Uncertain economic times call for flexibility

One of the many lessons resulting from the COVID-19 pandemic and resulting economic downturn is that it’s imperative to build flexibility into your estate plan. Indeed, many people had been taking advantage of the current, record-high gift and estate tax exemption by gifting assets tax-free to family members. 

But then circumstances drastically changed earlier this year, and many are now much more reluctant to give away substantial amounts of wealth, for fear that they may need access to it down the road. This is where a spousal lifetime access trust (SLAT) may work to your advantage.

Under the right circumstances, a SLAT allows you to remove significant wealth from your estate tax-free while providing a safety net in the event your needs change in the future. This trust type is an irrevocable trust that permits you, as trustee, to make distributions to your spouse, during his or her lifetime, if a need arises. 

Typically, SLATs are designed to benefit your children or other heirs, while paying income to your spouse during his or her lifetime. You can make completed gifts to the trust, removing those assets from your estate. But you continue to have indirect access to the trust by virtue of your spouse’s status as a beneficiary. Usually, this is accomplished by appointing an independent trustee with full discretion to make spousal distributions.

SLATs must be designed carefully to ensure that they achieve your objectives and that the trust assets aren’t included in your spouse’s estate.

SLATs provide welcome flexibility in uncertain times, but they must be planned and drafted carefully to avoid potential pitfalls. For example, to ensure that the assets are removed from your estate, you shouldn’t serve as trustee. It’s possible to name your spouse as trustee, but be aware that, if you do, distributions from the trust generally will be limited to those necessary for his or her health, education, maintenance or support. The trust should also prohibit distributions that would satisfy your legal obligation of support to your spouse.

To avoid inclusion of trust assets in your spouse’s estate, your gifts to the trust must be made with your separate property. This may require additional planning, especially if you live in a community property state. And after the trust is funded, it’s critical to ensure that the trust assets aren’t commingled with community property or marital assets.

Keep in mind that a SLAT’s benefits depend on indirect access to the trust through your spouse, so your marriage must be strong for this strategy to work. There’s also a risk that you’ll lose the safety net provided by a SLAT if your spouse predeceases you. One way to hedge your bets is to set up two SLATs: one created by you with your spouse as a beneficiary and one created by your spouse naming you as a beneficiary. 

If you and your spouse each establish a SLAT, you’ll need to plan carefully to avoid the reciprocal trust doctrine. Under that doctrine, if the IRS concludes that the two trusts are interrelated and place you and your spouse in about the same economic position as if you had each created a trust for your own respective benefit, it may undo the arrangement. In other words, the IRS may treat each trust as if the grantor had named him- or herself as a life beneficiary, thereby erasing the tax benefits. To avoid this outcome, the trusts’ terms should be varied so that they’re not substantially identical.

Building flexibility into your estate plan is well worth your time — especially during times of economic uncertainty. A SLAT provides you the option of retaining some access to your money while taking advantage of tax-free wealth transfers. Talk to your estate planning advisor to learn whether a SLAT is right for you.