The popular practice by high-net worth investors of using tax-friendly trusts to build wealth could be in a state of flux, warn estate attorneys.
With a new administration in the White House, proposals are circulating in Washington, D.C., to reform existing gift and estate tax exemptions. In technical terms, these are referred to as 'exclusions' that estates can claim in filings to the Internal Revenue Service.
Whether or not any such tax exemptions end up actually being changed, many legal experts are suggesting this could be an opportune time for high-net worth investors and business owners to revisit their estate planning strategies.
"The gift and estate exclusion — i.e., how much you can claim as an exemption for estate tax purposes — right now is at its highest level ever," says Bryan Doane, an estate planning attorney at Doane & Doane in Palm Beach Gardens, Fla., who is a member of IFA's network of estate planning attorneys.
Changes enacted by Congress hiked that amount for an individual taxpayer to $11.18 million in 2018, a notable increase from the previous year's $5.49 million. With inflation adjustments for 2021, the estate tax exclusion is now up to $11.7 million. (For estates held as a couple, the exemption this year is $23.4 million.)
In particular, says Doane, estate planners are fielding a lot of questions these days about what's known as Spousal Lifetime Access Trusts, or SLATs.
The purpose of a SLAT is to allow one spouse to set aside his or her assets in a tax-advantaged way. Here's how it works: A husband, for example, can set up a SLAT and name his wife as the trustee. That means she would have the right to distribute the money to herself as needed for health, maintenance and support.
"You're setting aside assets into an estate tax-free pot where any growth in those assets' value won't be subject to estate tax," says Doane. "At the same time, you've got to be aware that you're basically burning up your credit in terms of the estate tax, which is now up to $11.7 million per person."
That can be significant since estate taxes progressively rise to as much as 40% after assets surpass that $11.7 million threshold. "These SLATs are becoming popular since they're treated as grantor trusts," says Doane. This means the person who established the SLAT — the grantor or settler — is the one who is paying the income tax on the income generated by the assets held in the SLAT.
This is different from a 'non-grantor' trust. Using such a legal structure, taxes on any income — such as dividends and distributions or income that results from the capital gains of assets sold in that trust — are the responsibility of the trust.
As a result, Doane likes to emphasize with clients that a SLAT is best used as a means to let an estate's assets grow over time in a tax-savvy fashion. "The person who has set it up, the grantor, can reap a tax estate benefit over the long-term," he says, "since assets put into the SLAT grow unreduced by capital gains taxes."
That's why establishment of a SLAT generally is considered to be an "income-tax neutral" estate planning strategy for the spouse who's gifting assets, Doane observes. "It's important to remember that income generated by this type of an irrevocable trust remains taxable to the grantor," he says.
Such a division of assets can prove more problematic for couples living in a community property state, notes Casey Little, an estate planning attorney at Fahlman Olson & Little in Mercer Island, Wash., who is also a member of IFA's network of estate planning attorneys. "The issue would be if a husband, for example, owns most of the property and assets," he says.
In a community property state, if the husband converts "a big pile into a SLAT and the wife files for divorce at some point" then he would end up with a smaller estate than if he hadn't funded the SLAT, points out Little. These types of trusts do, though, allow for the naming of an independent trustee who isn't a beneficiary when it's established. In such a structure, the grantor is offered a greater degree of flexibility since an independent trustee is afforded broad discretion to make trust distributions.
Another thorny issue that can face couples in a community property state, adds Little, relates to those who prefer not to hold their assets separately. In these cases, he warns that each spouse is legally entitled to half ownership of the estate's assets.
This could become a problem if one spouse dies. "If you don't clarify beforehand that the assets going into the SLAT are separate properties held by the grantor," says Little, "then the beneficiary spouse could be deemed as the grantor of half of that trust. The net result in such a situation is that the estate tax benefits for a family would be greatly diminished."
In community property states, he urges couples considering a SLAT to first create what's known as a Separate Property Status Agreement. This is a separate legal document that stipulates which assets each spouse owns.
"Even if you've built wealth as a couple and considered it as community property in the past, you can still use this type of an agreement to unwind that wealth for estate tax purposes," says Little. "But it's a good practice to do this before establishing a SLAT so that assets can be transferred in a way that clearly demonstrates the proper division of each spouse's property and assets."
It's important for couples to keep in mind that SLATs can only be set up as irrevocable trusts, notes Ron Wargo, an estate planning attorney at Friedmann Goldberg Wargo Hess in Santa Rosa, Calif. He is also a member of IFA's network of estate planning attorneys. "There are still ways to change certain provisions of an irrevocable trust," says Wargo. "But by and large, making major changes in these types of trusts aren't permitted."
That's why SLATs aren't for everyone, he adds. "Any couple who is considering whether to set up one of these irrevocable trusts should keep in mind that they might not have as much flexibility as they'd like with those assets in the future," says Wargo. "That's simply because of the fact that the more assets you bring into a SLAT, the less control you might have over the entire estate."
Before deciding on whether to use a SLAT or not, he recommends that taxpayers understand the IRS can actually invalidate such a trust's tax privileges if the grantor is deemed "exerting too much control."
An example might be a house given to the wife for estate tax purposes. The IRS could have a problem with that if the grantor, say the husband, still lives in that same house. Another instance might be a business in which the grantor is still in control. "Typically, you don't want to put a business in which you're still active into a SLAT," says Wargo.
So, while a SLAT might be a great idea for tax purposes, such a trust "should be viewed like a passive portfolio," adds Wargo. "These are essentially nest eggs — the best approach is to put certain assets into a SLAT with the intention of the spouse never using those assets in order to gain the most in tax savings as that trust's value grows."
In fact, he estimates that less than 5% of his clients who ask about SLATs wind up deciding such trusts are the best solutions. "There are other types of trusts you can use to protect your assets from estate taxes that can prove to be less restrictive in applying a broader estate planning strategy," says Wargo.
In many cases, he suggests simply using a straightforward irrevocable trust with only a couple's children named as beneficiaries. "Then, you don't have as much of a risk that the parents are going to try to be too active in terms of using any those assets," he says.
A good rule of thumb for those considering a trust to help develop a more tax-efficient retirement plan might be to check with an IFA wealth advisor before making any moves. Besides conferring with some of our clients' existing estate lawyers, we also offer the IFA estate attorneys network for anyone who isn't currently working with an experienced attorney.
This article originally appeared on IFA.
