Alimony Trusts: R.I.P.

Take-Away: The 2017 Tax Act overhauled the tax treatment of spousal support that is paid incident to a divorce or legal separation. Along with those changes in the taxation of a spousal support award is the repeal of the alimony trust which was equivalent to a legal exception to the grantor trust taxation rules. The repeal of these historic tax provisions was recently addressed in Treasury’s Notice 2018-37.

Background: Prior to 2019, spousal support paid by a former spouse (payor) was normally tax deductible as an ‘above-the-line’ [IRC 215] deduction, while the support payments received by the other former spouse (recipient) was included in the recipient’s taxable income [IRC 71(a).]To obtain this tax treatment, the spousal support award had to terminate on the recipient’s death. These two tax shifting provisions of the Tax Code were repealed, effective as of December 31, 2019. [Tax Act Section 11051(a).]

Spouses’ Choice: If spouses become divorced any time during 2018, they may choose to have either tax consequence regime apply to their agreement, i.e. continue to be taxable to the recipient, or not taxable to the recipient, as they mutually agree. Support orders entered after 12/31/18 will be income tax-free to the recipient. Existing spousal support awards put in place prior to 2018 will normally continue with their same income tax consequences at the time the award was agreed upon or entered by the divorce court, i.e. they are intended to be Unclear, however, is the impact if a court modifies a preexisting spousal support award after 2018- is it an ‘old’ support order or a ‘new’ support order?
Two Sets of Rules: As if life was not already complicated enough, with this repeal there will now be two sets of rules that pertain to the taxation of spousal support: those awards that occurred before 2018 and those awards that will occur starting in 2019. Those spousal support obligations that occur in 2018 may go either way in how they are taxed, with the divorcing parties (or I suppose an astute trial judge making the decision for the litigants) choosing which tax regime the support order will follow.

Repeal of IRC 682: Notice 2018-37 also confirmed the consequences of the repeal of IRC 682 by the Tax Act, which was commonly called the alimony trust exception. This repeal is also effective on December 31, 2018. IRC 682 provided the rules with regard to the income tax treatment of income distributed from a trust that was payable to a former spouse who was legally divorced or separated from the settlor of the trust. IRC 682 provided that trust income distributed to the recipient-beneficiary was taxable to the recipient-beneficiary, regardless of other provisions of the Tax Code that might tax the income to the settlor of that trust (i.e. the conventional grantor trust rules.)

Alimony Trust History: IRC 682 was a formal exception added to the Tax Code to avoid the normal grantor-trust rules when the grantor creates an irrevocable trust for the benefit of the grantor’s spouse. [IRC 677.] Even after the divorce, the trust remained a grantor trust for income tax reporting purposes [IRC 672(e)(1)]. Thus, the divorce between the grantor and his/her spouse (trust beneficiary) did not negate the impact of IRC 677. All of which is why a formal exception was created to the general grantor trust rules found in IRC 682. As a result, the income tax consequences of IRC 682 paralleled the income tax treatment rules under IRC 71 and IRC 2015- the recipient spouse was taxed on trust distributions, not the grantor of the trust.
Benefits of Alimony Trusts: From time to time alimony trusts had practical tax consequences that were different from a normal alimony obligation imposed in a judgment of divorce, where money simply changed hands pursuant to court order. Some features of a trust appealed to one or both spouses: (i) assets transferred to the trust were not subject to the recipient-beneficiary’s creditor claims; (ii) a professional managed the alimony trust’s assets, which provide comfort to both the payor and the recipient who may not have had much experience in handling investments; (iii) conditions could be imposed on the recipient-beneficiary before he/she became eligible to receive a distribution from the trust; (iv) the trust corpus could revert to the payor upon the trust’s termination; (v) the recipient-beneficiary was assured that the payor would not ‘play games’ by withholding spousal support payments to extract a post-divorce concession; and (vi) sometimes the distributions from the trust to the recipient were not fully taxable, since only distributable net income (DNI) of the trust would be carried out with a trust distribution to the recipient-beneficiary and thus be taxable or with separate tax attributes, e.g. capital gains distributed and taxed at 20%, in contrast to a ‘straight-up’ spousal support payment, all of which was taxable to the recipient as ordinary income. In sum, while the creation of an alimony trust was not for everyone, there were occasions when such a trust was a helpful device to bridge the emotional negotiations to get the payor and recipient to reach a divorce settlement.
Notice 2018-37: This Notice says that IRC 682 will continue to govern the taxation of trust income that is payable to a former spouse if the trust is executed prior to December 31, 2018, unless the trust instrument is modified after that date to provide otherwise. After 2018, IRC 682 disappears, so it will no longer be available as a tool to shift the income tax burden. The Notice requests comments with regard to whether guidance and clarification is needed that relates to the grantor trust provisions of IRC 672, 674 or 677 in light of the repeal of IRC 682. One take-away from this Notice is that if spouses were good candidates to use an alimony trust, they better act before the end of this calendar year.

Planning Reaction to the Repeal:

Beware Phantom Income to the Payor: The result of all these Code section repeals is that on December 31, 2018, IRC 682 disappears from the Tax Code. If an alimony trust already exists, will the income tax consequences change, since there will no longer be any IRC 682 to provide ‘protection,’ i.e. shift income report consequences away from the payor-grantor? That may be one of the reasons for comments elicited by Treasury in the Notice. The Comments to the Tax Act repeal state: ’income used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse.’ It may very well be that the ultimate result of the repeal of IRC 682, and after comments are received by the Treasury under Notice 2018-37, is to shift the income tax burden of the income generated by the IRC 682 alimony trust back onto the grantor-payor, which will come as a big surprise to grantor-payors who thought that they had shifted the income tax burden onto their former spouse as part of a carefully negotiated divorce settlement, essentially causing the former alimony trust to now become the equivalent of an intentionally defective grantor trust created for a former spouse.
Threat to IRC 199A Deduction?: We also have to be concerned about the impact of this possible ‘new’ phantom income attributed to the grantor-payor if that phantom income makes the grantor-payor ineligible to claim the new IRC 199A deduction due to his/her higher reported taxable income for the year, when the phantom income is added to their regular income.
Use a CRT: As was mentioned in one of my missives long ago, a good substitute to the use of an alimony trust might be a charitable remainder trust. The charitable remainder trust (CRT) provides many of the practical features of the ‘old’ alimony trust, e. creditor protection for the beneficiary, professional management of trust assets, an independent trustee which is not prone to ‘play-games’ by withholding distributions to the recipient-beneficiary, etc. Moreover, a charitable remainder trust could be structured to pay the annuity or unitrust amount to the recipient first, and upon the recipient’s death the payor could then become the beneficiary of the CRT for his/her lifetime. And unlike a QTIP Trust which is required to distribute all of its income to the recipient-beneficiary for his/her lifetime, the distributions from the CRT to the recipient can be conditioned upon the recipient-beneficiary remaining unmarried. [IRC 664(f).] Finally, the payor-settlor of the CRT would receive an up-front charitable income tax deduction for the value of the CRT’s remainder interest, which tax deduction if large enough could be used in the year the CRT was created and funded, and carried forward for the next 5 calendar years, thus sheltering the payor-settlor’s other income from taxation when he/she is attempting to re-build their wealth after their divorce.
Drafting: If an irrevocable trust is created for a spouse as part of current estate planning, e.g. a Michigan Qualified Dispositions in Trust (asset protection) or spousal lifetime access trust (SLAT), then it would be wise to include a ‘divorce clause’ in that irrevocable trust, which causes the former spouse to automatically forfeit their beneficial interest in the trust, merely with the filing of a divorce or separate maintenance action. Example: Rather than say in the irrevocable trust ‘the trustee may pay to or for the benefit of my wife, Mary Smith, and my children such amounts of income or principal as the trustee deems necessary for their health, support and education….’ the trust might say instead ‘the trustee may pay to or for the benefit of the person to whom I am then currently married, and my descendants, such amounts of…’. In addition there should also be a provision buried in the trust boilerplate that provides: ‘If there is a divorce or separate maintenance action pending between me and a trust beneficiary, the trustee shall make no distributions from this trust either to or for the benefit of that trust beneficiary so long as that legal action is pending.’

Conclusion: Negotiating divorce settlements will never be the same after 2018 with the repeal of IRC Sections 71(a), 215, and 682. Rather than wait until the end of this year, now may be a good time to think about the impact of this shift in income tax burdens onto the payor or recipient, and how additional phantom income will impact other opportunities the payor may be exploring.