The federal gift, estate and generation-skipping transfer (GST) tax exemptions are at an all-time high—currently $11.58 million for individuals and $23.16 million for married couples—but may not remain so for long. Some politicians advocate steep reductions in the exemptions, and the exemption amounts could be reduced as early as 2021 if this year’s elections bring a change in the control of Congress and the White House. Even if Congress takes no action in the near term, the current exemption amounts will sunset at the end of 2025 and revert to their pre-2018 levels, adjusted for inflation, unless legislation is enacted to extend them. See Is Now the Time to Use Your Lifetime Exemption?
With the future tax landscape uncertain, many wealthy individuals are considering making large gifts to younger family members by the end of the year to take advantage of the higher exemptions while they can. The IRS has issued final regulations confirming that individuals who make gifts to use up the current exemption amounts will not face adverse estate or gift tax consequences (commonly referred to as a “clawback”) if the exemptions revert to their pre-2018 levels after 2025.
Another reason to consider larger gifts for Washington and Oregon residents is that those states do not have a gift tax. And property given away during life will not incur the Washington or Oregon estate tax.
In all cases, it is important to note that gifted property retains the transferor’s basis and thus loses the opportunity for a step-up in basis at death. However, a repeal of basis step-up at death may also be on the horizon.
Some individuals may worry about the economic risk of giving away large sums if their financial circumstances change and they need access to the assets they’ve given away. One strategy that addresses this concern is the spousal lifetime access trust (sometimes called a spousal limited access trust or “SLAT”). The SLAT is an irrevocable trust created by one spouse for the lifetime benefit of the other spouse and descendants. By creating a trust for the benefit of one’s spouse, an individual can remove assets from his or her estate for estate tax purposes while ensuring the assets remain available for the couple’s support during marriage. A SLAT is similar to a “credit shelter” type trust that is often created for the benefit of a surviving spouse after the death of the first spouse to die, only it is created during lifetime.
Structuring the Trust
A SLAT may require that all net income be distributed to the spouse, or it may make income distributions discretionary. Although the person who transfers assets to a trust generally cannot receive distributions from the trust, the trustee can distribute funds to the transferee spouse if needed, and the spouse can give the funds to the transferor without gift tax consequences. Assets that ultimately are not needed by the senior generation can pass to children (and if GST exemption is allocated to the trust, grandchildren and more remote descendants) free of estate, gift and GST taxes.
Married couples can choose among several variations of the SLAT strategy. For example, one spouse might create a trust for the other spouse and descendants and give the trust up to twice the exemption amount—i.e., $23.16 million (based on the 2020 exemption amounts), less any lifetime taxable gifts—by “splitting” the gift on the couple’s gift tax returns to take advantage of both spouses’ exemptions. Under this approach, the transferor spouse would lose indirect access to the trust assets when the beneficiary spouse dies.
To mitigate this risk, a couple might choose instead to create two trusts, with spouse No. 1 transferring his or her exemption amount to a trust for the benefit of spouse No. 2 and descendants, and spouse No. 2 transferring his or her exemption amount to a trust for the benefit of spouse No. 1 and descendants. Under this approach, if one spouse dies, the other spouse will still have access to the assets in the trust of which he or she is a beneficiary. This strategy requires very careful planning, as the IRS may challenge the structure under the “reciprocal trust doctrine”: If the trusts grant each spouse the same or similar benefits, the IRS may argue that each spouse is in essentially the same economic position as if he or she created a trust for him- or herself. As a result, each trust will be disregarded for estate tax purposes. To reduce the risk of IRS challenge, it is important to differentiate the trusts, including, for example, by appointing different trustees, giving different assets to each trust, creating the trusts at different times, and/or varying the dispositive terms of each trust. One way to avoid IRS attack is to have spouse No. 1 transfer assets to a trust for the benefit of spouse No. 2 and descendants, and spouse No. 2 transfer assets to a trust solely for the benefit of descendants (and not spouse No. 1). This strategy generally avoids the reciprocal trust issue (subject to certain exceptions) but results in one spouse having no direct access to the trust funds.
Regardless of the SLAT variation used, couples should consider what would happen in the event of a divorce and whether to address divorce in each trust agreement. For example, should one spouse continue to be a beneficiary of a trust created by the other spouse after a divorce or be automatically removed? If the spouse continues as a beneficiary, the transferor will continue to be liable for income taxes on the trust’s income and gains after a divorce under the “grantor trust” rules, which cause individuals to be treated as owning the assets of trusts they have funded for income tax purposes under certain circumstances. This may not be the desired result.
Clients in Washington, Idaho and other community property states should also consider the community property aspects of SLATs. A couple may have to agree that assets are separate property to implement some of the strategies described above, which may require amendment of agreements governing their community property.
Issues to Consider
As with any estate planning strategy, the gifted assets should be those that the transferor expects will appreciate in value. The transferor should consider the potential income tax consequences, such as the loss of the step-up in income tax basis at death. The best assets to give are ones with high basis or that the recipient is unlikely to sell.
Clients should also consider the possibility that a beneficiary spouse dies earlier than expected and so the assets in the SLAT pass to children and grandchildren, and out of the senior generation’s hands. This potential result may cause clients to be more cautious about the extent they fund the SLATs with assets on which they rely for income.