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.