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George F. Bearup, J.D. Senior Legal Trust Advisor

7-Apr-21

The Spousal Unity Rule and a Future Divorce

Take-Away: The 2017 Tax Act dramatically change the tax implications of a divorce settlement. Adjusting to those new tax rules has become a challenge in structuring spousal trusts, since some of the existing rules went unchanged, like the spousal unity rule.

Background: The 2017 Tax Act (the Act) made fundamental changes to the income tax treatment of distributions made to a former spouse from a trust. The Act repealed IRC 215 which permitted a taxpayer to deduct the alimony or spousal support that was paid to the other spouse. As a conforming amendment, IRC 71 was repealed, which had required the recipient of spousal support to include those payments in the recipient’s taxable income for the year of receipt. The Act also included as a second conforming amendment the repeal of IRC 682 for spouses whose divorce or separation agreements were executed after December 31, 2018. IRC 682 had permitted a trust to be established for a former spouse where the income from the trust was taxed to the beneficiary. IRC 682 was an exception to the spousal unity rule.

Spousal Unity Rule: When a spouse establishes a trust for the other spouse the Tax Code applies what is referred to as the spousal unity rule. [IRC 672(e)(1)(A).] This rule is presumably based on the belief that spouses form a single economic unit. This rule provides that, for purposes of the grantor trust rules, a grantor is treated as holding any power or interest held by any individual who was the grantor’s spouse at the time of the creation of the power or interest in the trust. Accordingly, a trust established for a spouse normally falls under the grantor trust rules which causes the trust’s income tax liability to be paid by the settlor-spouse.

  • Tax Effect: A grantor/settlor holds any interest held by the grantor-settlor’s spouse in the trust, if that person was the grantor’s spouse at the time the power of interest in the trust was created. Consequently, if the married couple subsequently become divorced the spousal unity rule continues to apply and the trust continues to be treated and taxed as a grantor trust; thus, the grantor-settlor will still be liable to pay the income taxes associated with distributions from the trust to their ex-spouse.
  • Divorce or Separation: IRC 672(e), the spousal unity rule, says nothing about its application if the spouses divorce or legal separate after the creation of the power or interest in the trust for one spouse.
  • Enter IRC 682: Prior to the Act, IRC 682 came to the rescue of the grantor/settlor, by providing that after the divorce the ex-spouse would have to include the trust’s income in the ex-spouse’s income, thus taxable to the ex-spouse and not to the grantor-settlor. It does not say that the trust is no longer to be treated as a grantor trust, rather it is just an exception to the normal grantor trust rules.

ACTEC Proposal: Many commentator have argued, so far unsuccessfully, that once the marriage ends, there is no longer any reason for the spousal unity rule to apply to trust distributions to a former spouse. What has never been clear was the tax treatment of an irrevocable trust established for a spouse, when the spouses later divorce. Would that trust continue to be classified and taxed as a grantor trust for income tax reporting purposes? After the elimination of IRC 682 ACTEC wrote to the IRS to suggest that either the spousal unity rule of IRC 672(e) no longer apply once the spousal relationship has been formally terminated, or that IRC 682 continue to apply to the income generated by ‘spousal’ trusts that existed on December 31, 2018. We are still awaiting a response.

Alimony Trusts: The former IRC 682 was often referred to as an alimony trust. IRC 682 was originally intended to protect the grantor-spouse from a requirement to include trust income payable to a former spouse in their gross income if the trust principal or income could revert to the grantor within the meaning of IRC 676 or 677. Specifically, IRC 682(a) provided rules that described how the income of a trust is taxed if it is payable to a spouse or a former spouse of the trust’s settlor from whom the taxpayer is divorced or legally separated under a divorce decree, a judgement of separate maintenance, or under a written separation agreement.

  • 1988 Amendment: IRC 682 was expanded in 1988 to apply to: (i) a power or interest held by an individual who became the spouse of the grantor after the creation of the power or interest (but only after their marriage); and (ii) whether or not the grantor-settlor and his or her spouse were living together at the time of the creation of the power or interest in the trust. It also provided that the spousal unity rule did not apply to any power or interest created in the spouse if, at the time of the creation of the power or interest in the trust, the spouses were legally separated under a decree of divorce or separate maintenance.
  • Shifts Tax Burden: Under the former IRC 682(a) the trust’s income was includible in the gross income of the settlor’s former spouse and was not includible in the settlor’s gross income, despite the fact that technically the trust would be classified as a grantor trust when the spousal unity rule is applied. This same Tax Code section also applied for purposes of computing the taxable income of the trust. [IRC 682(b)] and that the settlor’s former spouse was considered a beneficiary of the trust for purposes of other sections of the grantor trust rules, i.e. IRC 641-through 685.
  • Exception to the Spousal Unity Rule: The Regulations under IRC 682 provided that “income of a trust, which is paid, credited or required to be distributed to the wife in a taxable year of the wife, and which, except for the provisions of IRC 682 would be includible in the gross income of her husband, is includible in the wife’s gross income and is not includible in the husband’s gross income.” [Treasury Regulation 1.682(a)-1(a)(1).] In effect, IRC 682 effectively overrode the grantor trust rules and established different rules for the treatment of distributions from a grantor trust to the settlor’s former spouse that might have been taxed to the grantor/settlor under IRC 676 or 677 due to the spousal unity rule.

Repeal of IRC 682:  The problem with the Act’s repeal of IRC 682 for divorce or separation agreements executed after December 31, 2018 is if the divorce or separation instrument is executed after that date, IRC 682  no longer applies to trusts created when the grantor and his or her spouse were married, like a SLAT that was created in 2012. The effective date of the repeal of IRC 682 is tied to the divorce or separation agreement, not to the date that the trust was created. Therefore, with a trust like a SLAT created for a spouse years ago, if the divorce or separation agreement is executed after January 1, 2019,  the trust will not be covered by IRC 682 and the grantor/settlor will continue to be taxed on the trust’s distributions to their ex-spouse.

  • QTIP and SLAT Trusts: The repeal of IRC 682 affects many types of existing ‘marital’ trusts like lifetime marital deduction trusts, e.g. a lifetime QTIP trust, or a spousal lifetime access trust, or SLAT.
  • Notice 2018-37: The IRS announced in this Notice that it will issue regulations that clarify that IRC 682  will continue to apply with regard to trust income that is payable to a former spouse who was divorced or legally separated under a divorce or legal separation document that was executed on or before December 31, 2018, unless that instrument is modified after that date and the modification provides that the changes made by the Act also apply to the modification. We are still waiting for those final regulations and the possible termination of the spousal unity rule if the marriage ends in a divorce or legal separation.

Lingering Interpretation Problem: While this discussion has focused on the repeal of IRC 682, it is important to note that the spousal unity rule also applies to other Tax Code sections that also create a grantor trust classification. For example, in 1986 IRC 674(c) [the power to control the beneficial enjoyment of the corpus or income of a trust held by trustees when none of whom are the grantor] and IRC 675(3) [when the grantor has borrowed corpus or income of a trust and has not completely repaid the loan before the beginning of the taxable year] were both amended to provide ‘for periods during which an individual is the spouse of the grantor (within the meaning of section 672(e)(2)), any reference in this subsection to the grantor shall be treated as including reference to such individual.”  Thus, in other situations naming a spouse as trustee, or giving a spouse powers, triggers the spousal unity rule, which may persist even after the spouses are later divorced.

Conclusion: The effect of former IRC 682 was to prevent the settlor-spouse from paying the tax on income that was distributed to the settlor’s former spouse. With the repeal of IRC 682, payments from such a trust, or for that matter any spousal support payments made to a former spouse, are no longer tax deductible by the payor or taxable to the payee after December 31, 2018. The larger question, still unanswered, is whether the spousal unity rule of IRC 672(e) continues to apply, even after the spouses obtain a divorce or become legally separated, causing the grantor to continue to be taxed on trust income because their former spouse held a power or control over the trust that the grantor created. Hopefully the IRS will change its position and find that the spousal unity rule no longer applies once the spouses are divorced.