The Dark Side to Non-Reciprocal SLATs

Spousal Lifetime Access Trusts (SLATs) are the hottest thing in planning these days. In full disclosure, I often recommend them myself. One recent Ohio case, however, shows the potential dark side to SLATs. Ironically, it implicates those that are typically much safer for tax and asset protection purposes (i.e., non-reciprocal). 

In Dayal v. Lakshmipathy, 2020-Ohio-5441, a husband funded a SLAT for his wife and children in December of 2012 with nearly $4.6 million, filing a gift tax return to that effect (although the court referred to it erroneously as an “estate tax return”). Remember when the big fear was the exemption going from $5 million to $1 million in 2013 and everyone rushed to use the disappearing exclusion amount? Sound familiar to anyone? His wife was trustee and his attorney was special trustee (it was not stated, but presumably the wife’s interest was limited to ascertainable standards whereas the special trustee had wider discretion to make distributions, which is a common SLAT design).

Great estate tax planning. But, after 24 years of marriage, the wife filed for divorce in 2016. The husband argued that the SLAT, now worth $6,790,251, should be considered marital property for purposes of dividing their assets in the divorce. The domestic relations trial court magistrate and judge agreed with the husband and final entry was issued in 2019. The appellate court, however, recently reversed, finding that the trust was clearly a gift from husband to wife and therefore her interest in the trust was her separate property. 

It is doubtful the Ohio Supreme Court would take a further appeal and even if it did, it is unlikely they would reverse the decision. After all, you have what was very clearly intended to be a gift to an irrevocable trust by the obvious plain language and intent of the donative instrument, not to mention the testimony of the estate planning attorney in the case. In Ohio as in most states, gifts and bequests that are shown to be given to only one spouse are considered separate (not marital) property of the donee. Ohio R.C. 3105.171.

One odd provision (at least for Ohio trusts when there is no community property) even went so far as to state that the trust “shall be owned… as separate property and not as community property, it being the Grantor’s intent that such property is in the nature of a gift or inheritance from the Grantor.”

End Result: the spouses split their marital assets (excluding the trust) equally, but with no compensation for the $6.7 million still accessible to the wife, since the trust was not considered a marital asset for this purpose. There was never a similar gift from wife to husband into trust. This was not a case that we often see where spouses try to make “non-reciprocal for tax purposes but really kind of reciprocal for all practical purposes” SLATs. Had Husband made a gift to Wife and she then funded a SLAT for him and their children, it may have been problematic for estate/gift tax purposes under the reciprocal trust doctrine enunciated in U.S. v. Grace (depending on the terms), but at least the property division would have been more equal in the end. Ultimately, you wonder which is more concerning to the Husband. Despite removing $1.8 million of growth in the SLAT from his estate, he may wish he had never made the gift, since his ex-wife may now be much wealthier than he is.

What if the appellate court had upheld the trial court and found the trust to be marital property? Could this arguably endanger the SLAT with the prospect of estate inclusion under IRC 2036/2038? Perhaps – courts (e.g. Estate of Tully) have found that the potential for a divorce or having future children, etc. is an “act of independent significance” that generally precludes application of these “string sections”, but I’m not so sure these taxpayer-friendly cases would control if the divorce actually occurs before death, causing the trust to indirectly benefit the settlor by becoming subject to a property division and causing an argument that the beneficiary is now 50% grantor. I am not sure that IRC 2516 protects such a settlement regarding trusts for others from being a transfer for gift tax purposes the way it would protect distributions directly between spouses from being a transfer. At least the upside of the divorce decision is that the SLAT is clearly still outside of both the husband and the wife’s estate for estate tax purposes (if they have large enough net estates so that this result would be a positive rather than a negative).

Lessons to Learn: does this case mean we should make trust gifts between spouses more “kind of reciprocal”, risking undermining the estate, gift and asset protection goals of the trust planning? No, obviously not. But, we should be more careful whenever one spouse makes unequal gifts to the other to inform the donor spouse of the potential negative consequences in the event of a divorce.