Consider adding a testamentary limited power of appointment to make SLATs more effective.

A spousal lifetime access trust, or SLAT, is a trust created by one spouse (grantor spouse) for the benefit of the other spouse (beneficiary spouse). The purpose of a SLAT is to put assets beyond the reach of the estate tax (and creditors), while allowing the spouses to retain access to the assets. Thus, a SLAT lets you have your cake and eat it too.

The grantor spouse creates the SLAT while both spouses are living, rather than at the death of the grantor spouse. The trust lasts for the lifetime of the beneficiary spouse, unless sooner depleted. A SLAT authorizes the trustee to distribute income and/or principal to the beneficiary spouse upon terms specified by the grantor spouse. Typically, payments are allowable for the beneficiary spouse’s health, support, maintenance, and education. The grantor spouse can benefit indirectly through the beneficiary spouse, so long as the spouses remain on good terms and the beneficiary spouse is living.

But what happens when the beneficiary spouse dies with the grantor spouse surviving? How do we preserve the grantor spouse’s access to trust assets without causing estate inclusion? 

One option is to structure the SLAT so that the beneficiary spouse possesses a testamentary limited power of appointment. The grantor spouse would be a permissible distributee under the power. The beneficiary spouse could then exercise the power via his will so as to make grantor spouse a beneficiary of the same trust or a different trust.

Some have criticized this approach on IRC § 2036 grounds. They point out that grantor spouse, as creator of the trust and thus the power of appointment, would be treated as exercising the power in favor of herself. Support for this theory comes from the Introduction to Division V of the Restatement (Second) of Property, Donative Transfers, which states the “appointment is said to ‘relate back’ to the time of the creation of the power and to operate as if it had been originally contained in [the granting instrument].” Under this “relation back doctrine,” grantor spouse would be treated as the grantor of a trust for her own benefit, which (subject to the exception discussed below) would normally cause inclusion in grantor spouse’s estate under IRC § 2036. However, the Restatement goes on to say that the relation back doctrine “has never been consistently followed, and it is often misleading to view the modern law of powers of appointment in terms of that doctrine.” Moreover, it is not clear that Tennessee follows this English common law concept.

Even if the relation-back doctrine applies, inclusion under IRC § 2036 is not a given. Rev. Rul. 2004-64 involves a grantor trust. It posits three scenarios regarding Grantor A’s right to be reimbursed by the trust for income taxes payable by Grantor A but attributable to trust income. In one scenario, neither the trust nor state law require or permit the trust to reimburse A. In another scenario, the trust is required to reimburse A. In the third scenario, the trustee may, but is not required to, reimburse A.

Regarding the third scenario, the IRS states as follows:

[A]ssuming there is no understanding, express or implied, between A and the trustee regarding the trustee’s exercise of discretion, the trustee’s discretion to satisfy A’s obligation would not alone cause the inclusion of the trust in A’s gross estate for federal estate tax purposes. This is the case regardless of whether or not the trustee actually reimburses A from Trust assets for the amount of income tax A pays that is attributable to Trust’s income.

The ruling goes on to say that the result would be different if certain other factors are present. These include:

  • an understanding or pre-existing arrangement between A and the trustee regarding the trustee’s exercise of this discretion;
  • a power retained by A to remove the trustee and name A as successor trustee; or
  • applicable local law subjecting the trust assets to the claims of A’s creditors.

In other words, if:

  • A creates a trust;
  • The trustee has discretion to make distributions to A;
  • There is no implied agreement that the trustee will make distributions to A;
  • A cannot name herself trustee; and
  • The trust assets are not subject to A’s creditors under state law;

There should be no inclusion under IRC § 2036.

In our scenario, assuming the relation-back doctrine applies, grantor spouse would be treated as creating a trust for her own benefit by virtue of beneficiary spouse’s exercise of the testamentary limited power of appointment. Provided there is no implied agreement between the trustee and the grantor, and further provided that the grantor spouse cannot name herself as trustee, our scenario clearly satisfies the first four points above. But what about the last point? Would trust assets be subject to grantor spouse’s creditors under Tennessee law in this scenario?

The answer under the Tennessee Trust Code is no. The comments to T.C.A. § 35-15-103 state as follows:

[A] person who becomes a beneficiary of a trust due to the exercise of a power of appointment by someone other than such person is not considered under the Tennessee Uniform Trust Code to be a settlor of a trust. This is true even if the person who so became the beneficiary created and funded the trust and granted the power of appointment to another. Therefore, if the settlor did not otherwise retain a beneficial interest in the trust that was otherwise reachable (e.g., the settlor did not name himself as a beneficiary of the trust at the time it was created) the mere fact that some other person exercises a power of appointment to later make the settlor a beneficiary will not create an interest that is reachable by the settlor’s creditors.

Accordingly, under principles enunciated in Rev. Rul. 2004-64 and the Tennessee Trust Code, if the beneficiary spouse under a SLAT exercises a testamentary limited power of appointment in favor of the grantor spouse, thereby making grantor spouse a beneficiary of the trust, the trust will not be includible in grantor spouse’s estate under IRC § 2036.

Posted by Joel D. Roettger, JD, LLM, EPLS