| Home Online Publications Online Issues TTA Home Table of Contents Case Study | |
Using Trusts in Divorce Tax Planning Editor: Editor’s note: This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 6th Edition, by Anthony J. DeChellis and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ((800) 323-8724; ppc.thomson.com/sitecomposer2). 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 tax advisers (and family law attorneys) into the relatively unfamiliar territory of trust taxation. However, there are both economic and tax reasons for using trusts in a divorce context. Any of these may be sufficient to justify the costs and complexities of using a trust vehicle to achieve economic and tax benefits. 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 handle a large lump-sum settlement prudently. The funding spouse may also want to use a trust when the other spouse is a spendthrift, compulsive gambler or 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 continuous claims for additional support. Alternatively, the recipient spouse may be concerned that the funding spouse suffers from the same problems described above. 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 business’s failure may jeopardize the funding spouse’s other income and assets and, thus, 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 that spouse from exercising shareholder rights (i.e., interfering with the business). Obtaining Desired Income Tax Results Special rules apply to the grantor and beneficiaries of a trust used in a divorce situation; see Sec. 682. Trusts covered by Sec. 682 are often known as alimony trusts. The law refers to “husband” and “wife,” but applies equally to men and women. Sec. 682 refers to the taxpayer who establishes and funds the trust as the “paying” or “transferring” spouse and the trust beneficiary as the “receiving” spouse. A properly drafted and funded alimony trust may result in child support or property settlement payments being taxed in a way that more closely resembles alimony. Generally, trust distributions are taxable to the recipient, are not subject to alimony recapture and can continue after the receiving spouse’s death. Requirements: An alimony trust is one that, without the special rules of Sec. 682, would be a grantor trust for income tax purposes, because the funding spouse maintains beneficial ownership of the trust assets. (The grantor trust rules are described in Secs. 671–677.) Sec. 682’s special rules apply to individuals divorced or legally separated under a decree of divorce or separate maintenance, or separated under a written separation agreement. These are the same written instruments required for alimony. Taxation: Although 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 trust income designated as child support in the divorce decree or separation agreement. That income is includible in the paying spouse’s income (i.e., the child support payment is treated as if received by the paying spouse and then paid directly by that spouse as child support). Planning tip: The trust instrument should specify the trust distributions that represent child support to ensure that the recipient is not taxed, especially if the trust will make both child support and nonchild support payments. Paying Deemed Child Support Generally, payments that decrease or cease when a child reaches a certain age, leaves home, finishes school, etc., are deemed child support, rather than alimony. Unlike Sec. 71, Sec. 682 does not contain language as to deemed child support; see Sec. 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.
Estate Taxes A properly drafted divorce-related trust under Sec. 682 can often result in marital property being excluded from the transferring spouse’s gross estate at a very low gift tax cost. In addition, the trust can be drafted to exclude the property from the receiving spouse’s gross estate as well, thereby passing property to the children with no estate tax; see Letter Ruling 200408015. |
