Spousal Lifetime Access Trusts

A “Crummey” Trust is a popular device used in making gifts that qualify for the $13,000/ $26,000 annual exclusion from gift tax. Most other forms of gifts that qualify for the annual exclusion require an immediate or at least a very early (i.e., age 21) distribution of the assets to the beneficiary. Since 1998, the gift tax annual exclusion has been indexed annually for inflation. The Crummey Trust takes its name from a court case upholding this type of trust and supporting its tax benefits.

Each time a contribution is made to a Crummey Trust, a temporary right (usually 30 days) to demand withdrawal of that contribution from the trust is available to the beneficiaries. If the demand right is not exercised, the contribution remains in the trust for management by the trustee. Because the right of withdrawal is not usually exercised, the trustee may use the funds (income and/or principal) for some purpose desired by both the trust grantor and the beneficiaries.

In funding Crummey Trusts, the vehicle of choice is most often life insurance, because when the grantor-insured dies, the insurance proceeds (which are income tax free) can be used to provide benefits to the surviving spouse, children and/or grandchildren. Properly structured, the insurance proceeds are not taxed in the estate of the grantor or the estate of the grantor’s spouse. Moreover, when both spouses have died, the insurance proceeds can then be used to help pay the federal estate tax that may be due. This is accomplished by having the Crummey Trust purchase assets from, or loan money to, the estates of the grantor and/or the grantor’s spouse as allowed in the trust document. In essence, the irrevocable life insurance trust (“ILIT”) allows death taxes to be paid for the estate rather than from the estate.

For an existing policy transferred to the trust, the grantor-insured must survive at least three (3) years from the transfer of the policy to the trust. Otherwise, the insurance proceeds will be included in the grantor’s estate. This three-year rule can be avoided on a new policy by having the trust apply for the policy as the initial owner.

The main advantage of an ILIT is the reduction of the gross estate by the annual gifts to the trust and the exclusion of the life insurance proceeds from the estate. As long as the grantor-insured establishes an irrevocable trust and retains no “incidents of ownership” over the policy, no powers over the trust that could be construed as ownership, and retains no benefit under the trust, the insurance proceeds received by the trust will be excluded from the grantor’s gross estate.

The problem, however, of having life insurance owned by an ILIT is that the policy’s cash values can be “locked up” inside the ILIT. The Spousal Lifetime Access Trust (“SLAT”) is a special type of ILIT that addresses the issue of providing access to life insurance cash values, while simultaneously keeping the life insurance proceeds out of the grantor-insured’s gross estate.

How a SLAT Works.

1. One spouse (the “grantor”) gifts cash to an ILIT. The gifts must come from the grantor’s separate property and not from jointly-titled property. The gift tax annual exclusion ($13,000) and the gift tax exemption ($1,000,000) can be used to shelter these gifts from taxation.

2. The grantor’s spouse (and/or other family members) is named as trustee of the ILIT.

3. The trustee uses the cash gifts to purchase a life insurance policy on the grantor’s life. The ILIT is the owner and beneficiary of the policy.

4. During the grantor’s lifetime, the trustee has the discretion to take loans and withdrawals from the policy’s cash value, which may be income tax free (if within limits and up to basis).

5. The trustee may make distributions to the grantor’s spouse for health, education, maintenance, and support. In addition, the grantor’s spouse may be given the right to withdraw the greater of $5,000 or 5% of the trust principal annually. Trust income and principal may also be “sprinkled” down to children/grandchildren. The grantor’s spouse can also borrow from the ILIT.

6. The ILIT protects the beneficiaries from potential creditors, ex-spouses, professional liability, and other unforeseen threats.

7. When the grantor dies, the death proceeds are income and estate tax free to the ILIT and retain their character (income tax free) when distributed to the grantor’s spouse and descendants, as described in Paragraph 5 above.

8. When the grantor’s spouse dies, ILIT assets pass estate tax free to the grantor’s descendants. Moreover, by designing the ILIT as a generation-skipping trust, ILIT assets can also escape estate taxation in the estates of the grantor’s descendants.

9. After the grantor’s death, the trustee of the ILIT can be given the discretion to loan money to or purchase assets from the grantor’s (and/or the grantor’s spouse’s) estate to provide liquidity to pay estate taxes and other settlement costs.

10. With careful drafting, the ILIT can purchase a survivorship policy. But, in this case, a third party co-trustee must serve with the grantor’s spouse, and all incidents of ownership with respect to the policy should be vested in the third party co-trustee.

SLATs, like many other estate planning techniques, have some drawbacks. Access to cash values are available only to the grantor’s spouse (and/or other beneficiaries) – not the grantor. Thus, the grantor only has “indirect” access to cash values through his/her spouse. Therefore, divorce or the death of the grantor’s spouse will further diminish this limited access. The SLAT must be carefully drafted and funded to avoid inadvertent estate tax exclusion. However, the SLAT will be attractive to many couples looking for flexibility during a period of estate tax uncertainty.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.