The Tax Cuts and Jobs Act of 2017 (TCJA) became effective on Jan. 1, 2018. Included in TCJA was a change to the “unified credit” exclusion amount available to individuals for gifts made during life and the transfer of assets at death. Prior to 2018, the unified credit was $5 million, adjusted for inflation ($5.49 million in 2017). Effective in 2018, the unified credit was doubled to $10 million, adjusted for inflation ($11.7 million in 2021; $23.4 million for a married couple). However, TCJA included a “sunset” provision, providing that the unified credit will return to the pre-2018 level effective Jan. 1, 2026. With the inflation adjustment, this is estimated to be approximately $6 million ($12 million for a married couple) in 2026. In November 2019, the IRS issued Treasury Regulation IR-2019-189 confirming its position that large gifts made between 2018 and 2025 will not be “clawed back” into the individual’s estate when the current exclusion amount sunsets in 2026.
This creates a unique opportunity for high-net-worth individuals to maximize their unified credit using the historically high exclusion amount before it expires. Time is of the essence in deciding whether to take advantage of this opportunity. The Biden administration and Congress have proposed reducing the exclusion amount before the 2026 sunset. Some proposals have even suggested reducing the unified credit to $3.5 million.
Currently, an individual can make a gift in 2021 of $8 million. If the individual dies in 2026, when the unified credit is approximately $6 million, the individual will have used their entire exclusion amount, but the excess $2 million of the gift will not become taxable, even though the $8 million gift exceeds the $6 million exclusion amount available at the individual’s death. Individuals who are able to gift the entire $11.7 million available in 2021 (or $23.4 million for a married couple) could utilize their entire unified credit under the favorable Treasury Regulation without negative tax consequences at their death. It is important to note that the impact extends beyond the initial gift – all future appreciation on the assets gifted is also excluded from the individual’s taxable estate.
A great way for married couples to take advantage of this gifting opportunity is with the use of spousal lifetime access trusts (SLAT), sometimes referred to as spousal limited access trusts. With a SLAT, one spouse (the “grantor” or “donor” spouse) gifts property to an irrevocable trust for the benefit of the other spouse (the “beneficiary” spouse). By making a gift to a SLAT, the assets placed in the SLAT – and all the appreciation on those assets – are not included in either spouses’ taxable estate at their death.
During the beneficiary spouse’s life, the SLAT can be exclusively for the benefit of the beneficiary spouse, or the trustee can have discretion to make distributions to children and descendants. This can allow the beneficiary spouse to make lifetime distributions to their children in excess of the annual gift tax exclusion (currently $15,000 per year per recipient) without the distributions being considered gifts for tax purposes. The SLAT can also be generation skipping, allowing the donor spouse to utilize some or all of their generation skipping transfer tax exclusion (currently also $11.7 million).
SLATs can be drafted in many ways. The SLAT can allow the trustee to make discretionary distributions of income and principal to the beneficiary spouse (or other beneficiaries), or income distributions can be mandatory with access to principal either prohibited or at the discretion of the trustee. When creating the SLAT, the donor spouse decides how and when the assets of the SLAT can be accessed for the benefit of the beneficiary spouse or other beneficiaries. By creating flexibility in distributions, the donor spouse can ensure that the assets are available should their “fortunes turn” and the assets are needed in the future. The donor spouse can also enjoy the benefit of the SLAT assets indirectly through the beneficiary spouse. Of course, after the beneficiary spouse’s death, the donor spouse no longer has this indirect benefit, so the SLAT should not be overfunded. Divorce is another risk with SLATs, but this can also be addressed in the planning stages.
In addition to the flexibility in determining how and to whom distributions may be made, the beneficiary spouse may be named the trustee (the donor spouse cannot be the trustee). If the beneficiary spouse is the trustee, distributions must be either mandatory or subject to an “ascertainable standard,” essentially limited to the health, education, maintenance, and support of the beneficiary spouse. In reality, this is relatively broad access. However, if you do not want to limit the trustee’s discretion, an independent or corporate trustee may be used. While the beneficiary spouse does have access to the SLAT, assets includible in the spouses’ taxable estates should be exhausted before tapping the SLAT assets because using the SLAT draws those assets back into the donor or beneficiary spouse’s estate(s) to the extent not exhausted during life. The intent is to fund the trust with assets that will not be needed during the lifetimes of the donor or beneficiary spouse to maximize the appreciation in the trust.
A SLAT is a “grantor trust” for income tax purposes, meaning the income, including capital gains, generated in the SLAT is taxed to the donor spouse at the donor spouse’s tax rate, which is typically lower than the income tax rate for trusts. The payment of the taxes by the donor spouse is not considered an additional gift by the donor spouse because the trust’s terms require the payment. This allows the trust assets to compound and further reduces the ultimate taxable estate of the donor spouse.
One tradeoff for lifetime gifting versus transfers at death involves cost basis. Assets that pass at death receive a “step-up” in cost basis while lifetime gifts receive the donor’s “carryover” basis. Because the SLAT is considered a grantor trust, this allows the trust to include a “swap power.” If, during the donor’s life, the SLAT includes low basis assets while the donor retains high basis assets, the donor can swap an equal amount of cash or high basis assets for the low basis assets held by the SLAT. At the donor’s death, his estate would then include the low basis assets that would then be “stepped-up.” Note: the Biden administration has proposed eliminating the step-up in basis to the extent that estate taxes are not owed, so this point may become moot.
The assets transferred to the SLAT must belong exclusively to the donor spouse. Joint assets or assets belonging to the beneficiary spouse must not be used. Funding, including valuation discounts and the possibility of having each spouse fund a SLAT for the benefit of the other spouse and avoiding the pitfalls associated with all of these issues, should be discussed during the planning stages.
Finally, another benefit of a SLAT is asset protection. Because the gift to the SLAT is irrevocable, the assets placed in the SLAT are not subject to the claims of the donor spouse’s creditors. In addition, with the proper use of discretionary distributions and spendthrift provisions, the assets are not subject to the claims of the beneficiary spouse’s creditors (or the creditors of other beneficiaries if children and descendants are included).
SLATs are just one of many vehicles available for estate and gift tax planning. Other options include, among others, irrevocable life insurance trusts, qualified personal-residence trusts, grantor-retained annuity trusts, generation-skipping trusts, and charitable-remainder trusts.
As mentioned previously, with the potential changes to the tax laws on the horizon, time is of the essence. If you are considering gifting or other strategies as part of your overall estate planning, you should speak to your legal advisor.