Use It or Lose It: It’s Time to Maximize on Your Estate and Gift Tax Exemption with Tax-Efficient Estate Planning

With potential risks of retroactive application of any changes in the tax laws, including a reduction of the currently $12.06 million unified gift and estate tax exemption, affluent individuals who have not already fully used their exemption may wish to implement lifetime gifting strategies, such as a Spousal Lifetime Access Trust (SLAT) and an Intentionally Defective Grantor Trust (IDGT), sooner than later. 

What is a Spousal Lifetime Access Trust (SLAT)?

A Spousal Lifetime Access Trust (SLAT) is a lifetime gift from one spouse (“donor”) to an irrevocable trust for the benefit of the donor’s spouse. A SLAT is funded by gift while both spouses are alive. Because assets transferred to a SLAT (as well as any appreciation on them) will be removed from the donor’s estate, they will not be subject to estate tax when the donor dies. The donor maximizes his or her gift tax exemption by making a lifetime gift to the SLAT, and the donor’s spouse is named as the current beneficiary of the trust. Children, grandchildren, and more remote descendants also may be named as either current or remainder beneficiaries.

To prevent the value of the assets transferred to the SLAT from being included in the estate of the donor’s spouse, provisions are drafted into the trust so as not to qualify the gift from the donor to the donor’s spouse for the marital deduction and instead the donor’s gift tax exemption is applied to shelter the transferred assets from gift tax. Optimal candidates for the SLAT are assets that are likely to appreciate in the future.

The donor’s spouse may serve as trustee; provided, however, that the power to make distributions to the donor’s spouse is restricted by an “ascertainable standard,” which includes a beneficiary’s need for health, education, maintenance and support.

Who Should Consider a SLAT?

For married persons who want to take advantage of the increased exemption from the estate and gift tax but are not sure that they can irrevocably part with so much wealth, a SLAT may be an appropriate solution.

SLATs offer married persons the opportunity to maximize the donor’s gift and estate tax exemption for shifting assets out of the donor’s estate as well as the estate of the beneficiary spouse, while allowing the donor’s spouse to continue benefiting from those transferred assets. On the death of the donor’s spouse, the trust may continue for the benefit of descendants, and the donor can allocate the exemption from generation-skipping transfer tax to the SLAT, making the trust exempt from future estate tax for multiple generations.

Attributes of a SLAT

A SLAT allows the donor spouse to transfer up to the donor spouse’s available exemption amount without gift tax. When the donor spouse dies, the value of the assets in the SLAT and the future appreciation on these assets are excluded from the donor spouse’s gross estate and are not subject to the federal estate tax. Because there is no claw back, any exemption amount used when the trust was funded over the exemption amount allowed at the time of the donor spouse’s death should also escape federal estate tax.

SLAT as an Irrevocable Trust
To achieve these tax benefits, the SLAT must be an irrevocable trust. To that end, when creating a SLAT, the donor spouse must irrevocably transfer assets to the SLAT, forever parting with the income from and use of those assets. However, because the beneficiary spouse may receive distributions of income or principal from the SLAT during his or her lifetime, the donor spouse indirectly may continue to benefit from the income and principal of these assets through the beneficiary spouse. Of course, by accessing the assets in the SLAT, unless those assets are consumed, the couple returns assets to one of their estates, potentially subjecting their value to estate tax at death and losing some of the benefit of the original transfer.

Why a SLAT is Treated as a Grantor Trust
For federal income tax purposes, a SLAT is treated as a “grantor trust.” This means that the donor spouse, as the grantor of the SLAT, is for income tax purposes treated as owning the assets of the SLAT. As such, the income from the trust’s assets is included in the donor spouse’s gross income, requiring the donor spouse to pay income tax thereon. Although the donor spouse pays income tax on income received by the trust (and not by the beneficiary spouse), this has the added benefit of allowing the assets of the trust to compound without being diminished by income taxes. Because the donor spouse is obligated to pay the income tax attributable to the trust’s income, this tax payment is not a gift to the trust (and is not subject to gift tax).

Asset Transfer to a SLAT
Transferring assets to a SLAT may also provide a measure of protection from creditor claims on the donor spouse, the beneficiary spouse, the spouses’ children and more remote descendants. Assuming the transfer to the SLAT is not a fraudulent conveyance made in order to hinder or delay creditors of the donor spouse from reaching such assets, the transferred assets should be free from the claims of the donor spouse’s creditors. Further, assuming that the terms of the SLAT include a proper spendthrift clause, preventing the assignment of the SLAT’s assets by its beneficiaries, and that the power to make discretionary distributions to the beneficiaries are solely held by an independent trustee, who is not a beneficiary and not related to or subordinate to the beneficiary or donor spouse, the assets of the SLAT should also be out of reach from the beneficiary’s creditors.

The Flexibility of the SLAT

The flexibility of the SLAT results in great part from its ability to distribute income and principal to the beneficiary spouse, which can be used by the family unit, including the donor spouse, while excluding the transferred assets from the estates of both the donor spouse and the beneficiary spouse. It is important to note, however, that the ability, albeit indirectly, of the donor spouse to access the funds in the SLAT through the beneficiary spouse will end should the beneficiary spouse die while the donor spouse is alive. Furthermore, following a divorce, the ability of the donor spouse to indirectly access the funds in the SLAT will cease while the donor’s now ex-spouse remains a beneficiary of the SLAT. Accordingly, as difficult as it is for couples to contemplate divorce while married, planning for divorce should at least be considered when drafting the terms of any SLAT. A provision can be included in the SLAT agreement that defines the beneficiary spouse as the individual to whom the donor spouse is currently married.

Learn more about SLAT estate planning

Using Intentionally Defective Grantor Trusts (IDGT) to Benefit your Descendants

Another estate planning gifting strategy to maximize on the current high gift and estate tax exemption is making gifts and/or sales to an Intentionally Defective Grantor Trust (“IDGT”), which applies your exemption to lifetime gifts made to the trust for the benefit of your children, grandchildren and more remote descendants. An IDGT is a complete transfer of assets to a trust for estate and gift tax purposes but an incomplete or “defective” transfer for income tax purposes such that the donor (“grantor”), and not the beneficiary, is taxed on all the trust’s income, even though it is the beneficiary who is receiving the distributions from the trust.  By allocating the generation-skipping transfer tax exemption to the gifts made to the IDGT, the trust can be exempt from future estate tax for multiple generations. In the case of a sale to an IDGT of a minority interest in an entity or a fractional interest in real property, valuation discounts can be leveraged to shift more of your assets (and any future appreciation) out of your future estate without applying more of your gift tax exemption. So long as the grantor is alive and has capacity, this “grantor trust” status for income tax purposes causes the nonrecognition of capital gain on the sale. The “grantor trust” status of the trust may be “turned off” in the future by a release of certain powers held by the grantor so that the trust becomes a “nongrantor trust,” thereby shifting the income tax liability from the grantor to the beneficiaries who receive income distributions from the trust. Thanks to the grantor trust status, individuals who already have previously exhausted their gift and estate tax exemption through prior gifting may implement sales to IDGTs to remove additional assets from the estate without incurring gift tax and income tax. 

There are additional tax-efficient estate planning strategies that can be used before any changes in tax laws that may reduce the estate and gift tax exemption and/or increase the estate and gift tax rate go into effect. It is therefore especially important to consider your options now.  To discuss these opportunities, please contact Jacqueline Yu at [email protected] or 310-313-1195.