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

13-Feb-18

Charitable Remainder Trusts: An Old Tool to Fix a New Problem

The Tax Cut and Jobs Act (the 2017 Tax Act) provided several surprises, although I am not sure that it actually delivered that much simplification to a complex tax code as was promised. One big surprise was to make alimony or spousal support no longer tax deductible by the payer or taxable to the recipient. Unintended consequences may result from that change, especially when the shifting of income tax liability is a key component to settling a contentious divorce. A court order that compels one spouse to pay their former spouse financial support using after-tax dollars is not going to be readily embraced.

2017 Tax Act Changes: A quick summary of the new alimony rules follows.

  • Alimony, or spousal support as used in Michigan, is no longer deductible by the payer, thus eliminating the payer’s above-the-line income tax deduction under IRC 215.
  • The recipient of a spousal support award is no longer required to include that support award as taxable income under IRC 71(b).
  • Taxable income paid via alimony was treated as earned income under IRA rules so that the recipient could use alimony payments to make IRA contributions. That will no longer be an opportunity for the recipient, who may not have any other sources of income from which to make an IRA contribution.
  • These new rules will apply to any divorce or legal separation instrument as defined in IRC 71(b)(2) that is executed after December 31, 2018.
  • These new rules will also apply to any divorce or legal separation instrument that is executed before December 31, 2018 and modified after that date, if the modification expressly provides that the amendments made by these new rules applies to that modification.
  • The old income tax with regard to alimony rules will not return beginning in 2026.
  • An alimony trust, which was a statutory exception to the grantor trust rules of IRC 672(e), and expressly authorized under IRC 682(a), was permanently eliminated (not just suspended.)
  • Consider the impact of the enlarged standard deduction and the loss of many income tax deductions under the 2017 Tax Act on this dramatic change in income tax treatment of spousal support awards. A recipient-spouse with no taxable earnings will receive no benefit from his or her enlarged standard deduction while the standard deduction for the payer with taxable earnings will be smaller. Thus this change in the tax treatment of an alimony award will affect both the payer and the recipient in many cases.

Past Income Shifting: Historically, the alimony paid by one spouse was tax deductible above the line (i.e. not subject to any ‘floors’ like other income tax deductions) claimed by the payer. The recipient ex-spouse reported those payments as taxable income. The result was to intentionally shift that taxable income from the payer’s high income tax bracket to the recipient’s lower income tax bracket. It was this ability to deduct these support payments that often led the payer to agree to a divorce settlement, knowing that part of the settlement to be paid by him or her was going to be tax deductible, which helped to lead the parties to a negotiated settlement. That income-shifting opportunity that will no longer exist to couples who are going through a divorce.

Alimony Trusts: I initially thought it might be possible to achieve close to the same after-tax outcome if an alimony trust was used to shift income to the recipient trust beneficiary, as IRC 682(a) and Treas. Regulation 1.682(a)(1) provided:

Income of a trust (i) which is paid, credited or required to be distributed to the wife in a taxable year of a wife, (ii) which, except for the provisions of Section 682, would be includible in the gross income of her husband, is includible in her gross income and is not includible in his gross income.

With an alimony trust rather than one spouse paying directly to their former spouse support as ordered by the divorce court [which is no longer income tax deductible to the payer and taxable to the recipient ex- spouse], instead income producing assets were transferred into an irrevocable trust as part of the divorce settlement, a trust that named the former spouse as its sole income beneficiary. All the income was paid to the ex-spouse, either for lifetime, or more often for a specified number of years, or upon the occurrence of a specified event, (e.g. the ex-spouse’s remarriage; attains a college degree.) The trust income to the ex-spouse was taxable to that ex-spouse, despite IRC 672(e) which normally requires grantor trust treatment when one spouse creates an irrevocable trust for the benefit of their spouse. There was no income tax deduction available to the settlor-spouse who created the alimony trust, but then the trust income was not reported by trust settlor as taxable income. That was the tax treatment required by IRC 682(a) for an alimony trust, which has been a part of the Tax Code since 1984. In sum, an alimony trust was a statutory exception to the normal grantor trust rules, which otherwise caused the grantor of a trust to pay income taxes on the income generated by the trust that was created for the benefit of the grantor’s spouse.

But, as noted above, alimony trusts were repealed under the 2017 Tax Act [HR 1 Section 11051] which means that can alimony trust can no longer be used as an alternative to the loss of an income shifting tax deductible spousal support obligation. And unlike many of the 2017 Tax Act provisions which have a 2025 sunset provision, e.g. IRC Sections 71(b) and 215, alimony trusts under IRC Sections 682(a) and2516 are permanently repealed, which makes one wonder what happens to those existing alimony trusts if the income-shifting authorization of IRC 682(a) no longer classifies the trust, and in turn causes the trust to revert back to normal grantor trust taxation to the settlor-spouse.

Spousal Access Trust Option: While the use of a spousal lifetime access trust (SLAT) in lieu of an alimony trust to help settle a contested divorce sounds appealing, it may not work because of IRC 672(e) which classifies the SLAT that is created for a soon-to-be-ex-spouse on the eve of a divorce a grantor trusts for income tax reporting purposes. It may be possible to structure a SLAT to avoid the grantor trust rules, e.g. require the consent of an adverse party to distributions of trust income to the recipient spouse [IRC 674; Reg. 1. 674(a)-1] but that required consent from an adverse party may prove to be entirely unacceptable to the SLAT beneficiary who expects to rely upon trust distributions for his or her continuing support.

Charitable Remainder Trust Option: Creating a charitable remainder trust (CRT) might be a viable option to a spousal support award that is no longer tax deductible by the payer, but only if the payer has some long-range philanthropic goals. A CRT is a tax exempt trust under the Tax Code. Transfers to a CRT where a spouse is named as the CRT lifetime beneficiary will qualify for the federal gift tax marital deduction. [IRC 2523(g).] The gift of the remainder interest in the CRT qualifies for the federal gift tax charitable deduction. [IRC 2522(a).]

A CRT created under IRC 664 could be established for a spouse’s lifetime, or for a term of years, e.g. 20 years. The CRT would pay to the ex-spouse an annuity amount or a unitrust amount (usually 5% of the CRT’s assets) annually. But there are some significant differences between a SLAT and CRT that is created for a spouse on the eve of a divorce. Those differences include:

  • The CRT would not be taxed as a grantor trust, unlike the SLAT, as the trust is a charitable tax-exempt trust.
  • Annual distributions from the CRT are subject to the tiered income taxation on distributions, meaning that some distributions to the recipient spouse might be taxed as capital gain or tax-exempt income, or a ‘return’ of principal, and not all distributions would be taxed as ordinary income to the recipient.
  • The CRT settlor would be able to claim a present income tax charitable deduction for the present value of the remainder interest that is dedicated to ultimately be distributed to the charitable remainder beneficiary. The size of this charitable income tax deduction could permit the settlor’s use of the income tax charitable deduction because the amount of this charitable income tax deduction could exceed the size of the settlor’s standard deduction in the year the CRT is funded.

Qualified Contingencies: One other significant advantage that a CRT would have over any other type of lifetime marital deduction trust, like a QTIP trust, is that the distributions from the CRT can terminate on the occurrence of a qualified contingency. [IRC 664(f).] With a lifetime QTIP trust the income must be paid at least annually to the spouse-beneficiary for that spouse’s lifetime, without any contingencies or limitations on the spouse’s right to receive QTIP trust income. In contrast the CRT can impose qualified contingencies on the spouse beneficiary’s entitlement to continue to receive annual distributions from the CRT.  A qualified contingency means any provision of a trust which provides that, upon the happening of a contingency, the payments [described in paragraph (1)(A) or (2)(A) of subsection (d) (as the case may be)] will terminate not later than such payments would otherwise terminate under the trust. [IRC 664(f)(3).] For example, a CRT could provide annual annuity or unitrust payments to the beneficiary spouse until that former spouse remarries, at which time the right to receive the annual CRT payment could be forfeited to reflect that former spouse’s change in marital status. If a qualified contingency is imposed on the CRT beneficiary’s continuing right to receive the CRT’s annuity or unitrust payment, that contingency will not be considered when calculating the settlor’s charitable income tax deduction for the gift of the CRT’s remainder interest to charity. [IRC 664(f)(2).]

Benefits of Using a CRT: Obviously, not every divorce where an alimony award is likely will an CRT be considered as a viable option. But there are definitely situations where a CRT might be an acceptable replacement for an alimony award that will no longer be tax deductible by the payer. The following are some of the reasons or occasions when a CRT might be warranted, besides trying to replicate the income- shifting formally available under a spousal support award:

  • The recipient lacks financial sophistication to manage the CRT assets;
  • The recipient needs an assured, reliable, stream of payments which is required to be made from the CRT to retain its charitable trust status;
  • The payer is a bankruptcy risk;
  • The CRT assets are no longer owned or controlled by the payer;
  • The recipient needs the income for a definite period of time and not be subject to the risks of the payer’s disability or death when a customary alimony obligation would terminate;
  • The CRT contains a spendthrift clause which protects its assets from the recipient’s creditors;
  • The recipient wants an objective intermediary between the two ex-spouses to make and follow investment management specified under the CRT;
  • Appreciated assets can be liquidated by the CRT trustee without having to pay an immediate capital gain tax, which means more assets will remain in the CRT to be reinvested by the trustee for the benefit of the recipient;

If a CRUT can be used as a hedge against future inflation, if its assets continue to grow in value; and

  • The payer wishes to have a reversion of the transferred assets once the CRT beneficiary’s rights ends, as the CRT could be set up for two-consecutive lives, with the payer identified as the second life to receive CRT distributions (or a child from the marriage could be named as the second beneficiary, but that might jeopardize the CRT’s tax qualified status if the value of the charitable remainder interest drops below 10% of the initial value of assets transferred to the CRT.)

Structuring a CRT: The different income tax treatment associated with CRT distributions can make it difficult to decide how the trust is best structured and what assets are used to fund the trust. Usually the CRT beneficiary will want to be assured of a definite amount to be distributed from the trust in order to construct a reliable cash-flow budget, which suggests a charitable remainder annuity trust (CRAT) that requires a specific amount to be distributed for a specified period of time to the CRT beneficiary. But if the CRT is intended to provide financial support for the beneficiary for the balance of his or her lifetime, then a charitable remainder unitrust (CRUT) might be a better choice, since the CRUT beneficiary is entitled to receive a fixed percentage of the assets held by the CRUT at the end of each calendar year, so that if CRUT assets grow in value, a larger unitrust amount will be distributed to the beneficiary, to provide some hedge against inflation.

Funding a CRT:  Some assets will work well as the subject of a CRT, such as assets with substantial appreciation which can be liquidated by the CRT trustee without having to pay an immediate capital gain tax. Other assets will not work well. For example, a CRT cannot hold S corporate stock. Similarly, a CRT that generates unrelated business income tax [UBTI is defined in IRC 512] will cause the CRT to be subject to the 100% excise tax on that UBTI. Nor should encumbered property be used to fund the CRT, since that would make the CRT a grantor trust when the payer spouse remains personally liable for the debt.  But a leased commercial real estate building that produces a predictable stream of rental income could be transferred to the CRAT; the CRAT could use the remaining duration of the commercial lease as its express term of years.

Conclusion: After decades of consistent income tax rules applied to spousal support obligations, which were fundamental to most divorce lawyers and judges, we now have a new set of rules to work with, or around, which will impact how divorce settlements are structured. Other legal documents like prenuptial agreements, where provisions are included in anticipation of future divorces which provide the payment of tax-deductible alimony if the marriage fails will have to be renegotiated (assuming the recipient is willing to revisit the distasteful process of negotiating a prenuptial agreement when happily married, where he/she will be asked to give up tax-free distributions under the new tax rules should a divorce occur.) An CRT may not be the perfect solution to the change in the income tax deduction rules that are associated with an alimony obligation, but it should at least be considered, particularly when you consider that the CRT can contain a qualified contingency like remarriage to the continued distributions much like a prior spousal support award that was often conditioned on the recipient spouse remaining unmarried.