” over the assets of the SLAT because the transferring spouse should not be the trustee of the SLAT. While the non transferring spouse can be the trustee of the SLAT, in order to safeguard that the assets of the SLAT are not included in the taxable estate of the non-transferring spouse, distributions of income and principal to the non-transferring spouse should be limited (such limitations as “health, education, maintenance, and support” and “greater of $5,000 or 5% of SLAT fair market value each year” provisions); such a limitation can be avoided if an independent third party is the trustee of the SLAT. In addition, to strengthen use of the SLAT as an asset protection structure with respect to claims of creditors of the transferring spouse and the non-transferring spouse, an independent third party should be the trustee of the SLAT.

Fourth, while there may be a desire for each spouse to set up a SLAT for the direct benefit of the other spouse, such “dual SLATs” can run afoul of the “reciprocal trust” doctrine. As applied to “dual SLATs”, the “reciprocal trust” doctrine generally provides that spouses cannot create substantially similar trusts for each other; if the “reciprocal trust” doctrine is violated, neither of the “dual SLATs” may be recognized for tax purposes (including that each spouse would be treated as trustee of such spouse’s own trust). Care must be taken in drafting “dual SLATs”, as to all of their extent of interrelatedness, separate timing, and specific provisions, to avoid the application of the “reciprocal trust” doctrine.

In addition to the above-described four major drawbacks, other concerns with the SLAT are the irrevocability of the trust agreement that evidences the SLAT, the requirement of an annual income tax return for the SLAT, and the legal costs to establish and maintain the SLAT.

If you have any questions concerning the SLAT, please discuss them with your advisers.

Note – Deadlines for Proper Annual Maintenance of Entities

Entities can provide useful asset protection, tax, business marketing, and business structuring advantages. However, it is important to remember that the cost of an entity is not limited to its formation cost. Instead, it is also generally required for an entity to pay an amount as part of its proper annual maintenance. The specific deadline by which the entity must pay for its proper annual maintenance will vary by the applicable state(s) in which the entity was formed (and was qualified to do business). In Delaware, for example, corporations must pay an annual franchise tax by March 1 of each year, and limited liability companies, limited partnerships, and general partnerships must pay an annual “entity” tax by June 1 of each year. These franchise taxes and “entity” taxes are in addition to any income taxes owed by the entity in any year. Failure to pay these franchise taxes and “entity” taxes in a timely manner will result in the entity owing interest and penalties with respect to these unpaid amounts, not being in good standing (which can taint the validity of entity action), and possibly ultimately being involuntarily dissolved or cancelled. Please make certain that you know and meet the specific deadlines by which all of your entities must pay for their proper annual maintenance in their applicable jurisdictions.

If you wish to discuss any of the above, find Pen Pal Gary’s contact info here.

Disclaimer: please note that nothing in this article is intended to be, or should be relied on as, legal advice of any kind. Neither LHBR Consulting, LLC nor Gary Stern provides legal services of any kind.