Build the perfect spousal lifetime access trust

The use of a spousal lifetime access trust, or SLAT, to eliminate the risk of changes in the estate and gift tax system can help separate legacy assets from lifetime assets. SLATs can be a planning solution to address the difficulties of making that separation. This article will help estate planners explore building the perfect SLAT and addressing potential design challenges.

Legacy planning focuses on building a strategy to maximize the impact a client’s wealth has on the people and causes they care about. In a legacy plan, the goal is to position the ownership of assets so they can be used to benefit those people and causes, and prevent them from ending up with creditors, predators, former spouses and the government (in the payment of taxes).

A current challenge many legacy plans are facing is a potential change in the transfer tax exemption. As I write this article, a person can transfer up to $11.7 million without the imposition of gift or estate tax. Other than 2010, when there was no estate tax, this is the largest amount of wealth that the law has allowed to be given free of tax. But that valuable giving tool is currently at risk both from current bills in Congress that would shrink that amount to $3.5 million and from current law that will cut that amount in half on Jan. 1, 2026.

With these potential changes, many people not currently subject to the transfer tax would be, and they are looking to their advisers for a solution to the problem. When I hear this concern, I often tell my clients any solution starts with the separation of those clients’ assets between those they will spend during their lifetimes (“lifetime assets”) and those they will not (“legacy assets”).

Lifetime vs. legacy assets, and why the distinction is important

The first critical step of the legacy planning process is separating legacy assets from lifetime assets. Lifetime assets are those that will be liquidated or and spent down during a lifetime. Legacy assets are all assets that are not lifetime assets; in other words, those that are not spent before death. Stated another way, lifetime assets are used by the client to spend on people or causes they care about; legacy assets are used for others. For most people, the process of calculating which of their assets are legacy vs. lifetime assets is a two-part process: (1) determine, based on assumptions, how much of their assets, income and appreciation will be spent personally for their wishes, hopes, dreams and desires (these are their lifetime assets), and (2) based on those same assumptions, how much of their assets, income and appreciation they will not spend (these are their legacy assets). Once this calculation is complete, the next step, in theory, is simple. Give away legacy assets immediately. If the calculations are correct, they will not use the legacy assets; therefore, either they will end up in the hands of people they want to have them, such as families, friends or charities, or they will end up in the hands of people they do not want to get them, such as creditors, predators, former spouses or the government. The quicker they give legacy assets away, the greater control they have in getting them to the people they want to have them and keeping them away from others.

The challenge: assumptions

This “easy” solution of giving away legacy assets as fast as possible is almost never chosen. The reason lies in the inherent weakness of assumptions. When thinking about the calculation of lifetime and legacy assets, the presumption is that lifetime assets are precisely what will be spent during a lifetime. The last lifetime dollar would be spent on a coffin. In other words, the calculation leaves no room for error. And if the assumptions are too aggressive, that means the lifetime assets will be insufficient to pay for one’s wishes, hopes, dreams and desires. Or, stated in a less eloquent, but more frightening way, they will run out of money.

Having said that, presuming reasonable assumptions are made, there is an equal chance that the assumptions will be too conservative, ending up with more lifetime assets than those given away. Understanding those two possibilities helps to explain why almost no client gives away all the legacy assets. If the two possibilities are being aggressive and risking being penniless or being conservative and having the possibility of having too many assets exposed to creditors and taxes, the more palatable approach is the conservative one.

But is there a possibility of being more aggressive in classifying assets as legacy assets, but at the same time having the ability to convert the assets back to lifetime assets if the assumptions prove wrong?

A SLAT provides a solution to this conundrum, allowing clients to convert legacy assets back to lifetime assets if the assumptions prove incorrect.

Basics of creditor protection

If someone owns property, and then incurs some type of creditor exposure, those assets are subject to seizure by those creditors. To avoid that risk, the property owner can give those assets away, but of course, that means the owner does not have the use or enjoyment of that property. Thinking about that, a potential solution is to give the property away to a trust wherein there is a possibility that the property can be used for the creator’s benefit. The challenge is that in most states, the law defeats that planning idea; if the trust creator is also a trust beneficiary, the trust’s assets continue to be subject to seizure by the creator’s creditors.

Basics of estate inclusion

Likewise, giving property away avoids the inclusion of that property in the gross estate and subject to estate taxes. Given that there is also a gift tax that taxes lifetime transfers, gifts tend to have two advantages over bequests:

• Any future appreciation in the property given away is not subject to the tax.
• A gift can be made at a time where the donor knows exactly what the exemption is. That is not true of a bequest; the exemption has a possibility (perhaps even a strong one) of changing before the would-be donor passes away. This is becoming greater in planning importance given the political volatility of the estate tax exemption.

The main disadvantage of an outright gift is the possibility of making the incorrect assumption that the gifted property is legacy property and the donor needing to use the property for lifetime expenses. It seems logical a concerned donor would attempt to deal with this concern by giving property to a trust wherein the donor has the possibility of enjoyment of the property if needed. But like the laws surrounding creditors, this planning technique will generally prove fruitless. The property of that trust will likely come back into the donor’s estate at death.

Spousal trusts as a solution

The problem with using a trust as a purported solution to issues of creditor protection, estate inclusion and potential future enjoyment is that the law prevents the trust’s creator from having a beneficial interest in the trust. What the law does not prevent is creation of a trust for another; that trust will protect the property from the creator’s creditors and inclusion in the creator’s estate. The obvious challenge is when the trust is created for another, it is this person who has the possibility of enjoyment, not the creator. Logically, the only solution to this problem would be if this other person’s economic interests were aligned with the creator’s. Is there such a person?

In a marriage that can be characterized as an economic partnership, that person would be the creator’s spouse. In this type of marriage, there is no mine and yours, only ours. So, if one spouse takes property and transfers it to a trust for the other, and the other spouse does the same, the spousal partnership continues to have the possibility of enjoyment over all of the trust property. This enjoyment allows the property of these trusts to be accessed if the need arises to convert the trusts’ legacy property back to lifetime property. Each trust can be designed so that the non-creator spouse can be the beneficiary of the trust, and with careful design, the trustee as well. In fact, to a large extent, the trust can be designed to mimic the outright ownership of the non-creating spouse. So if assumptions were incorrect, the spouses can collectively access the trusts’ property, converting it from legacy to lifetime property.

SLATs create an effective and elegant solution to “safely” converting lifetime property to legacy property, thereby protecting the property from creditors and estate taxes. But there are some risks in using SLATs that need to be explored. Those risks include the premature death of a spouse, divorce and something known as the “reciprocal trust doctrine.”

Using a SLAT to overcome political risk

A prerequisite to SLATs working well is that the marriage is an economic partnership. So, the first two planning risks deal with situations that terminate that partnership: divorce and death. The third and fourth risks are legal risks; one is a design risk, colloquially referred to as the reciprocal trust doctrine, and the final risk is a usage risk, or what I call the ATM risk.

Partnership termination risks: divorce and death

The planning premise of using SLATs is that, if the marriage is an economic partnership, then assets controlled by either spouse are available to both spouses. An economic partnership exists when assets, income and financial decisions belong to the spouses collectively, rather than being divided between them. The reason this is critical is that when each spouse gives up their control and enjoyment rights by making a gift into a trust controlled by the other, there needs to be confidence that they will continue to have “spousal influence” over those assets.

Of course, there are situations where spousal partnerships terminate. The first is divorce. When my clients elect to use SLATs as part of their plans, because we spend so much time educating and discussing this concept of a spousal partnership, one of the questions they inevitably ask is what happens if they get divorced. That is a thoughtful question because if a spouse’s ability to access and enjoy all assets, including the assets in both SLATs, is dependent on the spouse’s interdependence, a legal process meant to end the marital partnership eliminates that critical collaboration.

But, as I explain to my clients, if the SLATs are funded with equal values, the creation and funding of the SLATs does nothing that the divorce would not have done. An explanation might be helpful. Assume mom and dad have $8 million of assets. Mom and dad then get divorced. Generally, those assets will be divided equally: After the divorce is final, mom and dad will each have $4 million. Now assume instead of keeping all $8 million, mom and dad split their $6 million of legacy assets and each gives $3 million to a SLAT for the other. In the divorce, the court will award half of their $2 million in lifetime assets to each spouse, and each spouse will also control $3 million of SLAT assets. In other words, each spouse will have control, use and enjoyment of over $4 million of assets, the same level of economic control they would have had without the SLATs.

The death of one of the spouses also terminates the partnership and is also a question frequently asked by clients considering SLATs. Let’s go back to our $6 million legacy asset and $2 million lifetime assets example. While mom and dad are alive and married, the marital partnership has $8 million at its collective disposal. However, assume mom passes away. Remember, SLATs are designed so either spouse has access to the trust they created through the control provided to the other spouse. Therefore, when mom passes away, dad loses access to the $3 million in the SLAT he created for mom.

When I talk clients through the “death” problem with SLATs, I use a three-tiered approach. First, remembering that SLATs receive legacy but not lifetime assets, mom and dad’s plan was built under the assumption that the $2 million of lifetime assets should be sufficient for their lifetime spending; the legacy assets should only need to be accessed in “emergencies.” So, the first question is whether dad even has a problem in the first place. He thought $2 million was sufficient, and he still has access to $5 million (the lifetime assets and the $3 million in the SLAT mom created for him). Practically speaking, dad should be fine. Second, we address the presumptions in the plan. The plan is designed so the SLAT assets will not be spent and will be left alone to appreciate. Using the rule of 72, if the assets grow at 8%, within nine years, the $3 million in the SLAT mom created for dad will be worth $6 million. In other words, if neither spouse dies in the near future, appreciation itself will replace the assets given away to the trust for the predeceased spouse. Finally, there is a planning technique that can be used; each spouse can be given a testamentary power of appointment, a fancy legal term for a power to transfer trust assets to someone at death. If mom had such a power, she could potentially transfer the assets in her SLAT to dad.

Legal risks

The first legal risk is a design risk. In other words, if the design of the SLATs is incorrect, the value of the assets in the trusts will be brought back into mom and dad’s estate. This risk is known as the reciprocal trust doctrine and it was first espoused by the Supreme Court in 1969 in a case called Estate of Grace. Basically, what the Grace case says is if mom creates a trust for dad and dad creates an identical trust for mom, then the court will “unwind” the trusts and treat each spouse as creating a trust for himself or herself. That treatment would cause estate inclusion, defeating the purpose of using SLATs. The key to avoiding the reciprocal trust doctrine is to not use identical trusts. “Identical” is an issue of practicality (are the two trusts practically identical), and the courts and the IRS have provided guidance over the years since Grace as to just how different the trusts need to be to avoid estate inclusion. The best advice to avoid the reciprocal trust doctrine: use experienced, specialized estate planning counsel to create SLATs.

The second risk is not a design risk, but a usage risk. In creating the SLATs, one of the warnings I always give to clients is to only use the SLATs for their personal needs in emergencies, which always leads to some version of “what is an emergency?” My answer is always the same: Don’t use the SLAT like an ATM. The reason for that is the SLAT works if the creator does not retain enjoyment over the trust assets. The retention of enjoyment has a legal component, which we will meet because dad, for example, retains no right to enjoy the property given to the trust for mom. But there is a practical component as well. If every time mom and dad want to buy something, they pull money from the SLATs (as they would from an ATM), the court may find that, in practicality, neither gave away anything and they retained everything. Again, this ATM issue is why we start with separating lifetime from legacy assets. If that is done, and done thoughtfully, it should truly only be an emergency when legacy assets will need to be used.

So, in conclusion, SLATs are a phenomenal tool to take advantage of currently favorable gift and estate tax laws. They should be designed by an estate planning expert and used only when necessary. But if these challenges are addressed, SLATs give individuals the power to have their cake and eat it too.