When negotiating a settlement for a client going through divorce proceedings, creating a trust for a soon-to-be ex-spouse is usually the furthest thing from a client’s mind. Why would you create something that, on its face, seems to benefit your ex-spouse? But what if I told you that depending on the situation, trusts can be used for tax planning? Read more to find out when and when not to use one.
Can Trusts Be Used For Divorce Tax Planning and Equitable Distribution?
Reasons Why Trusts Are Often Not Used in a Divorce
The use of trusts in divorce situations is often not considered for a number of reasons. A client typically needs to have significant wealth in order for it to make sense to create a trust under these circumstances. Additionally, by the time parties are close to settlement, there is usually a fair amount of animosity that has built up between the parties. Divorcing parties aren’t usually in a very “trusting” mood when it comes to their soon-to-be ex-spouse. Lastly, utilization of a trust to facilitate support payments in a divorce is a concept that may not be familiar to some family law attorneys.
But what if the stars aligned and all of the barriers mentioned above were removed? Can the use of a trust result in tax and other efficiencies in the planning and settling of a divorce? I believe the answer is yes, but it takes the right situation.
Benefits of Using Trusts in Certain Situations
In addition to the possible tax benefits of utilizing a trust in a divorce situation, either or both parties may find the economic protection offered by trusts useful in their settlement. The “paying” spouse may want to create a trust for the “receiving” spouse if he/she lacks financial sophistication or knowledge to handle large sums of money. Additionally, what if the receiving spouse has addiction issues (gambling, drugs, etc.)? Property paid to someone battling these issues would most likely be squandered in a short amount of time. Without sufficient funds, it is possible the receiving spouse could look to the paying spouse for additional claims of support.
By creating trusts to be used for tax planning, the paying spouse can deposit the settlement into the trust and rest assured that the principal is protected and will only be used for legitimate support purposes.
Also, if drafted properly, a trust can be created to manage and vote the stock of a closely held business interest in situations where the actual stock is part of the settlement. This would be useful in cases where stock is required to be transferred to a spouse who is not involved in the business and may not be familiar with the business operations. You wouldn’t want an individual with lack of knowledge about the business voting on company issues. The voting powers attached to stock ownership could rest with the trustee, not the uninformed receiving party.
The use of an alimony trust could also provide possible benefits for both the paying and receiving spouses.
The term “alimony” trust may be a bit of a misnomer. Usually, the payment of alimony yields a tax deduction for the paying spouse and income recognition for the receiving spouse. If an alimony trust is utilized, however, contributions to the trust by the paying spouse do not result in a tax deduction. You might end up asking the following question: “If I’m giving up a tax benefit, why am I doing it?” Understanding the answer may take a bit of time, but once understood, hopefully you will see the benefit of the trust.
The statutory authority governing the operation of an alimony trust appears in section 682 of the Internal Revenue Code (IRC). If drafted properly, the trust may result in child support or settlement payments being taxed in a way that closely resembles traditional alimony – a “deduction” (explained a little later) for the paying spouse, and income recognition for the receiving spouse.
Technically, an alimony trust is a grantor trust under IRC sections 671 – 677 (the funding spouse maintains beneficial ownership of the trust assets). However, because of the special rules listed in the above-mentioned IRC section 682, the trust is taxed as a non-grantor trust. This is important because it shifts the tax liability on the income generated in the trust to the recipient (to the extent distributed) and away from the paying spouse. Any undistributed income is taxed to the paying spouse.
Here is an example of how it works:
Paying Spouse and Receiving Spouse enter into a divorce settlement agreement that will pay Receiving Spouse $20,000 per year. A portion of the $20,000 is for child support, but the agreement (by design) does not specifically carve out an amount for child support. Paying Spouse funds the alimony trust with assets sufficient to generate the $20,000 that will be distributed to Receiving Spouse. In Year One, the trust generates exactly $20,000 of income and distributes all of the income to Receiving Spouse. Paying Spouse does not get a deduction for the amount contributed to the trust, nor for the amount distributed to Paying Spouse. The trust gets a deduction for the $20,000 distributed and has no tax liability. Receiving Spouse includes the $20,000 distribution in his/her income for Year One.
In Year Two, the trust generates $23,000 of income and, pursuant to the agreement, distributes $20,000 to Receiving Spouse. The tax treatment is the same for the trust and the Receiving Spouse. However, because the trust is considered grantor to the extent of the undistributed income, Paying Spouse will include $3,000 in his/her income for Year Two.
At this point, the paying spouse may still be saying, “I’m still not sure how this benefits me.” The answer: even though the paying spouse is not receiving an alimony deduction, he/she also isn’t picking up the income generated from the assets contributed to the trust. If he/she retained the assets and paid alimony in the traditional way, he/she would have received a deduction for the $20,000 (assuming no child support), but he/she would have also picked up the $20,000 generated by the assets for a net of zero. By not getting the deduction but also not picking up the income, he/she is in the same net zero position.
The receiving spouse under the example above will have to include income that could have been excluded child support, but the negotiated trade-off could be that payments from the trust could continue for him/her after traditional alimony or child support would normally end. Paying Spouse usually won’t object because the payments are coming from the trust, not him or her. Also, if structured as such, the payments could continue after the receiving spouse’s death – perhaps to children or grandchildren.
As stated at the beginning of the article, the use of a trust is complicated and not right for every situation. However, if asset protection is an issue, or the marital assets are sizeable, it might make sense that (after some number crunching) trusts be used for tax planning when properly drafted.