Advanced SLAT Issues

In a previous article, we discussed the basics of Spousal Lifetime Access Trusts (“SLATs”).[1] Generally, SLATs are irrevocable trusts established by one spouse during such spouse’s lifetime with the other spouse being a beneficiary of the trust. Often both spouses will establish a SLAT, but they must be carefully structured and administered to prevent application of the reciprocal trust doctrine, else the SLATs can be “uncrossed.” SLATs have become an increasingly popular vehicle for lifetime gifting because they allow taxpayers to use their federal lifetime gift and estate tax exclusion (“Exclusion”) while maintaining at least an indirect benefit from the assets transferred and also provide flexibility as to how descendants ultimately inherit assets. Now, we can build upon that general foundation and discuss some tax specific issues one should be aware of regarding SLATs.

Divorce Issues

Because SLATs can generally make payments to the grantor’s spouse without the consent of an adverse party, they are typically taxed as grantor trusts under Section 677.[2] The treatment of grantor trust status results in the grantor being treated as owning the trust property personally for income tax purposes, and therefore including all items of income, deductions, and credits of the trust in his or her personal computation of taxable income as if he or she had received them directly.[3] As long as the grantor and spouse are married, there’s usually no problem, because the grantor is paying taxes on income that is available to his or her spouse and, therefore indirectly, to the grantor.

Repealed by the 2017 Tax Act, Section 682 provided that the income of a grantor trust that was payable to a former spouse was taxable to the former spouse, not to the grantor. With the repeal of Section 682 and corresponding amendments to related sections, if the parties divorce, the grantor will lose the indirect access to the trust property, but will still be responsible for paying the taxes on the SLAT’s income. On the other hand, the former spouse is still eligible to receive the trust’s income, without paying any income taxes thereon.

Section 677 relies on Section 672(e) for determining whether a spouse’s beneficial interest is attributable to the grantor. Section 672(e) only tests whether the grantor and spouse were married at the time the trust was created. Therefore, most of the usual methods for toggling grantor trust status are not available to divorced taxpayers, thus taxpayers must resort to alternative methods to avoid unintended consequences of grantor trust treatment in a divorce scenario. The following are some alternatives that might be available to existing SLATs:

  1. Decant or modify the SLAT to eliminate or modify the spouse’s interest in the trust. This option brings with it a host of fiduciary concerns that probably would be heightened in the event of a divorce.
  2. Grant an independent trustee the authority to reimburse the grantor for income taxes paid on the trust’s income (or at least on the income that is distributed to the former spouse) but ensure that such reimbursement is not mandatory. This option also raises fiduciary concerns and is only available if the trustee is authorized to reimburse the grantor for taxes paid under the terms of the trust agreement or state law. In addition, a pattern of reimbursement could cause the trust property to be included in the grantor’s estate.
  3. Enter into an agreement with the former spouse whereby the spouse agrees to pay the taxes attributable to the income distributed to him or her. This solution is probably unpalatable to the former spouse, absent other accommodations to him or her with respect to the property settlement.
  4. Terminate the trust and distribute the assets outright to the spouse and/or other beneficiaries. This will likely defeat the grantor’s purposes in creating the trust in the first place.

Savvy taxpayers should consider including the following provisions in future SLATs to address potential grantor trust issues on divorce:

  1. Require that in the event of divorce, distributions to the spouse from the SLAT be subject to the consent of an adverse party, since that would eliminate grantor trust status under Code §677(a). The grantor would need to be careful, however, to not include any other provisions in the agreement that would cause grantor trust status under §672(e).
  2. Grant an independent trustee the authority to reimburse the grantor for income taxes paid on the trust’s income, if those taxes relate to income payable to the former spouse (see item 2 above).
  3. State in the trust agreement that the spouse’s beneficial interests in the trust are dependent upon the spouse remaining legally married to, and living with, the grantor (i.e. a “floating spouse” provision). The trust would remain a grantor trust under §672(e), but at least the income would not be payable to the former spouse.

Death of Grantor Issues

On the death of the beneficiary spouse, the assets held in the SLAT are distributed in accordance with the trust agreement, often to be further held in trust for the benefit of the grantor’s descendants. On the death of the grantor spouse, the trust is no longer a grantor trust, and therefore will follow normal trust income tax rules. In the event the beneficiary spouse of a SLAT dies prior to the grantor spouse, the grantor spouse can be left with many costs (including a sizable annual tax liability) with little to no assets to pay for such because the grantor was relying on the indirect benefit of the SLAT. Taxpayers should consider options such as the following to mitigate this issue:

  1. Give the beneficiary spouse a limited testamentary power of appointment in favor of the grantor spouse. Although one should carefully structure the trust to prevent application of Sections 2036 and 2038. Additionally, the IRS might argue that Section 2036 should apply based on the existence of an implied agreement that the beneficiary spouse would appoint the assets back to the grantor. However, in the absence of this, if the beneficiary spouse independently exercises any such power, this should not cause estate tax inclusion.
  2. Include a special power of appointment, whereby an independent third party is granted the power to appoint trust assets for the benefit of the grantor spouse.
  3. Use a hybrid domestic asset protection trust (“DAPT”), whereby a third party is granted the power to add the grantor spouse as a beneficiary of the trust.
  4. Grant an individual the power, in a non-fiduciary capacity, to loan the trust assets to the grantor spouse. This individual could be required to charge adequate interest on the loan to avoid tax issues.
  5. Purchase wealth-replacement life insurance on the life of the beneficiary spouse, which can be used to meet the grantor spouse’s needs.

A common planning tool with SLATs (and grantor trusts in general) is for the grantor to sell assets (usually appreciated) to the SLAT in exchange for a promissory note. For income tax purposes, this sale is ignored because the grantor is treated as selling assets to himself. This can create issues if the grantor dies during the term of the promissory note. Practitioners are split on the proper tax consequences should that occur.

Some practitioners argue, based on Madorin v. Commissioner,[4] that upon the grantor’s death there is a deemed transfer to a newly-formed non-grantor trust, which is a disposition causing the grantor’s estate (or other beneficiaries which succeed the grantor) to recognize income. Others, relying on Section 453B(c) and Crane v. Commissioner,[5] conclude that Mandorin should not apply based on the principle that transfer at death generally do not constitute realization events, even if an identical transfer during lifetime would trigger realization. Depending on which position is taken, a variety of arguments exist as to the proper treatment of basis for both the assets in the trust and the promissory note.[6]

State Law Considerations

If assets are available to the creditors of the grantor spouse, then they could be included in the grantor’s estate under Sections 2036 and 2038.[7] Under Section 505 of the Uniform Trust Code, creditors may reach the maximum amount that can be distributed from an irrevocable trust to or for the benefit of the grantor. In the event the grantor spouse has some remainder benefit in the SLAT after the death of the beneficiary spouse, the grantor spouse may be treated as the grantor of a new trust established for his or her benefit upon the death of the beneficiary spouse.

For state law purposes, this would result in the deemed newly created trust being a “self-settled trust” and subject to claims of the grantor spouse’s creditors. A similar result can occur in the event a beneficiary appoints assets into trust for the benefit of the grantor spouse, such as by the beneficiary spouse upon his or her death. This is known as the “relation back doctrine,” because the formation of the SLAT and the later appointment into trust for the grantor spouse are deemed to be integrally related and therefore should be treated as parts of the same transaction, such that the later appointment should relate back and be given the same effect and treatment as the formation of the SLAT.

Many states have fixed this issue by statute, by stating that such trusts are not deemed self-settled if assets end up in a trust for the benefit of the grantor spouse after the death of the beneficiary spouse. Such states include Texas, Kentucky, and Mississippi,[8] among others. Taxpayers not fortunate enough to live in such states could structure the SLAT as a DAPT, assuming their state has a DAPT statute. If their state has neither statutory protection, the taxpayer could form their SLAT in a state that does. However, this is not guaranteed to succeed. For example, the grantor’s state of residence may assert that public policy prevents using an asset protection trust in another state.[9] Depending on the law of the jurisdictions in question, doing so could at least provide a possibility of protection as opposed to the guarantee of no protection that results from forming the SLAT in a state with no statutory protection. Finally, where possible, taxpayers should fund their SLATs with the separate assets of the grantor spouse to maximize the likelihood of the desired tax results. In community property states, this may require additional documentation and transfers.

Conclusion

SLATs have become an increasingly popular estate planning tool for taxpayers to use their federal gift and estate exemption during their lifetime, however they are not without their potential issues. While many of these issues may never come up for the majority of taxpayers, they can be critical issues when they do occur. If contemplated prior to formation of the SLAT, many such issues can be minimized or negated all together. This article is intended to not only make taxpayers aware of these issues, but also provide options for addressing them. As always, prudent taxpayers should seek out some proper planning advice as to how best address these issues before they actually arise.

[1] Devin Mills, Spousal Lifetime Access Trusts Basics (March 1, 2022), https://www.esapllc.com/slat-planning-2022/.

[2] Note that this is the general treatment and that SLATs can potentially be structured to not be grantor trusts, often referred to as SLANTs.

[3] IRC §671.

[4] Madorin v. Commissioner, 84 T.C. 667 (1985).

[5] Crane v. Commissioner, 331 U.S. 1 (1947).

[6] See these resources for a more in-depth discussion of certain practitioners’ positions: Jonathan G. Blattmachr, Mitchell M. Gans & Hugh H. Jacobson, Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor’s Death, 97 J. TAX’N 149, 153 – 154 (September 2002); Michael D. Mulligan, A “Reality Of  Sale” Analysis Of Installment Sales To Grantor Trusts: Properly Structured, The Best Transfer Tax Strategy (August 2015); William R. Culp, Jr., Paul M. Hattenhauer, & Briani Bennett Mellen, The Tax and Practical Aspects of the Installment Sale to a Spousal Grantor Trust, 44 ACTEC L.J. 63 (Winter 2019).

[7] See Rev. Rul. 76-103, 1976-1 C.B. 293, Estate of Paxton v. Comm’r, 86 T.C. 785 (1986), and Outwin v. Comm’r, 76 T.C. 153 (1981).

[8] Miss. Code Ann. §§ 91-8-504(d)(2) & (3).

[9] See Huber v. Huber, 2013 WL 2154218 (Bkrtcy. W.D. Wash. May 17, 2013).