Couples with significant assets must balance a number of financial concerns after they get married. For example, most spouses want to balance maintaining access to assets with protecting funds from unnecessary income and estate tax penalties. The problem is that most tactics that remove funds from a taxable estate also remove them from the estate owner’s control.
One of the most popular solutions to this dilemma is the Spousal Lifetime Access Trust (SLAT). These irrevocable trusts offer unique tax benefits and protections while still allowing the couple to benefit from the assets they hold. However, SLATs are not a perfect solution. In fact, they can have serious drawbacks if a couple chooses to get divorced.
That doesn’t mean a SLAT is a bad option. It means that you must take care when drafting yours to ensure it doesn’t negatively impact your finances if you split up. Here’s how SLATs work, how they can impact divorces, and how to address the complications an irrevocable trust may add to your split.
What Are Spousal Lifetime Access Trusts?
SLATs are irrevocable trusts established by a donor spouse (the grantor) to support a recipient spouse (the beneficiary). The beneficiary may also be named as a trustee over the trust. The trust often designates additional beneficiaries, such as the couple’s children or other descendants. All beneficiaries may receive distributions from the trust for life, though this is not required.
The purpose of a SLAT is to transfer the donor spouse’s available exemption without being subject to the gift tax while retaining control over the funds transferred. The assets granted to the SLAT and any post-gift appreciation are sheltered from estate and gift taxes. Furthermore, SLATs established as “grantor trusts” are not obligated to pay income taxes on their assets. Instead, the grantor remains responsible for income taxes so the trust’s funds can grow without being diminished.
Furthermore, these trusts permit both spouses to retain control over gifted assets under the “spousal unity rule.” This rule is defined under Section 672(e) of the Internal Revenue Code. It states that a grantor is treated as “holding any power or interest held by the grantor’s spouse at the time the power or interest was created.” In other words, as long as the spouses remain married and the recipient remains a beneficiary of the trust, the grantor maintains the right to benefit indirectly from the distributions made to the beneficiary.
In some cases, couples will establish reciprocal SLATs. Each spouse establishes and funds an independent trust to benefit the other person so both parties have a measure of protection. However, this must be carefully managed to avoid violating the reciprocal trust doctrine. This usually requires the trusts to be established with a gap in time and different language used in each contract.
The most important thing to note about spousal lifetime access trusts is that they are irrevocable. Once established, their features cannot be changed, including the assets included, the rules for distributions, and most importantly, the beneficiaries.
Benefits and Risks of SLATs
Spousal lifetime access trusts have pros and cons that are equally significant. The most valuable benefits of a SLAT include:
- Sheltering funds from estate taxes: As grantor trusts, SLATs permit couples to protect assets up to the estate tax exemption limit and their future increases in value from the 40% inheritance tax.
- Retaining control over assets: The spousal unity rule permits not just the beneficiary but also the grantor to maintain a certain amount of control over its holdings for the duration of their marriage.
- Maintaining income as a couple: The ability to take distributions from the trust ensures that the couple can continue to benefit from the assets despite removing them from their taxable estate.
In other words, as long as a couple remains married, a SLAT may be an excellent option for high-net-worth spouses.
However, a SLAT can also have significant drawbacks, including:
- Ongoing income taxes: The benefits of a grantor trust come at the expense of the grantor retaining the obligation to pay income taxes on the gifted assets. This can be somewhat mitigated by funding the trust with assets that do not generate income taxes.
- Lack of flexibility: Since irrevocable trusts cannot be altered, they lack flexibility once established. The terms the couple sets when creating the trust cannot be changed easily.
- Loss of control during divorce: Critically, if a couple divorces after establishing a SLAT, the grantor may lose all control over and income from the gifted assets.
This last point is the heart of the so-called SLAT divorce trap.
How to Address a SLAT in Your Split
The most effective way to prevent a SLAT from becoming a problem during a divorce is to structure it carefully when you establish it. In many cases, it’s possible to avoid losing control over SLAT assets if the original trust is clear that the recipient spouse only remains a beneficiary as long as they stay married to the grantor.
But what if you already have a SLAT in place? That’s when things get more complicated. A poorly written spousal lifetime access trust can result in the grantor remaining on the hook for income taxes on the assets while losing indirect control and income from them after divorcing.
However, there are potential solutions. Depending on the language of the trust documents and your circumstances, it may be possible to address the tax liability by setting up a postnuptial agreement, decanting the trust, or negotiating during your divorce settlement. However, none of these solutions is guaranteed. If you have a SLAT in your divorce, you should contact an experienced high-net-worth divorce attorney to discuss your situation. The expert lawyers at Kaspar & Lugay LLP can help you understand your options and choose the best solution for your finances. Learn more about how we can assist you during your divorce by scheduling your consultation with our Marin County law firm today.
