Why So Many Taxpayers have SLATs
Lots of taxpayers have set up irrevocable trusts in recent years to use exemption (that is the amount you can give away without an estate or gift tax). In 2020 and 2021, the harsh Democratic estate tax proposals were the catalyst for a tidal wave of this type of planning. That amount this year is $12,060,000. While the figure is inflation adjusted each year, it is also scheduled to be cut in half in 2026. So, in addition to the many families that have made gifts already, likely many more (unless there is a change in the tax laws) will do so before 2026. The idea of this planning is to lock in the current high exemptions to avoid estate tax in the future. But for most, even rich folks, these exemption amounts are huge, so they have to preserve access to the trusts they make gifts to. A common way that is done is to have each spouse the beneficiary of the other spouse’s trust (e.g., husband as beneficiary of the trust wife creates and vice versa). Because each spouse can access the assets in the other spouse’s trust, these trusts have commonly been called “spousal lifetime access trusts.” Because lawyers love acronyms (it makes us sound smarter) we call them “SLATs.” SLATs have become the planning mechanism du jour because they seem to fit the current planning environment so well for married couples (leaving aside the unquantifiable risks of the technique).
Blended Families Raise Risks with SLATs
But let’s talk about a different risk and concern that doesn’t get enough press time, who are the couples setting up these SLAT plans? 65% of families are blended families. Therefore, it would likely seem that a large number of couples doing SLAT planning are comprised of blended families. Does that matter? Yep, it might matter a lot. Blended families have kids from prior relationships. That makes for more complexity in the plan and greater risks of who is put in charge of the trust and who is given various powers over trust assets (more on all of this below). Also, depending on which survey you read, blended families may have divorce rates as high as 65%. So, that too may have an impact on the plan and the details that should be included in the SLAT document. Studies have also shown, as might be expected, that blended families face more stress than traditional families.
One more piece of background before we can dig in.
Why Each Spouse’s SLATs should be Non-Reciprocal (Different)
There is a legal doctrine, called the “reciprocal trust doctrine” that could be important to consider in planning any SLAT. This doctrine suggests that if the trusts are too similar (and there is not much clarity on what that means) that the trusts could be “uncrossed.” That means that the trust husband set up for wife might be treated as his trust and vice versa. That would unravel hoped for tax or assets protection benefits (creditors, not just the IRS, can assert this doctrine to pierce the irrevocable trusts used in the plan). So, lawyers drafting SLATs will incorporate different provisions in each spouse’s trust in an effort to differentiate one trust from the other. But as with so many tax concepts the law is murky. There is no clearly defined guidance as to what is sufficient to make a trust non-reciprocal from another trust and the powers and rights you use to differentiate the trusts have real significance. If the differences are done pursuant to a plan to differentiate the trusts might that itself support a challenge that the trusts are too similar? Uncertain. There are many different views on this issue by different tax experts, but that is beyond this article.
How Might You Make SLATs Different from Each Other?
Many estate planners have their own favorite list of differences to bake into each trust to try to deflect a reciprocal trust challenge. But there are lots of recipes and no assurance how well the SLAT cake will fare if challenged. Difference might include:
· Different trustees.
· Different state laws (e.g., one trust in Delaware and the other in South Dakota).
· Different powers of appointment (these are rights given to a person to change the trust or to appoint trust assets to a designated class or group of people or a new trust).
· Different distribution standards (one trust can make distributions with a broad range of rights while the other is more restricted in what can be distributed).
· Different beneficiaries (e.g., add Aunt Jane to husband’s trust but not to wife’s trust).
· Using different lawyers to create each trust.
· Having time pass between each trust.
The question of the day for SLATs is “how many units of difference do we need between each SLAT so that they are not reciprocal?” The problem is there is no detailed checklist or recipe that works. We don’t really know. While there is some case law and rulings, they are generally older and limited. So, it might be a judgement call for the attorney (or attorneys) drafting the trusts. But the focus for this discussion is how the differences many attorneys build into these trusts may affect blended families in particular.
Why SLAT Differences Matter
But here’s the rub. The different provisions integrated into each trust to make the different from each other have real economic significance. Many of the differences may have a real impact on the financial security of each spouse. In an intact marriage that can be an issue, but in a blended family situation, it may be an even greater concern. With a greater potential for divorce, more stress in the marriage, different children or beneficiaries named, etc., the risks of the differences having an unintended and undesired consequence could be greater. The more detailed discussion following will help clarify this concern.
Deeper Dive as to SLATs Differences
The illustrations below should drive home the point that the differences that may be baked into a non-reciprocal trust plan have real and substantial economic consequences. But that is the entire point, those differences may be what makes the plan sustainable against attacks by the IRS or creditors (although neither of those hoped for results are assured). So, the more substantive economic differences between the trusts, especially in a blended family, the greater the risk that one spouse may subvert the entire plan.
5 and 5 Power: A commonly used right or power in trust drafting is the so-called “5 and 5 Power.” This gives a person the right to withdraw the greater of 5% of the trust corpus or $5,000, each year. This odd sounding right is based on tax laws that would cause any power that is a hair broader to cause all the trust assets over which a person holds a greater power to be included in the powerholder’s estate. Another way to say it is that withdrawing not more than 5% of a trust’s assets annually is the greatest power you can give someone and keep those assets outside the powerholder’s estate. So, if husband’s trust that he created for wife does not have that power, but wife’s trust she created for husband does have that power, that might be a meaningful difference between the two trusts. That means wife would not have the right to pull out 5% of the assets from the trust she is beneficiary of. But husband could pull out 5% of the assets from the trust he is beneficiary of every year. Say the trust hubby can access has $10 million. He can withdraw, no questions asked by anyone, 5% of that, or $500,000 a year, every year, year in and year out. That is unbalanced, but that is the point. That is a difference that has real economic consequences. What if there is stress in the marriage (seemingly likely in a blended family based on the stats), or the marriage even gets rocky? Hubby keeps pulling out $500,000 every year and wife gets to pull out nothing. See the potential issue in every family but especially in a blended family? Let’s expand this example a tad.
Limited Power of Appointment: A power of appointment is a right given to someone under the terms of a trust to appoint or direct the trust assets be distributed to whoever the powerholder chooses subject to the terms of the power. For example, you create a SLAT and in the trust give your spouse the right to appoint trust assets (either during her lifetime or at death under her will, or both) to any person other than herself, her creditors, her estate, or creditors of her estate. That odd sounding formulation is, under the tax laws, the maximum right to appoint asset that can be given without causing assets to be included in the powerholder’s estate. That is critical as key purposes of the SLAT is to keep assets out of the estate (and out of the reach of creditors which often have similar rules). This particular power is referred to as a “broad limited power of appointment” in tax jargon. That is a power granted under some SLAT plans to one spouse but not in the other trust to the other spouse. The goal of this is to endeavor to differentiate the trusts. But consider the impact. Husband has no power of appointment in this example under the trust wife created for him and descendants. But the wife has a broad limited power of appointment during her lifetime and/or at death under the trust the husband created for her. So, after the trusts are formed, wife secretively goes to a new lawyer and signs a new will exercising that power of appointment, so all of those trust assets pass only to her children from a prior marriage. No one will know until she dies, and that exercise may completely upend the intended dispositive scheme that the couple had agreed to.
Beneficiary Variations: SLATs commonly have various phases with different trust provisions governing each phase. For example, there could be trust provisions during the grantor’s lifetime that provide for specified distribution standards to the named beneficiaries. This might be referred to as a lifetime trust. The grantor is the person that sets up the trust and puts assets into it. During that period of time the trust may be treated as a “grantor trust” for income tax purposes (assuming it was structured that way). After the grantor dies, if the spouse is alive asset may pass to a family trust for the benefit of the spouse and all descendants. That trust will also have specified beneficiaries and distribution standards. On the death of the last spouse, the assets may pass in further trust to children or other named beneficiaries. To differentiate the trusts the wife might be named a beneficiary of the family trust after husband’s death. But in the trust wife creates for the husband and beneficiaries, the husband might not be named as a beneficiary of the family trust or the lifetime trust. Having significant differences in who is a beneficiary of the lifetime or family trust, or material differences in distribution standards for each spouse under each trust, might be ways that the trusts are differentiated. But all that has real economic teeth. Let’s say that the husband is not a beneficiary of the family trust formed under the wife’s SLAT. That could be a real economic hardship on him and force him to spend down assets in his own name thereby reducing or even eliminating what his children from a prior marriage might receive on his passing. That might make one set of the children rather unhappy. Again, the steps taken to differentiate trusts from the reciprocal trust doctrine are not just window dressing, they can have real and substantial financial impact.
HEMS Distribution Standard: So, we lawyers love our acronyms. “HEMS” stands for health, education, maintenance and support. This is an important but somewhat quirky sounding construct that is important to many irrevocable trusts. You can be named a trustee of a trust that someone else, e.g., a parent, creates for you and also be a beneficiary. But if the assets in that trust are to be protected from your creditors and avoid inclusion in your estate your ability as a trustee to make distributions to yourself as a beneficiary have to be limited to a HEMS standard (this is also called an “ascertainable standard”). This is a bit tough to quantify but perhaps this example might be correct (notice the uncertainty?): you can distribute funds to yourself to pay the costs of maintaining your current standard of living, such as your home, food, etc. You probably should be able to pay for vacations at a level consistent with your standard of living. If you opt to have the trust distribute $2 million to buy a small yacht, that might be beyond the HEMS standard. So, the use of a HEMS standard is useful in many trusts. In differentiating trusts between spouses, the husband for example may only be permitted to receive a distribution pursuant to a HEMS standard. The wife as beneficiary of the other trust might, in the discretion of an independent trustee (not herself) be permitted to receive distributions without restrictions. That could be a material difference. These types of provisions reduce the access to a particular trust to less than it might otherwise be. The use of a HEMS distribution standard may also limit the ability to decant (merge) a trust in the future. There may be other ramifications as well.
Independent Counsel: Consider advising clients to have independent counsel. Some advisers think that this is crucial to the success of SLATs for them to be non-reciprocal. That probably doesn’t happen very often in the real world because it will add to the cost and the discomfort. Given how different provisions in an irrevocable trust can be (just review the points in the preceding paragraphs) will the blended couple be comfortable using different law firms? In an intact family there may be no children from a prior marriage to worry about so the couple might be less worried about using independent law firms (can’t say I’ve seen it done though). But for the blended family how would each spouse in that second or third marriage know how they are being provided for or their children? That is really the point. They won’t. But think of how that might go awry.
Fiduciaries: Who is named as trustee? Many lawyers encourage couples to have different trustees. Some lawyers prefer different institutional trustees since there can be no “wink-wink” arrangements with an institution so that the IRS or a creditor will have to assume proper administration and no under-the-table agreement on what to do. Other lawyers feel that the choice of trustee is irrelevant. Some folks eat the cookie part of the Oreo first, others (like me) eat the crème middle first. There is no certainty as to the implication of who is named trustee (I recommend independent trust companies in different states). But if you subscribe to the theory that different trustees might matter, also consider who is named in each of the other fiduciary positions in the trust. There may be a separate trustee for distributions, investments, insurance, and more. Are they independent? In a blended family has someone been named that might favor one side rather than the other? Should your brother-in-law be named as a trustee or in another fiduciary capacity? Might he favor distributions to his nieces and nephews and leave your kids from your prior marriage high and dry? The choice of fiduciaries can have profound impact on any trust plan but especially in a blended family context. Also, many irrevocable trusts include a position called “Trust Protector.” That person is often given selected powers which can be, well, quite powerful. The Trust Protector is often given the right to remove and replace trustees. If an institutional trustee is named to provide independence and assure fair and impartial treatment of eventual beneficiaries, the Trust Protector, perhaps that old college roomie can replace the independent institution with an old friend of one spouse. That might impact ultimate distributions to the children from each prior marriage.
Non-Fiduciary Positions and Powerholders: Modern complex trusts can have a bevy of different positions. For example, someone might be given the power in a non-fiduciary capacity to loan trust assets to the settlor. That is done to assure characterization of the trust as a grantor trust for income tax purposes (that’s just how the tax rules work, if you have that provision in the trust it is grantor for tax purposes). This power also can give the settlor spouse access to assets in the trust. Consider, husband sets up a trust for wife and descendants. So long as wife is alive and the couple married, the husband might indirectly benefit from trust assets through her. For example, if the wife gets a distribution that she uses to pay for living expense, the husband benefits. If the trust owns a vacation home wife as a beneficiary can live in the home without paying rent. Husband, as the spouse of the wife/beneficiary, can use the vacation home in his capacity of being a spouse. But if wife dies prematurely the husband’s “indirect” access to trust assets terminates. But if a person is given a power, in a non-fiduciary capacity, to loan money to husband, that may provide husband the ability to access trust assets if needed. Including this power might be an affirmative step that provides financial protection for the settlor’s spouse. Perhaps one trust includes a loan provision and the other might not. Perhaps both trusts include a loan provision. But loan provisions can have real economic bite and could be manipulated to change future results. Say husband has a loan power in his trust and his college roommate is given the power to loan him trust funds. He loans husband most of the funds in the trust at the minimum interest rate permitted by law. Husband invests the funds outside the trust and effectively transfers growth from the trust to his personal name and gives him the ability to shift that value to his children from a prior marriage in contradiction to the trust provision that mandate equal distribution to all children on death. When husband dies and assets pass to the children under the terms of the trust, the main asset of the trust is a loan to husband. But husband has given away all of his assets to his children before death. So, the wife’s children inherit a partial interest in a note owed to them and their stepfather’s trust and have to collect it against an estate with inadequate assets. Perhaps a bit extreme of an example, but again, a lot of the differences in SLATs can have unintended consequences. They can be real.
How is Spouse Defined: That might sound like an odd question. If you are married to Jane isn’t Jane your spouse? Yes, but you might use in the trust a concept that some have called a “floating-spouse.” Instead of saying “Jane Smith, my wife, is a beneficiary” your SLAT might say “whoever Grantor is married to from time to time shall be a beneficiary.” This way, if your spouse dies prematurely (see the discussions above about the economic risks of premature death) and you remarry you would again regain the possibility of indirect benefit from the trust. That could be a good approach for that reason, but your current wife might not be particularly appreciative of losing access to the trust you create for her if you divorce. Consider that the risk of divorce is so much higher in second marriages than first marriages (and worse still in third and later marriages). The floating spouse approach might be setting the stage for a problem in the future.
Conclusion
SLATs have become one of the more commonly used estate planning tools. SLATs can provide incredible tax and asset protection benefits (if they work). But if you’re in a blended family, or other non-traditional family structure (as the majority of American families are) then extra care must be taken to consider the myriad of ways traditional SLAT planning can create issues for your situation.