The SLAT Series, Part IV: Forward-Looking Application of IRC Section 2036

How do circumstances at the time of funding a SLAT, their foreseeability, and marital synergies affect the bona fides of transfer tax planning?

This is the fourth installment of a comprehensive overview of spousal lifetime access trusts, or SLATs. For a series index and the first article in this series, click here. For the prior article in this series, click here.

Table of Contents

1. Intro

2. The True Cost of 2036 Inclusion

3. Express or Implied Understanding

   1. Income Tax Exposure

   2. Estate Tax Exposure

   3. Time of Funding Versus Time of Distribution

4. Anticipated Distribution Strategy and 2036

5. Key Takeaways and Conclusion

Intro

In prior articles in this series, we indirectly discussed both a benefit and curse of SLATs: the potential to overfund them.  This is compounded by (1) a recent tendency to myopically focus on the potential sunset of the basic exclusion amount, and (2) the mathematics of the anti-clawback mechanism under Treas. Reg. 20.2010-1(c).  Combined, as mentioned in this video on planning for the sunset, this means truly moving the needle post-sunset requires a lifetime gift of not just the one-half of the exclusion that might go away, but instead the entire basic exclusion. 

Few, if any, couples can afford to have one of them – much less both of them – gift away >$13,610,000 each.  (I say greater than, because the sunset will take into account two more inflation adjustments – one on a $10,000,000 base in 2025, and another on a $5,000,000 base in 2026.)  In the first article in this series, I argued that SLATs are perhaps the safest way to accomplish this.  But, SLATs are not risk-free.  One major risk is the application of IRC Section 2036(a).

(In this vein, I will be punting the reciprocal trust issue.  Before even tackling reciprocal trusts, certain economic fundamentals discussed herein must be addressed.)

This risk, to be further explained below, may not seem significant under current law and Regulations.  The quantified risk is often assumed as re-inclusion of the post-death growth in value of one SLAT in the gross estate of a (deceased) grantor spouse, with an added benefit of a step-up in income tax basis for appreciated assets.  This risk is further reduced when such growth is depleted by distributions to the beneficiary spouse (which could reflect joint expenses of the married couple).  It is in this pattern of distributions, however, that we find some of the central issues.  These central issues are compounded where each spouse sets up a SLAT for the other, which will not be the focus of this article as noted above. 

One area where the planning public has been criminally underserved is in what to do with SLATs after they have been implemented.  As articulated to me by an advisor a few years ago:

My clients just completed a bells-and whistles tax plan, including charitable planning and SLATs.  But, now they have simple questions such as where to fund payments for groceries.  Now that the ink has dried, they can’t get their attorney to address these questions without paying $700 per hour.

The problem, however, might not be the attorney.  Capacity of representation and potential conflicts aside (between married couple, grantor of SLAT, and trustee of SLAT – each of which presents a separate issue), many tax planners have a subconscious realization that facts and circumstances matter.  The optics of a SLAT arrangement may carry as much, or even more, weight than the actual structure of the SLATs.  Indeed, the manner of administering SLATs can create issues.  And, if the issues weren’t muddy enough with joint representation in this situation, it may even be the case that a spousal trustee of a SLAT needs their own independent representation in that fiduciary capacity.  Both the potential for distributions at the time of SLAT funding and the actual distributions after SLAT funding can trigger gross estate inclusion for the grantor spouse – thus creating a conflict between not just the grantor spouse and beneficiary spouse, but also the beneficiary spouse (especially as trustee) and remainder beneficiaries. 

The True Cost of 2036 Inclusion

While not yet final, a number of practitioners (myself included) have written and spoken extensively about proposed Treasury Regulations relating to the anti-clawback mechanism described above. 

What is settled under current law is the anti-clawback formula.  If the sunset does indeed occur, the applicable credit against estate tax will be based on the greater of (1) the applicable exclusion granted under law at death, or (2) the applicable exclusion amount actually applied to lifetime gifts during life.  It is this greater-of formula which leads to the mathematical assumption that we must gift away more than the reduction in the basic exclusion amount at the time of sunset in order to effectively use the portion of the exclusion which might go away. 

But, there is a problem under the proposed Regulations.  If 2036 applies to cause gross estate inclusion of assets gifted during life, then the lifetime use of basic exclusion to fund that gift could be ignored under this greater-of formula. 

This means our risk calculus for SLATs extends not just to estate tax on post-gift appreciation (to the extent not depleted by distributions), but also possible estate tax on the portion of the basic exclusion used to fund the SLAT if the sunset occurs (which is not correlated to distributions unless the SLAT is fully distributed to the beneficiary spouse – in which case we commit the cardinal sin of applying both spouse’s basic post-sunset exclusions to the same assets). 

So, anticipated and actual distribution strategy is in the driver’s seat of this outcome.  We must look to both the circumstances existing at the time of funding a SLAT, and changed circumstances that affect the administration of the SLAT.  This article focuses on some of the forward-looking factors at the time of funding the SLAT that often fly under the radar. 

Express or Implied Understanding