"Having your cake and eating it too" is usually beyond what we can deliver in wealth management. That has been especially true when making gifts to reduce one's estate size and subsequent taxes. Reducing the size of your estate can lower the tax against assets (estate tax) and, possibly, the tax on the income those assets produce (income tax). Many clients who are comfortable making gifts frequently choose to use an Irrevocable Life Insurance Trust (ILIT).1 An ILIT, as the name implies, is an irrevocable trust that allows clients to remove assets from their taxable estate. Although other assets may be used, life insurance is often purchased to benefit from the leverage it provides, e.g., a dollar of premium typically buys many more dollars of insurance (depending on the insured's age, health, etc.).
Unfortunately the ILIT is frequently seen as akin to a "locked safe" because of its rigidity and inflexibility. Hence some clients may be somewhat reluctant to make substantial gifts despite the obvious benefits to heirs such as wealth preservation.
An attractive alternative can be found in the Spousal Lifetime Access Trust or "SLAT." Therein one spouse makes a gift and the Trustee has the right to make distributions to the other spouse. Thus the SLAT can be used to provide the other spouse with access to a potential cash flow (from cash values within the trust) while the insured (or insured's') remains alive.
What makes this discussion so timely? As of January 1, 2013 the current lifetime gift exemption is scheduled to decrease from its lofty $5,120,000 to $1,000,000. Simultaneously the top estate tax rate will increase from 35% to 60% (includes the 5% surtax for estates between $10 and $17.184 million). Even if Congress does move, few predict the opportunity to "lock in" this year's gift exemption will be equaled for many years to come (if ever). Acting this calendar year could very easily be the last chance to capture the benefits and preserve an estate from significantly greater estate taxes.
To illustrate, let's assume we establish an ILIT and make an irrevocable gift. That removes the gift from the donor's estate so it is not subject to estate tax at death. Since this arrangement is irrevocable, the grantor is restricted from altering, cancelling or amending trust terms (however a third party trustee can with appropriate rights as provided within the trust document). ILIT cannot be altered, cancelled or amended. Likewise any life insurance policy within the ILIT usually cannot be accessed until the insured's passing. Once death occurs, the insurance proceeds are received into the trust (tax-free), where they are available to pay any remaining estate taxes or for distribution to the trust's beneficiaries free of both income and estate taxes. The heirs get liquidity so assets need not be "fire-saled" and help offset estate costs like taxes (if applicable).
A Spousal Lifetime Access Trust (or SLAT) operates in the same manner except with one significant difference; the trustee is allowed to make distributions to the non-grantor spouse for the spouse's health, education, maintenance and support.2 The potential benefit of this distribution strategy cannot be overemphasized. That one is able to make the gift(s) and thereby remove that amount from the couple's potentially taxable estate and still derive some future cash flow benefit for the other spouse, is nothing short of remarkable.
There are three SLAT strategies to consider:
Single: The most basic approach, wherein one establish a SLAT which purchase insurance on his or her life. The other spouse may be the trustee and beneficiary.
Joint: This approach, also known as second to die, differs only in that the insurance policy's death benefit would be payable upon the death of the second spouse.3
Dual Spousal: The ultimate hybrid strategy which has each spouse create a SLAT for the other's benefit with similar (but not identical) features. This strategy helps retain the most flexibility in both estate and cash flow planning.
When implementing any of these SLAT strategies, several points should be considered:
INDIVIDUAL GIFT: It is important that the gift be made from each grantor's separate property so to minimize the risk of the SLAT assets being included in the spouse/beneficiary's gross estate (IRC Sec. 2036).4 For residents of community property states, the gift should be formally separated first. One way is to fund the SLATs from individually titled accounts.
INSURED SHOULD NOT SERVE AS TRUSTEE: At the very least, the trustee could be the grantor's spouse. Legal experts will often recommend that an independent third party be the trustee or at least serve as co-trustee.
PROHIBITED DISTRIBUTIONS: Distributions cannot be made to the grantor's spouse as part of the grantor's legal support obligation.
RECIPROCAL TRUST DOCTRINE: The IRS has ruled that when two SLATs of substantially identical nature are created, there is an incidence of "consideration" that can serve as a basis to "uncross" the trusts and include its proceeds in the decedent grantor's estate.5 Some estate planning attorneys argue that if the terms of each SLAT are not identical, this can be prevented.6
SLAT's like many estate planning strategies have their drawbacks. Key among these is that the grantor has only indirect access to the trust property through his or her spouse. So a divorce or the death of the non-grantor spouse will terminate this limited access. If this is a concern, the dual trust strategy could provide a valuable solution. Keep in mind that all estate planning strategies (particularly advanced ones such as these) should be carefully drafted by qualified legal experts to avoid inadvertent estate tax inclusion.
Again, lifetime gifting is highly advisable – sooner rather than later – given the scheduled reduction of the Lifetime Exemption from $5,120,000 in 2012 to $1,000,000 in 2013).
The bottom line, for those who hesitate to gift for one reason or another: The Spousal Lifetime Access
Trust can help you reduce your taxable estate and provide future cash flow during your retirement. It is truly a potential for "having our cake and eating it too!"
Uncertainty over the economy and financial markets has many people concerned about their financial futures. For friends, relatives and colleagues who may find this information helpful, please feel free to share with them. Remember, for those who could benefit we offer a complimentary, no obligation "Second Opinion" that can offer an objective financial review. Keep us in mind for those who may be seeking a wealth management firm like ours—one that delivers services according to the needs and perspectives of its clients.
This information is not considered a recommendation to buy or sell any investment or insurance. We strongly recommend an advanced tax and estate planning expert be contacted for further information.
Mitchell E. Kauffman, MBA
Certified Financial PlannerTM
Masters of Science in Financial Planning
Mitchell Kauffman provides wealth management services to corporate executives, business owners, professionals, independent women, and the affluent. He is one of only five financial advisors from across the U.S. named to Research magazine's prestigious Advisor Hall of Fame in 2010, and among a select list of 100 over the 20 years prior.
Inductees into the Advisor Hall of Fame have passed a rigorous screening, served a minimum of 15 years in the industry, acquired substantial assets under management, demonstrate superior client service, and have earned recognition from their peers and the broader community.
Kauffman's articles have appeared in national publications, and he is often quoted in the media. He is an Instructor of Financial Planning and Investment Management at the University of California at Santa Barbara, Santa Barbara City College, and Pasadena City College.
For more information, visit www.kauffmanwealthservices.com or call (866) 467-8981. Kauffman Wealth Services is an independent Registered Investment Advisor and serves clients from two office locations: 140 South Lake Avenue, Pasadena, CA 91101 and 550 Periwinkle Lane, Santa Barbara, CA 93108. Securities offered through Raymond James Financial Services, Inc., member, FINRA/SIPC.
1 For additional information on "ILIT As An Effective Estate Planning Tool" see our website http://kauffmanwealthservices.com/2011/12/ilit-as-an-effective-estate-planning-tool/ at www.KauffmanWealthServices.com.
2 The SLAT concept has existed for some time and was given new energy following an IRS Private Letter Ruling (PLR 9748029). Therein the IRS determined that a spousal ILIT structure did not require that the life insurance proceeds be included in the subject's estate. It is important to remember that PLR's are only binding between the tax payer requesting it and the IRS. They can provide helpful insight into IRS opinions but cannot be cited as precedent. Be sure to consult your tax and legal advisor.
3 If survivor life insurance that insures the non-grantor spouse is being used, then the non-grantor spouse should not be the ILIT trustee and should not have power of appointment or withdrawal rights even under the commonly used "5 by 5 clause' (e.g. power to withdraw the greater of a) $5,000 or b) 5% of the trust's fair market value annually. To do so could cause the policy's death benefit to be included in the decedent's estate (see IRC Sec 2042). The client's legal counsel should be asked to review applicable state trust law prior to naming the non-grantor spouse as sole trustee of a Spousal ILIT as it is important to determine whether that law permits a trustee/beneficiary to make distributions to himself or herself. The appointment of an independent co-trustee or permission of a court with appropriate jurisdiction may be required to make such distributions.
4 Journal of Financial Planning, Dec. 2011 "Prudence in Establishing a Spousal Lifetime Access Trust" by Jon J. Gallo,J.D. (pg. 44-45)
5 See Lehman v. Comm'r 109 F.wd 99 (2nd Cir 1940); US v. Estate of Grace, 395 U.S. 316 (1969); Estate of Bischoff v.Comm'r, 69 T.C. 32 (1977);
6 Estate of Green v. U.S., 68 F.3d 151 (6th cir. 1995)