Executive Summary
In late 2012, a new estate planning strategy emerged - the so-called "Spousal Lifetime Access Trust" (or SLAT for short). The basic concept of the SLAT was relatively straightforward: it would function like a bypass trust, but be funded during life instead of at death, with the intention of using it to take advantage of the then-current $5.12M estate tax exemption before it dropped back to $1M as was scheduled for 2013.
Ultimately, the estate tax fiscal cliff didn't happen, but the SLAT remains valid in 2013 and beyond for a new purpose: planning around state estate taxes, and the mismatch between the numerous states that have only a $1M state estate tax exemption and no gift tax, while the Federal gift and estate tax exemptions are at $5.25M. Given this "decoupling" of the state estate tax from its Federal gift tax - and the lack of any state gift tax backstop - couples have a unique opportunity to manage or avoid state estate taxes by creating "supercharged bypass trusts" in the form of SLATs funded during life.
The caveat to the strategy is the "reciprocal trust" doctrine, which can cause SLATs to become "uncrossed" and taxable in the original donor's estate. Fortunately, reciprocal trust treatment can be avoided. Unfortunately, though, the rules to avoid reciprocal trust treatment are based on the facts and circumstances of the situation, and consequently a focus for the IRS and estate planning attorneys in the coming years may be figuring out how best to avoid the reciprocal trust doctrine without actually ruining the client's financial and estate planning goals.
Nonetheless, though, the reality remains that the SLAT may be increasingly popular in the coming years, at least until states implement a gift tax, recouple to the Federal gift and estate tax system, or just repeal their state estate taxes entirely.
Purpose And Prior Use Of A Spousal Lifetime Access Trust (SLAT)
What is a Spousal Lifetime Access Trust?
The Spousal Lifetime Access Trust (SLAT) is similar to a bypass trust, providing access (albeit limited, just as with a bypass trust) to income and/or principal for the needs of a surviving spouse. The difference, however, is that a SLAT is funded via gift while the donor is still alive, as opposed to a bypass trust that is funded by bequest when someone passes away.
As with a bypass trust, the SLAT can provide access to just a spouse or a spouse and children, may automatically distribute income or make income distributions discretionary, and may prevent any distributions of principal or also allow principal distributions at the trustee’s discretion (which in turn may or may not be limited to distributions for health, education, maintenance, and support, depending on the trustee). The fundamental goal, similar to a bypass trust, is to get assets into a trust that can still provide some financial assistance to a beneficiary, but done in a manner that those assets - and any future growth upon them - will not be included in the beneficiary's estate.
SLATs became especially popular in late 2012 as a vehicle to receive $5.12M gifts from high-net-worth clients who wanted to take advantage of the then-current gift tax exemption which would have potentially dropped down to only $1M in 2013 with the looming fiscal cliff. For instance, imagine a couple that had $20M of total net worth. Under 2012 law, they had combined $10.24M of exemptions, leaving only $9.76M exposed to estate taxes. With the exemption scheduled to fall down to $1M in 2013 though, there was a risk that their estate tax exposure would rise from only $9.76M to a whopping $18M (exacerbated further by the fact that the estate tax rate was scheduled to increase from 35% to a top rate of 55%!). To avoid this result, the couple could each fund $5.12M into a SLAT for the benefit of the other spouse in 2012, reducing their assets outright down to $9.76M and limiting their exposure to estate taxes in 2013. Of course, such gifting would utilize the couple's entire lifetime exemption, but it was viewed as far more favorable to use the whole exemption when it was $5.12M, than wait and risk only being able to use a $1M exemption in the future!
SLATs in 2013 And Beyond
Of course, the need for a SLAT to plan for a potentially-declining estate tax exemption ended with the American Taxpayer Relief Act, which permanently locked in the 2012 estate tax exemption and rate going forward, and won't be necessary again for such purposes until/unless a new law is passed that will definitively schedule the estate tax exemption to be reduced (notably, the President's 2014 Budget did include such a recommendation to take effect in 2018, although it remains unclear whether the proposal will gain any momentum). However, even without a looming decrease in the estate tax exemption, it turns out that under current law there's another popular reason for some clients to consider SLATs: the mismatch between the Federal gift tax exemption and state estate tax exemptions.
The issue at hand is that there are still 22 states (soon to be 21) that have a state gift or inheritance tax, but only one of them (Connecticut) actually has a gift tax. About half a dozen have some type of gift-in-contemplation of death rule (which essentially states that gifts made shortly before death will still be included in the decedent's estate as though the gift never occurred), although their rules and details vary. For the rest of the states, there simply is no gift tax, even though many of these states have an exemption of only $1M. The opportunity this creates: to plan for state estate taxes using SLATs instead of bypass trusts.
For instance, imagine a couple that has a combined net worth of $4M (held as 50/50 between the couple). The couple currently has no exposure to Federal estate taxes, but live in a state that applies a state estate tax of 16% on assets above $1M. If the husband passes away, he can leave up to $1M in a bypass trust for his wife, with the remaining $1M left outright to his wife (and eligible for the marital deduction). Going forward, though, the wife now has $3M of net worth, which exposes her to a potential estate tax of $320,000 (the excess $2M above the state exemption at a 16% rate). However, if the husband chooses to fund a SLAT, he can put all $2M into a trust for his wife's death before he passes away; as a result, his wife will only be exposed to state estate taxes on her own personal $2M net worth, which is only $1M above the threshold and thus only exposed to $160,000 in estate taxes. The net result - by using a SLAT, the husband can put all of his assets into a SLAT to keep them out of his wife's estate, instead of being constrained to "only" the $1M state estate tax exemption that would apply when funding a bypass trust at his death.
Notably, SLAT strategies may also become very popular for higher net worth clients as well. After all, if the client’s goal is to fund a bypass trust with the Federal $5.25M exemption, doing so at death can result in a state estate tax liability of $680,000 (at 16% state estate tax rates on the excess $4.25M that goes into a bypass trust but is above the state estate tax exemption); however, if the bypass trust as a SLAT is funded during life instead, the client may be able to put the entire $5.25M into the trust without any of the $680,000 state estate tax exposure!
One challenge of using SLATs is that, because neither spouse is deceased yet, it’s not always clear which spouse should fund a SLAT – the husband for the wife, or the wife for the husband? To the extent that it’s intended as an alternative to a bypass trust with a higher dollar amount, the goal may be to fund a SLAT from any spouse in poor health – and anticipated to pass away soon – for the benefit of a surviving spouse, truly establishing a “super bypass trust” funded during life to avoid future state estate taxes. In other situations, though, this may not be feasible, either because gift-in-contemplation-of-death rules require that the trust be funded sooner rather than later, or simply because both spouses are in reasonable health and it’s not clear which may pass away first (but there’s a desire to take some planning action). The easiest resolution to this is to simply have both spouses create SLATs for each other with some of the assets (so that each spouse removes some assets from his/her estate). In this approach, each spouse would keep enough such that the spouse’s individual assets that are kept, plus the SLAT assets for his/her benefit, would be enough to maintain his/her lifestyle as a surviving spouse. The important caveat, though, is that IRS rules are not favorable to so-called “reciprocal trusts."
Avoiding The Reciprocal Trust Doctrine
The so-called "reciprocal trust" doctrine essentially states that if Person A creates a trust for B, and Person B creates an identical (i.e., reciprocal) trust for A, that the courts can "uncross" the trusts and treat the situation as though each person created a trust for his/her own benefit. Thus, if a husband created a $5M SLAT for his wife and the wife created a comparable $5M SLAT for her husband, the IRS may well claim that the end result is simply that each person made the equivalent of a $5M trust for themselves... which would cause the trust to be included in each individual's estate under IRC Sections 2036 and/or 2038 (since the deemed donor to the trust is the beneficiary of the trust and/or has some deemed control of it), and defeat the estate planning purpose of the strategy. Notably, the rule would only apply to the extent the economic interests overlapped - thus, for instance, if husband put $2M into a SLAT for wife, but wife put $5M into a SLAT for husband, only the $2M would be at risk for being uncrossed. Nonetheless, that still largely defeats the purpose of at least the husband funding a SLAT.
As a result, in situations where there's a married couple, it's necessary to plan the structuring of SLATs around the potential for the reciprocal trust doctrine. As shown in the earlier example, in some situations there may not be a need or desire to create SLATs in both directions in the first place, such as where the husband is in very poor health and there is only be a desire to have the husband fund a SLAT before he dies (but the healthy wife doesn't need to fund a SLAT in reverse). Where there is a desire to create two SLATs, techniques to help keep them separate include: different trustees or co-trustees; different rights to the trust (e.g., one might have access to income, but the other only to principal); different beneficiaries (e.g., one might be for just the spouse, while the other might be for spouse and children); different powers (e.g., one might have a special Power-of-Attorney to change the distribution of assets to certain family members or charities); fund with substantively different assets (e.g., one trust gets cash and securities, and the other receives a share of the family business). Another strategy to avoid the rule is simply to space out the trusts in the first place; if one is created now, and the other isn't established until years from now, it's difficult for the IRS to claim they were purely reciprocal (although obviously the caveat is that waiting too long may diminish the benefit of the strategy, but that "risk" is part of what substantiates the trusts aren't reciprocal!).
Unfortunately, the “reciprocal trust” doctrine is ultimately up to the judgment of a court, if challenged, which means there are no “safe harbor” rules to follow to guarantee the strategy will be safe. As a result, expect to see a lot of focus from the estate planning community in the coming years to figure out how to structure SLATs to most easily avoid reciprocal trust treatment, while being “as reciprocal as possible” to avoid or minimize any disruption on the client’s overall financial and estate planning goals.
At some point in the coming years, states will likely close their state estate tax "loophole" - either by establishing a gift tax to backstop their estate tax exemption, creating a robust gift-in-contemplation-of-death rule to reduce at least the use of deathbed SLATs, recoupling to the Federal system to take advantage of the Federal gift tax system (including the IRS' enforcement of it), or just outright repealing their state estate tax. Until then, though, the SLAT remains a remarkably viable to manage or avoid state estate taxes while staying within the Federal gift and estate tax rules.
Would a SLAT be a good form of life insurance trust to reduce state estate taxes? It also seems like the reciprocal trust doctrine would be avoided when the majority of assets are held by one spouse.