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How couples can lock in gift and estate tax exemptions

Estate, Gift, & Trust Planning

Many affluent married couples planning their estates face a dilemma: Although they’d like to take advantage of the record-high federal gift and estate tax exemption — $12.92 million per person for 2023 — before it disappears, they’re not yet ready to part with significant amounts of wealth. One strategy that may offer the best of both worlds is the spousal lifetime access trust (SLAT). This trust type makes it possible for couples to leverage the current exemption amount while retaining access to trust assets.

Shielding Assets from Taxes

A SLAT is an irrevocable trust that one spouse creates for the benefit of the other. The grantor spouse uses his or her gift tax exemption to shield the gift from taxes and, provided the trust is designed properly, its assets will be kept out of both spouses’ taxable estates. Typically, the beneficiary spouse is the current beneficiary of the trust. Any remaining assets pass to the couple’s children or other heirs, although it’s possible for the children to be current beneficiaries as well.

To qualify for the gift and estate tax exemption, the donor spouse must give up all rights to the trust assets. Nevertheless, the donor retains indirect access to them through the beneficiary spouse. The safest way to provide such access is by appointing an independent trustee with discretionary authority to make distributions to the beneficiary. It’s also possible for the beneficiary to act as trustee, but in that case distributions must be limited by an “ascertainable standard,” such as amounts necessary for the beneficiary’s health, education, maintenance or support.

Funding the trust

To preserve a SLAT’s tax benefits, donor spouses must fund the trust with separate property. Contributions of jointly owned or community property can be included in the beneficiary spouse’s taxable estate, so it may be necessary to transfer, retitle or partition property before funding the trust. After the trust has been funded, its assets can’t be commingled with marital assets.

Ideally, you should fund a SLAT with assets you expect  to appreciate in value. That’s because once assets are transferred to the trust, all future appreciation is removed from your estate  (and bypasses your spouse’s estate), allowing you to leverage the current exemption. 

Suppose you transfer assets worth $5 million to a SLAT, and their value grows to $12 million in 10 years. That appreciation in value avoids taxation in your estate, even though you used less than half of your exemption amount, and regardless of how much the exemption may have shrunk since you made the gift. Avoid contributing assets that may depreciate in value over time. If you do, you risk wasting a portion of your exemption.

Reviewing other potential issues

Because the benefits of a SLAT depend on indirect access to its assets through the beneficiary spouse, you risk losing those benefits if you get divorced or your spouse dies. So it’s a good idea to build some protections into the SLAT. For example, you might:

  • Make benefits available only to a current spouse, not former spouses, or 
  • Provide that the trust terminates, or the beneficiary spouse ceases to be a beneficiary, in the event of divorce. 

A common technique for mitigating the risk of death is for each spouse to create a SLAT for the other (see “His and her SLATs” below). Also, some states have enacted SLAT-friendly laws that allow donor spouses to become beneficiaries after the death of beneficiary spouses.

Also consider potential income tax implications. The tax basis of assets transferred at death is “stepped-up” to their market value, minimizing or eliminating capital gains when your heirs receive them. Assets transferred to a trust, however, retain the donor’s basis, which can result in a significant capital gains tax bill when the assets are sold. So, it’s important to weigh a SLAT’s potential estate tax savings against its potential income tax costs.

His and Her SLATS

One way to reduce the risk of losing a spousal lifetime access trust’s (SLAT’s) benefits if the beneficiary spouse dies is for each spouse to establish a SLAT for the benefit of the other. Even if the beneficiary of one trust dies, the donor spouse can retain access to the other trust.

However, careful planning is critical to avoid the reciprocal trust doctrine. Under that doctrine, the IRS can “uncross” the trusts — and include their assets in both of the donors’ estates — if it concludes that they’re so similar that the economic effect is about the same as if the spouses had  
each created trusts for their own benefit.

To avoid this result, work with your advisors to be sure that the two SLATs are sufficiently different that they can’t be viewed as a quid pro quo for each other. There are several potential ways to do this, such as creating the trusts at different times or including powers in one 
trust (such as a special power of appointment) that aren’t included in the other.

Dont wait

The increased gift and estate tax exemption is scheduled to “sunset” at the end of 2025. At that point, it will return to its previous level of $5 million (adjusted for inflation). It’s also possible that Congress will reduce the exemption amount earlier than that. So, if gift and estate taxes are a concern, the sooner you act to preserve the current exemption with a SLAT or other vehicle, the better. Be sure to work with your Lenox advisor to ensure your SLAT is designed and implemented properly.