Spousal Lifetime Access Trusts (SLATs) and Grantor Retained Annuity Trusts (GRATs) 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 GRATs both save estate tax, but they’re used in different circumstances.
• 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.
• GRATs Efficiently Transfer Volatile Assets: GRATs are ideal for people with volatile, liquid assets who are looking to transfer assets to their children. GRATs transfer assets using an IRS-sanctioned formula where returns above a certain baseline are allowed to pass to the donor’s heirs.

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.

What is a GRAT?

A GRAT is a type of irrevocable trust that moves assets out of a person’s taxable estate without using that person’s lifetime gift and estate tax exemption. It’s a powerful gift and estate tax strategy. The basic idea is that a person (the “grantor”) transfers an asset to the GRAT and sets an annuity term (usually two years). A portion of the principal is returned to the grantor each year until the end of the term. The exact size of each annuity payment is based on a standardized formula, but basically the grantor is entitled to receive the full amount of the original principal amount plus interest that is based on the government’s interest rate, known as the “7520 rate.” By the end of the term, the original principal (plus some interest) has been returned to the grantor. Any remaining amount in the trust passes to the grantor’s named beneficiaries free of estate tax or gift tax. The GRAT’s magic comes from the ability to transfer wealth to beneficiaries free of tax by simply funding the trust with assets that outperform the 7520 rate. The 7520 rate is equal to roughly 120% of the yield on a 7-Year Treasury Note, so it typically comes out to somewhere in the 3%-5% range. (You can learn more about GRATs here and you can estimate the potential returns here.)

GRAT Example

Imagine that Christine 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 she contributes $6 million to a two-year GRAT when the 7520 rate is 4%, the GRAT will pay her approximately $6.3 million over the course of the first two years. But because the GRAT’s assets are appreciating at 9% while the 7520 rate is only 4%, there will be a remainder left over at the end of Year 2. That remainder — about $500,000 — will pass to Christine’s remainder beneficiary, perhaps a grantor trust for the benefit of her daughter. If Christine decides to set up “Rolling GRATs” — that is, GRATs where the annuity payments are used to fund new GRATs — and she keeps setting up new GRATs each year for 25 years and naming the grantor trust for her daughter as the remainder beneficiary, by Year 25 she will have transferred about $33.1 million to trusts for her daughter, saving her daughter the equivalent of about $14.5 million of tax.

GRATs funded during two-year periods where Christine’s investments performed poorly would fail, but Christine and her daughter would be no worse off than if Christine hadn’t funded the GRAT (aside from the cost of setting up the GRAT).

Note that in this example the GRATs don’t transfer as much wealth as the SLAT described above. But that’s not always the case. If the assumed returns had been higher or more volatile, the GRAT could have easily outperformed.

Benefits of GRATs

1. Estate Tax Savings: The primary advantage of a GRAT is its ability to transfer assets to a grantor’s beneficiaries free of gift tax or estate tax.
2. Ideal for Volatile Assets: Compared to other estate-tax strategies, GRATs are particularly well suited for transferring highly volatile assets. In fact, GRATs thrive on volatility. On average, a GRAT funded with highly volatile assets will generally outperform a GRAT funded with less volatile assets even if the overall percentage growth of the underlying assets is the same.
3. Downside Protection: If GRATs had a motto, it would be “Heads, you win, tails you don’t lose.” A GRAT funded with an asset that drops in value will fail to pass on assets to the beneficiaries, but that failure won’t leave the beneficiaries any worse off than they would have been if the GRAT hadn’t been created. In contrast, with other estate-tax strategies, transferring assets that later drop in value can be tax inefficient.
4. Potential Income-Tax Savings: Although GRATs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because a successful GRAT can transfer assets to other taxpayers, who may be in lower tax brackets. When those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket.
5. Relative Liquidity: Compared to many other tax strategies, GRATs have little impact on a grantor’s liquidity. During the term of the GRAT, a portion of the grantor’s assets are in the trust, but the grantor can always borrow from the GRAT without any tax consequences.
6. Direct Control: The grantor can act as trustee of the GRAT during the GRAT term, which means he or she retains direct control over the trust’s assets and how they are invested.

Drawbacks of GRATs

1. GST Inefficiency: A person cannot allocate generation-skipping transfer (”GST”) tax exemption to a GRAT during the annuity period. This makes GRATs less suited to transferring assets to grandchildren or more distant descendants than SLATs, intentionally defective grantor trusts, or other dynasty trusts. Still, GRATs can be a powerful estate-tax strategy alongside other, more GST-efficient strategies.
2. Irrevocability: When a grantor makes a gift to a GRAT, he or she is forfeiting the right to the excess growth above the 7520 rate. That said, if desired, a grantor can prevent too much wealth from being shifted to his or her beneficiaries by “swapping” assets out of the GRAT before the end of the term.
3. Not Ideal for Illiquid Assets: GRATs work very well when funded with liquid assets, but they are often not the best fit for gifts of illiquid assets, like real estate or privately held stock. Illiquid assets in a GRAT will need to be valued at least three different times (upon funding, upon the first anniversary of funding, and upon the second anniversary of funding). The IRS can potentially challenge each valuation. In contrast, liquid assets like public stock don’t need to be appraised at all.

Should You Set Up a SLAT or a GRAT?

SLATs and GRATs both save estate tax, but they’re used in different circumstances.

SLATs are highly estate-tax efficient and make a lot of sense for people who are interested in transferring wealth to future generations while retaining indirect access to the trust principal via their spouse. Gifts to SLATs are generally GST exempt, which means that SLATs can make distributions to grandchildren or great-grandchildren without the distributions triggering any generation-skipping transfer tax. They are well suited to receiving any type of asset — liquid or illiquid.

GRATs are ideal for people with volatile assets that are easy to value, like individual stocks or crypto, who are looking to transfer assets to their children. GRATs are particularly useful for people who have limited unused lifetime gift tax exemption, since GRATs don’t require lifetime gift tax exemption in order to work.

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

Conclusion

SLATs and GRATs are both powerful tax strategies. SLATs make sense for people looking to transfer assets and are okay using lifetime gift tax exemption. GRATs make sense for people with volatile assets who are looking to transfer assets to a trust without using any lifetime gift tax exemption.

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