Although the American Taxpayer Relief Act of 2012 (ATRA) provides some much-needed clarity about tax rules for estate planning, developing an estate plan remains complex. However, one relatively simple technique may be beneficial for some high-income married couples. It’s called the “spousal lifetime access trust”—or SLAT, for short.
SLATs are especially popular in situations involving a second marriage in which you want to provide protection for a new spouse while also making sure that children from your prior marriage ultimately will get their fair share of family wealth.
A SLAT is an irrevocable trust established by one spouse for the benefit of the other as well as for children and grandchildren. (Often, both new spouses will establish a SLAT.) The transfer of assets to the trust is treated as a taxable gift, but it can be sheltered from tax by the lifetime gift tax exemption. Assuming a SLAT is structured properly, the value of the assets, plus any appreciation, will go to your heirs free of estate tax. The trust also shields the assets from claims by creditors or ex-spouses.
Under the terms of the trust, lifetime distributions may be made to meet the needs of a current spouse—although generally, if there’s money available outside the trust, it’s preferable to use those funds first before making regular distributions from the trust to the spouse. Taking assets from the trust to benefit the spouse will reduce the long-term effectiveness of the SLAT.
Now, let’s examine the tax consequences of a SLAT on three fronts:
1. Gift taxes. The taxable gift to the trust can be covered by the lifetime gift tax exemption. Now that ATRA has established permanent limits, you can rely on a generous exemption with greater certainty. The unified estate and gift tax exemption now can shelter up to $5 million from tax, indexed annually for inflation. (It is $5.49 million for 2017.) The only catch is that because this is a unified exemption, whatever part of it you use to avoid taxes on gifts won’t be available to reduce estate taxes later.
2. Estate taxes. The assets you transfer to a SLAT are removed from your taxable estate. Thus, estate taxes aren’t a concern for the trust, and that frees up any remaining estate tax exemption for other assets.
3. Income taxes. A spousal limited access trust is considered to be a “grantor trust” for income tax purposes. This means that if you establish a SLAT for the benefit of your spouse, you must report the trust’s taxable income on your personal tax return. But the trust itself pays no tax; assets can grow and compound inside it without being eroded by income taxes. The trust will be required to pay income tax only after your death.
Is that all there is to a SLAT? Not quite. There are a few other planning considerations that merit your attention. For instance, if your spouse dies first or if you get divorced, you won’t have access to the funds in the SLAT, regardless of your needs. Due to this possible scenario, it is usually best to transfer only those assets that you can reasonably afford to live without. That way, you’ll be protecting yourself without harming your spouse.
As mentioned above, it is common for each spouse to set up a SLAT for the benefit of the other. However, under a special tax law doctrine for reciprocal trusts, the two trusts need to be different in a meaningful way—if they’re identical, the assets will be included in the taxable estate of the person who established the trust. Typically, this harsh result can be avoided if the SLATs are set up at different times with varying provisions and are funded separately.
Finally, the transfer of assets to a SLAT is a gift, so the person who creates it must file a federal gift tax return. Because your spouse is a beneficiary of the trust, gifts generally are not eligible for gift-splitting—an approach that calls for each spouse to report one-half of the gift. For this reason, you’ll want to take care not to exceed your lifetime gift tax exemption when funding the trust. Because that exemption is now so generous, however, most people still will find plenty of room to maneuver.
Also keep in mind that estate planning is about more than just taxes. You’ll need to factor in a wide range of financial and personal factors before committing to a SLAT. We can work with your estate planning advisors to help you decide whether this technique makes sense in your situation.
This article was written by a professional financial journalist for Forbes Financial Planning, Inc and is not intended as legal or investment advice.