“I am suddenly feeling ill.” I overhear a friend feign a cough as he calls his boss, reporting his absence from work by reason of sickness. As we tee off together from the first hole at our favorite golf course, my friend reports to us, his golfing buddies, that while he has no vacation days remaining, he is fortunate to have one sick day remaining. Since he loses that sick day at the end of the year, he might as well use it by spending this beautiful summer day on the golf course.
In this month’s update, I wish to briefly summarize the current federal estate tax landscape and how a type of irrevocable trust structure called a “Spousal Lifetime Access Trust” could serve to allow high-net-worth clients to “use” their current federal estate tax exemption amounts before these exemptions are lost, either by reason of the “sunset” of current tax law in 2026 or by reason of legislative changes that are likely to occur before then.
Current Status of Federal Estate Tax Rules
The federal estate tax exemption has been in constant flux. Between 1997 and 2017, there were only five years in which the federal estate tax exemption amount for a particular year was the same as the previous year. Most recently, the Tax Cuts and Jobs Act enacted in December of 2017 (“2017 Tax Act”) doubled the federal estate and gift tax exemptions from $5.49 million to approximately $11.0 million. However, the 2017 Tax Act scheduled these exemption amounts to automatically expire on January 1, 2026. As a result, in the absence of any legislative action taken before then, the federal exemption will be reduced from current levels ($11,180,000 for 2019, adjusted for inflation annually), back to $5,000,000 on January 1, 2026.
Spousal Lifetime Access Trusts
Just last week, the IRS issued final tax regulations giving high net-worth taxpayers assurance that no estate taxes would be imposed in a scenario in which wealthy taxpayers gifted assets based upon current (higher) federal exemption amounts, but then died at a time when the exemption amounts have reverted back to previous (lower) federal estate tax exemptions.
While the IRS regulations confirm that the current (higher) federal exemption amount can be utilized by a high-net-worth individual who dies before the sunset of the 2007 Tax Act, a high-net-worth individual who lives past our current “high water mark” of the federal estate tax exemption might consider taking action now to fully use the current exemption.
In order to lock in the tax benefits of making a lifetime gift to use this higher exemption amount, a client should consider the use of a type of irrevocable trust called a “spousal lifetime access trust” (“SLAT.”) While these types of irrevocable trusts can be structured several ways, a SLAT is typically structured to achieve the following objectives:
- Intentionally Name a Spouse as the Beneficiary. The SLAT can be created by a husband or wife (the so-called “grantor”) for the benefit of the grantor’s spouse, as the primary beneficiary. By naming the grantor’s spouse as beneficiary, the assets contributed to the SLAT can be kept available for the needs of the spouse, should the spouse need those assets for living expenses in the future. Of course, the ideal tax strategy is to avoid consuming those assets so as to allow a greater amount of assets to pass to the children free of estate taxes.
- Intentionally Use Exemption. The transfer of assets to the SLAT will be a so-called “taxable gift” so as to intentionally use some (or all) of the grantor’s remaining federal estate tax exemption. This achieves two important estate tax benefits. First, the gift “locks in” current federal exemption amounts, without the possibility that the IRS could “claw back” the value of any gifts made in excess of a future lower federal exemption amount. Second, the transfer to the SLAT allows for any appreciation in the value of the contributed assets to pass free of federal and state estate taxes.
- Intentionally Treat Trust as Defective For Income Tax Purposes. Trust tax rules typically require that an irrevocable trust file its own tax returns and pay its own income taxes. Since trust tax brackets have a compressed marginal tax rate structure, there is rarely any tax benefit to having income taxed at a trust level rather than an individual level. A SLAT can be structured so that it is “intentionally defective” with respect to income taxes, such that the items of income and loss attributable to the trust holdings can be reported on the grantor’s personal returns. Not only does this reduce administrative work, but the grantor’s continuing obligation to pay the income tax associated with the SLAT frees up the SLAT assets to continue to grow free of all associated tax obligations.