The once-in-a-lifetime opportunity to gift $5.12 million without gift or generation-skipping transfer (GST) tax will - without further Congressional action - expire on December 31, 2012. On January 1, 2013, the gift tax exemption will revert to $1 million and the top tax rate will revert to 55%.
While many high net worth married couples might like to take advantage of their $5.12 million gift tax exemptions, they may be reluctant to do so because of lost access to the gifted property's income and principal. One strategy to keep the gifted income and principal within reach is a Spousal Lifetime Access Trust ("SLAT"). In simple terms, a SLAT is an irrevocable trust set up by one spouse for the benefit of the other spouse.
For example, assume husband ("grantor-spouse") creates a SLAT for the benefit of wife ("beneficiary-spouse") and funds it with his $5.12 million gift tax exemption. During wife's lifetime, the Trustee (which may be wife) can distribute to wife income and principal as needed for her health, education, maintenance and support. Wife can also be given the power to withdraw the greater of $5,000 or 5% of the trust principal annually, and a testamentary limited power of appointment to "rewrite" the trust upon her death. Thus, through wife, husband retains "indirect" access to the SLAT's income and principal.
When wife passes away, the unappointed trust property (including appreciation) passes - estate tax free - to the children and, depending on state law, even more remote descendants (if husband allocated his generation-skipping tax exemption to the SLAT gift). An added benefit of a SLAT is that it protects the beneficiaries from creditors, including ex-spouses.
Grantor Trust Status.
For income tax purposes, the SLAT is a grantor trust for the lifetime of the grantor-spouse. Thus, in the above example, husband reports the SLAT's income and capital gains on his personal tax return. Payment of the SLAT's income taxes allows the SLAT to compound "tax free". Such payments are essentially a tax-free gift to the beneficiaries of the SLAT. To provide the cash to pay the taxes, if necessary, the SLAT can give an independent trustee the discretion to reimburse the grantor-spouse for any taxes paid.
Hedging the Bet with an ILIT.
One obvious problem in the above example is that, upon wife's death, husband loses his indirect access to the trust's income and principal. One simple solution is for wife to create an irrevocable life insurance trust ("ILIT") for the benefit of husband. The ILIT would be funded with a life insurance policy on wife's life to "replace" the wealth lost to husband at wife's death. If necessary, the SLAT can loan the ILIT the funds needed to pay premiums under a split-dollar arrangement.
Avoiding the Reciprocal Trust Doctrine.
Can each spouse create a SLAT for the benefit of his/her spouse so as to increase the gift to $10.24 million? It's possible, but the IRS could unwind the transactions under the reciprocal trust doctrine. If applicable, each spouse will be treated as having established a trust for his/her own benefit, resulting in estate inclusion of each spouse's "own" trust at his/her death.
However, if the trusts are significantly different from each other, the reciprocal trust doctrine will not apply. There is no "safe harbor" as to what constitutes a sufficient difference between two trusts to avoid the reciprocal trust doctrine. Therefore, the best approach is to make the trusts so different that the spouses are not in the same economic position after the trusts are created. Following are ways SLATs may be drafted to differ from one another: