Several bills proposing higher tax rates on wealthy individuals, the reduction of tax exemptions, and the disallowance of certain tax planning strategies are circulating in Washington DC, and President Joe Biden has also expressed an intent to retroactively implement some of these changes.1 As a result, many wealthy individuals are contemplating ways to protect their assets and preserve them for future generations. Although it’s uncertain what will become law, it’s important to evaluate estate planning needs and take advantage of the existing law, as appropriate.
Under the existing Tax Cuts and Jobs Act of 2017, the lifetime gift, estate, and generation-skipping transfer tax exemptions are currently $11.7 million per person, with a top transfer tax rate of 40%. These exemptions will remain in place until the law is changed or until their expiration on December 31, 2025.2 In either event, the exemptions could be significantly reduced, and may even fall to as low as $3.5 million per person for estate tax and $1 million per person for gift tax if certain proposals are enacted.3 Under the latter proposal, individuals would be able to pass 70% less wealth from estate taxes compared to what they can under current law, and 90% less wealth from gift taxation. In short, 2021 may be the last year to use or lose the $11.7 million exemptions.4
The $11.7 million exemption can be used at death to reduce estate tax or during life when assets are gifted. The use of the lifetime gift tax exemption requires a transfer of property, with the donor relinquishing direct access and control over the assets.
It’s no secret that the use of a lifetime gift tax exemption may be highly beneficial to a family’s long-term wealth. Specifically, the ability to move assets outside of an individual’s taxable estate today, rather than at death, often results in decades of asset appreciation that falls outside of the taxable estate. However, many individuals are hesitant to transfer significant assets due to the presumed loss of control and access.
The use of a lifetime gift exemption works well when donors retain sufficient assets in their personal names, to maintain their accustomed standard of living. In situations where the cash flow to continue this standard of living is questionable, or where the donor otherwise wants to maintain indirect access to gifted assets, individuals may make gifts to an irrevocable trust, with their spouse as a beneficiary. This type of irrevocable trust is commonly referred to as a Spousal Limited Access Trust (SLAT). If properly drafted and administered, this kind of trust can, under current law, be excluded from the taxable estates of both the grantor and his or her spouse.
Spousal Limited Access Trust
SLATs are appealing to married individuals seeking to use their lifetime gift tax exemptions. The formation of a SLAT requires one spouse to establish a trust, fund it with a gift, and name a trustee – who can be the other spouse. The spouse establishing the SLAT cannot be the trustee or a beneficiary of the SLAT. The beneficiaries of a SLAT are typically the trust creator’s spouse and descendants. The distribution provisions and beneficial interests may be structured in endless ways, but the spouse beneficiary remains in place for his or her life. So, if the spouse beneficiary is living and married to the spouse who formed the SLAT, both spouses presumably have access to the trust’s assets.
A SLAT can be a great tool for estate planning, in light of a married couple’s retained potential access (direct and indirect) to the assets. It allows the use of the exemption for wealth transfer while also ensuring a measure of financial security and peace of mind. However, extreme care must be taken to evaluate the effect of all trust language and its application under state law, to fully understand limitations that may exist with respect to distributions. Furthermore, when both spouses wish to form a SLAT the situation becomes more complicated as the trusts cannot be identical, as explained further below.
Access to SLAT Assets
Access to SLAT assets is provided by naming beneficiaries and conditions under which they receive distributions of trust income or principal. A beneficiary can be designated as “primary” and given distribution preference over other beneficiaries. Additionally, some non-spouse beneficial interests might not start until an event has happened, such as the death of another beneficiary – a spouse for example. SLATs often name the spouse as the “primary” beneficiary and even the sole trust beneficiary during his or her lifetime, to provide the opportunity for liberal distributions to the spouse.
The conditions under which distributions of income and principal may be made are often more complex. Liberal distribution provisions provide beneficiaries with increased access to trust assets. But increased access generally weakens the asset protection from taxes provided by the trust. For estate tax planning purposes, trusts commonly include provisions that prioritize the preservation of non-estate taxable trust assets when beneficiaries can spend other taxable assets in the estate.
Many trusts permit distributions for a beneficiary’s “health, education, maintenance, or support” (HEMS). Often attached to this standard distribution provision is a requirement or request that the trustee consider the beneficiary’s other assets and accustomed standard of living when making distributions. While the HEMS standard seems quite liberal, the imposition of a requirement or request that the trustee consider the beneficiary’s other assets may significantly restrict distributions. This is especially true where state law creates additional duty in this respect.
As explained above, the provisions in the SLAT document dictate the ability of a spouse beneficiary to receive distributions. Therefore, it is imperative to understand these terms of the trust and the impact the terms have on distributions. The addition of language including a preference to spend other assets first, or that other assets be considered when making trust distributions, may significantly hinder a trustee’s ability to make distributions to a beneficiary. Therefore, detailed review of all trust distribution provisions is highly recommended.
If the intent is to provide the spouse beneficiary of a SLAT with liberal access to trust assets, then the trust provisions need to provide the trustee with the power to do so. For example, requirements for a trustee to consider other assets can be excluded. Further, if a traditional HEMS standard is used for distributions while a spouse is the beneficiary and trustee, consider also adding a provision permitting distributions for any reason, at the discretion of an independent trustee. Such a provision can avoid distribution limitations associated with a HEMS standard.5
A spouse beneficiary can also be given the right to withdraw the greater of $5,000 or 5% of the trust’s assets each year, without the consent of the trustee or the need to satisfy any distribution standard. This withdrawal right can be above and beyond whatever discretionary distributions the trustee makes. This withdrawal right may cause 5% of the trust’s assets to be included in the spouse beneficiary’s taxable estate if he or she dies with such power. To mitigate this issue, this withdrawal power is often allowed only for a short period (for example a month) each year. If the spouse beneficiary doesn’t die during that designated time, the 5% asset inclusion in his or her estate won’t apply.
Access to SLAT Assets if the Spouse Beneficiary Dies
An individual who places assets in a SLAT has indirect access to them via their spouse beneficiary, but generally only if their spouse is alive. However, estate planning experts have developed solutions to address a donor spouse’s loss of access if the spouse beneficiary dies before they do.
One option is for the SLAT to include a limited power of appointment in favor of the beneficiary spouse that can be exercised in his or her testamentary documents. Through this power, the beneficiary spouse can appoint the SLAT assets at death to a separate trust, of which the donor spouse is a beneficiary. This way the surviving spouse gains access to trust assets during his or her lifetime, while also excluding those assets from the taxable estate. The assets remaining at the death of the surviving spouse would generally continue in trust for the couple’s descendants.
A more complex option arises through certain state laws. In states with specialized trust laws, it’s possible for a donor spouse to become a beneficiary of the SLAT following the death of the beneficiary spouse. This can be accomplished in Delaware, for instance, by designating a trust protector in the trust document who can add the surviving donor spouse as a beneficiary of the SLAT following the death of the beneficiary spouse.6
Added Complication: The Reciprocal Trust Doctrine
We have discussed the benefits of a SLAT, how they should be drafted for optimal access to assets, and even potential solutions for retained access by the donor spouse. The ability to use a lifetime gift tax exemption in this flexible manner is quite beneficial – so much so that couples may want to use both of their lifetime gift tax exemptions and form two SLATs.7 But this strategy must be executed in a way that avoids triggering the Reciprocal Trust Doctrine.
The Reciprocal Trust Doctrine has evolved through the courts as a substance-over-form analysis of gifts, resulting in no change to a donor’s financial position. The U.S. Supreme Court has spoken on the Doctrine and provided a test, whereby trusts are deemed reciprocal when “interrelated” and when an “arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as beneficiaries.”8 In other words, an arrangement where each spouse creates a SLAT with identical terms naming the other as beneficiary and trustee would violate the Reciprocal Trust Doctrine, resulting in the gifted assets being included in their taxable estates.
Although it’s possible for a married couple to each establish a SLAT using each of their lifetime gift tax exemptions, care must be taken in drafting. Specifically, the choice of trustee, distribution provisions, and powers of appointment are all major factors the courts have looked at in determining economic position. Therefore, when two SLATs are created, it’s not advisable for both spouses to be sole trustees of the respective trusts, for both spouses to have the same distribution rights, or for to have the same powers of appointment. The result is a loss of some flexibility which may limit some of the access, direct or indirect, to one of the SLATs. This factor should be weighed in the financial planning analysis, which should be prepared in concert with wealth management advisors when a couple is determining how much gifting to SLATs is appropriate for their family.
Planning for a Retroactive Gift Tax Exemption Reduction
As previously discussed, one significant concern, however, is that a legislative reduction in the lifetime federal gift exemption may be enacted retroactively to the beginning of the year. If this occurs, individuals who made gifts in reliance on the $11.7 million exemption may later be considered to have made a gift that exceeds the new “retroactive” lifetime gift exemption and be hit with an unintended gift tax bill.
For example, assume Joe gifts $11.7 million to a SLAT on October 1, 2021 using his entire available lifetime federal gift tax exemption. On November 1, 2021, the law is enacted to reduce the lifetime federal gift tax exemption to $1 million, effective January 1, 2021. Joe would now be considered to have made a gift that exceeds his lifetime exemption by $10.7 million, which, at the current 40% federal gift tax rate, would result in an unintended federal gift tax of approximately $4.28 million. If both Joe and Carol had established SLATs in this way, their combined unintended federal gift tax liability would exceed $8.5 million.
A retroactive reduction in the lifetime gift tax exemption is presumed constitutional and a possibility. However, estate planning experts have been planning for this type of scenario for years. To mitigate the risk of retroactive reduction of the lifetime gift tax exemption, it’s possible to build in safeguards when creating and funding a SLAT, such that any gift exceeding the ultimate reduced lifetime gift tax exemption would be returned to the transferor and not be considered a gift. Such provisions are commonly drafted into SLATs and other irrevocable trusts to manage unexpected gift determinations.
This protection can be accomplished through several approaches, such as gift disclaimers that can be exercised in a nine-month period under federal tax law,9,or formula adjustment clauses that reduce a gift to a value not subject to gift taxation.10 A Qualified Terminable Interest Property Trust can also be funded to qualify for the marital deduction so that there wouldn’t be a taxable gift.11
One other possibility would be for a grantor to create a SLAT and then sell $11.7 million of assets to the SLAT in exchange for a promissory note of the same amount. If retroactive reduction of the exemption does not occur, the grantor could forgive the entire note. If the exemption is instead retroactively reduced, for example, to $1 million, then the individual could forgive just $1 million of the note and the trustee could repay the $10.7 million balance back to the individual.
While the news of potential adverse changes to the tax law may be discouraging, there are many planning tools still available for wealthy individuals seeking estate planning, including SLATs. Using SLATs with the guidance of legal, tax, and wealth advisors, engaging in appropriate financial planning to determine suitability of gifting in concert with SLATs, and customizing provisions in the SLAT to suit family objectives, can optimize the benefit of SLATs within the overall family estate plan.