Gift Planning Flexibility with SLATs SPATs and DAPTs

Tax News You Can Use | For Professional Advisors

December 23, 2024

If we believe the car commercials, now is the season of giving. And putting aside holiday presents, making gifts is a subject that has been top of mind for estate and tax planners as the deadline for the sunset of the Tax Cuts and Jobs Act (TCJA) at the end of 2025 approaches. Taxpayers with estates worth more than $7 million ($14 million for a married couple) have faced growing pressure to make taxable gifts before the scheduled sunset. There currently is hope and speculation that the incoming administration will make good on its campaign promise to extend or make permanent the provisions from the TCJA, including the bonus estate and gift tax exemption, which would alleviate this pressure. However, making lifetime gifts to use the exemption can be an important tax planning tool even without the sunset because the future appreciation on the gifted assets can be excluded from the donor’s taxable estate.

Concern About "Over-Giving"

An issue for many families, however, is that a taxpayer must make cumulative taxable gifts in excess of the $7 million basic exemption to use the extra "bonus" exemption from the TCJA that, by its terms, will expire at the end of 2025. Taxpayers may want to get the estate tax benefit of making a gift to an irrevocable trust to use the bonus exemption, but feel uneasy about putting too many of their assets beyond their reach if they have a change in circumstances or if the assets they retain for their support prove insufficient. These are important concerns, and taxpayers who do make gifts need to understand that the gift is irrevocable and the grantor cannot change their mind at a later date.

Taxpayers in this situation can consider gift options that combine certain types of beneficial interests for their spouses (and on occasion themselves), while also achieving the benefits of a completed gift for tax purposes, such as Spousal Lifetime Access Trusts (SLATS), including "back-end" and "back-door" SLATS, Special Power of Appointment Trusts (SPATs) and Domestic Asset Protection Trusts (DAPTs). Note that several of these options are relatively new ideas without the benefit of IRS guidance, and most of them are only available in certain jurisdictions where the laws on creditor’s rights and powers of appointment enable this type of trust.

What is a SLAT and How Does it Work?

SLAT is a newer term for a type of irrevocable gift trust that has been around for hundreds of years — namely, a lifetime trust that benefits the donor’s spouse and potentially other beneficiaries as well. The name "Spousal Lifetime Access Trust" reflects the donor’s spouse’s ability, as beneficiary, to receive distributions from the trust. The estate and gift tax treatment of this type of trust is well settled. For married taxpayers not concerned about the possibility of divorce, a SLAT can be a useful way to make a completed gift while the donor’s spouse, as a beneficiary, has access to distributions during the spouse’s lifetime. As long as the couple remains a single economic unit, this can solve the worry about giving away too much. After the gift, the assets in the SLAT are excluded from each spouse’s taxable estates.

A few of the downsides of SLATs arise if the marriage ends. A SLAT is and will permanently be a grantor trust for income tax purposes due to the status of the spouse as a beneficiary, even if the parties later divorce. This means that the donor spouse will continue to owe income tax on all trust income, even though the income is distributed to the donor’s former spouse, which can be a nasty surprise. Upon divorce, the beneficiary spouse may continue to be a beneficiary, or their interest could terminate. From the donor spouse’s perspective, it is the same situation that they were trying to avoid by using a SLAT in the first place — namely, they have the tax benefit of having moved the assets out of their estate, but the concern about whether they have retained sufficient assets for their own support remains. Even if there is no divorce, a similar situation occurs on the death of the beneficiary spouse if the donor spouse survives.

To maximize the benefit of the gift, estate, and GST exemption, ideally, the trust would primarily be for grandchildren and more remote descendants with few if any distributions made to the spouse or even the children. This is because, in most cases, the donor could make gifts to their spouse without using any gift tax exemption and could make gifts to their children without using any GST exemption. Thus, while the trust may permit distributions to those beneficiaries in times of need, pushing assets back into the spouse’s or child’s estate where they will be subject to estate tax can be counterproductive.

Back-End and Back Door SLATs

In response to one of these concerns (the death of the beneficiary spouse before the donor spouse), planners have devised certain variations on the SLAT. The "back-end" SLAT grants the donor a limited beneficial interest after the death of the beneficiary spouse. The "back-door" SLAT gives the beneficiary spouse a testamentary power of appointment that can be exercised to appoint the assets to the donor spouse. These provisions appeal to many donors, but it is important to understand the limitations that apply to them.

The back-end SLAT is only available in states that permit self-settled trusts that are not subject to the claims of the grantors’ creditors or have an enabling statute. Florida garnered media attention when it enacted SLAT legislation in 2022. There are a handful of other states, including Delaware and South Dakota, which have long permitted self-settled asset protection trusts. However, there are other states, like Texas and Arizona, that do not fall in that category. Key to this planning is a trust agreement that complies with all required provisions of the particular statute. For example, in Florida, the beneficiary spouse’s interest must be for life (it cannot terminate upon divorce). And in states that have statutes that enable the donor spouse to have a beneficial interest after the death of the spouse but do not allow self-settled asset protection trusts, there is some concern that giving the trustee discretion to reimburse the donor spouse for income taxes could cause estate tax inclusion issues.

With a back door SLAT, the donor spouse is not automatically a beneficiary upon the beneficiary spouse’s death. However, the beneficiary spouse has a power of appointment that includes the donor spouse as one of the permitted appointees. The beneficiary spouse can use this power, typically upon the beneficiary’s death, to appoint the assets to the grantor spouse or a trust for their benefit. This permits a second look at the beneficiary spouse’s death to assess the amount of assets available to the donor spouse. This approach also requires that, under state law, the appointive assets are not reachable by the donor spouse’s creditors to prevent the assets from being includible in the donor spouse’s estate.

State law in this context is the law that governs the trust. Donors have some ability to choose the governing law — for example, by selecting a trustee that is located in the desired state. It is important to note, however, that there is not a lot of precedent to rely on that creditors who pursue the donor in the donor’s state of residence will not be able — under at least some circumstances — to reach the trust assets. That makes the back-door and the back-end SLAT less "tried and true" techniques.

What About Unmarried Taxpayers?

The SLAT and its variations are designed for married couples, particularly where there is not concern about divorce. What kind of planning is available for taxpayers who are unmarried, or who are concerned about divorce and do not want to rely on the spouse as a beneficiary? This is where SPATs and DAPTs come into play.

A SPAT is a Special Power of Appointment Trust. A special power of appointment, also known as a limited power of appointment, gives a person the right to direct the trustee to distribute assets to a person other than the power holder, the estate of the power holder, or the power holder’s or estate’s creditors. It may be limited to a list of specific individuals or entities or may include a broad class of potential appointees. When creating a trust for beneficiaries other than the grantor, the trust instrument can give another person the power to appoint the assets back to the grantor later. This can be accomplished several ways, but the most straightforward way is to create a trust for named beneficiaries (such as children or siblings) that provides a beneficiary of the trust or a separate powerholder the right to appoint the assets to the grantor (or to a class that includes the grantor). However, it is important to note that state law must be clear that this does not give the grantor’s creditors rights if the assets are so appointed, as that would cause estate tax inclusion. This approach is useful if the grantor only needs reassurance that assets could be appointed to them later.

For a grantor who wants to be a beneficiary of the gift trust from the outset, the option is a completed gift to a domestic asset protection trust, or DAPT. A DAPT is a trust established by the grantor that names the grantor as one of the beneficiaries. This is only permitted in states that have adopted specific enabling statutes, as, in general, a self-settled trust (grantor is a beneficiary) is both subject to the claims of the grantor’s creditors and is includible in the grantor’s taxable estate.

While the original purpose of DAPTs was to allow grantors to put aside assets at a time when they have no outstanding creditors, and have those assets protected from claims from future creditors, they can also be a way to use the bonus exemption. In a DAPT, the trustee is authorized to make distributions to the grantor from the outset. Distributions do depend on the trustee’s exercise of discretion and may require the consent of other beneficiaries, so the grantor does not have the same ability to use the assets as they would if they had retained them. In addition, these should be assets of last resort for the grantor to maintain the creditor protection, rather than assets the grantor intends to access on a regular basis or in a pattern of distributions for lifestyle expenses.