Chapter 14 and divorce issues.

In many divorce cases, agreements are drafted between the parties without regard to all tax consequences. The income tax consequences--alimony being taxable to the payee spouse and deductible by the payor spouse and child support being neither deductible by the payor nor taxable to the recipient--are fairly well known. Property transfers between spouses incident to divorce are nonrecognition events for income tax purposes. In the gift tax arena, however, what appears to be an all-encompassing exclusion under Sec. 2516 from the gift tax may not always be so.

Sec. 2516 provides that in divorce situations a transfer of property or an interest in property made pursuant to a written settlement agreement to either spouse in settlement of marital or property rights or a transfer to provide support for children during their minority will be deemed to be a transfer for full and adequate consideration, i.e., the transfer will not be treated as a gift. For this exclusion to apply, divorce must occur within the three-year period beginning on the date one year before the agreement is entered into-whether or not such agreement is ratified by the divorce decree. Such transfers may be outright or in trust. However, a transfer in trust or as a split interest may cause unexpected gift tax consequences for those not versed in the Chapter 14 valuation rules,, namely Sec. 2702 and related regulations.

In structuring divorce settlements, the transferor spouse's attorney is usually trying to find a way to satisfy the settlemen desires of the parties without putting the property in the hands or the discretion of the ex-spouse. often this is done either through a split-interest transfer or, typically, through the use of a trust. A common structure would be one in which payments are to be made to an ex-spouse for a period of years with the remainder going to the children. Often an independent trustee is used so that the spouse receiving the payments is not subject to the whim of the payor spouse and there is less opportunity for continuing friction between the parties. The independent trustee also provides some comfort to the transferor spouse that the property placed in trust will eventually be received by the children. However, when a transfer is made in trust and a remainder interest goes to an applicable family member, the valuation rules of Chapter 14 come into play. According to Regs. Sec. 25.2702-1(c)(7), the complete exclusion from gift tax under Sec. 2516 is available only if the transferor spouse retains the remainder interest and thus the property reverts to him. Thus, if the settlement is structured such that the corpus is to be ultimately received by the children, there is potential for abuse.

IRS Letter Ruling 9235032 addressed the interplay between Secs. 2516 and 2702. The transaction proposed involved a divorcing couple and the required payments defined in their settlement agreement. Under the agreement, the taxpayer (H) was required to pay his ex-spouse (W) a stated amount per month until her death. Should H predecease W, the taxpayer's estate would be required to fulfill the obligation by making direct periodic payments, purchasing an annuity or establishing a trust to make the payments. H was required to pay W a stated amount per month for the support of their child (A) until the child attained majority; he was also required to pay A's college expenses. H proposed to establish an inter vivos irrevocable trust to provide for W's maintenance payments. H would not be a trustee of the trust and was precluded by the trust document from being appointed as a successor trustee.

The taxpayers requested guidance as to whether the transfer to fund the trust would constitute a transfer for full and adequate consideration under Sec. 2516 and therefore would involve a gift only to A as a remainder beneficiary. The Service stated that the funding of the trust, to the extent of the value of W's annuity, would be a transfer falling within the Sec. 2516 gift exclusion. However, H would be treated as making a gift subject to the gift tax to the extent the fair market value of the property transferred exceeded the value of W's annuity, determined in accordance with Sec. 7520. The remainder interest in the trust for A's benefit is a gift for gift tax purposes and would likewise be valued under Sec. 7520. Thus, the gift is the full value of the property less the value of the annuity interest to the ex-spouse. Had this been structured as an income interest to the ex-spouse instead, the rules of Sec. 2702 would assign a zero value to the spouse's interest and cause the transferee to pay gift tax on the full value of the property, as a gift of a future interest not subject to the annual exclusion of $10,000 per donee under Sec. 2503. Thus, care must be taken when structuring settlements of this type to prevent unwanted gift tax consequences.

The IRS went on to state that even though the transferor spouse did not technically retain an interest in the property transferred in trust, in the event he died during the ex-spouse's annuity period, the full value of the property would be includible in his gross estate under Sec. 2036(a) because he had retained "(1) the possession or enjoyment of, or the right to, income from the property or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom . . . " by virtue of the fact that the transfer in trust was used to discharge his legal obligation. Therefore, practitioners must also be aware of the potential estate tax inclusion, particularly when the payor spouse is in ill health or elderly.

Therefore, in structuring divorce settlements (particularly those involving transfers in trust), creative ways of avoiding current or future gift or estate tax problems need to be considered. One method might involve splitting the trust into two different trusts--one for the ex-spouse and the other for the children. The transfer to the ex-spouse could provide the spouse with income or an annuity payment for a period of years with the remainder back to the transferor spouse. Sec. 2516 would shield this entire transfer from gift tax. The second trust structured for the children could be funded with an asset that produces a high amount of current income such that the transferor would retain a significant annuity (bringing the gift tax value down under Sec. 2702) but would provide enough accumulated income to satisfy the remainder interest need for the children.

Another alternative would be to provide the gift to the minor children in such a manner that it would be incomplete at the time of the transfer. This may be done by putting in a condition that would prevent the transfer from being deemed a gift at the time of the transfer. Until the condition lapses and the gift becomes completed at a later date, the gift tax consequences can be planned around. Finally, in light of the gift tax consequences, it might be more advantageous to rearrange the settlement entirely to be sure that it falls squarely within the exclusion of Sec. 2516.

When structuring divorce settlements it is important to consider the gift and estate tax implications. Even if it is necessary to renegotiate the settlement, this is far better than dealing with disastrous tax consequences that may otherwise occur.