Use It or Lose It…Examining the Efficacy of the Spouse And Family Exclusion Trust or Spousal Lifetime Access Trust

On January 1, 2024, the Applicable Exclusion Amount (“AEA”) reached a record high amount of $13.61 million. The AEA is the amount that any person can pass to a non-spouse without incurring an estate tax. An individual can pass an unlimited amount to the U.S. citizen spouse without worry about incurring a gift or estate tax. In 2011, legislation set the “permanent” exclusion amount at $5 million, as adjusted for inflation. The Tax Cuts and Jobs Act of 2017 (“TCJA”) temporarily doubled the exclusion amount from $5 million to $10 million, as adjusted for inflation. Provisions of the TCJA cause the doubled amount to sunset on December 31, 2025. Thus, on January 1, 2026, the exclusion will return to $5 million, and with inflation adjustment it’s expected to be around $7 million at that time. Any transfer exceeding the AEA will be taxed at a rate of 40% on the overage. Given the nearly $7 million difference between the current AEA and the reduced AEA in the future, individuals whose estates exceed $6.5 million need to think about how to take advantage of today’s AEA. Using the AEA now ensures that individuals get to utilize the higher amount before it sunsets.

Let’s look at a quick example. Assume that an unmarried client has $15 million. They could give away $13.61 million this year and retain $1.39 million. At the client’s death in 2026, they’d only owe tax on the $1.39 million in their estate. If the client were married, that client could use a Spouse And Family Exclusion (SAFE) Trust, (sometimes called a Spousal Lifetime Access Trust (SLAT)) to hold the gift. Such a trust is set up by one spouse for the benefit of the other spouse and their children. The SAFE Trust appeals to many married individuals because even though the donor spouse gifts assets to the SAFE Trust, because the gift benefits their spouse, the donor spouse has indirect access to the assets.

For persons with wealth that exceeds twice the AEA, it may make sense for each spouse to consider establishing a SAFE Trust for the benefit of the other. This allows each spouse to utilize their AEA while having direct access to the assets in the trust of which they are the named beneficiary and indirect access (through their spouse) to the assets of the trust for the benefit of their spouse. Of course, this structure carries some risk. The spouses need to ensure that sufficient differences exist between the two trusts to avoid the “reciprocal trust doctrine.” Under the reciprocal trust doctrine, if the trusts are mirror images of one another, or relatively mirror images, the IRS will recharacterize two trusts and treat the trusts as if each spouse created a trust for himself or herself which will cause inclusion of the assets in the trust in the donor/decedent spouse’s estate.

Let’s assume that Amy and Sheldon have $30 million, $15 million each, and wanted to take advantage of the temporarily increased AEA. Sheldon gifts $13.61 million to a trust for the benefit of Amy and their children. Likewise, Amy gifts $13.61 million into a trust for the benefit of Sheldon and their children. Each spouse now only has $1.39 million left in their respective estates. The attorney drafting the trusts needs to design them in a manner that avoids the reciprocal trust doctrine. Generally, that means creating as much difference between the trusts as possible. For example, one trust might name one of the spouses as Trustee, but the other trust might name a third party as Trustee. Perhaps the trusts have different standards for distribution of income and principal. One trust might give the spouse a 5 and 5 power and the other might give the spouse a limited power of appointment. The more differences that that the trusts have, the less likely that they run afoul of the reciprocal trust doctrine.

If the trusts have been structured properly, then neither estate will include the assets of the trust. Unfortunately, without estate tax inclusion, the assets in the trusts do not receive a step-up in basis at death. For this reason, it’s important to consider what assets to use for funding the SAFE Trust. Given that the estate tax rate exceeds the long-term capital gains tax rate, the benefit of removing the assets from the estate likely outweighs the potential for capital gains taxes in the future.

The SAFE Trust has certain risks. First, there’s the risk that one spouse fails to create a SAFE Trust for the other. There’s always the risk of the spouses divorcing. Finally, there’s the risk that one spouse dies prematurely thereby causing the surviving spouse to lose indirect access to assets in the SAFE Trust for the benefit of that decedent spouse. Everyone has unique circumstances, including different levels of risk tolerance, which means that the SAFE Trust is not a one-size-fits-all solution. Regardless, given the sunset of the doubled AEA on January 1, 2026, it’s a great time to open the discussion about ways to take advantage of the AEA before the sunset.