SLAT: A flexible tax reduction strategy

SLAT benefits:

• Lifetime access to cash. A SLAT differentiates itself from a standard ILIT by providing the spouse access to life insurance cash value during the spouse’s lifetime. If properly structured, cash flow, by way of policy loans and withdrawals, is received income tax-free (IRC Section 72(e)).

• Flexibility. The spouse can access cash for living needs.  There is also the potential to “unwind” the gift by way of lifetime distributions to the spouse.  In some cases, through lifetime access, the spouse-beneficiary will be able to recover more than the amount gifted to the SLAT.

• Tax-free death benefit. A properly drafted and funded SLAT passes the death benefit free from estate and income taxes. Depending on underwriting factors such as age and health, no other asset can match the tax-free leverage of life insurance.

• Estate liquidity.  The tax-free death benefit (IRC Sec. 101(a)) paid to a SLAT provides cash for any number of liquidity needs such as estate taxes, income taxes and final expenses. By providing estate liquidity, a SLAT may help prevent a forced sale of family assets.

• Creditor protection. When making gifts to a SLAT, the grantor gives up complete dominion and control over the gifted funds, irrevocably. Therefore, assets held in a SLAT, including life insurance, are insulated from the grantor’s creditors.

• In addition, assuming the SLAT includes a spendthrift provision, the beneficiary’s creditors would generally be barred from invading the trust. Protection from creditors generally applies to both policy cash value and the death benefit. (Creditor protection laws vary by state and are complicated. Individuals should consult with an asset protection specialist to see how creditor protection laws may apply to particular circumstances.)

• Ongoing tax-free gifts. Because most SLATs are grantor trusts, the grantor is responsible for any income taxes payable, ensuring that trust assets will not have to be invaded. Income taxes paid by the grantor are, in essence, additional tax-free gifts to heirs.

• State estate tax reduction. Twenty one states currently have state estate and/or inheritance taxes and most of them have exclusion amounts well below the federal exclusion. The discrepancy can be large. For example, in 2014 the federal estate tax exclusion was $5.34 million versus $675,000 for New Jersey. By funding a SLAT during lifetime (as opposed to a bypass trust at death) couples are able to avoid an estate tax exclusion “discrepancy,” saving hundreds of thousands of dollars in state estate taxes, where applicable. 

Planning considerations

• The grantor cannot have direct access. To avoid “incidents of ownership” in the life insurance policy (as governed by IRC Section 2042), the grantor must not be a trust beneficiary and cannot have direct access to trust assets, including life insurance cash value.  This ensures that the life insurance death benefit is removed from the grantor’s estate.

• Happily married. There is risk that the spouse could refuse to share trust distributions with the grantor. Also, in the event of divorce, the spouse access provision will generally terminate. Therefore, a happy marriage is a prerequisite to creating a SLAT.

• Spouse as trustee. It is not recommended that the spouse serve as trustee. There is an increased risk that trust assets could be brought into the spouse’s estate for estate tax purposes. However, it is not prohibited. If a spouse serves as trustee, he or she must be vigilant to limit distributions to “ascertainable standards” such as health, education, maintenance and support (the HEMS provision). 

• Reciprocal Trust Doctrine. The SLAT concept is so powerful that many married couples set up SLATs for each other. However, if spouses set up “mirror image” trusts to benefit each other, the assets may be brought back into their taxable estates because the couple’s economic position has not changed. Many courts refer to this as the reciprocal trust doctrine. To avoid application of the doctrine, the trusts may differ in: (1) timing — trusts established at different times; (2) funding — different assets may be used to fund the SLATs; and (3) beneficiaries — the SLATs can name different remainder beneficiaries.

• Predeceased spouse. If the spousal beneficiary predeceases the insured, lifetime access to cash terminates. To protect against the risk of a predeceased spouse, life insurance should be purchased on the life of the spouse to protect against the risk of loss. The life insurance could be personally owned or owned by a third party such as a trust (but see, reciprocal doctrine above).

• Modified endowment contract (MEC). Properly structured life insurance policy withdrawals are received first as a recovery of basis followed by gains (FIFO tax treatment). This tax advantaged access is one of the hallmarks of permanent life insurance, but life insurance characterized as a MEC does not receive the same tax treatment. Gains are taxed first, followed by basis recovery (LIFO tax treatment). With a MEC, it makes no difference whether the cash distribution is characterized as a policy withdrawal or loan. Therefore, it is generally not recommended that a SLAT own life insurance characterized as MEC.

The SLAT is creating a great deal of positive buzz for good reason: It combines the estate tax savings of an ILIT with lifetime access to tax-advantaged cash value. It’s a powerful combination worth investigating.

See also:

Dealing with out-of-state property issues in estate plans

The politics of repealing the estate tax

8 uses for life insurance that most consumers are clueless about

What (and why) you need to know about digital estate planning