Using trusts in divorce tax planning

Editor: Patrick L. Young, CPA

The use of trusts in divorce situations is not often considered for a variety of reasons. First, only a small percentage of the divorcing population has the wealth to fund a trust with an amount sufficient to obtain significant economic and tax benefits relative to the trust's costs. Second, divorcing spouses are usually in an adversarial relationship. An inherent mistrust often exists between the parties that must be overcome to use a trust vehicle. Finally, the use of a trust may bring practitioners (and family law attorneys) into the relatively unfamiliar territory of trust taxation.

However, there are economic and tax reasons for using trusts in a divorce context. Any one of the reasons may be sufficient to justify the costs and complexities of using a trust vehicle to achieve these benefits.

Using trusts for economic protection

Either or both spouses may want to use a trust for economic protection. For example, the spouse funding the trust may be concerned that the other spouse does not have the level of financial sophistication or knowledge to prudently handle a large lump-sum settlement. The funding spouse may also want to use a trust when the other spouse is a spendthrift, a compulsive gambler, or a chemically dependent person. If the recipient spouse were to squander, for whatever reason, the wealth that might otherwise be placed in trust, the funding spouse could be exposed to continual claims for additional support.

Alternatively, the recipient spouse may be concerned that the funding spouse suffers from the same problems described in the preceding paragraph. In addition, the recipient spouse may be concerned that the funding spouse will be unable or unwilling to fulfill future financial obligations. For example, if the funding spouse currently has substantial assets and income and is involved in a very high-risk business, the recipient spouse may be concerned that the failure of the business may jeopardize the funding spouse's other income and assets and, therefore, the ability to pay future alimony, child support, or installments for property interests. A properly drafted and funded trust can help achieve the economic goals of both spouses in such situations.

A trust may also be useful when stock is a significant marital asset. If some or all of the stock is transferred to a spouse who is not active in the business, transferring the stock to a trust for the receiving spouse's benefit keeps the receiving spouse from exercising shareholder rights (i.e., interfering with the business).

Common trust types

While an alimony trust is no longer available for divorce or separation agreements executed after Dec. 31, 2018, taxpayers may still be able to use other types of trusts to transfer income recognition to the receiving spouse. The two common trust types that could be useful are as follows:

Irrevocable trust: The taxpayer could establish an irrevocable trust where the former spouse is the income beneficiary and the taxpayer's children are the principal beneficiaries. In IRS Letter Ruling 201707007, the IRS ruled that where a husband agreed to transfer shares of a closely held business to an irrevocable trust for the benefit of his wife pursuant to their divorce in settlement regarding marital support obligations and property rights, the transfer met the requirements of Sec. 1041 and the husband did not have to recognize gain or loss on the funding of the trust. The terms of the trust provided that the wife was to receive all net income from the trust during her life and could receive discretionary distributions of principal, but the trustee could not sell the shares of stock contributed to the trust or distribute them in kind. The agreement provided that the shares would be transferred within six years after the entry of the divorce decree. If the wife predeceased the husband, the shares would revert to the husband. If the husband predeceased the wife, the shares would revert to his estate at her death.

Charitable remainder trust (CRT)If the taxpayer plans to donate a significant sum to charity, he or she could establish an irrevocable CRT to provide income to the former spouse for a set period of time, with the remainder interest transferred to the charity at the end of the term. The CRT should not be established until after the marriage is dissolved, in order to avoid any grantor tax issues. The taxpayer will receive a current charitable contribution deduction for the fair market value of the remainder interest that will be distributed to the charity. During the term of the trust, the spouse would be taxed on the income distributed from the trust.

Caution: Establishing a trust may involve a gift (e.g., the remainder interest) that may result in a gift tax. However, gift tax may not be currently payable if the donor's applicable exclusion is available to offset the gift tax.

Alimony trusts for pre-2019 divorces obtain desired income tax results

For trusts established by a divorce or separation instrument executed prior to Jan. 1, 2019, special rules applied to the grantor and beneficiaries (former Sec. 682). Trusts covered by former Sec. 682 were often known as alimony trusts. The law refers to "husband" and "wife," but it applies equally to men and women, including same-sex couples. This section refers to the taxpayer who establishes and funds the trust as the "paying spouse" or "transferring spouse" and the trust beneficiary as the "receiving spouse."

Observation: The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, repealed Sec. 682 for any divorce or separation agreement executed after Dec. 31, 2018 (TCJA §§11051(b)(1)(C)and (c)(1)). The IRS plans to issue regulations providing that former Sec. 682 will continue to apply to income received by a spouse from an alimony trust set up by a divorce or separation agreement executed before Jan. 1, 2019 (Notice 2018-37).

A properly drafted and funded alimony trust established before Jan. 1, 2019, may result in child support or property settlement payments being taxed in a way that more closely resembles alimony from pre-2019 divorce or separation agreements. Generally, trust distributions are taxable to the recipient. Also, trust distributions are not subject to alimony recapture and can continue after the receiving spouse's death.

Taxation of alimony trusts

Although the trust assets may revert to the grantor, the trust is treated as a nongrantor trust for tax purposes. The receiving spouse is taxed on income to the extent it is distributed. The only exception is for child support payments (discussed below). Any undistributed income is taxed to the transferring spouse (grantor).

Child support

The receiving spouse is not taxed on any trust income designated as child support in the divorce decree or separation agreement. That income is includible in the income of the paying spouse. In other words, the payment for child support is treated as if received by the paying spouse and then paid directly by that spouse as child support.

Observation: The trust instrument should have specified the amount of trust distributions that represent child support to ensure that the recipient is not taxed. This is especially true if the trust makes both child support and non-child support payments.

Using an alimony trust to pay deemed child support

Generally, payments that decrease or are eliminated when a child reaches a certain age, leaves home, finishes school, etc., are deemed child support rather than alimony. Unlike former Sec. 71, former Sec. 682 does not contain language regarding deemed child support. (See former Secs. 71(c)(1) and (2), which treat certain spousal payments as deemed child support because of the timing of payment reductions.) Thus, an alimony trust can be used to make payments that would be deemed child support if paid directly by the payer. Using the trust to make the payments results in tax treatment similar to alimony. The receiving spouse, rather than the paying spouse, is taxed on the payments.

Observation: The trust instrument should have specified the amount of trust distributions that represent child support to ensure that the recipient is not taxed. This is especially true if the trust will make both child support and non-child support payments.

Note: When child support distributions are expressed in the agreement as a fixed sum and there is insufficient trust income to pay the required amount in full, the income is first considered applied in satisfaction of the child support requirement (Regs. Sec. 1.682(a)-1(b)). The amount determined as child support is includible in the paying spouse's income.

Example. Using alimony trust for deemed child supportJ and L divorced in 2017. Their three minor children live with L. J pays L $1,000 per month, per child, until each child reaches age 18. J and L want L to be taxed on the payments.

Option 1: J pays L directly. The payments will not qualify as alimony. Instead, they will be deemed child support, which is neither deductible by J nor included in L's income.

Option 2: J established a trust funded with sufficient assets to produce at least $36,000 in annual taxable income. The trust instrument requires the trustee to pay L $3,000 per month as long as all three children are under the age of 18. The monthly payment is reduced by $1,000 per month as each child reaches age 18. The trust instrument also requires that any trust income in excess of the required payment to L be paid to J. L includes the trust distributions in her income. Although J gets no alimony deduction, he does not have to include the income and thereby achieves a result equivalent to alimony.

This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 21st edition (April 2020), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).

 

Contributor

Patrick L. Young,CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

 

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