Financial Planning Insights

Part III of III: The Goldilocks Planning Solution to the Reduction in the Transfer Tax Exemption

By Joe Maier | Johnson Financial Group

7 minute read time

Using a SLAT to Overcome Political Risk: Addressing the Challenges

This is the third and final part of a three-part series on the use of a spousal lifetime access trust (or SLAT) to eliminate the risk of changes in the estate and gift tax system. The first part focused on the separation of legacy assets from lifetime assets and why that is important. The second part explores the SLAT as a planning solution to minimize estate taxes. This third part addresses some design challenges that need to be managed in building an effective SLAT (or SLATs).

Background

In the first part in this series, we focused on separating lifetime and legacy assets. In the second part, we discussed how to design an effective SLAT. In this third part, we highlight some challenges that planners need to address in using SLATs. As mentioned in part two, a prerequisite to SLATs working well is that the marriage is an economic partnership. So, the first two planning risks deal with situations that terminate that partnership: divorce and death. The third and fourth risks are legal risks. One is a design risk, colloquially referred to as the reciprocal trust doctrine. The final risk is a usage risk, what I call the ATM risk.

Partnership Termination Risks: Divorce and Death

The planning premise of using SLATs is that, if the marriage is an economic partnership, then assets controlled by either spouse are available to both spouses. An economic partnership exists when assets, income and financial decisions belong to the spouses collectively, rather than divided between them. The reason this is critical is that when each gives up his or her control and enjoyment rights by making a gift into a trust controlled by the other, there needs to be a confidence that he or she will continue to have “spousal influence” over those assets.

Of course, there are situations where spousal partnerships terminate. The first is divorce. When my clients elect to use SLATs as part of their plans, because we spend so much time educating and discussing this concept of a spousal partnership, one of the questions they inevitably ask is what happens if they get divorced. That is a thoughtful question because if a spouse’s ability to access and enjoy all assets, including the assets in both SLATs, is dependent on the spouse’s interdependence, a legal process meant to end the marital partnership eliminates that critical collaboration.

But, as I explain to my clients, if the SLATs are funded with equal values, the creation and funding of the SLATs does nothing that the divorce would not have done. An explanation might be helpful. Assume Mom and Dad have $8,000,000 of assets. Mom and Dad get divorced. Generally, those assets will be divided equally: after the divorce is final, Mom and Dad will each have $4,000,000. Now assume instead of keeping all $8,000,000, Mom and Dad split their $6,000,000 of legacy assets and each gives $3,000,000 to a SLAT for the other. In the divorce, the court will award half of their $2,000,000 lifetime assets to each spouse, and each spouse will also control $3,000,000 of SLAT assets. In other words, each spouse will have control, use and enjoyment over $4,000,000 of assets; the same level of economic control they would have had without the SLATs.

Death of one of the spouses also terminates the partnership and, therefore, is also a question frequently asked by clients considering SLATs. Let’s go back to our $6,000,000 legacy asset and $2,000,000 lifetime assets example. While Mom and Dad are alive and married, the marital partnership has $8,000,000 at its collective disposal. However, assume Mom passes away. Remember, SLATs are designed so that either spouse has access to the trust he or she created through the control provided to the other spouse. Therefore, when Mom passes away, Dad loses access to the $3,000,000 in the SLAT he created for Mom.

When I talk clients through the “death” problem with SLATs, I use a three-tiered approach. First, remembering that SLATs receive legacy not lifetime assets, Mom and Dad’s plan was built under the assumption that the $2,000,000 of lifetime assets should be sufficient for their lifetime spending; the legacy assets should only need to be accessed in “emergencies.” So, the first question is whether Dad even has a problem in the first place. He thought $2,000,000 was sufficient, he still has access to $5,000,000 (the lifetime assets and the $3,000,000 in the SLAT Mom created for him); practically, Dad should be fine. Second, we address the presumptions in the plan. The plan is designed so that the SLAT assets will not be spent and will be left alone to appreciate. Using the rule of 72, if the assets grow at 8%, within 9 years, the $3,000,000 in the SLAT Mom created for Dad will be worth $6,000,000. In other words, if neither spouse dies in the near future, appreciation itself will replace the assets given away to the trust for the predeceased spouse. Finally, there is a planning technique that can be used; each spouse can be given a testamentary power of appointment; a fancy legal term for a power to transfer trust assets to someone at death. If Mom had such a power, she could potentially transfer the assets in her SLAT to Dad.

Legal Risks: the Reciprocal Trust Doctrine and the ATM risk

The first legal risk is a design risk; in other words, if the design of the SLATs is incorrect, the value of the assets in the trusts will be brought back into Mom and Dad’s estate. This risk is known as the reciprocal trust doctrine and it was first espoused by the Supreme Court in 1969 in a case called Estate of Grace. Basically, what the Grace case says is if Mom creates a trust for Dad and Dad creates an identical trust for Mom, then the court will “unwind” the trusts, and treat each spouse as creating a trust for himself or herself. That treatment would cause estate inclusion, defeating the purpose of using SLATs. The key to avoiding the reciprocal trust doctrine is to not use identical trusts. “Identical” is an issue of practicality (are the two trusts practically identical) and the courts and the IRS have provided guidance over the years since Grace as to just how different the trusts need to be to avoid estate inclusion. The best advice to avoid the reciprocal trust doctrine: use experienced, specialized estate planning counsel to create SLATs.

The second risk is not a design risk, but a usage risk. In creating the SLATs, one of the warnings I always give to clients is to only use the SLATs for their personal needs in emergencies, which always leads to some version of “what is an emergency?” My answer is always the same: don’t use the SLAT like an ATM. The reason for that is the SLAT works if the creator does not retain enjoyment over the trust assets. The retention of enjoyment has a legal component, which we will meet because Dad, for example, retains no right to enjoy the property given to the trust for Mom. But there is a practical component as well. If every time Mom and Dad want to buy something, they pull money from the SLATs (like they would from an ATM), the court may find that, in practicality, neither gave away anything and they retained everything. Again, this ATM issue is why we start with separating lifetime from legacy assets. If that is done, and done thoughtfully, it should truly only be an emergency when legacy assets will need to be used.

So, in conclusion, SLATs are a phenomenal tool to take advantage of currently favorable gift and estate tax laws. They should be designed by an estate planning expert and used only when necessary. But if these challenges are addressed, SLATs give you the power to have your cake and eat it too.

SLAT Series

senior couple sitting on opposite sides of a bench in a park, ignoring each other.

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ABOUT THE AUTHOR

Joe Maier

Joe Maier

SVP Director Wealth Strategy JD, CPA | Johnson Financial Group

Joe has extensive experience helping high‐net worth individuals, family offices, business owners and corporate executives meet their wealth and legacy goals. His areas of specific interest and skill include business succession planning, financial and estate planning, and wealth transfer strategies.