By: Kathy Davis, CPA, Tax Advisory Services Manager, Anglin Reichmann Armstrong, P.C.
Kathy Davis, CPA, originally wrote this article as a Voices column for Financial Planning magazine in September 2023.
The Spousal Lifetime Access Trust (SLAT) has been an estate planning tool for many years, but it has gained popularity due to the pending sunset of current estate and gift tax exemption laws. In 2025, the $12.92 million gift and estate tax exemption per individual will revert to the prior law’s $5 million exemption cap. That is a big gap to manage through gifting and estate planning strategies.
However, there are three big risks with SLATs: divorce of the couple utilizing a SLAT, the premature death of the beneficiary spouse and ongoing tax compliance.
In other words, SLATs are not fool-proof. They can carry more risks compared to other trusts regarding access and taxation. These risks should be weighed as equally as the benefits before moving forward with funding them.
Loss of Access
Divorce is a tricky situation for assets in general, but an irrevocable SLAT carries a risk of losing indirect access to assets by the donor spouse. In addition, the divorced donor spouse may end up paying taxes on assets only available to the ex-spouse. While it may be possible to renegotiate the terms of the SLAT as part of a divorce settlement, there are obvious complications with divorce attorneys in the mix on top of estate planning attorneys and CPAs.
Another access risk is the premature death of the beneficiary spouse. Although SLATs can be worded to return assets to the donor spouse in the event of the beneficiary’s death, the surviving spouse has essentially wasted the exemption and may be taxed on assets returned. Assets would be indirectly available to the surviving spouse through secondary beneficiaries, but distributions given back to the surviving spouse potentially would become income on that surviving spouse’s tax return.
If a couple has more than one SLAT, provisions are often differentiated to comply with reciprocal trust doctrines, and one spouse may have less access to assets than the other. These economic implications should be modeled as “what-if” scenarios before setting up multiple SLATs.
Taxes and More Taxes
Although SLATs are designed to reduce the size of an individual’s taxable estate while still providing indirect access to assets through spouses or family members, there are pitfalls to their administration and tax treatment.
SLATs can work perfectly well with the assistance of knowledgeable estate attorneys and CPAs, helping you follow terms and tax filing requirements to the letter. There are also many ways to ruin a SLAT if not managed consistently as part of gifting, tax planning and administration. Mismanagement leads to taxation and penalties.
First of all, a timely gift tax return must be filed after funding a SLAT. Also, the donor will need to decide if the assets in the SLAT will be used within the beneficiary’s lifetime or if assets are intended to pass to the next generation. The CPA filing the gift tax return may need to allocate a generation skipping tax. With this preparation in mind, failure to file a timely gift tax return can result in accrued interest, penalties or even the asset never officially being removed from the donor’s estate.
Because SLATs are typically set up as a grantor trust for income tax purposes, the grantor also pays the income tax on behalf of the trust. Quite often, the mechanics to report this income is overlooked. A grantor trust with income will be require the set-up of a taxpayer identification number. Plus, IRC§6012(a)(4)-(5) imposes an income filing requirement on trusts with taxable income of $600 or more. This is an annual income test for the assets held in trust, therefore, grantors must be aware of how much interest income, dividends or capital gains have been earned in the SLAT, and on a timely basis, share this information with their CPA who must properly calculate any annual tax obligation and necessary payments
If certain assets held in trust are sold, there are also income tax obligations for the donor spouse. For example, if the donor spouse places the couple’s appreciating vacation home in trust and the couple decides to sell the asset at a later date, the donor spouse will incur income taxes on the home’s increased value if they decide to sell. Selling assets in the trust with capital gains triggers capital gains tax for the donor spouse. This means that individuals must be careful about the types of assets placed in the SLAT and whether their increase in value will result in additional taxation.
Anticipate Ongoing Administration
SLATS can be expensive and complex. With the assistance from a collaborative planning team of professionals, SLATs can offer another option for reducing the size of an estate and tax planning. However, this is not “a once and done” financial planning and forecasting instrument. Individuals and their advisors should all be on the same page regarding trust provisions for access, the method and timing of distributions and future tax implications.
Individuals should also understand where there are gaps in the financial plan. Advisors should run scenarios regarding divorce, disability, pre-mature death or long-term care needs, to name a few. Once it is determined that a SLAT is the best option for future needs, there will be ongoing financial considerations as individuals age and their lives change. Be prepared to have those conversations.
For further assistance or questions relating to the content of this article, please reach out to Kathy Davis, CPA.