Estate tax planning can become complicated when multiple parties are involved. For example, you may be concerned about providing assets to a surviving spouse of a second marriage, while also providing for your children from your first marriage. Of course, you also want to take advantage of favorable estate tax provisions in the law.
Fortunately, there’s a relatively simple way to meet your objectives with few dire tax consequences. It’s commonly called a spousal lifetime access trust (SLAT).
A SLAT in action
Essentially, a SLAT is an irrevocable trust established by a grantor spouse for the benefit of the other spouse — called the beneficiary spouse — plus other family members, such as children and grandchildren. The beneficiary spouse is granted limited access to the trust’s funds.
As a result, the assets generally are protected from the reach of the beneficiary spouse’s creditors. This ensures that the remainder beneficiaries — namely, the children and grandchildren — will have a nest egg to rely on.
According to the SLAT terms, lifetime distributions are made to the beneficiary spouse to meet his or her needs. Preferably, if other funds are available to the beneficiary spouse outside of the trust, those funds are used first instead of making regular distributions to the spouse. Otherwise, distributions from the SLAT to the beneficiary spouse will reduce the trust’s effectiveness over time.
Favorable tax provisions
One of the primary attractions of a SLAT is that it’s designed to minimize federal tax liabilities. First, the transfer of assets is treated as a taxable gift, but it can be sheltered from gift tax by a combination of the annual gift tax exclusion ($15,000 for 2021) and the gift and estate tax exemption ($11.7 million for 2021).
However, be aware that use of the exemption during the grantor spouse’s lifetime reduces the available estate tax shelter at death. In addition, remember that the exemption is currently scheduled to revert to $5 million (adjusted for inflation) after 2025. And the new administration in Washington could further dilute this benefit.
Second, assets transferred by the grantor spouse to a SLAT are removed from his or her taxable estate. Thus, estate taxes aren’t a concern, thereby allowing the remaining estate tax exemption to be used for other assets.
Third, a SLAT is considered to be a “grantor trust” for income tax purposes. In other words, when a grantor spouse establishes a SLAT for the benefit of the beneficiary spouse, the trust’s taxable income is reported on the grantor’s personal tax return, but the trust entity pays zero tax. This may be advantageous because the assets can compound inside the trust without any income tax erosion. On the death of the grantor spouse, the trust is required to pay income tax.
Other planning considerations
If the beneficiary spouse dies first or you get divorced, you won’t have access to the funds in the SLAT, regardless of your needs. Because of this possible scenario, it’s usually best to transfer only those assets that you can reasonably afford to live without. In this way, you’re protecting yourself without harming your spouse.
As mentioned above, the transfer of assets to a SLAT is a gift, so the grantor must file a federal gift tax return. Because his or her spouse is a beneficiary of the trust, gifts generally aren’t eligible for gift splitting where one-half of the gift is reported by each spouse. Accordingly, you might fund the trust with an amount no higher than the lifetime gift tax exemption, which still gives most people plenty of leeway.
Finally, don’t forget that a SLAT is an irrevocable trust. Thus, once the grantor spouse transfers assets to the trust, he or she can’t get them back.
Look at the big picture
Estate planning is about more than just taxes. Factor in all the relevant financial and personal factors before you commit to a SLAT. Your estate planning advisors can provide guidance as to whether this technique makes sense for your situation.
SIDEBAR: Be careful with reciprocal trusts
Typically, a spousal lifetime access trust (SLAT) is established by a grantor spouse for a beneficiary spouse. It’s a one-way street. But SLATs may also be used on a reciprocal basis. In other words, each spouse can set up a SLAT for the benefit of the other.
However, bear in mind that under special tax rules for reciprocal trusts, the SLATs must be different in a meaningful way. If they’re identical, the assets will be included in the taxable estate of the grantor. Typically, this result can be avoided if the trusts are set up at different times with varying provisions and are funded separately.