By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
The once-in-a-lifetime opportunity to gift $5.12 million without gift or generation-skipping transfer (GST) tax will — without further Congressional action — expire on December 31, 2012. On January 1, 2013, the gift tax exemption will revert to $1 million and the top tax rate will revert to 55 percent.
While many high-net-worth married couples might like to take advantage of their $5.12 million gift tax exemptions, they may be reluctant to do so because of lost access to the gifted property’s income and principal. One strategy to keep the gifted income and principal within reach is a spousal lifetime access trust (SLAT). In simple terms, a SLAT is an irrevocable trust set up by one spouse for the benefit of the other spouse.
For example, assume husband (grantor-spouse) creates a SLAT for the benefit of wife (beneficiary-spouse) and funds it with his $5.12 million gift tax exemption. During wife’s lifetime, the trustee (which may be wife) can distribute to wife income and principal as needed for her health, education, maintenance and support. Wife can also be given the power to withdraw the greater of $5,000 or 5 percent of the trust principal annually, and a testamentary limited power of appointment to “rewrite” the trust upon her death. Thus, through wife, husband retains “indirect” access to the SLAT’s income and principal.
When wife passes away, the unappointed trust property (including appreciation) passes — estate tax-free — to the children and, depending on state law, even more remote descendants (if husband allocated his generation-skipping tax exemption to the SLAT gift). An added benefit of a SLAT is that it protects the beneficiaries from creditors, including ex-spouses.
Grantor trust status
For income tax purposes, the SLAT is a grantor trust for the lifetime of the grantor-spouse. Thus, in the above example, husband reports the SLAT’s income and capital gains on his personal tax return. Payment of the SLAT’s income taxes allows the SLAT to compound “tax free.” Such payments are essentially a tax-free gift to the beneficiaries of the SLAT. To provide the cash to pay the taxes, if necessary, the SLAT can give an independent trustee the discretion to reimburse the grantor-spouse for any taxes paid.
Hedging the bet with an ILIT
One obvious problem in the above example is that, upon wife’s death, husband loses his indirect access to the trust’s income and principal. One simple solution is for wife to create an irrevocable life insurance trust (ILIT) for the benefit of husband. The ILIT would be funded with a life insurance policy on wife’s life to replace the wealth lost to husband at wife’s death. If necessary, the SLAT can loan the ILIT the funds needed to pay premiums under a split-dollar arrangement.
Avoiding the reciprocal trust doctrine
Can each spouse create a SLAT for the benefit of his/her spouse so as to increase the gift to $10.24 million? It’s possible, but the IRS could unwind the transactions under the reciprocal trust doctrine. If applicable, each spouse will be treated as having established a trust for his/her own benefit, resulting in estate inclusion of each spouse’s own trust at his/her death. However, if the trusts are significantly different from each other, the reciprocal trust doctrine will not apply. There is no safe harbor as to what constitutes a sufficient difference between two trusts to avoid the reciprocal trust doctrine. Therefore, the best approach is to make the trusts so different that the spouses are not in the same economic position after the trusts are created. Following are ways SLATs may be drafted to differ from one another:
1. Income —In one SLAT, provide that the beneficiary-spouse is the sole income beneficiary; and, in the other SLAT, allow income to be sprinkled among the beneficiary-spouse and the couple’s descendants. Further, in one SLAT, allow income to be accumulated; and, in the other SLAT, require all of the income to be distributed annually.
2. Principal — In one SLAT, allow principal to be sprinkled among the beneficiary-spouse and the couple’s descendants; and, in the other SLAT, make the beneficiary-spouse the sole principal beneficiary. Further, in one SLAT, allow distributions to the beneficiary-spouse (acting as sole trustee) for health, education, maintenance and support (HEMS) only; and, in the other SLAT, allow an independent trustee to make distributions to the beneficiary-spouse for HEMS, as well as best interests. Finally, in one SLAT, give the beneficiary-spouse an annual $5,000/5 percent withdrawal power; but not in the other.
3. Limited powers of appointment — In one SLAT, give the beneficiary-spouse a testamentary limited power of appointment (LPA) to rewrite the trust; but not in the other. Or, in one SLAT, give the beneficiary-spouse the broadest LPA possible (i.e., anyone other than the beneficiary-spouse, his/her estate, his/her creditors or the creditors of his/her estate); and, in the other SLAT, limit the potential appointees to the grantor-spouse’s descendants and charity. Further, in one SLAT, allow the LPA to be exercised during lifetime; and, in the other, SLAT only at death.
4. Final takers — In the event no descendants are surviving, use different remote contingent beneficiaries in each SLAT (i.e., siblings, nieces, nephews, charities, etc.).
5. Trustees — In one SLAT, have the beneficiary-spouse act as the sole trustee; and, in the other SLAT, have the beneficiary-spouse serve as co-trustee with a third party (which may be a child). In one SLAT, allow the grantor-spouse to remove and replace trustees; and, in the other SLAT, allow the beneficiary -spouse to remove and replace trustees.
6. Assets — Fund one SLAT with liquid assets (i.e., cash, marketable securities, bonds, etc.); and the other with illiquid assets (i.e., real estate, closely-held business interests, etc.).
7. Timing — Separate the creation and funding of the two SLATs by at least one to three months.
SLATs, like many other estate planning techniques, have some drawbacks. Access to trust assets is available only to the grantor’s spouse (and/or other beneficiaries) — not to the grantor. Thus, the grantor only has indirect access to the trust property through his/her spouse. Therefore, divorce or the death of the beneficiary-spouse will eliminate this limited access. But, as mentioned above, the loss of access caused by the death of the beneficiary-spouse can be remedied by an ILIT. And divorce can be covered by allowing the trustee to loan money to the grantor-spouse without security and at below market interest rates. Finally, the SLAT must be carefully drafted to avoid inadvertent estate tax inclusion — particularly if reciprocal SLATs are established. In summary, SLATs will be attractive to many high-net-worth couples looking to maximize their $5.12 million gift tax exemptions, while retaining some access to the gifted assets.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.