The SLAT Series, Part I: Estate Tax Credit Mechanisms

Examining common problems with spousal lifetime access trusts

Executive Summary: Spousal lifetime access trusts (SLATs) create a great vehicle to use the portion of the basic exclusion amount which might get lost after the sunset of the TCJA, especially in the face of current and proposed anti-clawback regulations. The SLAT may address one of the biggest issues with lifetime gifts - loss of subsequent benefit from transferred assets - by allowing a grantor spouse to indirectly benefit from the SLAT through a beneficiary spouse. But, there are several tax and non-tax risks and trade-offs inherent in the creation, structuring, funding, and administration of SLATs which will be covered in later articles.

Over the past decade or so, we have faced a unique estate tax planning environment. The specter of reduction of the estate tax basic exclusion from its currently-high level of $13,610,000 (the inflation-adjusted amount for 2024) to one-half of the 2026 inflation-adjusted amount, due to the sunset of the basic exclusion, has resulted in a push to make lifetime gifts that use more than the one-half portion of the basic exclusion that might go away.

Why do you have to use more than one-half of the basic exclusion? To answer that question, you need a bit of a lesson on how exactly the basic exclusion works under current law, current regulations, and proposed regulations. I will cover that below, but first I want to turn my attention to a gifting vehicle commonly used by married couples for lifetime use of the basic exclusion amount - the spousal lifetime access trust, or SLAT.

Intro to SLATs

This will be the first of a series of articles on SLATs, the others of which will be behind a paywall as part of my new subscription offerings, dealing with some of the nuances and issues that often pop up when creating and administering SLATs.

To understand SLATs, you must understand the problem they solve. Traditionally, lifetime wealth transfers had the primary purpose of freezing the estate tax value of transferred assets. This was usually accomplished by either a gift, or a sale (to a grantor trust) in exchange for a promissory note for cashflow-producing assets. In the case of a gift, the eventual estate tax calculation would include in adjusted taxable gifts the date-of-gift value of assets (in lieu of using date-of-death value). In the case of a sale, the eventual estate tax calculation would include unspent proceeds of installment payments and interest, and/or the balance of the promissory note valued as of date-of-death.

The outcome is that, in either case, future income and appreciation in the value of property is removed from the estate tax base - hence the “freezing” of value. In the case of a sale for a promissory note, the freeze would not be absolute, as interest on the note balance would be part of the gross estate. But, this estate tax saving effect of this freeze strategy could be bolstered by the possibility of a discount on gifted/sold assets, as well as the depletion of the estate using rate arbitrage by the payment of income tax by the grantor on behalf of a grantor trust (a result condoned by Rev. Rul. 2004-64).

I will discuss the grantor trust tax payment strategy, and its possible pitfalls, in a later article. But, this strategy recognizes that the combined federal and state income tax rate might be less than the maximum estate tax rate in many circumstances. So, while payment of tax is not eliminated, the effective tax rate is lowered when choosing to pay income tax on the frozen/shifted grantor trust income instead of estate tax. Of course, this effect cannot be examined in a vacuum - exposure to estate tax is the ticket to entry for a step-up in basis in appreciated assets at death, and transfers to grantor trusts do not automatically qualify for a step-up in basis at the grantor’s death as I explained in this article.

These three goals - (1) freeze, (2) squeeze (through valuation or time-value-of-money discounts), and (3) burn (through payment of income taxes on behalf of a trust or even lifetime payment of gift tax) - formed the backbone of estate tax planning beyond implementation of the basic tax planning will/revocable trust. That is, until the possibility of a reduction of the basic exclusion amount came into play. With this possibility, lifetime use of the exclusion became a fourth, and more recently a primary, goal of lifetime wealth transfers.

Understanding how will require a dive into the estate tax credit mechanism, which is often misunderstood and thus explained in (perhaps greater than needed) detail below. But, when examined in isolation, lifetime use of exclusion can be accomplished without an estate tax freeze, and possibly without a squeeze or burn. This is important, because lifetime transfers for freeze purposes often create a permanent loss of access to the use, enjoyment, benefit, or income from transferred assets.

Why? Because of a series of Code Sections - 2035 through 2038, and even 2040 and 2042 - which effectively ignore lifetime transfers for estate tax valuation purposes in cases where the decedent has made a lifetime transfer of ownership on paper, but economically has retained economic or control rights over transferred property. The outcome is a loss of the freeze and possibly squeeze, as previously-transferred property is valued at its date-of-death fair market value as if the decedent owned it at death as a result of the application of these Code Sections.

With a high exclusion amount, this creates a conundrum. Individuals with estate tax potential feel the need to use some exclusion before they lose it (explained in greater detail below), but without the loss of access to assets for the substantial gift levels needed to use the one-half portion of the exclusion that may be lost. This is indeed possible, although subject to some proposed anti-abuse rules discussed further below, but the trade-off for most direct and indirect access is a loss of the freezing of estate tax value.

For married couples, this is where SLATs come to the rescue. In effect, a SLAT is the lifetime equivalent of the irrevocable trust often set up under an estate plan for use of remaining exclusion at death, often called a credit shelter trust, bypass trust, or family trust. The SLAT is set up primarily for a spouse, but often also for children and descendants, with the intent of using some or all of an individual’s basic exclusion amount for gifts to the SLAT. The trade-off of loss of access and control to gifted assets is somewhat tempered by the possibility that distributions to the beneficiary spouse could indirectly benefit the grantor spouse.

This allows for lifetime use of exclusion, coupled with indirect access to gifted assets through a spouse without running afoul of Code Section 2036 - thus preserving the freeze and squeeze goals of traditional lifetime transfers of wealth. Likewise, as I will explain in a later article, the SLAT is usually a grantor trust, allowing for an income tax burn (sometimes bolstered by the spouses filing jointly). But, as I will explain in another article, the termination of the marriage (by divorce or death) can cut off the grantor spouse’s access to the trust while also creating unexpected income tax, property settlement, and maintenance determination outcomes.

The risk of SLATs is bolstered when each spouse creates a SLAT for the other. In such a situation, there is a possibility of the IRS treating the SLATs as reciprocal depending on the timing, funding, and similarity of each SLAT. The outcome is that the identities of grantor spouse and beneficiary spouse under each SLAT are uncrossed, leading to a determination that each SLAT is effectively self-settled for estate tax purposes (and possibly even for state law creditor protection purposes). On the estate tax side, the outcome is a loss of the freeze and squeeze by causing SLAT assets to be valued at date-of-death for at least the first spouse to die. Reciprocal SLAT issues will be discussed in a separate article in this series as well.

As introduced below, there is a risk that reciprocal uncrossed SLATs could also run afoul of proposed anti-clawback regulations.

Having examined SLATs and their benefits, trade-offs and risks from a 30,000-foot level, I thought it would be helpful to consider the broader picture of why the sunset of the estate tax basic exclusion is such a huge deal now.

Estate Tax Credit and Clawback

The estate and gift tax applicable exclusion amounts are highly misunderstood. Many people view them in the nature of a deduction, or floor beyond which the 40% maximum gift and estate tax rates kick in. However, this is not correct. Instead, the applicable exclusion amount is applied as a tax credit against gift/estate tax, known as the applicable credit. The outcome is similar in many cases to the math involved in a floor/deduction analysis, but not always.

Here is a quick overview, but to create some context for the image, I will explain it over the next several paragraphs:

(And yes, I know I am probably missing some parentheses to isolate functions so this is not perfect under order of operations.)

To understand why we use a credit mechanism instead of simply subtracting the exclusion from net values, you must first understand that gift and estate tax rates are progressive. The reason we use 40% in most cases is because the bracket for 40% kicks in over $1,000,000, which is under the exclusion amount anyway. The outcome is that gift/estate taxes are, under the current brackets and rates, only ever paid out of pocket on cumulative wealth transfers that would fall into the 40% bracket anyway.

To further understand why, it also helps to understand the dual and unified purposes of the gift and estate taxes, and the possibility of rate fluctuation.

In a world with only an estate tax, it is easy for someone during life - even on their deathbed - to avoid the estate tax by giving everything away. The gift tax is designed to avoid this outcome.

On a separate note, where rates are progressive or change over time, the tax value of the exclusion changes as well. If we treat the exclusion as a deduction or subtraction from the total value of transfers during life or at death, it becomes much more valuable at higher gift/estate tax rates than at lower rates.

As a result, both of these possibilities are combined into the gift and estate tax to create a unified system that, outside of time-value of money, neither incentivizes nor disincentivizes transfers during life versus at death. This also leaves open the possibility for Congress to change gift/estate tax rates, without also causing this rate change to similarly incentivize or disincentivize the timing of wealth transfers nor causing prior wealth transfers (especially those at higher rates) to be punished.

To achieve this outcome, the calculation of gift and estate tax is always cumulative. What this means is that there is always a running score on total gifts made during life, which also carries over to the estate tax return as the final reconciliation of total transfers. This total is based on the fair market value of each transfer, valued as of the date of transfer for lifetime gifts and the date of death (or alternate valuation date) for the net of whatever remains at death.

This also means that the applicable exclusion amount (but not the annual exclusion - a subject for another time) is applied as a credit instead of as a deduction. By doing so, the timing-neutral nature of wealth transfers is maintained in the face of tax rate differences and fluctuations.

In the case of the gift tax, this is determined by adding current-year taxable gifts to prior years’ cumulative taxable gifts, and then determining a tentative tax on this amount (and then subtracting tentative tax on prior years’ cumulative taxable gifts). The applicable exclusion is a credit against this tentative tax, determined by plugging the applicable exclusion into the gift and estate tax rate table. In other words, the total credit is the amount of tax that would be due on a transfer equal to the exclusion amount.

Then, at death, the estate tax is calculated on the sum of two tax bases. The first is the taxable estate, which is the gross estate (valued at date-of-death or alternate valuation date) minus deductions. The second, known as adjusted taxable gifts, reflects cumulative taxable gifts (valued at date-of-gifts), but decreased by any property pulled back into the gross estate under the aforementioned Code Sections 2035-2038, 2040, or 2042 (which reintroduces post-gift appreciation, and possibly prior valuation discounts, to the gross estate). The tentative tax on these two tax bases is offset by the applicable credit, along with other possible credits such as the prior transfer credit.

In the rare case that gift tax is paid out-of-pocket during life, it is recalculated using rates in effect at death. If the gift tax that “would have” been paid in the form of estate tax at death is lower than the gift tax paid during life, a credit is given for this disparity as well - reflecting the intent not to punish lifetime wealth transfers taking place at a time where gift/estate tax rates were higher.

The outcome is that exclusion is never truly “used” in the traditional sense - it always applied as a full pending credit based on whatever exclusion is created under law in the year of transfer or death, but “use” is reflected in its iterative application to cumulative wealth transfers.

The gift and estate tax rates start at 18% for cumulative transfers of up to $10,000, ending up at a rate of 40% for cumulative transfers over $1,000,000. This top bracket, where most tax calculations will be made, expresses the tax as $345,800 on the first $1,000,000, plus 40% on the excess over $1,000,000. This $345,800 figure represents the effective tax under the progressive brackets for transfers up to $1,000,000, essentially riding up the rates from 18% to 39%. The rates and brackets for the year of calculating transfers is always used - even if the rates change year to year (which they have not in a long time but this should still be acknowledged).

And, importantly, these progressive rates kick in from $0, not from the exclusion threshold. The outcome is that you never truly pay gift/estate tax out-of-pocket in any bracket other than the 40% bracket. But, at the same time, your “effective” estate tax rate reflects the credit - meaning that the total gift/estate tax out-of-pocket as compared to the net tax base only approaches, but never exceeds, a 40% limit.

To illustrate this calculation, it helps to use this rate table to determine our applicable credit. Let’s take the 2024 basic exclusion amount of $13,610,000. Essentially, the applicable credit is $345,800 + ($12,610,000 x 40%), or $5,389,800. Why did I use $12,610,000? Because $345,800 represents tax on the first $1,000,000, meaning that you must subtract that first $1,000,000 before applying the 40% rate to the balance.

Now, before I move on, it is helpful to consider that the applicable exclusion is composed of two elements. One is the basic exclusion amount, which is the $13,610,000 amount given to every individual U.S. citizen or resident. The other, which is usually only seen in the case of a widow, is the deceased spousal unused exclusion amount - effectively, this is the unused basic exclusion amount of a deceased spouse preserved for a surviving spouse through a portability election.

I bring that up to note that it is only the basic exclusion amount that is affected by the sunset, and by the anti-clawback regulations, that I am about to discuss.

So, what is the sunset? It is the recognition that the tax law changes implemented by the Tax Cuts and Jobs Act of 2017 (the TCJA) only had a 9-year shelf life. On the side of the basic exclusion amount, this is an amount that is adjusted for inflation each year for years after 2011. This inflation adjustment is applied to a base of $5,000,000. However, the TCJA doubled this base to $10,000,000 before application of inflation adjustments for years 2018-2025. The TCJA also tweaked the method of determining the inflation adjustment. The outcome is that, on January 1, 2026 (barring Congressional changes before then), the pre-inflation base of the basic exclusion amount will be reduced back to $5,000,000. After inflation adjustments, the post-sunset basic exclusion amount will probably end up north of ~$7,000,000.

Similarly, back in 2012, there was a proposed sunset of the basic exclusion back to $1,000,000, with an increase to the maximum estate tax rate from 40% to 55%. This created a conundrum. What if, for example, someone were to gift $5,000,000 during life? If they died post-sunset, would their applicable credit be based on the reduced $1,000,000 basic exclusion? To do so would seem to run contrary to the tax neutral balance that seems to be the goal between the gift and estate taxes.

To counter this, Code Section 2001(g)(2) was added to allow publication of Treasury Regulations addressing this disparity. This Code Section clarifies that the tentative tax on the tax base, and applicable credit, are always calculated based on the gift tax rates in effect for the year of calculation. But, in the case of the applicable exclusion, it leaves room to calculate the credit based on the applicable exclusion from the year of a gift.

As a result, this removed some of the risk of a clawback of any exclusion amount used during life. But, the $5,000,000 exclusion was made permanent at the end of 2012, eliminating the need for clarification or regulations on this clawback mechanism - at least until the TCJA came along and created a new possibility of exclusion reduction.

Anti-Clawback Regulations - Final, and Proposed

In 2020, we finally received the awaited regulations. Treas. Reg. 20.2010-1(c) now generally clarifies that the applicable credit against estate tax will be based on the greater of (1) the applicable exclusion amount available under law at death, or (2) the applicable exclusion amount actually used as applicable credit against gift tax on lifetime cumulative taxable gifts.

So, while it has taken a long, meandering path to get here, this is why I brought up the point about using more than one-half of 2025 basic exclusion for lifetime gifts if you want to avoid losing some exclusion post-sunset.

Let’s say, post-sunset, the basic exclusion is $7,200,000, also meaning a loss of $7,200,000 of pre-sunset basic exclusion. Let’s also say that, during life, you gift away $5,000,000 and use that amount of exclusion as applicable credit against that lifetime gift. If you die post-sunset, your applicable credit against estate tax would be based on the higher of these two amounts. But, the higher amount will be the post-sunset $7,200,000 basic exclusion. The outcome is that your lifetime gift of $5,000,000 did not move the needle. Why? Because the $5,000,000 exclusion you actually used was less than the $7,200,000 portion that went away.

The outcome is that lifetime gifts for purposes of avoiding loss of the record-high exclusion are ineffective unless they exceed the one-half portion that will go away. Even then, they are not fully effective unless they use the entire portion of the exclusion that may go away. In other words, unless you gift $13,610,000 plus whatever added basic exclusion is received as an inflation adjustment in 2025, the “greater of” formula under the anti-clawback regulations is not maximized.

There is a problem, however. Not everyone can afford to part ways with an entire $13,610,000. This raised a question in the minds of a few practitioners who commented on the first round of proposed anti-clawback regulations before they were made final. That question was whether it might be deemed abusive to make a gift that uses lifetime basic exclusion, but which is intentionally structured to maintain benefit and control over gifted assets until death such that they get pulled back into the gross estate?

In other words, if you intentionally make a gift on paper that will avoid the freeze and squeeze by virtue of getting pulled back into the gross estate under Code Sections 2035-2038, would you still get to use the “greater of” formula at death to determine applicable credit against estate tax based on assets that were, functionally, taxed in the gross estate as if they had never actually been transferred during life?

Under a second round of proposed anti-clawback regulations, the answer is no. In other words, if you were to set up a trust for yourself with the remainder to others, this is a valid, completed gift to the other beneficiaries that is subject to gift tax (without reduction for your retained interest under Code Section 2702) and thus uses your exclusion as applicable credit against gift tax. But, if these proposed regulations are finalized, the exclusion used for this lifetime gift could not be claimed as applicable credit against estate tax.

Interestingly, this set of proposed anti-clawback regulations would not apply to lifetime transfers that use the DSUE. In terms of ordering, however, you would have to use your DSUE before dipping into your basic exclusion. If you needed to get there, you could create a trust for yourself - which I termed the “DSUE GRIT” in this video - without losing the benefit of DSUE applied during life as applicable credit against estate tax. This could also be a useful hedge against loss of a previously-deceased spouse’s DSUE if you remarry, and are unlucky enough to be widowed a second time (which ordinarily would result in the loss of the unused portion of the DSUE from the first deceased spouse).

Which brings us full circle, after this extensive lesson on gift and estate taxes, to the true utility of the SLAT.

SLAT and Anti-Clawback

If the goal is to make lifetime gifts to use the portion of the basic exclusion that might go away, without running the risk of clawback of this portion of the basic exclusion, the SLAT may be the optimal vehicle to maintain indirect access to the trust assets so long as you are married. And, as some thought leaders have discussed, it may even be possible to build in a “floating spouse” provision - allowing a grantor to regain indirect access through a new beneficiary spouse in the event of remarriage.

If you are worried about Code Section 2036 inclusion through this indirect access, there is some precedent for avoiding such an outcome. For example, in Rev. Rul. 70-155, the IRS noted that a transfer of a residence from one spouse to another may not create an express or implied understanding of continued enjoyment under Code Section 2036 even if the donor spouse continues to live there. (In fact, some thought leaders have cited this and follow-up rulings for the proposition that a residence could even be transferred to a SLAT without running afoul of Code Section 2036, even if the grantor spouse continues to occupy the residence rent-free.)

So, with a SLAT, it’s all sunshine and rainbows right? In the words of Lee Corso, “Not so fast, my friend.” As I will examine in this series, there are tons of pitfalls and trade-offs with the use of SLATs, some of which I mentioned in the intro to this article. And, there are also opportunities which you must be intentional about building in from the outset, because they can be difficult to add later depending on the state in which the SLAT is administered.

So, stay tuned - both for more on SLATs, and more on the new subscription portion of my newsletter. The series on SLATs, and other pending courses and series (including a comprehensive review of the “why” behind practically every type of trust that is part of traditional or modern U.S. estate planning), will be part of a monthly subscription to launch in 2024. But, don’t worry - I will still have plenty of quality free content, such as this article and the intros to most series.

For the next article in this series, click here.