Under current federal estate and gift tax law, a married couple can gift up to $23.16 million ($11.58 per person), and that gift, as well as all future appreciation on the gift, will pass generation to generation completely free from transfer taxes (i.e. no gift taxes, estate taxes, or generation-skipping taxes). This amount is likely to be lowered by the federal government in the future. Acting now, however, will ensure that the exemption is used.
In general, individuals are reluctant to give up control over, and access to, a large amount of their assets. The purpose of this Alert is to focus on taking advantage of the current federal exemption, while retaining a large degree of control over, and even potential access to, the gifted assets through the use of Spousal Lifetime Access Trusts (“SLATs”).
SLATs are appropriate for clients who:
- can afford to utilize all (or a portion of) their lifetime exemption from gift tax;
- wish to retain a mechanism of receiving income and even principal from these gifted assets;
- do not wish to give up de facto control of the transferred assets; and
- want to protect assets from future creditors (including their children’s creditors).
The Mechanics of SLATs:
- The “grantor” spouse establishes an irrevocable trust for the benefit of the other spouse, children and more remote descendants (and even charities).
- The grantor spouse then gifts up to $11.58 million to the trust—the gift ideally consisting of income producing property and/or property that will appreciate significantly in value over time.
- The trustees (who can be the other spouse and someone “independent” of his or her choosing) have the ability to distribute assets of the trust to the designated beneficiaries (i.e. the grantor’s spouse and descendants) for their health, education, support and maintenance, or otherwise in the trustees’ discretion.
- Each spouse can set up a SLAT for the benefit of the other spouse (with sufficient differences between the two trusts to avoid the reciprocal trust doctrine and IRS scrutiny).
Benefits of the SLAT:
- Retained Control. The grantor spouse can reserve the power to remove and replace the trustee(s) of the SLAT (with certain limitations), in order to retain some control over the assets. Also, the grantor spouse can continue to serve as investment advisor for the trust, so that he/she can direct the investment of the trust’s assets.
- Access to Assets. By including his/her spouse as a potential beneficiary, the grantor maintains access to trust funds, via permitted distributions to the spouse, in case of a “rainy day” scenario. (Accessing principal would not be a tax efficient use of the lifetime exemption, but, nonetheless, the option is there if needed.)
- Tax Efficiency. All assets transferred to the trust, plus the future growth on the assets should not be included in the estate of the grantor spouse or the other spouse because the property is owned by the trust. If the generation-skipping transfer tax exemption is utilized, assets can be held in trust for multiple generations without those assets being subject to estate tax or generation-skipping transfer tax upon the death of either spouse, children, grandchildren and future generations.
- Flexibility. If the estate tax is repealed, or if the need for the assets to be removed from the grantor’s estate is eliminated, or if the grantor and his/her spouse need supplemental funds, the trustee should be able to access the trust property and distribute those sums to the grantor’s spouse.
- Creditor Protection. In addition, if the trust document contains the appropriate provisions and restrictions, the trust assets should be protected from the grantor’s creditors, the spouse’s creditors, and the trust beneficiaries’ creditors.
Downsides of the SLAT:
- Loss of Step-up. Upon the death of the grantor spouse, any assets in the SLAT will not be stepped up in basis for capital gains tax purposes (unless the asset is swapped out of the trust pre-death). Thus, high basis assets are ideal for a SLAT.
- Irrevocable. Since the trust is irrevocable, the provisions cannot be changed in the future. As discussed above, however, the assets can be distributed to a spouse, but that would not be tax-efficient.
- Distributions. If distributions to a spouse take on too much of a pattern, the IRS could argue that the trust should be ignored and the assets taxed in both spouses’ estates. Therefore, distributions should only be made if absolutely necessary.
- Divorce. In the event of divorce, distributions from only one of the two trusts would be permitted for each spouse.
- Death. If one of the spouses passes away, the surviving spouse loses access to one of the trusts. Of course, additional distributions can be made from the remaining trust from which the spouse has access, if necessary.
Income Tax Aspects of the SLAT:
Grantor Trust. Typically, SLATs are structured as grantor trusts for income tax purposes – meaning that the grantor is responsible for the income tax with respect to the trust. Having the grantor pay the income tax may be beneficial as it can allow the trust to grow unencumbered by the obligation to pay tax. Furthermore, the grantor’s tax payments are not considered further gifts to the trust.
The New Twist
More recently, an entirely different use of SLATs has been gaining momentum. The strategy is motivated primarily by the desire to save on state and local income taxes (SALT), rather than estate taxes.
How does it work?
- A New York or New Jersey resident creates a SLAT in a jurisdiction that is free of SALT taxes to nonresidents (e.g. Delaware, Florida, Texas).
- At least one trustee needs to be in that jurisdiction (and no trustee may be in the grantor’s home state of New York or New Jersey).
- The trust may not own real property in the grantor’s home state of New York or New Jersey.
- The source of the trust income – the underlying trust asset generating the income – must not be located in the grantor’s home state of New York or New Jersey.
- The trust will be structured as a non-grantor trust for income tax purposes, so that the trust will be its own taxpayer in a jurisdiction free of SALT taxes. To avoid grantor trust status, the SLAT may not permit the grantor to borrow or substitute trust assets, or pay income tax on behalf of the trust, and any distributions to a spouse will require approval by an “adverse party.” All of this is necessary to ensure that the SLAT is not taxable in New York or New Jersey together with the rest of the client’s income.