Spousal Lifetime Access Trusts, or “SLATs,” may be the ideal vehicle for clients interested in pursuing wealth-transfer tax planning. Before deciding whether SLATs may be right for you and your family, it’s important to review certain fundamentals of the wealth transfer tax system.

Background

The federal wealth transfer tax system consists of three different taxes: 1) estate tax; 2) gift tax; and 3) generation-skipping transfer tax. The centerpiece of the federal wealth transfer tax system is the “basic exclusion amount” (commonly referred to as the “exemption”) which exempts assets up to a certain value from the imposition of gift or estate tax. In 2020, each individual has a federal basic exclusion amount of $11,580,000 and the federal gift and federal estate tax rates are 40 percent.

Taxable gifts made during an individual’s lifetime reduce the basic exclusion amount. Any basic exclusion amount remaining upon the individual’s death is converted into a credit and applied against the estate tax imposed on the decedent’s taxable estate. To the extent any amount of the applicable credit remains unused after reducing the federal estate tax to zero, such amount is converted back to the basic exclusion amount and is portable and can be “acquired” by the surviving spouse for the surviving spouse’s use during lifetime or at death.

Timing Considerations

Now is a remarkable time for wealth transfer tax planning, due to a confluence of different factors.

Reduction of Basic Exclusion Amount

The Tax Cuts and Jobs Act (the “Tax Act”) was signed into law by President Trump on December 22, 2017. The Tax Act provided for a substantial increase of the basic exclusion amount from $5,490,000 in 2017 to $11,180,000 in 2018 (indexed for inflation). The increased basic exclusion amount provided for in the Tax Act is only temporary such that on January 1, 2026 the basic exclusion amount will revert back to its pre-2018 level as adjusted for inflation. Absent Congressional action to extend the basic exclusion amount at the increased Tax Act level, the basic exclusion amount will decrease to approximately $6,000,000 as of January 1, 2026; $5,500,000 less than is currently available, which will be lost if left unused. Further, with November elections on the horizon, a Democratically controlled Congress and White House could reduce the basic exclusion amount prior to 2026 to raise revenue; presumptive Democratic Presidential nominee Joe Biden has indicated plans to eliminate adjustments to income tax basis on death, which would result in beneficiaries bearing the tax burden upon the sale of appreciated inherited property.

COVID-19 and Current Economic Conditions

The pandemic’s effect on the economy has generally been negative. While some businesses may be defying the odds, most publicly traded and privately owned business are suffering, and asset values and investment portfolios are worth significantly less than they were a month or two ago. In the wealth transfer planning context, this means you are able to transfer more assets now at depressed values without incurring a current tax than you were able to transfer prior to the economic downturn. In other words, this is a transfer tax “bargain” due to the current state of the economy. The cyclical nature of the economy indicates that over time asset values will rise and the transferred assets will (hopefully) see their values increase with all such appreciation occurring outside of your taxable estate.

New York State Tax Law

New York State tax law provides each individual resident with a basic exclusion amount of $5,850,000 (indexed for inflation) in 2020. New York State estate tax rates are bracketed (like personal income tax rates) with marginal rates ranging from 5 percent to 16 percent for taxable estates in excess of $10,100,000. Unlike the federal system, New York State tax law does not provide for portability of any excess basic exclusion amount to a surviving spouse upon the death of a spouse. This means that any basic exclusion amount unused at death is lost for New York State estate tax purposes. New York State tax law does not impose a gift tax or a generation-skipping transfer tax. While New York State tax law does not impose a gift tax, the New York State estate tax calculation requires adding back to the New York taxable estate gifts made within three years of death. Gifts made beyond three years prior to death are not included in the New York taxable estate and effectively escape New York State estate tax.

Generation-Skipping Transfer Tax

The federal generation-skipping transfer (“GST”) tax is a tax imposed on wealth transfers to generations more than one generation below the individual making the transfer (i.e. grandchildren and more remote descendants). While the basic exclusion amount relates at the federal level to both gift and estate tax, the GST tax and the GST tax exemption operate independently. In 2020, the GST exemption amount is $11,580,000 and, like the basic exclusion amount related to federal gift and federal estate tax, the GST exemption amount will decrease to approximately $6,000,000 on January 1, 2026 absent Congressional action before then. By allocating available GST exemption to assets transferred in trust now, before the exemption decreases, a dynastic trust exempt from GST tax can provide a lasting legacy for successive generations.

Spousal Lifetime Access Trusts (SLATs)

The factors outlined above suggest that making substantial gifts currently is beneficial from a wealth transfer tax planning perspective. For good reason, many donors may be reluctant to make large gifts directly to a spouse, children, and grandchildren. Outright transfers result in the immediate relinquishment of control by a donor to the recipient. Once controlled by the recipient, the assets are subject to the spending habits and lifestyle choices of the recipient and the assets may be accessible to the recipient’s creditors including a spouse in the context of divorce.

Transferring assets to a trust, specifically a SLAT, not only allows the donor to dictate the terms governing the transferred assets, it also allows the donor to protect the assets from the potential creditors of the beneficiaries and from the beneficiaries themselves. Uniquely, a SLAT provides continued access to the transferred assets to the donor’s spouse such that assets remain within the reach of the marital unit and can be accessed if needed in the future.

A SLAT is an irrevocable trust created by one spouse for the primary benefit of the other spouse and, to the extent desired, the descendants of either or both spouses. The donor-spouse makes a completed gift to the SLAT and the beneficiary-spouse maintains continued access to the transferred assets, subject to certain limitations. The powers retained by the donor-spouse and the beneficial interest of the beneficiary-spouse are tailored so that the assets of the SLAT are not included in either spouse’s estate for estate tax purposes.

The transfer to a SLAT is a taxable gift that uses the donor-spouse’s basic exclusion amount and removes the assets (and the appreciation on the assets) from the federal taxable estate of the donor-spouse and, provided the transfer occurs more than three years prior to death, from the donor-spouse’s New York State gross estate. If the donor-spouse desires to benefit grandchildren and future generations, the GST exemption can be applied to accomplish this goal as well.

Planning with SLATs can be done by each spouse for the primary benefit of the other spouse thereby providing each spouse with continued access to the assets of the SLAT created for his or her respective benefit.

Lifetime gifting to a SLAT is complex and not without drawbacks. For example, where both spouses make transfers to SLATs, the trust agreements must be sufficiently different and should occur at different times so the Internal Revenue Service does not unwind the transactions under the “Reciprocal Trust Doctrine” thereby eliminating the beneficial tax planning. Assets transferred to the SLAT will not receive an income tax basis adjustment upon the death of the donor-spouse because, by design, the SLAT assets are removed from the taxable estate.

The trust agreement will provide an independent trustee with the ability to cause SLAT assets to be included in the gross estate if it is desirable because it will reduce overall taxes to do so. Issues of continued control and governance arise in the context of transferring closely-held business interests to a SLAT. Reorganizing or recapitalizing the closely-held business to change the voting structure may be necessary. The donor-spouse’s indirect access to the SLAT via the beneficiary-spouse’s interest ceases to exist upon the beneficiary-spouse’s death or if the spouses divorce. In most cases, a valuation report prepared by a valuation expert will be required, and in all cases, a gift tax return will be required to be filed.