Make Use of the Gift Tax Exemption With Spousal Access Trusts

You may have heard that after more than a decade of changing estate tax exemptions, we finally have permanent law. The American Taxpayer Relief Act of 2012 (ATRA) sets the gift and estate tax exemption at $5 million, and indexes that amount for inflation beginning in 2012. For 2014, that gives individuals an exclusion amount of $5.34 million and for 2015, $5.43 million. Although technically permanent, it's only as permanent as any other tax law, which means it could change in the future.

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You might be considering making large gifts in 2014 or 2015 to use your gift tax exclusion while it’s still here. But you may also be concerned about giving away such a large amount. Wouldn’t it be nice to give it away but still have some ability to access it if something unforeseen happens? A spousal limited access trust may be a solution.

Spousal limited access trusts

A spousal limited access trust (SLAT), also known as a spousal lifetime access trust, is an irrevocable trust established by one spouse for the benefit of the other, and the couple’s children and grandchildren. The transfer of assets by the spouse establishing the trust is considered a gift and will use some or all of the individual’s gift tax exemption. The assets and their future appreciation can eventually pass to children, grandchildren, or future generations free of estate tax.

The trust document is written to allow for distributions to the other spouse to meet his or her needs. Generally, if funds are available outside of the trust, it is best to use those funds first rather than making regular distributions to the spouse. Distributions from the trust to the spouse reduce its effectiveness.

Using a SLAT to hedge against a downturn

As an example, let's assume that Sally, who is an executive, would like to make a gift of $5.43 million to use her entire gift tax exclusion in 2015. She and her husband, Fred, own their home jointly and have a joint brokerage account worth $2 million. In addition, Sally has $7 million in an account in her own name. She is concerned that she and her husband may have a future need for some of the gifted funds, particularly if there is another economic downturn.

Sally could establish a spousal limited access trust for Fred's benefit and transfer $5.43 million from her individual account to the trust. The trust could provide distributions to Fred for his needs and their children's needs. The intent would be for the funds to stay in the trust but Fred would have access to it if he needed more money. The trust could be distributed to their children at some point in the future, for example after both Sally and Fred have passed away, or it could stay in trust for future generations.

SLAT income tax implications

A spousal limited access trust is usually a grantor trust for income tax purposes. This means if you establish a SLAT for the benefit of your spouse, you will report the trust's taxable income and deductions on your personal income tax return. A grantor trust is disregarded for income tax purposes, so the trust will not pay taxes. This can be advantageous because it allows the trust to grow without the burden of income taxes. Upon the death of the grantor, the trust will no longer be a grantor trust and will then have to pay income taxes.

For example, Bob is the owner of a car dealership. In 2015, he transfers $5.43 million of nonvoting dealership stock to a spousal limited access trust for the benefit of his wife, Cindy. Each year the trust receives its proportionate share of income distributions from the dealership. The taxable income continues to be reported by Bob and he continues to pay the taxes on the income.

Five years later, Bob sells the dealership and retires. The trust's share of the sale is $10 million. Bob will pay the tax on the gain from the sale of dealership stock. Assuming Bob and Cindy have adequate resources outside of the trust to pay the tax and no distributions are made to Cindy, the entire $10 million can be reinvested by the trust. All of this growth in the trust will escape estate taxation and can eventually be passed on to their children and/or grandchildren.

What do you do if the tax liability is more than the grantor can reasonably afford to pay? It is possible to include a provision that gives the trustee the discretion to reimburse the grantor for the income tax liability associated with the trust's income. If this provision is included, it should be used only in the case of an unusual event, such as the sale of a business, and should not be used every year.

Planning considerations

A SLAT may seem like a fairly easy way to use your gift tax exemption while still providing a safety net in the event of an unforeseen need. However, there are some factors to consider before deciding if it is ideal for your situation.

Since the SLAT provides you an indirect ability to benefit from the trust funds through distributions to your spouse, if your spouse passes away or you divorce, you may no longer be able to benefit from those funds if needed. It is best to put only those funds in the SLAT that you can reasonably expect to do without. If you've left yourself sufficient funds outside of the trust, there shouldn't be a need for those trust funds.

To avoid this issue, some couples prefer to set up trusts for each other’s benefit; the husband would set up a trust for his wife and the wife would set up a trust for her husband. This requires extra planning to avoid the reciprocal trust doctrine, which applies when individuals set up trusts for each other's benefit that are essentially the same. If each spouse wants to establish a SLAT, the two trusts must be different in meaningful ways, such as being established at different times, having different provisions, and being funded with different assets.

The transfer of assets to a spousal limited access trust is a gift and will require filing a gift tax return. Because the spouse is a beneficiary of the trust, gifts to a SLAT are usually not eligible for gift-splitting, where one-half of the gift is reported by each spouse. Plan on funding the trust only with the amount of your available gift tax exemption or a lesser amount.

If you decide a spousal limited access trust is right for you, talk over the nonfinancial issues with your spouse and consult with your estate planning attorney and tax advisor to make sure any potential issues are addressed so that your ultimate estate planning goals are met.