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Assets that you own at your death are included in your taxable estate. Lifetime gifting offers an excellent opportunity to remove assets from your taxable estate, yet it is often psychologically and economically difficult for people to make gifts and completely relinquish control over an asset. For a client considering a lifetime gifting program, a Spousal Lifetime Access Trust (“SLAT”) (also sometimes referred to as a “Spousal Estate Reduction Trust” or “SERT”) offers a way to remove assets from your taxable estate, and thus avoid estate tax on these assets at your death, while at the same time both (1) allowing your spouse access to the income and principal of the trust during your spouse’s entire lifetime and (2) allowing Trustees you select to control trust investments and the timing and recipient of trust distributions.

OVERVIEW

A SLAT is an irrevocable trust created and funded by one spouse (the “Donor Spouse”) during his or her lifetime, for the benefit of the other spouse (the “Beneficiary Spouse”).  Typically, descendants or other family members are also beneficiaries. The Beneficiary Spouse is usually a Trustee of the trust, together with an independent co-Trustee. The independent co-Trustee must be someone other than a beneficiary of the trust or the spouse of a beneficiary, but can be a relative, friend, business associate, attorney, bank or other financial institution.

ADVANTAGES OF GIFTING TO A SLAT

Gifting assets to a SLAT provides a way to remove not only assets from the Donor Spouse’s taxable estate, but also any future appreciation of and income earned by these assets. Furthermore, although the Donor Spouse has removed the assets from his or her taxable estate, the Beneficiary Spouse is still given access to the income and principal, without having the assets taxed in either spouse’s estate. In addition, under current law the Donor Spouse reports trust income and capital gains on his or her personal tax return and pays the tax on income earned by the trust, thereby allowing him or her in effect to make an additional tax-free gift to the trust.

There are also non-tax advantages to gifting assets to a SLAT. Assets in a SLAT can be managed and invested by an experienced professional, and distributed to beneficiaries at the Trustees’ discretion. Trust assets also may be afforded some protection from the claims of creditors of the trust beneficiaries, or from the claims of a divorced spouse of a trust beneficiary.

WHAT CAN BE GIFTED?

The Donor Spouse can gift a wide variety of assets to a SLAT, including cash, stock, life insurance and real estate. Growth, rather than non-growth, assets are better gifts, as any future appreciation of the asset is removed from the Donor Spouse’s and Beneficiary Spouse’s estates. In order to obtain estate and gift tax benefits, it is essential that any asset gifted to a SLAT be owned solely by the Donor Spouse immediately prior to the gift (and not jointly with the Beneficiary Spouse). The Beneficiary Spouse should never transfer assets to the SLAT because doing so would cause a portion of the trust to be included in the Beneficiary Spouse’s taxable estate.

TAX RULES OF GIFTING TO A SLAT

The Donor Spouse can avoid paying a gift tax on the assets he or she transfers to the trust in one of two ways: making annual exclusion gifts, or using his or her lifetime gift tax exemption.

First, the Donor Spouse can make what are commonly referred to as “annual exclusion gifts.” Each person can give up to $18,000 per year, per person, to as many persons as he or she wishes. No federal tax is due[1].  Married couples can combine their annual exclusions, and the Donor Spouse can give the entire $36,000 to a person, with the Beneficiary Spouse consenting to the combination of their annual exclusion amounts. For example, assume a SLAT has four beneficiaries (the Beneficiary Spouse and three children) that can currently receive trust distributions in the discretion of the Trustees. The Donor Spouse can give $18,000 to each of his or her children, and can also use the Beneficiary Spouse’s $18,000 annual exclusion amount (with the spouse’s consent on an annual gift tax return) for a total of $108,000 ($36,000 for each child), plus a $5,000 contribution for the Beneficiary Spouse[2].  In this example, a total of $113,000 per year can be gifted to the SLAT completely free of gift tax.

In order to qualify gifts to a SLAT for the annual exclusion from gift tax, the transfers must be gifts of a “present interest,” i.e., the beneficiaries must be given the right to withdraw from the trust a share of the assets, up to the annual gift tax exclusion amount, although it is not necessary for them actually to exercise these withdrawal rights. The Trustees must notify each of the beneficiaries, in writing, of their rights of withdrawal. The beneficiaries must acknowledge receipt of the notice letter (often called a Crummey Notice). Letters for minors under age eighteen should be sent to their parent or legal Guardian.

What if the Donor Spouse wants to make a gift to a SLAT above the annual exclusion amount? In this case, federal gift taxes still could be avoided by using the Donor Spouse’s lifetime gift tax credit. Each person has a lifetime gift tax credit that exempts a portion of assets (currently $13,610,000) from federal gift tax. The Donor Spouse would allocate a portion of his or her lifetime exemption to the gift made to the SLAT.

A SLAT is a “grantor trust” for income tax purposes. As a result, although the assets in the trust are not includable in the Donor Spouse’s estate, the Donor Spouse must pay the tax on all income earned by the trust, regardless of whether the income is accumulated in the trust or distributed to the Beneficiary Spouse or the other trust beneficiaries. Although the IRS may seek to change this result in the future, under current law having the Donor Spouse pay the income tax generated by the trust does not result in an additional taxable gift to the trust in the amount of the income tax liability. Furthermore, if distributions are made to the trust beneficiaries during the Donor Spouse’s lifetime these distributions are income tax free. The grantor trust status will end upon the Donor Spouse’s death.

For example, assume a SLAT earns $100,000 of income in a taxable year. The Donor Spouse must report $100,000 of income on his or her tax return. The trust will retain the entire $100,000 for the benefit of the trust beneficiaries. If instead the trust had to pay the income tax on the $100,000 of income, the trust would retain only approximately $60,000 after paying the income tax. Thus, under current law, by paying the income tax himself or herself, the Donor Spouse is able to make an additional “transfer” to the trust of approximately $40,000, without incurring a gift tax or diminishing his or her annual exclusion or unified credit amounts.

ACCESSING THE TRUST ASSETS

Once assets are gifted to a SLAT, the Donor Spouse must relinquish all control over the assets. This is the price of estate tax exclusion. Access to the trust funds by the beneficiaries is determined by the provisions of the trust. The flexibility of the trust terms can vary depending on your preferences.

The most flexible alternative is to give the Trustees discretion to accumulate the income, or to “sprinkle” the income among the Beneficiary Spouse and the other trust beneficiaries, provided the Beneficiary Spouse’s needs are considered first. Authorizing the Trustees to accumulate income permits income not needed by the Beneficiary Spouse to be reinvested in the trust, where it will not be subject to estate tax at his or her death.

The Trustees of a SLAT also may be authorized to distribute the principal of the trust to the Beneficiary Spouse and/or your descendants. In addition, access to the trust principal can be increased by giving the Beneficiary Spouse an unrestricted right to withdraw five percent of the trust principal annually without the approval of the independent co-Trustee.

Upon the death of both spouses, there are a wide variety of options for distributing the trust assets to your descendants. Assets could be distributed to children free of trust, or the trust assets can be held in trust for your children, giving the Trustees the power to distribute income or principal to your children in the Trustees’ discretion. When your children reach a certain age or ages, they can be given the right to withdraw the trust principal, in whole or in part, if desired. As an alternative, the assets can be held in lifetime trusts for your children, giving the Trustees the flexibility to decide when your children are ready to receive the trust principal. This option allows the possibility of using the SLAT for generation-skipping planning, i.e., allowing assets to eventually pass to grandchildren or great grandchildren (if not needed by your children) free of all estate, gift and generation-skipping taxes.

SLAT ILLUSTRATION

To illustrate how a SLAT works, assume a SLAT is created by the Donor Spouse for the benefit of the Beneficiary Spouse, their three children and two grandchildren. The grantor, combining his or her spouse’s annual exclusion amount, makes $100,000 of annual exclusion gifts to the trust each year for ten years. The trust principal grows at 10% per year, and the Donor Spouse is in a 50% estate tax bracket.

At End ofTrust ValueEstate Tax Savings
1 year$110,000$55,000
5 years$671,561$335,781
10 years$1,753,117$876,559

As you can see, there are significant estate tax savings achieved by gifting assets to a SLAT. At the end of only ten years, the Donor Spouse has removed over $1,750,000 of assets from his or her taxable estate, without incurring any federal gift tax liability.  This results in a federal estate tax savings of more than $850,000. All appreciation on the assets in the SLAT has also been removed from the Donor Spouse’s and Beneficiary Spouse’s taxable estates. Because the Donor Spouse must pay the income tax on any income earned by the trust, the trust assets are actually even greater than if the trust were required to pay the income tax. Finally, although the grantor has relinquished control over the assets gifted for estate tax purposes, the SLAT can be structured so that his or her spouse still has access to the income and principal.

QUESTIONS COMMONLY ASKED BY CLIENTS CONSIDERING CREATING A SLAT

Q. What happens when the Beneficiary Spouse dies?

A: When the Beneficiary Spouse dies, the SLAT can either terminate and be distributed, or the trust can continue in which case the trust assets will be distributed to your descendants according to the trust provisions. Remember, under no circumstances can the Donor Spouse be a beneficiary.

Q. What happens if we get divorced?

A: If you wish, the SLAT can be structured so that if there were a divorce, the Beneficiary Spouse would no longer be considered a beneficiary of the trust.

Q. Am I limited to making my spouse and descendants trust beneficiaries?

A: No. Anyone can be included as a trust beneficiary. Parents, sister, brothers, nieces and nephews, even friends can be named as beneficiary. However, a SLAT is irrevocable and the trust beneficiaries cannot be changed once they are designated. In addition, if you want to qualify contributions to the trust for the annual exclusion from gift tax, the beneficiary must be given a right to withdraw the assets gifted up to the annual exclusion amount and must be a “real” beneficiary of the trust.

Q. If an independent co-Trustee is appointed, can the trust beneficiaries change the independent co-Trustee?

A: Yes. Often the Beneficiary Spouse is given the power to change the independent co-Trustee (so long as another independent person is appointed). After the Beneficiary Spouse’s death, the other trust beneficiaries may be given the right to change the independent co-Trustee.

Q. When I make gifts to the SLAT, do I have to file a gift tax return?

A: This depends on a variety of factors, including the amount gifted, whether the spouses elect to split their annual exclusions, whether you wish the trust to be exempt from the generation-skipping tax, and other tax considerations. You should consult with your attorney, financial advisor or accountant.

Q. Can my spouse and I both set up SLATs giving the other access to the trust income?

A: As a general rule, we do not recommend that you do so. Under the so called “reciprocal trust doctrine,” the assets in the trust created by each spouse could be included in that spouse’s estate.

CONCLUSION

In the area of estate planning, clients often have two diametrically opposed goals. On the one hand, they would like to retain control over their assets. On the other hand, they would like to structure their affairs in a way to minimize the estate taxes that will be due upon their deaths. We believe that in many ways the SLAT accomplishes those dual goals of control and estate tax reduction.

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U.S. Treasury Circular 230 Notice:  Any U.S. federal tax advice included in this memorandum is not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.

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[1] If the Donor is a Connecticut resident, no Connecticut gift tax would be due.  New York, Florida and most other states do not impose a gift tax, so these states do not pose a gift tax problem for these annual exclusion gifts either.

[2] Other tax concerns prevent the donor spouse from gifting more than $5,000 to the Beneficiary Spouse through the SERT vehicle.