Estate Planning Income Tax Spousal Rights

Beware of the SLAT Divorce Trap

Andrew M. Logan

The Spousal Lifetime Access Trust, or SLAT, has become one of the most popular estate planning strategies employed by married couples. It is an irrevocable trust created by one spouse (the “grantor”) for the benefit of the other spouse and, usually, other family members. Like many irrevocable trusts, the assets transferred to a SLAT, along with any appreciation generated after the transfer, should be removed from the grantor’s and beneficiary-spouse’s estate for estate tax purposes. One of the unique benefits of a SLAT is that it allows the grantor to retain indirect access to the trust’s assets through distributions to the beneficiary-spouse. SLATs seemingly provide a way for grantors to “have their cake and eat it too,” but there may be unanticipated tax consequences to the grantor if the marriage to the beneficiary-spouse ends in divorce.

Because the grantor’s spouse is a beneficiary, a SLAT is usually taxed as a so-called “grantor trust” for income tax purposes. This means that the grantor is responsible for paying the SLAT’s income and capital gains taxes, even though the SLAT’s assets have been removed from the grantor’s estate for estate tax purposes. Under current law, the grantor’s payment of the SLAT’s income tax liabilities is in effect an additional tax-free gift to the SLAT each year. These payments allow the assets of the SLAT to grow without being depleted by the payment of income taxes.

As long as the grantor and the beneficiary-spouse are married, they will both be able to reap the benefits of the SLAT.[1] However, if they divorce, the grantor will not only lose indirect access to the SLAT’s assets, but will also remain liable for its income taxes if the beneficiary-spouse remains a beneficiary of the SLAT following the divorce.[2] Section 672(e) of the Internal Revenue Code , the so-called “spousal unity rule,” provides that the grantor is treated as holding any power or interest held by the grantor’s spouse at the time the power or interest was created, even if that individual subsequently ceases to be the grantor’s spouse.

Consider the following example. In 2020, George created a SLAT for the benefit of his then spouse, Sally, which provided for discretionary income and principal distributions to Sally during her lifetime. In 2023, George and Sally divorced and the trust agreement provides that Sally will continue to be a permissible beneficiary of the SLAT even after a divorce. Accordingly, following the divorce, the SLAT will likely remain a grantor trust as to George because the spousal unity rule only looks at when Sally’s interest in the trust was created, and not at the time of the George and Sally’s divorce. This means that George will continue to be responsible for paying the taxes[3] on the SLAT’s assets, even though he no longer has indirect access to the trust property.[4] Fortunately for couples who are contemplating creating a new SLAT, the effects of the “divorce trap” can be mitigated with proper planning and structuring. For couples with existing SLATs, they should carefully review the trust terms to confirm what happens in the event of divorce. It may be possible to address the “divorce trap” issues in a post-nuptial agreement and/or a trust modification or decanting.

[1] Of course, if the beneficiary-spouse predeceases the grantor, the grantor would then lose his or her indirect access to the trust property.

[2] The trust agreement will typically address the beneficiary-spouse’s interest in the SLAT following a divorce. The trust agreement may provide that the beneficiary-spouse will continue to be a beneficiary following a divorce or will cease to be a beneficiary. The spousal unity rule is only implicated if the beneficiary-spouse continues to be a beneficiary following the divorce.

[3] In a number of states, the trust agreement can include a provision authorizing an independent trustee, in the independent trustee’s discretion, to make distributions to the grantor to reimburse the grantor for the income tax liabilities of the SLAT. If this reimbursement provision is structured correctly, it should not result in the assets of the SLAT being includable in the grantor’s estate for estate tax purposes.

[4] Prior to the Tax Cuts and Jobs Act of 2017, following a divorce from a spouse who continued to be a beneficiary of a SLAT, if distributions were made to the former spouse, the SLAT’s taxable income, up to the amount of distributable net income, could have been carried out to the spouse, potentially reducing the income to be reported on the grantor’s personal income tax returns. However, following the 2017 Act, this is no longer the case, and the grantor must carry the full amount of the SLAT’s income tax liabilities on his or her personal returns, regardless of whether distributions are made to the former spouse.

Estate Planning Matrimonial Law Spousal Rights

Don’t Forget the Will with the Prenuptial Agreement

Sean R. Weissbart

Sean Weissbart's headshot photo

Many prenuptial agreements include detailed provisions regulating the division of the parties’ property in a divorce but include no waivers of rights the law provides to a surviving spouse at death. The most well known of these rights is the right of election. The surviving spouse’s right of election, essentially, prevents the first spouse to die from fully disinheriting the survivor. Generally, in New York, if a surviving spouse does not inherit at least one-third of the deceased spouse’s assets, the surviving spouse can file a claim to receive this threshold amount—even when the deceased spouse’s Will (or other testamentary documents) names different beneficiaries.

It is common for prenuptial agreements—particularly between parties without children—to not waive spousal rights at death. After all, many individuals getting married have no objection to their beloved receiving at least one-third of their assets at death.

However, in some states, when a married person without children dies without a Will, his or her surviving spouse receives all of the deceased spouse’s assets. For instance, in New York, all assets of a married person without children dying without a Will (or other testamentary document) are distributed to the spouse; parents, siblings, nieces, nephews, and other relatives or friends receive nothing.

Consider the following example. Wanda, who has worked for years and has five million dollars of pre-marital assets in a brokerage account in her own name, is marrying Harry, who just graduated school and has few assets. Wanda requests that Harry sign a prenuptial agreement to protect this five million dollars from division in divorce, but the agreement is silent regarding distribution of her assets at death. Imagine Wanda has parents with limited means, a sick relative who needs money for medical care, and nieces and nephews she loves like children. If she dies before Harry without a Will (or other testamentary documents), these other loved ones would receive nothing.

What should Wanda do? The answer is simple. Before marrying Harry, Wanda should sign a Will that bequeaths assets to Harry and these close relatives. Of course, to avoid Harry exercising his right of election, her Will should bequeath to Harry, at least, the minimum threshold necessary to satisfy what Harry’s right of election would be; but her Will can freely dispose of her remaining assets however she’d like.

Many individuals sign prenuptial agreements, get married, but don’t simultaneously sign Wills. Indeed, the most common catalyst for a first Will is having children (you need a Will to appoint a guardian), which may happen years after marriage. So, in that rush to the alter, don’t forget to also sign a Will.