Shenkman Law
- -For clients whose wealth may compound in excess of the estate tax exemption, with or without an extension of the bonus exemption amount in 2026, shifting wealth into SLATs, so long as sufficient access is maintained, did and will continue to make sense for many clients.
- -A SLAT can give a formula general power of appointment (“GPOA”) to an elderly family member with a modest estate so that some portion of the assets in the SLAT can be included in that senior family member’s estate for an income tax basis step up (so-called “upstream planning.”).
- -A SLAT, like any irrevocable trust, can provide asset protection planning, and that will remain important for most clients regardless of the Republican impact on the estate tax system.
- -SLATs can be structured as non-grantor trusts to reduce or avoid state income taxation.
Is Solving the Reciprocal Trust Issue Jumping from the Frying Pan into the Fire?
This article was originally posted on Steve Leimberg’s Business Entities Email Newsletter Archive Message #3174.
SLATs Have Been and Will Remain a Popular Technique
With the Republican sweep in the 2024 election, there is uncertainty over whether the long talked about reduction of the estate tax exemption from $13,990,000 to about $7 million will in fact occur. Planning for this reduction had been the focus of many if not most estate planning conversations for years. That was a mistake because Spousal Lifetime Access Trusts (“SLATs”) or any of the variations of that technique can provide other important planning benefits.
So, regardless of whether the bonus exemption is extended or not, non-reciprocal SLATs have been and should remain a common planning tool.
Differentiating SLATs to Avoid the Reciprocal Trust Doctrine
For married couples, planning has often relied on, and as discussed above will continue to rely on, the use of non-reciprocal SLATs. A key issue practitioners are cognizant of with SLAT planning is the risk of the reciprocal trust doctrine. If the IRS or a creditor asserts that two distinct SLATs are too similar, or “reciprocal,” those trusts can be uncrossed. That means treating the husband’s trust he created for his wife as if the wife created it, and vice versa. That would result in a self-settled trust that could be included in the beneficiary/spouse’s estate and reachable by her creditors.
To endeavor to counter such a challenge practitioners have often incorporated differences into each trust. What differences should be built into each trust to make it sufficiently different. The case law on this doctrine is limited and, as much as practitioners wish, does not provide for bright line rules. Thus, judgment calls as to what quantum of differences are necessary.
One such difference could be significant time between the creation of each SLAT, but that has often not been possible because of concerns about impending law changes. Other differences may be different distribution provisions, withdrawal rights and powers of appointment. Sometime practitioners create a list of such differences that they believe might be adequate to deflect a reciprocal trust challenge. Those differences might suffice to deflect a reciprocal trust challenge that could torpedo the entire plan. In the Grace case, a key case addressing the reciprocal trust doctrine, the Court stated that trusts would be reciprocal if the SLAT plan “…leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.”[ii] Financial modeling of just the impact of a 5/5 power below illustrates how different the economics of just this one common drafting difference can have on the economics of the two SLATs as to the possible application of the reciprocal trust doctrine. The results are not a suggestion that merely using a 5/5 in one SLAT and not in the other will suffice to deflect a reciprocal trust challenge. The point is merely to consider the financial impact of differences being considered to address the litmus test of whether the parties are “…in approximately the same economic position.”
But there may be substantial economic risks that those same differences might create. Quantification of the possible impact may more clearly demonstrate what the real economic effects of these seemingly mere technical differences actually mean. Several of the commonly used techniques to differentiate SLATs will be discussed below and illustrated to demonstrate the perhaps surprising and substantial economic impact that they can have on the clients.
Economic Impact of SLAT Drafting Differences
What might it look like if one common drafting difference, the 5/5 power, is used? A “5 and 5 Power” gives the powerholder, in our illustrations the wife, the right to withdraw the greater of $5,000 or 5% of trust principal each year from the trust. IRC Section 2514(e). That odd sounding formula is based on a tax law provision that provides that so long as the powerholder cannot withdraw more than these parameters the assets of the trust will not be included in her estate by virtue of such a power.
But there is a flip side to this consideration that also must be considered. What might it look like if in this common such drafting difference, the 5/5 power is incorporated into a SLAT but is actually used by the beneficiary spouse holding this withdrawal right? What might be an economic difference to argue to the IRS to deflect a reciprocal trust challenge, may be a real economic difference that has a significant impact on the parties. In a blended marriage, which is common, this could be a real issue. It is likewise an issue with longevity if one spouse has a long over life (years after the death of the first spouse) or disability of the settlor spouse, and exercises the 5/5 power.
For example, the wife might have chosen not to exercise her 5/5 power while the husband was alive and competent, but may feel comfortable doing so when the husband has become incapacitated or dies. Thus, clients are caught between the proverbial “rock and a hard place.” The more differences that are incorporated into their SLAT plan to address the reciprocal trust doctrine, the greater the risk that their intended dispositive intent is altered.
So, clients need to understand that drafting differences to differentiate SLATs for purposes of the reciprocal trust doctrine can have real economic meaning. Second, when practitioners are trying to determine what differences might be required to differentiate SLATs, some of the commonly used drafting differences can have a profound impact. While simplifying assumptions will be made in the two hypothetical illustrations following, each will illustrate the potential power (which as above could be positive or negative depending on which lens it is being viewed from) of two of the changes. Other SLAT differences could similarly be evaluated.
Divorce of the spouses where one or both create SLATs also can have profound economic impact. Even post-divorce the settlor/spouse may remain liable on the income taxes on SLAT income that may continue to benefit the ex-spouse. Also, depending on the terms of the trust the ex-spouse may remain a beneficiary, perhaps a floating spouse clause might be used, or perhaps the SLAT mandates division in the event of divorce. While these and other matrimonial impacts could be material, they are not the addressed in more detail in this article.
Here is the fact pattern we used for this illustration.
– -Husband and wife are each 62.
– -This is the second marriage for each of them.
– -They each have children from their prior marriages.
– -They each use $10MM to set up SLATs.
– -For illustrative purposes, we assume no distributions to any of the children are made from either SLAT.
– -The illustration compares three cases. In all cases, wife dies at age 70 and husband dies at age 90.
– -In case 1, the SLAT for each spouse is the same.
– -In case 2, wife has the power of 5/5 and uses it during her lifetime to favor her children from her prior marriage. Husband has no special withdrawal powers which is a common approach used to differentiate SLATs so he cannot exercise a comparable economic power.
– -In case 3, wife has the power of 5/5 and uses it during her lifetime to favor her children. Husband has a limited power of appointment which he uses after her death to favor his children.
– -For illustrative purposes, we ignore the impact of gift taxes in case 2 and 3.
– -Investments are assumed to be invested identically in a diversified portfolio with an average return of 5.73%.
Husband and wife are each 62.
– -This is the second marriage for each of them.
– -They each have children from their prior marriages.
– -They each use $10MM to set up SLATs.
– -For illustrative purposes, we assume there are no distributions to any of the children from either SLAT.
– -Husband dies at age 70 and wife dies at age 90.
– -After husband dies, wife uses her power of 5/5 during her lifetime to favor her children from a prior marriage.
– -For illustrative purposes, we ignore the impact of gift taxes.
– -Investments are assumed to be invested identically in a diversified portfolio with an average return of 5.73%.
Analysis of the Illustrations
The wife’s exercising her 5/5 power after H dies for the remaining 20 years of her over life is a gross (pre gift tax) wealth transfer, inclusive of investment returns on that amount of approximately $17 million out of a total wealth transfer of approximately $51 million. That is approximately 33+% of the overall wealth transfer. First, this possibility could worry some clients sufficiently to avoid using this mechanism to differentiate each SLAT from the other. The magnitude of this is so material is it possible to say that the parties were left in the same economic position after the SLATs as before? Even more so, what if husband made gifts of his assets to the wife for her to fund her SLAT (the step-transaction doctrine would obviously be another issue to address). Look at the impact of this? And further, consider that the wife could legally begin the exercise of her 5/5 power, not after her husband died, but immediately after the funding of the SLAT husband created for her. Is it reasonable to suggest that this one difference of the 5/5 power between the two trusts does not differentiate them?
If the clients are uncomfortable using a 5/5 withdrawal power after realizing the economic impact it could have what might be done? Perhaps, the power could be constrained but that might make the purported difference appear ineffectual. Other differences might be used instead, but those differences may also have economic implications that with forecasting the client may determine that they are not comfortable with. Commentators have suggested that having time between the creation of each SLAT may differentiate them. Given the Republican sweep it is perhaps reasonable to assume that there will be no restrictive or harsh estate tax changes for four years. That provides an opportunity to leave substantial time between each SLAT to enhance that potential difference.
Conclusion
The risk of a reciprocal trust doctrine attack on a non-reciprocal trust doctrine plan is always a possibility. Unfortunately, there are not bright line tests on what power or aggregation of powers might suffice to deflect such an attack. The simplified examples in this newsletter have demonstrated that the 5/5 power and a power of appointment can have what appears to be material impact on the economics of the non-reciprocal trust plan. Nonetheless, each client will have to determine what magnitude of difference, and which specific differences, they might be willing to include. Further, practitioners might warn clients that the drafting differences to address the reciprocal trust doctrine in fact can have real, even dramatic, economic impact.
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