The New Paradigm: Spousal Access Trusts As A Tax Planning And Asset Protection Tool

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At the end of 2012 with the uncertainty of what was to happen to the gift and estate tax laws, many practitioners counseled their clients to create spousal access trusts (SAT).  Although the uncertainties in the tax laws for now are no longer present, it does not mean that SATs are no longer a useful planning technique for asset protection purposes.

A SAT is a technique whereby a spouse can gift property into an irrevocable trust for the benefit of his or her spouse yet still have the assets be used to benefit the family unit.  A SAT can be used either for estate tax purposes or asset protection.  The assets in the trust can be used by the donee spouse during his or her lifetime, or the assets can remain in the trust as a safety net for the donee spouse in case he or she needs them, or, if the donee spouse does not need them during his or her lifetime, the assets can remain in the trust to grow for the benefit of both spouses’ descendants.  Remember when creating a SAT is that if the donee spouse dies before the donor spouse, the donor spouse may lose the benefit of the assets.  Also, there should be language in the trust that terminates the donee spouse’s interest in the event of divorce.

So, how does it all work?  The donor spouse uses his or her lifetime exemption of $5.25 million for 2013 (as adjusted for inflation) and transfers the assets to an irrevocable trust for the benefit of his or her spouse.  If the trust is set up properly, these assets will be exempt from estate taxes in both spouses’ estates.  The trust acts like a credit shelter bypass trust, the only difference being that it is created during lifetime.  Although many practitioners may determine that their clients do not have enough assets to use this type of plan, clients who live in states with an estate tax, like Rhode Island, can use this technique to avoid state estate taxes as well.   

The practitioner should be reminded when creating the trust that in order to ensure that it is not included in the client’s estate, if the donee spouse is acting as trustee, he or she cannot distribute the funds to discharge a legal obligation of the donee spouse.  The practitioner might want to counsel the client to use an independent trustee who has the sole discretion to make distributions.  This avoids inclusion and creates creditor protection.  If the trust is set up for the benefit of the spouse and descendents GST should be allocated to the trust as well. 

If both spouses are setting up a SAT be careful of the reciprocal trust doctrine.  If two people create two separate trusts where they are each the beneficiary of the other trust, the IRS will say that the trust of which they are the beneficiary will be deemed to have been created by the beneficiary and therefore included in the beneficiary’s estate.  The spouses’ two trusts have to be sufficiently different to avoid the reciprocal trust doctrine.  This doctrine is factually driven and depends upon the terms of the trust and state law.  A drafting tip to avoid this is to give one of the spouses a liberal limited power of appointment over the trust.  Or make income mandatory in one and discretionary in the other.  Finally, it might be wise to create and fund the two trusts at two different times months apart. 

There has been some discussion that the limited power of appointment given to the donee spouse may include the donor spouse.  However, there is no clear authority on this and it has not yet been tested.  Therefore, the spouses should be willing to give up the assets as a gift to the other spouse and descendants with no ability to receive the funds back. 

Finally consider the income tax consequences of creating a SAT.  The practitioner should consider making the trust a grantor trust for income tax purposes.  This could be beneficial for two reasons.  First, the trust can grow without income taxes being incurred and paid for by the trust.  Second, the donor spouse’s estate is reduced by taxes paid. 

The SAT is a helpful planning technique that every estate planning practitioner should consider using.  Practitioners may think that since couples can now transfer $10.5 million tax free and it would seem that portability is here to stay that a SAT is not needed.  However, SATs should still be considered as a useful tool, especially in states where there is an estate tax or where asset protection is critical.