The spousal lifetime access trust: A safety net in uncertain times

If you’re married and looking for a last-minute strategy to take advantage of the $5.12 million federal gift and estate tax exemption, consider a spousal lifetime access trust (SLAT). Uncertainty about the future of the federal estate tax regime makes setting up a SLAT in 2012 particularly useful. But regardless of what happens to the exemption, the SLAT can continue to be a valuable tool for removing significant wealth from your estate while providing a safety net in the event your financial circumstances change.

How it works

A SLAT is simply an irrevocable trust that authorizes the trustee to make distributions to the grantor’s spouse, during the spouse’s lifetime, if a need arises. Like most irrevocable trusts, SLATs typically are set up to primarily benefit children or grandchildren.

You transfer cash or other assets to the trust, reducing or eliminating gift taxes using annual exclusion gifts as well as your lifetime exemption. You can also reduce exposure to generation-skipping transfer (GST) taxes by allocating some or all of your GST tax exemption to the trust.

After you transfer assets to a properly structured irrevocable trust, all future growth in the trust’s value takes place outside your estate and passes to your heirs free of estate and GST taxes. Irrevocable life insurance trusts (ILITs) are especially powerful, because death benefits received by the trust pass to your beneficiaries tax-free.

In addition to tax savings, irrevocable trusts offer several other benefits, including probate avoidance and some protection of the trust assets from your creditors and your beneficiaries’ creditors. They also provide a vehicle for consolidating and managing family assets.

The primary drawback of an irrevocable trust is that to obtain these benefits you must relinquish control over the trust assets. You may be reluctant to part with large amounts of wealth, particularly in uncertain economic times. That’s where a SLAT comes into play. So long as your marriage is strong, providing your spouse with access to the trust in the event of financial need will indirectly benefit you as well.

You can even appoint your spouse as trustee of a SLAT, provided his or her authority to make distributions is limited to an “ascertainable standard,” such as funds needed for your spouse’s health, education, maintenance or support. It may be preferable, however, to appoint an independent trustee with full discretion to make distributions to your spouse.

Planning considerations

There are several requirements and potential pitfalls to be aware of before creating a SLAT. To keep the trust assets out of your estate, you must not serve as trustee. Also, the trust document must prohibit distributions that would satisfy your legal obligation of support to your spouse. To ensure that the trust assets aren’t included in your spouse’s estate, your contributions to the trust must consist only of your separate property.

If you live in a community property state, you may need to “bifurcate” community property into equal shares of separate property to fund the trust. And once the trust is funded, you must take care to preserve the separate property status of the trust assets. For example, you should avoid commingling the trust assets with community property or taking other actions that might convert those assets into community property.

A disadvantage of a SLAT is that, if your spouse dies before you, you’ll lose the safety net it provides. Remember, your spouse is a beneficiary of the trust — you aren’t. Any financial benefits you enjoy from the trust are indirect ones provided by virtue of your spouse’s access to the trust.

One potential solution is to create two SLATs: You establish one for the benefit of your spouse and your children or grandchildren, and your spouse establishes one for the benefit of you and your children or grandchildren. That way, you’ll both be protected regardless of who dies first.

But with two SLATs, there’s a risk that the IRS will challenge your arrangement under the reciprocal trust doctrine. If such a challenge is successful, the tax benefits will be lost. See the sidebar “Watch out for the reciprocal trust doctrine.”

Upsides and downsides exist

If you’re married and planning large year-end gifts to make the most of the $5.12 million exemption, consider a SLAT. It allows you to potentially lock in the exemption but also provides some peace of mind by enabling your spouse to obtain funds if needed. Bear in mind, however, that there are significant tax and nontax risks associated with SLATs, and they haven’t all been discussed here. Before taking action, ask your estate planning advisor about the pluses and minus of this trust type for your situation.

Sidebar: Watch out for the reciprocal trust doctrine

If you’re considering setting up a spousal lifetime access trust (SLAT) for the benefit of your spouse while your spouse creates a SLAT for your benefit, be aware of the reciprocal trust doctrine.