With anticipating changes in tax laws happening next year, it's time to review your estate plan to ensure it will continue to achieve your goals by minimizing estate taxes.
The federal government currently imposes a gift tax on lifetime gifts and an estate tax on transfers on death. A properly structured estate plan can reduce taxes by taking full advantage of the available tax exemptions, specifically the gift and estate tax "unified credit". The unified credit permits every individual to transfer a specific amount of assets (an "exemption") tax-free either during their lifetime or at death.
The Tax Cuts and Jobs Act of 2017 (TCJA) increased the federal gift and estate tax applicable exclusion amount (known as the gift and estate tax "exemption"). In 2017, prior to the enactment of the TCJA, the federal gift and estate and exemption was $5.49 million. In 2021, the federal gift and estate exemption is $11.7 million. Thus, today, a married couple can transfer $23.4 million before having to pay a gift or estate tax. Based on the current political climate and growing deficit situation, many people anticipate the acceleration in a reduction in the exemption amount next year. If it is reduced next year, gifting assets this year allows you to use the higher exemption amount to reduce future estate taxes.
If the federal estate tax exemption is reduced from $11.7 million per person to the range of $3.5 million and $5 million in 2022, the clients who have a combined estate of over $7 million should carefully consider various gifting strategies. The federal gift and estate tax rates are 40% now and may go up next year. One of several planning suggestions is gifting to a Spousal Lifetime Access Trust (SLAT) for spouses and others. This will allow income to be paid to the donee spouse while using the available exclusion of the donor spouse. The assets transferred to the SLAT will not be taxable in either spouse's estate.
What is a SLAT?
A SLAT is a gift from one spouse (the donor spouse) to an irrevocable trust for the benefit of the other spouse (the beneficiary spouse). The SLAT is funded by gift while both spouses are alive, unlike the "bypass" or "credit shelter" trust.
The beneficiary spouse can receive distributions from the SLAT, yet the SLAT is designed to be excluded from the beneficiary spouse's gross estate and to not be subject to estate tax when the beneficiary spouse dies. To prevent the value of the assets of the SLAT from being included in the beneficiary spouse's gross estate, the SLAT will not qualify for the gift tax marital deduction (either because the donor does not make the necessary election or the terms of the trust prevent it from qualifying). This allows the donor spouse's exemption from the gift and estate tax to be applied to the value of the assets transferred to the SLAT, sheltering the transfer from gift tax.
Although the SLAT can be drafted to require the beneficiary spouse to receive the trust's income for life, this is not necessary, allowing the SLAT to have multiple beneficiaries, such as the beneficiary spouse and the couple's descendants.
Suppose a married couple, John and Jane owns and runs a family business. The business has been doing very well, and John and Jane anticipate that the value of the business will appreciate substantially over time. They want to minimize the impact of estate taxes and implement a tax-efficient strategy to pass wealth to their children and grandchildren. They also want to ensure that their assets are protected from their creditors and their children's creditors. At the same time, the life expectancy of both John and Jane is at least 20 to 30 years. While both are alive, John transfers his one-half interest in the family business to a trust for Jane's benefit. The transfer of John's one-half interest in the family business removes the assets from John's estate and Jane's estate and therefore shields the assets from estate taxes. The business can grow over the years without exposure to any additional estate or gift taxes on that growth. In addition, if the SLAT is drafted properly, the asset should be protected from John's and Jane's creditors, as well as the creditors of their descendants. Note that other types of assets may be transferred to a SLAT.
For many families, the thought of using both spouses' full exemptions from the estate and gift tax may not be practical. Instead, couples may find it desirable to use some of both spouses' exemptions or all of only one spouse's exemption. For example, if the donor spouse today creates a SLAT using the donor spouse's entire exemption, the other spouse's exemption would remain available even after the sunset in 2026. Creating a SLAT today could potentially shelter more wealth from the estate tax than would do nothing. To illustrate: If in 2021 the donor spouse uses $11.7 million to fund a SLAT and in 2026 the exemption reverts to $6 million, were the other spouse to create a SLAT (or die) in 2026, using the exemption at that time, the couple would have exempted from estate and gift tax, in the aggregate, $17.7 million. Had the couple not created the SLAT in 2021, and both died after the sunset in 2026, at a time with the exemption was $6 million, the total amount exempted from estate tax would be $12 million. Accordingly, on these facts, by engaging in SLAT planning now, the couple would be able to exempt from the estate and gift tax an additional $5.7 million.
A Note about State Estate Taxes
For Minnesotans, the state estate exemption is $3 million in 2021 and may go down next year. Minnesota uses a graduated scale to assess an estate's tax liability and their current estate tax rates range from 13% to 16%. It's worth noting that Governor Walz proposed to change the exemption to $2.7 million. Therefore, you may see the benefit of gifting more this year if your combined estate is over $6 million.
For married persons who want to take advantage of the increased exemption from the estate and gift tax, but are not sure that they can irrevocably part with so much wealth, a SLAT may be an appropriate solution. To achieve the tax benefits, the SLAT must be an irrevocable trust. When creating a SLAT, the donor spouse must irrevocably transfer assets to the SLAT, forever parting with the income from and use of those assets.
For federal income tax purposes, a SLAT is treated as a "grantor trust." This means that the donor spouse, as the grantor of the SLAT, is for income tax purposes treated as owning the assets of the SLAT. The income from the trust's assets is included in the donor spouse's gross income, requiring the donor spouse to pay income tax. Because the donor spouse is obligated to pay the income tax attributable to the trust's income, this tax payment is not a gift to the trust (and is not subject to gift tax).
Be aware of these rules when creating a SLAT:
- The donor spouse should not be a trustee of the SLAT.
- If the beneficiary spouse is a trustee of a SLAT, distributions should be mandatory or subject to an ascertainable standard that restricts distributions from the SLAT to providing for a beneficiary's health, education, maintenance, and support.
- Consider appointing a trustee who does not have an interest in the trust to make discretionary distributions among a number of beneficiaries (including the beneficiary spouse).
What are the risks?
- The reciprocal trust Doctrine
When each spouse creates a SLAT for the other, it's important to draft the trusts so that IRS will not invoke the reciprocal trust doctrine, which would cause the value of the trust that each spouse created for the other spouse to be subject to estate tax in the creator spouse's estate. The trusts should contain dispositive provisions that are substantially dissimilar so that the spouses are not in the same economic position after the creation of the SLATs. Eash trust could have a different trustee. Ample time should elapse between the creation of each trust.
- The "Step-transaction Doctrine"
Some amount of time should elapse between the gift to the donor spouse and when the donor spouse contributes assets to the SLAT. Not allowing enough time to elapse between transfers could permit the IRS to invoke the "step-transaction doctrine," which collapses multiple steps into one single integrated transaction.
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- Risk of death or divorce of the non-donor spouse
The SLAT is an irrevocable trust, so neither the grantor nor anyone else can change its terms. Although the trust is irrevocable, the donor spouse may indirectly benefit from the property gifted to the trust, as long as the non-donor spouse is living and remains married to the donor. If the non-donor spouse dies, the trust may terminate and be distributed to or continue for the benefit of the donor's children and other family members. In the event of divorce, a disadvantage of a SLAT is that the separated non-donor spouse will continue to benefit from the trust as a beneficiary while the donor spouse loses the indirect access in the same way that they would if the non-donor spouse passed away while they were still married. Divorce risk could be alleviated by terminating the non-donor spouse's beneficial interest in the trust in the event of divorce.
- Tradeoffs with respect to basis step-up at death.
The transfer of assets to the SLAT is irrevocable and permanently removes the assets from the donor's taxable estate; therefore, the assets in the SLAT will not obtain a "step-up" in cost basis upon the donor's death. The trust could provide specific language that allows the donor spouse the power to substitute or "swap" assets of equal value with the trust. This could allow the donor to remove assets with a low basis from the trust and substitute cash or assets with a high basis.
- Tax return filing requirements
Because SLATs are typically structured as grantor trusts, they do not require the filing of a trust tax return each year while the donor spouse is living. However, if the SLAT is not structured as a grantor trust, a separate income tax return will be required. The transfer of property to the SLAT will cause the need to report the transfer on a gift tax return (Form 709) in the year of the gift.
While tax law changes are uncertain, a SLAT may be an effective wealth transfer strategy to consider while the estate tax exclusion remains at historically high levels and if the donors have sufficient assets remaining outside of the SLAT to support their lifestyle. It is vitally important to work with your trusted financial advisor who can work with an experienced estate planning attorney and tax advisor that specialize in this area to see if this strategy makes sense for one's unique situation. At Echo Wealth Management, we use Echo Dashboard to show our clients their current and projected taxable estate. We have the processes to collaborate with estate attorneys and tax CPAs to implement various estate planning strategies.