Using trusts in divorce tax planning.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 ad·ver·sar·i·al adj. Relating to or characteristic of an adversary; involving antagonistic elements: "the chasm between management and labor in this country, an often needlessly 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 so·phis·ti·cate v. so·phis·ti·cat·ed, so·phis·ti·cat·ing, so·phis·ti·cates v.tr. 1. To cause to become less natural, especially to make less naive and more worldly. 2. or knowledge to handle a large lump-sum settlement The payment of an entire debt all at once rather than in installments; the payment of a set amount of money to satisfy a pecuniary obligation that might otherwise continue indefinitely. prudently. The funding spouse may also want to use a trust when the other spouse is a spendthrift One who spends money profusely and improvidently, thereby wasting his or her estate. Under various statutes, a spendthrift is a person who wastes or reduces her estate through excessive drinking, gambling, idleness, or debauchery in a manner that exposes that individual or , compulsive com·pul·sive adj. Caused or conditioned by compulsion or obsession. n. A person with behavior patterns governed by a compulsion. compulsive the state of being subject to compulsion. gambler or chemically dependent per son. 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 jeop·ard·ize tr.v. jeop·ard·ized, jeop·ard·iz·ing, jeop·ard·izes To expose to loss or injury; imperil. See Synonyms at endanger. the funding spouse's other income and assets and, thus, the ability to pay future alimony alimony, in law, allowance for support that an individual pays to his or her former spouse, usually as part of a divorce settlement. It is based on the common law right of a wife to be supported by her husband, but in the United States, the Supreme Court in 1979 , 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 An individual who conveys or transfers ownership of property. In real property law, an individual who sells land is known as the grantor. grantor n. 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 recapture n. in income tax, the requirement that the taxpayer pay the amount of tax savings from past years due to accelerated depreciation or deferred capital gains upon sale of property. (See: income tax) RECAPTURE, war. 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 Grantor trust A mechanism of issuing MBS wherein the mortgages' collateral is deposited with a trustee under a custodial or trust agreement. 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 re·vert v. 1. To return to a former condition, practice, subject, or belief. 2. To undergo genetic reversion. 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 Adj. 1. undistributed - (of investments) not distributed among a variety of securities undiversified - not diversified 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 non-child 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 spou·sal adj. 1. Of or relating to marriage; nuptial. 2. Of or relating to a spouse. n. Marriage; nuptials. Often used in the plural. 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. Example: John and Lisa are divorcing. Their three minor children will live with Lisa. John will pay her $1,000 per month, per child, until each child reaches age 18. John and Lisa want her to be taxed on the payments. Variation 1: John pays Lisa directly. The payments will not qualify as alimony; instead, they will be deemed child support, which is neither deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). by John nor includible in Lisa's income. Variation 2: John establishes a trust funded with sufficient assets to produce at least $36,000 annual taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . The trust instrument requires the trustee to pay Lisa $3,000 per month as long as all three children are under age 18. The monthly payment is reduced by $1,000 per month as each child reaches 18. The trust instrument also requires that any trust income in excess of the required payment to Lisa be paid to John. Lisa includes the trust distributions in her income. Although John gets no alimony deduction, he does not have to include the trust income and thereby achieves a result equivalent to alimony. 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. Editor's note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat. Trained by D. : This case study has been adapted from PPC's Guide to Tax Planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. 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). Editor: Albert B. Ellentuck, Esq. Of Counsel King & Nordlinger, L.L.R Arlington, VA |
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