This month’s blog includes an excerpt from an article written by Jay C. Judas, CEO, Life Insurance Strategies Group, LLC and Michael Fontanini, CLU®, CFP®, Vice President, Advanced Markets Sales & Design, Lion Street, LLC, that was published in Leimberg Information Services. A special thanks to contributions from life insurance luminaries Carolyn J. Smith, CPA, AEP®, CAP® and Christopher Daniels CFP®, CLU®, ChFC®.
A common practice for married couples to utilize their estate tax exemption while still offering some access to the assets is for each spouse to form a trust for the benefit of the other. This type of trust is referred to as a Spousal Lifetime Access Trust (“SLAT”).
Each spouse gifts up to their 2021 maximum exemption amount of up to $11,700,000 to a trust for the benefit of the other spouse and their children/grandchildren. Assets in each trust would not be included in either spouse’s estate at death.
At this point, there are a couple of pitfalls to avoid. “The two SLATs cannot be identical, or the reciprocal trust doctrine will be violated, and the Service will consider that each spouse had created the trust for his or her benefit,” says Carolyn J. Smith, CPA, AEP®, CAP® and a Senior Partner with C3 Financial Partners in Dallas, TX. “Residents of community property states such as Texas will first want to convert some of their community property into two separate properties. Couples in other states may also need to transfer a variety of assets to one another so each spouse has an identifiable set of assets.”
In an example, Maria establishes a trust for the benefit of her husband, Hector, and their children and funds the trust with a gift of $11,700,000. During his lifetime, Hector has access to the SLAT Maria established for him and when he passes, the SLAT will be divided up into separate trusts for the benefit of their children.
Sometime soon after Maria establishes the SLAT for Hector’s benefit, Hector does the same for her. A problem arises at the death of either Hector or Maria. While both Maria and Hector are living, they have access to the full $23,400,000 but, when one of them passes, the surviving spouse only has access to half the amount.
After Hector’s passing, Maria no longer has access to the SLAT’s assets which would have been accomplished via Hector. Likewise, when Maria dies, Hector no longer has access to the assets in the SLAT Maria established for his benefit. The surviving spouse is cut off from half of their combined trust contribution.
A solution involving life insurance can replace that loss of access. Each SLAT should purchase a life insurance policy on the life of the other spouse. When Maria passes, Hector will continue to benefit from his SLAT and his SLAT will collect life insurance death benefit proceeds to replace the access to the values of Maria’s SLAT which has gone to the trust’s beneficiaries.
Similarly, if Hector passes first, Maria will continue to have access to her SLAT and her SLAT will collect life insurance death benefit proceeds on Hector’s life, replacing the access to the values of Hector’s SLAT.
Adds Smith, “Proper documentation of each step in creating SLATs is the key to a successful implementation.”
Below is a diagram of how the strategy can work:
“Reversible” SLAT
In some instances, SLATs created by each spouse for the other may not be viable due to reciprocal trust doctrine concerns, an unmarried grantor, etc., or perhaps additional lifetime planning flexibility for the grantor(s) is desired with the SLAT(s). A “Reversible” SLAT (“Trust”), also known as a Wealth Retirement and Asset Protection (WRAP) Trust or an Ultimate Irrevocable Life Insurance Trust, allows the grantor/insured himself or herself to have indirect access to the trust’s assets, including the cash value of a life insurance policy inside the trust. The trustee is given the power to make loans from the Trust at any time as long as the grantor substantiates the loan with a promissory note. The note should bear interest at the prevailing rate and be secured by a pledge of the grantor’s assets.
The grantor’s ability to borrow using secured promissory notes is similar to the right to reacquire trust corpus by substituting property of equal value in IRC § 675(4)(C) and Revenue Ruling 2008-22.
Assuming the “Reversible” SLAT is income tax “defective”, meaning the grantor is treated as the owner of trust for income tax purposes, the payment of interest to the Trust should not create interest income for the Trust as the grantor and the Trust are considered a single entity for income tax purposes and any transactions between the two are disregarded for income tax purposes. (IRC §§ 671, 675, IRS Reg. 1.671-2(c), and Rev. Rul. 85-13). Interest that accrues or is paid in the year of the grantor’s death would be taxable to the Trust due to the resulting termination of grantor trust status.
The trustee can provide liquidity for the loan by taking tax-free policy loans from the carrier against the life insurance policy owned by the Trust. At the death of the grantor, the loan owed to the Trust, which is a debt that reduces the taxable estate for federal estate tax purposes, is repaid to the Trust and the repaid loans, together with the death benefit proceeds, are all estate tax-free since they are owned by the Trust.
For example, assume a grantor with $10 million of assets dies while still owning $5 million to his Trust. The $5 million owed to the Trust reduces his taxable estate from $10 million to $5 million, potentially saving $2,000,000 in federal estate taxes (disregarding any remaining exemption for simplicity sake). To optimize the mitigation of estate taxes, the grantor generally should borrow to fund necessity expenses, not to reinvest the money inside his or her estate.
“The grantor cannot have unlimited borrowing power as this could lead to the collapse of the policy and infringe upon the rights of the trust’s beneficiaries, says Christopher Daniels CFP®, CLU®, ChFC®, a Managing Partner with Passarelle Partners of Charlotte, NC. “Great care must be taken to draft the Trust and to properly arrange for the ability of the grantor to borrow from it.”
The Trust strategy is especially useful where clients with large estates are building wealth inside life insurance policies which have not been transferred to an irrevocable trust. Polices with cash values up to the federal estate tax exemption amount may be transferred without gift-tax consequence to a Trust, while preserving the ability to access the cash values. In such a situation, the grantor-insured would need to live at least three years to avoid a “clawback” of the death benefit proceeds for estate tax purposes (IRC §§ 2042 and 2035).
At present, there is no direct legal authority regarding the use of a “Reversible” SLAT and a client’s legal and tax advisors should make the decision on an individual basis on whether or not to include the language in a trust document in case such flexibility is later desired.
Below is a diagram of how the strategy can work:
Read our companion Tier One Interview with Janice Forgays by clicking here.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.