With the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act), individuals now have the ability to gift up to $5.12 million (increased for inflation from $5 million) without having to pay any gift taxes through the end of 2012. Never before have individuals been able to so easily shift so much wealth out of their estates tax-free during life and, come 2013, they may never be able to do so again. The provisions of the 2010 Tax Act are set to expire on Dec. 31, 2012.[i]
Given this short-term window, many advisors are counseling clients to strike while the iron is hot and utilize this tremendous opportunity for gratuitous wealth transfer. But, given the uncertain financial environment we now find ourselves in, many clients are apprehensive about giving up control and irrevocably transferring their wealth. To address this apprehension head-on, advisors should ask themselves what is the best way for their clients to use this increased lifetime exemption, while protecting them from future unforeseen financial changes. The spousal lifetime access trust (SLAT) may be the answer.
What is It?
In its most simplistic form, a SLAT is nothing more than an irrevocable life insurance trust (ILIT) that allows a trustee to make distributions to the grantor’s spouse during the grantor’s lifetime. As with a traditional ILIT, the SLAT can’t be revoked, altered or amended by the grantor, and the assets held by the ILIT at the grantor’s death, including death benefits from insurance owned by the trust, will be received by the SLAT free of estate taxes.[ii]
Like an ILIT, a SLAT is created to ultimately benefit children, grandchildren and other issue, but allows the trustee to make distributions to the grantor’s spouse—both during the grantor’s life and after death—should the spouse need supplemental income and/or access to trust assets. The trust can be drafted to provide distributions to the spouse during the grantor’s lifetime for health, education, maintenance or support, if necessary, or can be drafted more broadly to give an independent trustee absolute discretion to make distributions of income and/or principal to the spouse.
To fund the SLAT, the grantor can make annual contributions to the trust, which can be used to pay premiums for life insurance. Similar to funding an ILIT, these contributions may qualify as annual exclusion gifts if the beneficiaries have the right to withdraw contributions to the trust, also known as “Crummey” powers.[iii] Depending on the number of beneficiaries with the right to withdraw and the annual premium amount, the grantor may also make lifetime exemption gifts to the trust to pay premiums.
A SLAT can be used with either a single life or a survivorship life insurance policy. In a survivorship situation, only one of the insureds is the grantor of the trust and the other insured is a beneficiary. With proper drafting, the grantor’s spouse can serve as trustee of a SLAT that he’s a beneficiary of and which owns insurance on the grantor. However, to avoid any incidence of ownership over a policy insuring the lives of both the grantor and grantor’s spouse, the spouse shouldn’t serve as a trustee of a SLAT owning a survivorship policy.
The most potent benefit of a SLAT is the ability for the grantor’s spouse to receive distributions from the trust. By allowing distributions to the spouse during the grantor’s lifetime, the spouse may have tax-favorable access to the potential cash value of any insurance owned by the trust, along with access to the other trust assets.Because the spouse may access trust assets via distributions by the trustee, the grantor may indirectly benefit from these distributions as well.
The SLAT also provides the trust beneficiaries the same benefits as a traditional ILIT, including receipt of death benefit by the trust beneficiaries free of income and estate taxes,[iv] protection of assets from grantor’s and beneficiaries’ creditors, probate avoidance and management of assets subject to the terms of the trust. As an added bonus, Crummey letters also can be avoided when using the client’s lifetime exemption for gifts, rather than annual exclusion gifts, to fund the SLAT – particularly appealing to clients worried about beneficiaries exercising withdrawal rights or who simply don’t want beneficiaries to know about the large contribution to the trust.
Time is of the Essence
Although the SLAT isn’t a new technique, it has been underutilized in the past due to the grantor’s inability to make tax-free gifts over $1 million. With the enactment of the 2010 Tax Act and a reunification of the gift, estate and generation-skipping transfer (GST) tax exemptions at $5.12 million in 2012, clients may be more motivated to make large lifetime exemption gifts, but also hesitant to let go of control should their financial circumstances change in the future. By making the client’s spouse a beneficiary of a SLAT, thereby facilitating access to trust assets and appreciation via trust distributions, such concerns may be alleviated.
Moreover, by making a lifetime exemption gift to a SLAT, the client can reduce future estate tax liability by repositioning the asset and its appreciation outside the taxable estate.
Without any Congressional action, come Jan. 1, 2013, the 2010 Tax Act and its predecessor, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), will sunset. At such time, the gift and estate tax exemptions will be reduced to $1 million, with a maximum estate tax rate of approximately 55 percent, and the GST tax will be reduced to $1 million plus an amount equal to a cost-of-living adjustment (that is, indexed for inflation), with a 55 percent maximum tax rate. With only seven months until sunset, time is certainly of the essence!
Consider a hypothetical client, Mitch, who is an affluent 50 year-old male married to Karen, also age 50, with three children, and a total estate currently valued at $20 million. Mitch and Karen would like to purchase life insurance for estate tax purposes and to provide income replacement for Karen and their children in the event of Mitch’s death. Mitch is also interested in using his current gift tax exemption before it's set to expire, but is hesitant to irrevocably transfer such a substantial piece of his estate should he and his wife need additional supplemental income in the future or encounter unforeseen financial circumstances.
Mitch’s advisor suggests creating a SLAT in conjunction with a second-to-die policy to address Mitch’s goals and concerns. Mitch will transfer income-producing assets and cash worth a total of $5.05 million (after valuation discount, if applicable) to a SLAT that benefits Karen and their children. The trustee of the SLAT will then use income generated by the $5.05 million gift to purchase a second-to-die variable universal life policy[v] on Mitch and Karen’s lives with an initial death benefit of $5.77 million and premiums of $50,000 a year for 15 years.
As illustrated in ”Survivorship With No Distributions,” if Mitch and Karen don’t take any distributions from the trust and no distributions are made to other beneficiaries during their joint lives, the predicted trust value in year 30 would grow to approximately $28,046,285 (the value of the side fund ($22,280,727) plus the value of the death benefit ($5,765,558). This amount will be accessible to and pass on to the next generation (and possibly future generations) free of estate taxes and without having to incur any gift tax liability. Plus, by making a $5 million gift today of an appreciating asset, Mitch and Karen have effectively lowered their future estate tax liability by as much as $23 million dollars (assuming their current estate appreciates 3 percent a year).[vi]
What if Mitch and Karen want to receive distributions in the future to help supplement their income during retirement? For illustration purposes, assume Mitch and Karen would like to receive $150,000 in supplemental income starting at age 70. As illustrated in “Survivorship with Distributions,” not only can Mitch and Karen supplement their retirement income with distributions from the trust, but also, Karen can continue to support herself and her family should Mitch predecease her. Once Karen passes away, the trust assets are available to assist with any estate tax liability and will provide an additional inheritance to their children and grandchildren, on top of what they’ll inherit from their parents’ taxable estate.
Practitioners should properly counsel their client on the various considerations associated with the use of a SLAT.
Most importantly, transferring assets and/or money to a SLAT is an irrevocable transfer and the trust assets may only be used for the benefit of the trust beneficiaries. In the case of the SLAT, the grantor’s spouse is a trust beneficiary, so the grantor has indirect access to the trust via his spouse, but not direct access. If the spouse predeceases the grantor, or the grantor and spouse subsequently divorce, this indirect access may be lost.[vii] Practitioners should make clients aware of these issues and address any concerns.
Because the spouse is a beneficiary of the SLAT, the ability to gift split may not be an option. Typically, a gift in which the consenting spouse has a beneficial interest may not be split unless the spouse’s interest is ascertainable and severable from the interest of the other beneficiaries.[viii] If the client and his spouse are both interested in using their lifetime exemptions, a better alternative may be to have each spouse make a transfer to a SLAT of their own creation to benefit the other spouse.[ix]
Alternative Planning Technique
The many benefits of a SLAT shouldn’t be overlooked as a potential alternative planning technique for couples with more unique planning requirements. For example, a SLAT is a great alternative for married couples where one spouse is not a U.S. citizen, because a SLAT doesn’t have to meet the rigid requirements of a qualified domestic trust.[x] A SLAT may also benefit same-sex couples whose marriages or civil unions aren’t recognized at the federal level.
[i]At expiration of 2010 Tax Act, all provisions of the 2010 Tax Act and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will expire. See P.L. 107-16, Section 901 (as amended by P.L. 111-312). Once the 2010 Tax Act sunsets, the gift and estate tax exemption will be $1 million and the generation-skipping transfer tax exemption will be $1 million increased for inflation.
[ii]Attorneys familiar with such matters should draft trusts to take into account income and estate tax laws. Failure to do so could result in adverse tax treatments to trust proceeds.
[iii]Crummey powers (named after the taxpayer in the case of Crummey v. Commissioner) provide a right of withdrawal to trust beneficiaries that qualify the contribution to trust as a “present interest gift,” thus allowing use of the taxpayer’s annual exclusion.
[iv]Assuming the trust is properly structured.
[v] A single life policy could also be used in conjunction with or as an alternative to the second-to-die policy, but because estate taxes can be deferred until the death of the second spouse, a second-to-die policy was used in this hypothetical.
[vi]Calculation based on the assumption that a $5 million exemption at a 35 percent maximum tax bracket applies and death of the second spouse occurs at age 92.
[vii]In the case of divorce, a new spouse could take place of ex-spouse if the trust is drafted to consider such possibility.
[viii]See Treasury Regulations Section 25.2513-1(b)(4).
[ix]The client should consult legal counsel to avoid implications of the reciprocal trust doctrine.
[x]For more on the use of spousal lifetime asset trusts with noncitizens, see “Using a Spousal Access Trust as QDOT Alternative for a Noncitizen Spouse,” by Rachna Balakrishna, Estate Planning Journal, June 2008.