by Mitha Rao, JD, managing attorney, Rao Legal, LLC and Ryan Johnson, CPWA, Private Wealth Advisor, BMO Wealth Management**
The Biden Administration’s economic agenda has a heavy focus on social spending and the current proposal, approved by the House Ways and Means Committee on 9/13/21, will fund some of the spending by rolling back the Tax and Jobs Act corporate tax cuts and increasing tax rates on wealthy individuals. The current Administration largely telegraphed these tax increases on the campaign trail and in the Greenbook released earlier this year. Breaking with prior messaging that conspicuously did not address the expanded federal estate tax exemption set in 2017, the legislation included a rollback that would affect gifts and inheritances after 12/31/2021. Currently, this exemption is $11.7 million per person, or $23.4 million combined, but, even if the current legislation doesn’t pass, a reduction of this exemption is guaranteed. The exemption is already set to revert to $5 million, adjusted for inflation, beginning 1/1/26. In light of this guaranteed reduction in 2026 and the current legislation in Congress accelerating the sunset, married couples should consider creating a Spousal Lifetime Access Trust (SLAT) to take advantage of the current, historically high exemption. And even if married couples do not have a federal estate tax issue, a SLAT can nonetheless be strategic to avoid Illinois estate taxes.
What is a SLAT?
A SLAT is an irrevocable trust that provides an opportunity for married couples to reduce the size of their combined taxable estate. Unsurprisingly, a SLAT is especially popular prior to an anticipated reduction of the estate and gift tax exemption. Through a SLAT, one spouse (the donor spouse) gifts assets to benefit the other spouse while taking advantage of the donor spouse’s estate and gift tax exemption.
How does a SLAT work?
Although a SLAT is an irrevocable trust, it functions somewhat uniquely. Typically, a SLAT is set up as a grantor trust during the donor spouse’s lifetime. The donor spouse pays income tax (rather than the trust) and assets in trust can thus compound and pass tax-free to future generations.
Another unique advantage of a SLAT is that it mitigates the loss of control generally associated with irrevocable trusts. Through a SLAT, the donor spouse retains indirect access to gifted assets through the non-donor spouse. The non-donor spouse is the primary beneficiary and can therefore access assets and request distributions from the trustee if any financial resources are needed to maintain the couple’s standard of living. Any distributions could potentially augment the couple’s taxable estate, so such a request should be undertaken with the guidance of an advisor and attorney. The donor spouse may also include other family members (i.e., children and grandchildren) as beneficiaries and can structure the trust to minimize taxes generationally.
Some Nuances to Consider:
- Gift taxes.
The donor spouse’s transfer of assets to a SLAT is a taxable gift. Upon transfer, the gift will remove the assets (along with any appreciation) from the donor spouse’s taxable estate. Careful guidance from an attorney and advisor will ensure that gift taxes are avoided wherever possible.
- Basis step-up and “swap” powers.
The transfer of assets to a SLAT permanently removes the assets from the donor spouse’s taxable estate. Consequently, these assets will not obtain a step-up in cost basis upon the donor spouse’s death. But a SLAT can include language that enables the donor spouse the power to substitute or “swap” assets. If the donor spouse wishes to achieve a step-up in basis of an appreciated asset, he or she may exercise the power of substitution to swap such an asset with another asset so long as it is of equivalent value as of the date of substitution. The donor spouse will hold the “swapped” asset in his or her name and thereby have the asset included in his or her taxable estate.
- The reciprocal trust doctrine.
Each spouse may want to create his or her own SLAT to fully utilize both spouses’ exemptions. While this can be financially advantageous, the trusts must be structured to avoid running afoul of the “reciprocal trust doctrine.” This doctrine applies when the two trusts are interpreted as interrelated and the arrangement leaves each spouse in approximately the same economic position as if they had each created their own trust and named themself as life beneficiary. If this happens, then the trusts may be “un-crossed” and included in the donor spouses’ respective taxable estates. One way to avoid this doctrine is to create and fund the trusts at different times (in different years, for example).
- Death or divorce.
Upon the death of non-donor spouse, the grantor spouse loses indirect access to the trust assets. And in the event of divorce, the separated non-donor spouse will continue to benefit while the donor spouse will likely lose access to the trust assets. Careful drafting, however, can alleviate some of these risks.
As the House Ways and Means Committee advances its tax proposal, it is increasingly important to utilize planning strategies like SLATs to take advantage of record high exemptions and maximize wealth preservation before favorable conditions expire.
**The views and opinions expressed herein are those of the author and not BMO Harris Bank N.A.