Take-Away: A little used type of irrevocable trust in dissolving a marriage is an alimony trust which is expressly authorized under the Tax Code. The income tax implications for distributions from an alimony trust are sometimes much different from a direct payment of spousal support from one former spouse to the other. These trusts may become more prevalent in use if Congress repeals the current income tax deduction for spousal support payments.

Background:  We frequently encounter trusts that are created for spouses for a variety of reasons. A qualified terminal interest trust (QTIP) can be used to qualify the transfer of assets to an irrevocable trust for the federal gift tax marital deduction, to provide for a spouse’s lifetime, but give the donor  ultimate control over the remainder beneficiaries of that trust. Similarly, an irrevocable spousal lifetime access trust (SLAT) can be used to exploit each spouse’s lifetime federal gift tax exemption ($5.45 million) which continues to make the SLAT’s income available to the marital unit to preserve the spouses’ lifestyle, while removing all future appreciation of the SLAT’s assets from future federal estate taxation on the death of either spouse. Or, a spouse can create an irrevocable charitable remainder unitrust (CRUT) which is used to defer paying capital gains on appreciated assets that are transferred to the CRUT and then sold by the CRUT trustee, to provide a lifetime stream of  benefits to the spouse who is the sole beneficiary of the CRUT. But yet another trust, seldom encountered, is an alimony trust that can be used when the married couple divorces. A working knowledge of an alimony trust and when it is beneficial is important, especially if Congress eliminates most income tax deductions as part of its promised income tax reform.

Divorce Transfers: A key provision is IRC 2516 which renders nontaxable certain payments and transfers between former spouses that would otherwise be taxable. However, IRC 2516 applies only to payments and transfers made pursuant to a written agreement that resolves the divorcing spouses’ marital and property rights or provides for the support of minor children. In addition, the final decree of divorce must occur no later than two years after execution of the written agreement and no earlier than one year prior to the execution of the agreement. IRC 2516 provides that these transfers will be deemed to be made for full and adequate consideration, which negates the gift. As a result, most transfers of assets between spouses, or former spouses, incident to a divorce are without any tax consequences. But spousal support obligations are another matter.

  • Grantor Trust Rule: Suppose that the spouses plan for a divorce, and the payor-spouse wants to use a trust as part of the divorce settlement. The grantor-spouse is treated as holding a power or interest held by “any individual who was the spouse of the grantor at the time of the creation of sure power or interest.” IRC 772(e)(1)(A). If a former spouse remains beneficiary or trustee, the grantor spouse loses the flexibility to turn off grantor trust status, and the grantor will be taxed on the trust’s income, since it will be classified as a grantor trust.
  • Alimony Trust Rule: IRC 682 is intended to override grantor trust rules and causes trust income that is distributed to the former spouse to be included in the former spouse’s gross income for income tax purposes. However, income that is distributed from the trust in support of minor children remains taxable to the grantor. Restating these rules, once it is fully funded the alimony trust relieves the payor-spouse of future tax obligations when the trust income is payable to the payee-former-spouse. The payee-former-spouse is taxed on distributed income, while the alimony trust is taxed on undistributed income. The trust instrument can provide that upon the termination of the grantor’s support obligation imposed under the judgment of divorce, the trust principal will revert to the trust’s grantor. Thus, while this trust reversionary interest normally will cause the trust to be treated as a grantor trust for income tax reporting purposes, IRC 682 creates a special rule that treats an alimony trust as a non-grantor trust. Consequently the payee-beneficiary-spouse is taxed on the income distributed from the trust and the trust pays income taxes only on any excess income that is not distributed to the trust beneficiary.
  • Alimony Trust Advantages:  Some advantages that can be derived from using an alimony trust include the following: (i) an alimony trust limits contact between former spouses in the post-divorce period when emotions are still pretty raw; (ii) the alimony trust can be used to hold sophisticated income producing assets by an independent trustee that the grantor spouse may not want his/her spouse managing or voting, e.g. closely held business interests; (iii) the payee-beneficiary may not be competent to manage investment assets that are transferred to the alimony trust so a professional trustee can be used, not only for professional management of the investments but to insulate the trust beneficiary from his/her former spouse; (iv) the assets transferred to the alimony trust are sheltered from the payee-beneficiary’s creditors due to the spendthrift limitation used in the trust; and (v) the alimony trust can provide a consistent stream of income assuring the payee-beneficiary steady payments regardless of problems encountered by the payor-spouse (real or imagined) during the payment period.

Income Tax Implications:

  • Payee Pays the Income Tax: The income from the alimony trust is taxed to the payee-beneficiary.
  • No Deduction to Grantor: The grantor-spouse will not be entitled to an income tax deduction normally attributed to a spousal support payment obligation under IRC 71(b) [pertaining to the alimony or separate maintenance payment] and IRC 215 [pertaining to the deduction available to the payor-former-spouse.] The grantor is not making the payment to the former spouse, the trustee is making the payment.
  • Tax Reform Comment: I wonder if the income tax deduction for spousal support payments will disappear with the recent proposal to eliminate most income tax deductions under the promised income tax reform, and if so, whether there will be a second-look at using alimony trusts in lieu of a conventional spousal support award/obligation under a judgment of divorce if a payor-spouse can no longer deduct the spousal support payments made to a former spouse.
  • Disparate Income Treatment: One critical distinction between a conventional income tax deductible spousal support obligation and the distributions from the alimony trust is the character of the payments reported by the recipient. If a husband pays a spousal support award pursuant to a judgment of divorce to his former wife, the entire amount is taxable as ordinary income to the recipient former wife, regardless of the nature of the income earned by the husband. For example, a husband may only have capital gains income or tax exempt bond income available to pay his spousal support obligation to his former wife, none of those tax attributes will pass through to the former wife, who must treat the entire spousal support payment as ordinary income that is taxable to her. In contrast, if the payee-former wife is the beneficiary of an alimony trust, the income tax attributes of the income earned by the alimony trust and distributed to her will have their attributes passed through to her as well. Obviously a lot will depend on how the alimony trust defines ‘income’ for purposes of distributions to its trust beneficiary, e.g. does it exclude capital gains per general rules of trust accounting, or does it expand the definition of ‘income’ to include capital gains or tax exempt income? As such the after-tax consequences to the recipient former spouse can be much different depending on whether the payment is directly made by the former spouse, or payments are made through the use of an alimony trust.
  • IRS Priority Guidance Plan: The most recent IRS Priority Guidance Plan was released on August 15, 2016. No Priority Guidance was issued this past summer, apparently in expectation of major tax reform legislation on the horizon. But #2 in the 2016 IRS Priority Guidance Plan was ‘guidance on definition of income for spousal support trusts under IRC 682.’ No other reference is made to what problems or abuses that the IRS perceives with the use of an alimony trust, but it is something to watch for if an alimony trust is contemplated.

Conclusion:  Admittedly not much is known about alimony trusts and most spousal support awards are the direct-payment variety. But in those situations where there is not a lot of trust between divorcing spouses (and their seldom is) or the recipient spouse does not want to report all payments as ordinary income when capital gain income is the primary source of the spousal support, an alimony trust might serve those purposes.