SLAT: A flexible tax reduction strategy

For married couples seeking tax savings and lifetime access to cash, a spousal lifetime access trust (SLAT) has become increasingly popular in estate planning in recent years, and for good reason: It provides flexibility for couples wary of making large gifts to an irrevocable trust.

Traditionally, the irrevocable life insurance trust (ILIT) has been the liquidity planning technique of choice for married couples facing potential estate taxes. An ILIT is typically funded with a gift or series of gifts.

The gifted funds are used to purchase life insurance. If properly drafted and funded, ILIT ownership of life insurance removes the policy cash value and death benefit from a couple's taxable estates. However, the ILIT sometimes causes a significant tradeoff; control over funds gifted to an ILIT is lost forever, and this loss of control extends to life insurance cash value.

What is a SLAT?

In its most basic form, a SLAT is an irrevocable trust created by one spouse to benefit the other spouse. It takes a standard life insurance trust to the next level by unlocking life insurance cash values for living needs.

A SLAT is often drafted as a grantor trust where the grantor and the trust are considered one and the same for income tax purposes (IRC Sections 671-679 contain the grantor trust rules). This grantor trust status enables trust assets to grow free from income tax erosion, resulting in greater potential wealth transfers to the heirs.

The beauty of the SLAT is in its lifetime access provisions, which allow for discretionary (and sometimes mandatory) distributions of income and principal to a spousal beneficiary during the spouse's lifetime. In the life insurance context, cash value can be distributed to a spouse-beneficiary during the spouse's lifetime.

After the spouse's death, other beneficiaries such as children or grandchildren would be next in line. The lifetime access provisions are crucial and this type of flexibility is unavailable in a standard ILIT.

To avoid estate inclusion of the life insurance policy in the beneficiary's estate, the access provision is limited to an "ascertainable standard" (as governed by IRC Sections 2041 and 2514). In other words, the spouse cannot have unfettered access to policy cash value. Distributions are made by the trustee for specific purposes governed by the tax code such as for health, education, maintenance and support, also known as a HEMS provision. The good news is that the HEMS universe is large enough to cover most lifetime needs.

SLAT benefits:

Lifetime access to cash. A SLAT differentiates itself from a standard ILIT by providing the spouse access to life insurance cash value during the spouse's lifetime. If properly structured, cash flow, by way of policy loans and withdrawals, is received income tax-free (IRC Section 72(e)).
Flexibility. The spouse can access cash for living needs. There is also the potential to "unwind" the gift by way of lifetime distributions to the spouse. In some cases, through lifetime access, the spouse-beneficiary will be able to recover more than the amount gifted to the SLAT.
Tax-free death benefit. A properly drafted and funded SLAT passes the death benefit free from estate and income taxes. Depending on underwriting factors such as age and health, no other asset can match the tax-free leverage of life insurance.
Estate liquidity. The tax-free death benefit (IRC Sec. 101(a)) paid to a SLAT provides cash for any number of liquidity needs such as estate taxes, income taxes and final expenses. By providing estate liquidity, a SLAT may help prevent a forced sale of family assets.
Creditor protection. When making gifts to a SLAT, the grantor gives up complete dominion and control over the gifted funds, irrevocably. Therefore, assets held in a SLAT, including life insurance, are insulated from the grantor's creditors.
In addition, assuming the SLAT includes a spendthrift provision, the beneficiary's creditors would generally be barred from invading the trust. Protection from creditors generally applies to both policy cash value and the death benefit. (Creditor protection laws vary by state and are complicated. Individuals should consult with an asset protection specialist to see how creditor protection laws may apply to particular circumstances.)
Ongoing tax-free gifts. Because most SLATs are grantor trusts, the grantor is responsible for any income taxes payable, ensuring that trust assets will not have to be invaded. Income taxes paid by the grantor are, in essence, additional tax-free gifts to heirs.
State estate tax reduction. Twenty one states currently have state estate and/or inheritance taxes and most of them have exclusion amounts well below the federal exclusion. The discrepancy can be large. For example, in 2014 the federal estate tax exclusion was $5.34 million versus $675,000 for New Jersey. By funding a SLAT during lifetime (as opposed to a bypass trust at death) couples are able to avoid an estate tax exclusion "discrepancy," saving hundreds of thousands of dollars in state estate taxes, where applicable.

Planning considerations

The grantor cannot have direct access. To avoid "incidents of ownership" in the life insurance policy (as governed by IRC Section 2042), the grantor must not be a trust beneficiary and cannot have direct access to trust assets, including life insurance cash value. This ensures that the life insurance death benefit is removed from the grantor's estate.
Happily married. There is risk that the spouse could refuse to share trust distributions with the grantor. Also, in the event of divorce, the spouse access provision will generally terminate. Therefore, a happy marriage is a prerequisite to creating a SLAT.
Spouse as trustee. It is not recommended that the spouse serve as trustee. There is an increased risk that trust assets could be brought into the spouse's estate for estate tax purposes. However, it is not prohibited. If a spouse serves as trustee, he or she must be vigilant to limit distributions to "ascertainable standards" such as health, education, maintenance and support (the HEMS provision).
Reciprocal Trust Doctrine. The SLAT concept is so powerful that many married couples set up SLATs for each other. However, if spouses set up "mirror image" trusts to benefit each other, the assets may be brought back into their taxable estates because the couple's economic position has not changed. Many courts refer to this as the reciprocal trust doctrine. To avoid application of the doctrine, the trusts may differ in: (1) timing — trusts established at different times; (2) funding — different assets may be used to fund the SLATs; and (3) beneficiaries — the SLATs can name different remainder beneficiaries.
Predeceased spouse. If the spousal beneficiary predeceases the insured, lifetime access to cash terminates. To protect against the risk of a predeceased spouse, life insurance should be purchased on the life of the spouse to protect against the risk of loss. The life insurance could be personally owned or owned by a third party such as a trust (but see, reciprocal doctrine above).
Modified endowment contract (MEC). Properly structured life insurance policy withdrawals are received first as a recovery of basis followed by gains (FIFO tax treatment). This tax advantaged access is one of the hallmarks of permanent life insurance, but life insurance characterized as a MEC does not receive the same tax treatment. Gains are taxed first, followed by basis recovery (LIFO tax treatment). With a MEC, it makes no difference whether the cash distribution is characterized as a policy withdrawal or loan. Therefore, it is generally not recommended that a SLAT own life insurance characterized as MEC.

The SLAT is creating a great deal of positive buzz for good reason: It combines the estate tax savings of an ILIT with lifetime access to tax-advantaged cash value. It's a powerful combination worth investigating.

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