By Dr. James M. Dahle, WCI Founder
Regular readers will recall that our financial goals for 2021 included finally getting serious about our own estate planning. We're not proud to admit how long we waited to do this but are proud that we actually did it! A major part of our estate plan is a Spousal Limited Access Trust, sometimes called a Spousal Lifetime Access Trust, both abbreviated as SLAT.
Let's talk about what it is and why you might want to consider it.
What Is a Spousal Limited Access Trust (SLAT)?
Let's start by breaking down what a SLAT is by defining each of the terms.
- Spousal – The primary beneficiary of a SLAT is your spouse.
- Limited – The trust is often written so that the spouse can only access the contents of the trust to provide for their own health, education, maintenance, or support.
- Lifetime – Further provisions kick in when the primary beneficiary spouse dies.
- Access – This refers to the fact that the donor spouse still has access to the assets of the trust through the beneficiary spouse.
- Trust – A SLAT is an irrevocable trust, and, thus, the assets in it are removed from the estate.
At its most basic, a SLAT is a grantor trust set up by the donor spouse for the benefit of the beneficiary spouse. “Grantor trust” simply means that the donor spouse is responsible for the taxes on income in the trust; the trust does not file its own tax return.
What Is the Real Purpose of a Spousal Limited Access Trust?
What's the point, you may ask? Obviously, if you have a spendthrift spouse, this is a way to make sure the spouse is taken care of, but that's not usually the point of setting up a SLAT. The main idea behind a SLAT is reducing the estate tax paid. This is generally a trust used only by those with an “estate tax problem,” i.e. an estate that is or will be larger than the federal and any applicable state estate tax exemption amount at death. In 2022, that amount is $12.06 million per spouse, indexed to inflation. Under current law, that amount will be cut in half as of 2026, but Congress has discussed reducing it even before then.
How Does a SLAT Reduce Estate Tax?
A SLAT reduces estate tax through two mechanisms. The first is by removing any additional growth on an asset from the estate. The idea is to put assets into the SLAT that still have a long way to grow in value. That might be a small business, a farm, real estate investments, or a brokerage account. You fund the trust either gradually using gifts or, more likely, all at once using your estate tax exemption. Perhaps you put in $12.06 million in assets, using up your entire exemption, and then the assets grow to $30 million between the time the trust was funded and death. None of that $30 million will be subject to estate tax.
The second way a SLAT reduces estate tax is by purchasing additional rapidly growing assets from you in exchange for a promissory note. Imagine you have a $50 million business. You can gift $12.06 million into the SLAT and then the SLAT can buy the other $37.94 million with a promissory note. That note can have all kinds of terms (30 years, interest-only, etc.). However, there is a minimum interest rate that must be paid. In our current low-interest rate environment, that rate is less than 2%. Fixed. So as long as the asset you put into the SLAT performs better than that, you are increasing the percentage of your assets inside the SLAT while decreasing the percentage that is outside of the SLAT, further reducing any potential estate tax bill.
SLAT Trusts and Asset Protection
If you're interested in asset protection, the assets in a SLAT are protected from creditors of the donor, since the donor has effectively given away the assets. They are also protected from the creditors of the beneficiary, since the trust probably only pays out amounts for health, education, maintenance, and support (although other options are available). In fact, the trust can pay for those services directly, never actually paying cash to the beneficiary. Thus, there is no cash for the beneficiary's creditors. Even better, the trustee can simply not pay out anything, and therefore, there is no cash available to the creditors, inducing them to settle with the beneficiary.
Unfortunately, if there is a promissory note outside of the trust, the value of the note and the income associated with it may be available to the donor's creditors. However, there may be other methods of protecting that asset, such as placing it into a Domestic Asset Protection Trust (DAPT) in states that allow it. While that asset will be subject to estate tax and income tax, it will not be subject to creditors.
What About Living Expenses and Taxes?
You do not want to impoverish yourself by funding the SLAT. The grantor will still need money to live on and enough money to pay all of the taxes due on the income of the trust. Where will that come from? It either needs to come from other assets or from the payments on the promissory note. In our prior example: with a 1.8% interest rate and a $37.94 million note, the interest would be almost $700,000. While that sounds like plenty to live on, it might not go very far if the trust is producing $5 million in income each year. The tax bill on that might be $2 million or more per year. If you have a lot of assets outside of the trust, no problem. Using that money to pay the tax bill further reduces your estate tax problem. If you do not have a lot of assets outside of the trust, you might want to have a shorter note. For example, a 10-year 1.8% note would be paying out more than $4 million per year. That would cover the tax bill and living expenses, at least until the note is paid off.
The idea is that you let the value of the SLAT grow as much as possible, and in the meantime, you use the promissory note payments and other assets to pay living expenses, taxes, and charitable contributions.
Grantor, Beneficiaries, Trustees, Trust Protector
There are lots of different roles involved here. The Grantor is the one who funds the trust. The Beneficiary is the one who benefits from the trust. The Trustee is the person who manages the assets and distributions. The Trust Protector is the person who can replace the trustee in the event of misconduct. With a SLAT, the grantor cannot be a trustee and the beneficiary probably should not be—or at least there should be a co-trustee. The Grantor should not be a beneficiary, at least initially but can be added later. It is best to list all potential beneficiaries, at least in general terms, when the trust is first drafted. That would include the spouse as the primary beneficiary. As secondary beneficiaries, you could include children, other relatives, the donor spouse, a donor-advised fund, and/or a private charitable foundation. One suggestion from our attorney was that a family member of the beneficiary spouse serves as the trustee and a family member of the donor spouse serves as the trust protector.
The Reciprocal Trust Doctrine
If one SLAT is a good idea, aren't two better? One SLAT can be funded by the first spouse for the beneficiary of the second, and a second SLAT can be funded by the second spouse for the beneficiary of the first. This would allow you to use the exemption amounts of both spouses, thus doubling the amount that can be gifted into the trust. You have to be careful with this, though. Both the IRS and the courts may view two identical trusts as simply “reciprocal trusts” and view them as your own trust, negating any tax and asset protection benefits. The key to avoiding this is to not set up both trusts at the same time. You can also vary the terms and the beneficiaries of the trusts to avoid having the reciprocal trust doctrine apply.
Another benefit of not setting up two SLATs at once is that you preserve flexibility to set up another one in the event that estate planning laws or exemptions change in the future or simply to pass some non-trust assets to heirs without paying estate taxes.
8 Downsides of a SLAT Trust, and What You Can Do About Them
It all sounds great so far, right? Naturally, there is no free lunch. SLATs do have downsides, so you need to be aware of them.
#1 Cost and Hassle
You will generally spend thousands of dollars setting up and maintaining a trust like this. You will also need to fund the trust. All income from the asset must stay in the trust and all expenses for the asset must come from the trust. Good drafting of the trust document can minimize hassle, but there is no way around the expense.
There is no point to a SLAT if there is no estate tax problem. If there is an estate tax problem, the costs of the SLAT should be dwarfed by the available estate tax savings. A gift tax return will also need to be filed in the year the trust is funded.
What happens if you put all your money into a SLAT and then divorce the beneficiary spouse? Seems problematic, right? Luckily, provisions can be put into the trust document to take care of this (such as that the beneficiary is the CURRENT spouse or that, in the event of divorce, both spouses will be beneficiaries).
#3 Death of the Beneficiary Spouse
If the beneficiary spouse dies, the donor spouse loses access to those assets as they will pass on to the secondary beneficiaries. A testamentary limited power of appointment may overcome this limitation of a SLAT. I say “may” because it appears to be somewhat controversial. However, the way it is supposed to work is relatively simple—the will of the beneficiary spouse names the donor spouse as a beneficiary of the trust or, more commonly, as the beneficiary of a new trust formed at the death of the beneficiary spouse and funded with the assets of the SLAT.
#4 Loss of the Step-Up in Basis at Death
You should think twice before putting an asset into a SLAT that you plan to hold until your death. For example, if you hold the family farm until you die, your heirs will receive a step-up in basis as of the date of your death, reducing any income tax due when they sell the farm. Assets inside a SLAT do not get a step-up in basis at death. It is entirely possible that, for an asset held until death, the income taxes due are greater than any applicable estate taxes! So the SLAT strategy works best for assets that are likely to be sold prior to death. Paying the capital gains taxes from the assets outside of the SLAT further reduces the estate tax bill by lowering the size of the taxable estate.
If the SLAT contains more marketable securities, there is another option. The SLAT can have a “swap option” that allows the grantor to swap out low-basis shares inside the SLAT for equivalent but high-basis shares outside the SLAT. Once outside the SLAT, the low-basis shares can be used for charitable gifting, or they can qualify for the step-up in basis at death.
Note that the interest on the promissory note is not taxable, nor is it a taxable event to sell assets to the trust. This is the benefit of a grantor trust. The downside? That all the taxable income passes through to the donor. I worried this would be a big problem if the SLAT eats the rest of our financial life and we end up with 99% of our money in the SLAT somehow and no way to cover the tax bill from other assets. The way around it is to write a provision into the SLAT that allows it to reimburse you for taxes paid.
#5 You Need People to Trust
Trust is not just a noun; it is also a verb. Trusts work best when you can actually trust everybody involved—the grantor, the beneficiaries, the trustees, and the trust protector. While safeguards can be instituted (such as including a trust protector), it is best to give careful thought to the people involved with the trust.
#6 Donate Only Assets Owned by the Donor
Ideally, the donor will fund the trust only with assets owned solely by the owner. It negates the point of the trust to donate jointly owned assets. However, this one has an easy workaround. Spouses can give each other an unlimited amount of assets at any time. So, have the beneficiary spouse give the donor spouse the assets, and then the donor spouse can fund the trust with them. This can require additional paperwork in community property states.
#7 SLATs Are Ideally Only Used in an Emergency
The highest use of a SLAT is to maximize the amount of assets passed to heirs outside of the estate and, thus, to minimize any estate taxes due. The more that is left in a SLAT, the more money that is saved on estate taxes. While it can be used to benefit the beneficiary spouse, ideally it is not. The longer the term on any promissory note (interest-only is even better) and the fewer withdrawals to support the spouse, the better. However, if the beneficiary spouse (and also the donor spouse so long as the beneficiary spouse is alive or via the testamentary limited power of appointment) end up needing the assets, they can still be accessed. Be careful how much you put into the SLAT.
#8 Depreciating Assets Don't Go in a SLAT
Since the point of a SLAT strategy is to maximize the value of the SLAT at the death of both spouses, you only want appreciating assets in the trust. This is not the place for cars, boats, and consumer goods that are likely to depreciate in value. If you want those in a trust for privacy, for asset protection, or for avoiding probate, put them into a DAPT or a simple revocable trust.
Have more questions about estate planning or protecting your assets? Hire a WCI-vetted professional to help you sort it out.
If you are married with an estate tax problem and asset protection concerns, consider a SLAT as part of your estate plan. That's finally what we've accomplished, even if it took us a little longer than we expected.
What do you think? Do you have a SLAT? How did you structure it? Do you think the pros outweigh the cons? Comment below!