Spousal Lifetime Access Trusts & Closely Held Businesses

by Travis Neal

Business owners often face a unique estate planning challenge: how to minimize the estate tax implications when the business is worth more than the gift and estate tax exclusion. The Spousal Lifetime Access Trust (SLAT) is one estate planning tool that may address the issue. SLATs do not work for every high net-worth client seeking to remove assets from their estate. This article provides an overview of SLATs and presents some of the tax implications and drawbacks.

A SLAT is an irrevocable trust created during a married settlor’s lifetime. The SLAT allows a married settlor to remove assets from her estate, such as a closely held business or entity, while still benefiting from trust income indirectly through her spouse. Transfers of appreciating assets to SLATs allows the settlor to lock-in gifts of amounts up to the current gift and estate tax exclusion ($11.7 million in 2021) and avoid estate tax at death on the gifted assets as well as their appreciation, while enjoying the lifetime benefits from the trust payable to the beneficiary spouse. The settlor can still maintain managerial control of the business. The SLAT’s beneficiaries’ ability to exercise control over the interest held in the SLAT will be subject to the settlor’s limitations provided in the trust.

Discussion

With a SLAT, the “settlor-spouse” establishes an irrevocable trust for the “beneficiary-spouse” and if desired, the spouses’ children or grandchildren. The settlor-spouse must fund the SLAT with her separate property assets. This transfer reduces the settlor-spouse’s estate. At the beneficiary-spouse’s death, the SLAT’s assets may be distributed to the spouses’ children or grandchildren outright or in trust.

The beneficiary-spouse may be the SLAT’s sole or co-trustee. The SLAT directs the trustee to distribute income and/or principal to the beneficiary-spouse for his health, education, maintenance, or support (HEMS). If the settlor-spouse wants the trustee to distribute trust assets above what is needed for the beneficiary-spouse’s HEMS, she must appoint someone other than the beneficiary-spouse to be trustee or co-trustee. Otherwise, the trust assets may become subject to the beneficiary-spouse’s creditors and make the SLAT’s assets includable in the beneficiary-spouse’s estate.

SLAT Tax Implications

A SLAT can provide tax benefits to the settlor-spouse. The transfer to the SLAT will use the settlor spouse’s available estate and gift tax exclusion. During the beneficiary-spouse’s lifetime, the SLAT is taxed as a grantor trust, meaning the settlor-spouse is responsible for paying tax on the trust’s income, because the SLAT is held for the beneficiary-spouse’s benefit. IRC §677(a). The settlor-spouse can pay the income taxes on income earned by the SLAT, thereby making a tax-free gift to the SLAT’s remainder beneficiaries equal to the tax. Revenue Ruling 2004-64. All income and deductions of the SLAT are reported on the settlor spouse’s tax return. The SLAT’s trustee should file a blank Fiduciary Income Tax Return, Form 1041, for the SLAT. The Form 1041 will have a statement indicating that the SLAT has been established and that all income and deductions will be reported on settlor-spouse’s tax return.

The SLAT should have a separate checking or brokerage account and be considered a separate fiscal entity. The value of the SLAT’s assets, including any appreciation since the SLAT’s creation, are excluded from both the settlor-spouse’s and the beneficiary-spouse’s estate. The property received by the children will avoid wealth transfer tax.

Assets gifted or transferred to the SLAT do not receive an adjustment in income tax basis at the settlorspouse’s death because they are not included in the taxable estate. Gifted assets instead retain the settlorspouse’s carryover basis, resulting in potential capital gains realization upon the subsequent sale of any appreciated assets within the SLAT. This issue can be addressed by allowing the settlor-spouse to swap or exchange SLAT assets for non-trust assets of an equivalent value. This power means the SLAT will be disregarded for income tax purposes, and the assets swapped out of the SLAT will qualify for an income tax basis step-up at the settlor-spouse’s death.

SLAT Drawbacks

The most obvious disadvantage to a SLAT arises if the marriage dissolves. The beneficiary-spouse will continue to receive the benefits from the trust property after the dissolution. However, the SLAT may be written with a “floating spouse” provision defining the “settlor’s spouse” as the individual to whom the settlor is married at any given time. The validity of such a provision has not been tested in court.

The second drawback is when the beneficiary-spouse dies, the settlorspouse will lose the benefit of trust income and principal payable to the beneficiary-spouse. If the beneficiary-spouse dies prematurely, the loss of potential income to the settlor-spouse could be significant. This problem can be addressed by having the beneficiary-spouse create his own SLAT for the original settlorspouse’s benefit. However, the IRS may invalidate the two SLATs as “reciprocal trusts.”

The third SLAT drawback is common to irrevocable trusts: While the settlor-spouse receives indirect benefit from the SLAT, she no longer controls the assets transferred to the SLAT. The settlor-spouse will not be able to change the SLAT’s beneficiaries or their interests. One partial solution is for the settlor-spouse to allow the beneficiary-spouse to allocate remaining trust assets at his death (a limited power of appointment). As long as the spouses agree, the settlor-spouse can control indirectly the ultimate disposition of the SLAT’s assets. Finally, the settlor-spouse must be careful to transfer only her separate property (e.g., an inherited interest in a family business). To address this concern, the SLAT may provide that any contribution considered as having been made by the beneficiary-spouse will go into a separate sub-trust. However, the IRS has not ruled on whether this provision will suffice.

Conclusion

A SLAT allows a spouse to use the increase in the estate and gift tax exclusion while continuing to receive income from the assets transferred to the SLAT. If a spouse gifts an interest in a closely held business to the SLAT, the spouse can continue to maintain control of the business while removing that asset from the spouse’s estate. For clients with significant separate property wealth, SLATs are worth a closer look.

Travis Neal is an associate in the estate planning, probate, and trust administration group of Hartog, Baer & Hand, APC in Orinda. He has focused on trusts and estates law for over a decade, working with several Bay Area firms serving a diverse group of clients. He has counseled fiduciaries administering complex trusts and estates, and has helped clients craft estate plans tailored to their needs. Travis obtained his J.D., magna cum laude, in 2006 from the University of California, Hastings College of Law, where he was Order of the Coif and a member of the Thurston Honor Society.