The Taxation of Trusts After a Divorce or Marital Dissolution: a Need to Define "income"

• Publication year: 2016
• Author: By Justin T. Miller

The Taxation of Trusts After a Divorce or Marital Dissolution: A Need to Define "Income"1

By Justin T. Miller²

EXECUTIVE SUMMARY

If one spouse (the "Moneyed Spouse") creates an irrevocable grantor trust (a "Support Trust") for the benefit of another spouse (the "Non-Moneyed Spouse"), the tax consequences during marriage are fairly straightforward. In general, the Moneyed Spouse would be subject to tax directly on the trust's taxable income regardless of any distributions from the Support Trust to the Non-Moneyed Spouse.³

After a divorce or marital dissolution, it is highly unlikely that a Moneyed Spouse would want to continue to be subject to taxes on trust income that is distributed to his or her former spouse. Fortunately, section 682 of the Internal Revenue Code of 1986, as amended (the "Code"), provides a special exception to the usual grantor trust tax rules by requiring the Non-Moneyed Spouse - not the Moneyed Spouse - to include the amount of the "income" he or she is entitled to receive from the Support Trust in gross income.

The problem is that the Code and the Treasury Regulations thereunder ("Treasury Regulations") fail to define the term "income" for purposes of Code section 682. "Income" could mean "fiduciary accounting income" ("FAI") under Code section 643(b), which is determined under the trust instrument and local law, and typically would not include capital gains.⁴ On the other hand, "income" could mean "income determined for tax purposes" under section 1.671-2(b) of the Treasury Regulations, which would include capital gains - arguably, the more appropriate definition.

Without a definition of the term "income," there is no guidance as to whether a Moneyed Spouse may be subject to a tax bill in excess of 50%⁵ on a Support Trust's capital gain income - in addition to penalties and interest - even though that income was distributed to his or her former spouse.⁶

DISCUSSION

I. BACKGROUND

Support Trusts may be a practical post-marital planning tool for a Moneyed Spouse to provide support payments to a Non-Moneyed Spouse for a specified term.⁷ In addition, Support Trusts may be part of an an efficient estate planning strategy for a Moneyed Spouse to set aside funds for future generations in a manner that minimizes estate, gift and generation skipping transfer ("GST") taxes.

In a marital dissolution or divorce, a Support Trust also may offer both spouses a mutually beneficial settlement solution that provides significant advantages over the traditional payment of spousal support in the form of alimony. While it is common for a Moneyed Spouse to end up paying a Non-Moneyed Spouse spousal support in the form of alimony over a given term,⁸ there are several scenarios where alimony may not always be the most practical solution for both parties. For instance, a Moneyed Spouse with limited liquidity may be forced to sell an ownership interest in a closely held family business in order to fund alimony payments, or a Non-Moneyed Spouse may have legitimate concerns that a Moneyed Spouse's risky profession could lead to financial insolvency or bankruptcy prior to the payment of all alimony. In such circumstances, a better settlement solution for both parties in lieu of alimony may be the creation of a Support Trust by the Moneyed Spouse for the benefit of the Non-Moneyed Spouse.

With a Support Trust, the Moneyed Spouse transfers income producing assets into a trust (e.g., cash, securities and/or business interests), which is managed by a neutral third party outside of the control of both spouses (e.g., an independent institutional trustee). The trustee of the Support Trust would then distribute a defined amount (e.g., FAI, a specific dollar amount, or a percentage of the Support Trust's assets) to the Non-Moneyed Spouse in accordance with a given schedule (e.g., monthly, quarterly or annually) for a specified length of time. At the end of the trust term, the Support Trust's assets would either revert back to the Moneyed Spouse or could be distributed outright, or in trust, to the spouses' children or future descendants. Such a trust could provide both spouses with a significant number of advantages when compared to alimony, including: (i) minimization of future interaction between former spouses; (ii) prevention of the sale or transfer of a closely held business; (iii) asset protection in the case of financial insolvency or bankruptcy; (iv) continued payments in the case of death; (v) professional asset management; (vi) protection of assets for future generations; and (vii) income, gift, estate and GST tax savings.

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Despite the numerous potential advantages of Support Trusts, a major barrier preventing more widespread utilization of such a strategy is that the tax consequences of such trusts after the spouses are no longer married are unclear under the Code and Treasury Regulations.

II. GENERAL OVERVIEW OF THE TAX CONSEQUENCES OF SUPPORT TRUSTS DURING MARRIAGE⁹ A. Transfer of Property to Support Trust

When a Moneyed Spouse transfers property to a Support Trust for the benefit of a Non-Moneyed Spouse during marriage, or incident to a divorce, no gain or loss will be recognized for income tax purposes under Code section 1041.¹⁰ The transfer to the Support Trust also could be structured to be free of gift taxes under the unlimited marital deduction provided by section 2056 of the Code; for example, the Support Trust could be set up to benefit the Non-Moneyed Spouse for a term of years with a reversion to the Moneyed Spouse or it could be set up as an inter vivos (i.e., lifetime) qualified terminable interest property ("QTIP")¹¹ trust that provides FAI at least annually to the Non-Moneyed Spouse (i.e., a "qualifying income interest")¹² with the remainder to the spouses' children after death (either outright or in trust).¹³ In addition, section 2516 of the Code provides a special exception from gift tax if the transfer to the Support Trust is made pursuant to a written marital settlement agreement and the divorce occurs within a two year period beginning one year before the execution of the agreement and ending one year after the execution of the agreement.

However, without careful planning, section 2702 of the Code could cause a draconian gift tax result (i.e., a taxable gift equal to the full value of the transferred property) to the extent anyone other than the spouses will receive a current or remainder interest in the Support Trust.¹⁴ Fortunately, such a negative result may be minimized, or even avoided, with prudent planning, such as providing the Non-Moneyed Spouse with (i) a qualifying income interest in an inter vivos QTIP trust that qualifies under Code section 2056; (ii) a qualified annuity or income interest pursuant to Code section 2516;¹⁵ or, (iii) a power of appointment over the remainder of the trust limited to the spouses' issue.¹⁶

As an example, Michael, the Moneyed Spouse, and Nancy, the Non-Moneyed Spouse, are engaging in settlement discussions as part of the marital dissolution process.¹⁷ Michael and Nancy have agreed that Nancy should be entitled to support payments of $200,000 per year for a ten-year period. Nancy, however, may be worried that Michael, a professional athlete, will become financially insolvent or bankrupt before the end of the ten year term, which would preclude payment of alimony. Taking into account Michael's spending habits, appetite for risky alternative investments and the statistics applicable to professional athletes, Nancy's concerns may be valid.¹⁸

Rather than alimony, a mutually beneficial settlement solution for Michael and Nancy may be for Michael to contribute half of his $10 million diversified investment portfolio (i.e., $5 million) to a Support Trust. Based on conservative risk-adjusted projections, the $5 million portfolio could be expected to generate a sufficient return each year to provide support to Nancy for a term of ten years (e.g., a 4% annual return equal to $200,000 per year). The Support Trust could be structured so that there would be no income tax or gift tax consequences when Michael funds the trust for Nancy's benefit.¹⁹ Furthermore, the Support Trust could be administered by a neutral and unbiased third party (e.g., an independent institutional trustee), who would provide Nancy with a payment of $200,000 per year for ten years. The assets remaining in the Support Trust after the ten-year period could revert back to Michael, which also could be a prudent and conservative strategy to help ensure that Michael has adequate savings after the end of his professional career.²⁰

On the other hand, the spouses may not want any remaining assets to revert to Michael, and instead may want the remaining assets to go outright, or in trust, to their children. This could be the case if Michael has a substantial net worth and does not need the assets to revert back to him. For instance, Michael's advisors may have run a "Monte Carlo simulation"²¹ that shows a 99% probability that he will have a substantial amount of assets remaining in his estate upon his death, which could be subject to a significant future estate tax (i.e., 40% in 2015).²² In such a case, for estate planning purposes, it may be more tax efficient for both spouses to structure the transfer as a completed gift for gift tax purposes.²³ Depending upon how the transaction is structured, the transfer may use up a portion of a spouse's lifetime exemption amount (i.e., $5.43 million in 2015).²⁴As a result, any assets remaining in the trust at the end of the specified term could be transferred outright, or in trust, to the spouses' children free of future gift and estate taxes. In other words, a tax-efficient estate plan could minimize the value of the current gift for gift tax purposes under Code section 2702 and could eliminate a 40% estate tax on the future appreciation of the assets in the trust (which is commonly referred to as an "estate freeze").²⁵

B. Non-Grantor Trusts

Subchapter J of the Code²⁶...