Irrevocable Life Insurance Trust (ILITs) and Spousal Lifetime Access Trusts (SLATs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: SLATs and ILITs both save estate tax, but they’re used in different circumstances.
• ILITs are Extremely Tax Efficient: ILITs are highly tax efficient. The trust shelters the life insurance proceeds from estate tax, while the life insurance wrapper shelters the investment returns inside the policy from income tax.
• SLATs are Tax-Efficient Trusts for the Grantor’s Spouse: SLATs are very estate-tax efficient and make a lot of sense for people who want to transfer wealth to future generations and have not used their entire lifetime gift tax exemptions. What distinguishes SLATs from other irrevocable grantor trusts is that they name the grantor’s spouse as a primary beneficiary.

What is an ILIT?

An ILIT is a type of irrevocable trust that is designed to hold insurance. A person (the “grantor”) creates an ILIT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. Typically, the grantor funds the trust with cash, which the trust uses to acquire one or more life insurance policies, often on the grantor’s life. Once the life insurance policy is in the trust, it is outside of the grantor’s estate, and the proceeds will not be subject to gift tax, estate tax, or generation-skipping transfer tax. Because life insurance policies generally are not subject to income tax, ILITs are able to generate both income-tax savings (via the insurance policy) and estate-tax savings (via the trust). It’s possible for ILITs to own assets aside from life insurance, though generally they stick to holding life insurance policies plus a small amount of liquidity.

ILITs can hold any type of life insurance policy, from indexed universal life insurance (IUL) to term life insurance. But a specific type of variable universal life insurance policy, known as Private Placement Life Insurance (PPLI), works particularly well with ILITs and has become quite popular with high-net-worth individuals who are looking to transfer as much post-tax wealth to their family members as possible. Even after accounting for the fees that life insurance companies charge, an ILIT funded with PPLI will generally outperform other estate-tax strategies. (You can learn more about ILITs here.)

ILIT Example

Imagine that Ronald is a 40-year-old New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Ronald sets up an ILIT and then contributes $6 million to fund premiums on a PPLI policy, he will use up $6 million of his lifetime gift tax exemption, but the investments in the life insurance policy will be able to grow outside of his taxable estate. Even after fees, the policy will generate more than 8% annual post-tax returns. Meanwhile, the insurance charges will pay for a generous death benefit. If Ronald dies in Year 25, his beneficiaries will receive roughly $59.9 million of cash proceeds from the ILIT, and the total tax savings for his heirs will be about $39.9 million relative to if Ronald had done nothing.

Benefits of ILITs

1. Estate Tax Savings: The primary advantage of an ILIT is that it can shelter the proceeds of life insurance policies from estate tax upon the grantor’s death. Since the federal estate rate is 40% and in some states the effective estate tax rates (federal + state) are as high as 52%, this is an important benefit. When PPLI and ILITs are used in conjunction, the combined tax savings can be quite significant.
2. Asset Protection: An ILIT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, ILITs can help shield inherited assets from a divorcing spouse.
3. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to an ILIT when the trust is first funded. As a result, the ILIT is a popular form of dynasty trust.

Drawbacks of ILITs

1. Cash Funding: ILITs are typically funded with cash or cash equivalents so that the ILIT can pay large upfront insurance premiums. If an ILIT is funded with an appreciated asset, that asset will likely need to be sold in order to pay the insurance premiums.
2. Irrevocability: When a grantor makes a gift to an ILIT, the gift is irrevocable.
3. Less Liquid: SLATs and IDGTs are highly liquid, because the grantor can easily borrow from them. It’s possible for the grantor of an ILIT to borrow from the ILIT as well, but it’s not so simple. The grantor can’t borrow directly against the policy without causing estate-tax problems. The grantor can borrow from the trust itself (as opposed to the policy), but that requires the trust to have assets (perhaps borrowed from the policy) that it can lend to the grantor.
4. No Direct Control: Typically the grantor does not act as trustee of the ILIT, though he or she can remove and replace the trustee at any time.

What is a SLAT

A SLAT is a particular type of intentionally defective grantor trust (IDGT), and has much in common with other IDGTs. A person (the “grantor”) creates a SLAT and names the grantor’s spouse as either the sole initial beneficiary or one of the initial beneficiaries. Typically upon the sooner of the spouse’s death or divorce, the remaining trust principal is split into separate trusts for the grantor’s descendants. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. Yet, because the grantor’s spouse is a beneficiary, the grantor’s spouse can receive distributions. This can give the grantor “backdoor access” to the trust principal (though distributing SLAT principal to the grantor’s spouse is generally not very tax efficient). Because a SLAT is a “grantor trust,” the grantor has the option to pay the trust’s taxes, which is a way to transfer additional wealth to the trust. This makes SLATs even more estate-tax efficient than they would otherwise be. (You can learn more about SLATs here.)

SLAT Example

Imagine that Ellen is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Ellen sets up a SLAT for the benefit of her spouse and then contributes a $6 million asset to it, she will use up $6 million of her lifetime gift tax exemption, but the asset will be able to grow outside of her taxable estate. Ellen will also be able to pay the trust’s income taxes, allowing the trust to generate 9% annual post-tax returns and shifting more wealth out of Ellen’s taxable estate. After 25 years, the SLAT’s assets will be worth about $51.7 million! And if Ellen dies in Year 25, she will have saved her heirs about $20.4 million of tax relative to the counterfactual where she hadn’t funded the SLAT.

Benefits of SLATs

1. Estate Tax Savings: The primary advantage of a SLAT is its ability to use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. The grantor can pay the income tax on the trust’s income, effectively shifting even more wealth into the trust and out of the grantor’s estate. Finally, the grantor can lend to the trust free of any tax consequences — loans are another powerful tool that taxpayers use to shift wealth out of their estates.
2. Asset Protection: A SLAT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, SLATs can help shield inherited assets from a divorcing spouse.
3. Potential Income-Tax Savings: Although SLATs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. For example, if the grantor names both the grantor’s spouse and the grantor’s child as beneficiaries, the trustee can distribute an appreciated asset to the grantor’s child, who may be in a lower tax bracket. The distribution itself will have no tax consequences, but when the grantor’s child later sells the asset, he or she will pay less tax than the grantor would have paid, due to that lower tax bracket.
4. Liquidity and Indirect Access: Compared to many other tax strategies, SLATs have little impact on a grantor’s liquidity. Though the grantor will have transferred some portion of his or her assets to the trust, the grantor can borrow from the SLAT without any tax consequences. Moreover, the grantor’s spouse can receive distributions from the SLAT if necessary.
5. Ideal for Illiquid Assets: Unlike GRATs, SLATs work well whether funded with liquid or illiquid assets.
6. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a SLAT when the trust is first funded. As a result, the SLAT is a popular form of dynasty trust.

Drawbacks of SLATs

1. No State Income Tax Savings: Unlike non-grantor trusts, SLATs don’t save state income tax.
2. Grantor Trust Status Locked in: With grantor trusts where the spouse is not a beneficiary, the grantor can always turn off grantor trust status and, by doing so, transform the trust into a non-grantor trust. However, as long as the grantor’s spouse is a beneficiary of a SLAT, this isn’t possible. While grantor trust status is generally desirable, there are situations where grantor trust status is inefficient. The ability to turn grantor trust status off is a valuable perk, one that SLATs can’t offer.
3. Separate Property: SLATs must be funded with the grantor’s sole and separate property — if a SLAT is funded with the spouse’s property, the SLAT will fail to avoid estate tax (at least in part). Since many couples own most of their property jointly or as community property, this can be a problem. Where it is a problem, both spouses must agree in advance of the SLAT being funded that the property that’s funding the SLAT is the grantor’s separate property. Understandably, sometimes married couples aren’t comfortable signing documents that transfer property from one spouse to another.
4. Irrevocability: When a grantor makes a gift to a SLAT, the gift is irrevocable (though the grantor can swap assets in and out of the trust at any time, as long as the swapped assets are exchanged for other assets with equal value).
5. No Direct Control: Typically the grantor does not act as trustee of the SLAT, though he or she can remove and replace the trustee at any time, lend money to or borrow money from the trust, get reimbursed by the trust for the trust’s tax liabilities (if the grantor doesn’t want to pay), and swap assets with the trust.

Should You Set Up an ILIT or a SLAT?

ILITs and SLATs are similar strategies that save estate tax. In both cases, it’s possible to name a spouse as the trust’s beneficiary. Both are highly estate-tax efficient, and gifts to either ILITs or SLATs will generally be GST exempt, which means that ILITs can make distributions to grandchildren or great-grandchildren without the distributions triggering any GST tax.

But SLATs and ILITs are not identical.

For donors who are under 65 years old, in a position to gift $3 million or more to an irrevocable trust, and focused on maximizing what they pass on to their heirs, ILITs are a logical choice. Combining an ILIT with a PPLI policy will generally yield the highest post-tax return of any estate-tax strategy.

But for donors who don’t want to purchase a large insurance policy, or who want to maximize their access to trust liquidity, SLATs (or some other type of irrevocable trust) may be a better choice since SLATs are more liquid. SLATs are also better vehicles for receiving appreciated or illiquid assets, since they don’t need to generate cash in order to pay insurance premiums.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than a SLAT or an ILIT, depending on circumstances. Those strategies are also worth exploring. Moreover, SLATs and ILITs are not mutually exclusive; many people set up both.

Conclusion

SLATs and ILITs are both powerful tax strategies. ILITs make sense for people who are looking to make large gifts and want to maximize their heirs’ tax savings. SLATs make sense for people who want to name their spouse as a trust beneficiary and don’t want the trust to purchase life insurance.

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