Divorce Settlements: Using Trusts to Deal with Distrust

I had the dubious opportunity to serve both as a divorce attorney and an estate planning attorney for over 42 years. One lesson that I learned is that many divorce attorneys are not always cognizant of the income tax implications that arise in a divorce settlement. Many divorce attorneys even go so far as to expressly disclaim in their engagement letter any duty to provide income tax advice that is associated with a divorce settlement. This lack of tax advice is most frequently encountered when low basis assets are exchanged in the divorce settlement, bringing with them future capital gains tax exposure. I also found that some of the estate planning techniques that were suggested to the couple while married to minimize transfer taxes was equally helpful when they negotiated a settlement when their marriage came to an end. If divorce attorneys are uncomfortable giving tax advice, then they need to partner with an estate planning attorney, especially when it comes to implementing sophisticated settlement agreements. Some examples where basic estate planning trusts can help settle contentious divorces follow.

Qualified Terminable Interest Trust (QTIP): In almost every divorce there is an element of distrust. A fear that a former spouse will not pay spousal support when required, forcing the recipient spouse to drag the former spouse back to the court to obtain an order that compels payment. This fear of non-payment can be addressed through the adoption of a lifetime qualified terminable interest (QTIP) trust. The transfer of assets to the QTIP trust while the spouses are married will not result in the imposition of a gift tax due to the unlimited marital deduction. IRC 2523. The beneficiary-spouse is entitled to receive all of the income generated by the QTIP trust; he/she is not reliant upon their former spouse to timely pay their support award, which facilitates their ability to live on a budget. The QTIP trustee is required to make all income payments solely to the beneficiary-spouse. The beneficiary-spouse will be obligated to pay income taxes on the QTIP trust’s income payments, just like a spousal support award. IRC 219(f)(1). The settlor-spouse who creates the QTIP trust still controls who will ultimately receive the assets transferred to the trust, since the settlor-spouse identifies the remainder beneficiaries of the trust. Any new spouse of the beneficiary-spouse will not ultimately benefit from the QTIP trust on the beneficiary-spouse’s death. The assets held in the QTIP trust will be included in the beneficiary-spouse’s taxable estate; there will be a corresponding step-up in the income tax basis of the QTIP trust assets on the beneficiary-spouse’s death, per IRC 1014, which ultimately benefits the settlor-spouse’s designated trust remainder beneficiaries. A lifetime QTIP trust can also be structured so that the settlor-spouse, who created the QTIP trust, can become an income beneficiary of the same QTIP trust after the beneficiary-spouse’s death, without the QTIP trust assets being included in the settlor-spouse’s taxable estate (the beneficiary-spouse is treated as having created the trust for the settlor-spouse on the beneficiary spouse’s death).

Bypass/Credit Shelter Trust: Assume the settlor-spouse is fearful that the recipient-spouse will remarry, and the thought of continuing to have trust income paid to the former spouse after his/her remarriage is abhorrent. The QTIP trust rules require that the payment of all trust income to the settlor’s spouse, and they do not permit an early termination of the beneficiary-spouse’s interest before his/her death. Instead of using a QTIP trust to provide income for their former spouse’s lifetime, the settlor-spouse could create and fund a bypass or credit shelter irrevocable trust. The settlor-spouse will have to use part or all of their federal gift tax exemption to cover the transfer of assets into the bypass trust. But unlike the QTIP trust, the bypass trust can impose contingencies that will cause the beneficiary-spouse to forfeit his/her right to income and/or access to the bypass trust principal through the trustee’s exercise of discretion. Examples of these contingencies might include: the beneficiary-spouse remarries; the beneficiary-spouse receives an inheritance from another individual; the beneficiary-spouse’s earned income exceeds a specified floor; or after a specified number of years the benefits from the trust come to an end. Yet there are some drawbacks that are associated with the use a bypass trust to implement a divorce settlement: (i) there will be no step-up in the income tax basis of the assets upon the beneficiary-spouse’s death that will benefit the remainder beneficiaries; and (ii) as noted, the settlor-spouse will have to use some of his/her federal gift tax lifetime exemption to cover the transfer of assets into the bypass trust, as the marital deduction will not be available to shelter the transfer of assets. If the settlor-spouse wants to access these assets in the event that one of the contingencies arises, e.g. the spouse-beneficiary’s death, remarriage, or the lapse of a scheduled number of years, the bypass trust can provide a reversion to the settlor-spouse, but then the assets held in the bypass trust will be included in the settlor-spouse’s taxable estate. IRC 2036.

Charitable Remainder Trust (CRT): Perhaps the spouses are fighting over who will be stuck receiving low-basis assets that are destined to be liquidated. One spouse can create as part of a divorce settlement a charitable remainder trust (CRT) for the benefit of their soon to be ex-spouse. IRC 664 The settlor-spouse would acquire a current charitable income tax deduction equal to 10% or more of the value of the contributed assets to the CRT. If appreciated assets are transferred to the CRT, the CRT trustee can sell those appreciated assets and not incur current capital gains taxes, which leave more assets held in the CRT to be reinvested and used to pay the CRT’s annual distribution obligation to the spouse-beneficiary. Another variation can be that the settlor-spouse becomes the initial CRT beneficiary with the soon-to-be ex-spouse named as a successive lifetime beneficiary of the CRT after the settlor-spouse’s death, used perhaps as a device to replace spousal support that the settlor-spouse had been paying after the divorce. The settlor-spouse can also retain the right to change the identity of the CRT remainder beneficiary. With the CRT the beneficiary- spouse could retain a stream of income for his/her support for the balance of their lifetime without owning or controlling the underlying assets. A CRT, unlike a QTIP trust, could also contain a provision that terminates the CRT on the beneficiary-spouse’s remarriage, or for any other action that might be taken by him or her, e.g. bringing a suit to set aside the divorce settlement after the settlor-spouse’s death. IRC 664(f). While the imposition of a contingency that can cause a forfeiture of benefits under the CRT would void a federal gift tax QTIP marital deduction, the contingent interest conferred on the beneficiary-spouse is covered under an exception in the tax code. IRC 2056(b)(8); IRC 2523(g). A married couple who have created a joint CRT can formally divide that CRT in the event of their subsequent divorce. Rev. Rul. 2008-41, 2008-2 CB 170, or one of the spouses can renounce their beneficial interest in the CRT, which could result in an income tax charitable deduction of some amount for the spouse who renounces his/her interest in the CRT.

Life Insurance Trust (ILIT): Often in divorce settlements a spouse is ordered, or agrees, to maintain a life insurance policy for the benefit of their soon-to-be former spouse, such as a spousal support replacement device. If the insured former spouse wants to deduct the insurance premiums as tax deductible payments under IRC 71, the former spouse should be both the owner and irrevocable beneficiary of the insurance policy. Rev. Rul. 70-218, 1970-1 CB 19. But few spouses who come out of a divorce want their former spouse to benefit from their death. Other problems also are associated with the direct ownership of the life insurance policy by the former spouse. For example, if an existing life insurance policy is transferred from the insured owner to their former spouse as part of the divorce settlement, and the insured dies within three years of that transfer, the value of the death benefit is included in the insured’s taxable estate. See Smoot v Smoot, 115 AFTR2d 2015-1485 (DC Ga., 2015.) Even if the divorce settlement agreement requires the former spouse to contribute to any estate tax caused by the inclusion of the death benefit in the insured’s taxable estate, the former spouse will not be happy about having to contribute to the estate tax liability of his/her former spouse, and the fiduciary of the insured spouse’s estate may face real challenges trying to recover part of the death benefit from the reluctant former spouse to contribute towards that estate tax liability.

If an ILIT is used instead of the direct transfer of the policy ownership to the former spouse, the former spouse could be named as the beneficiary of the ILIT. But similar to the bypass trust, the ILIT instrument can impose several contingencies on the former spouse’s continued benefit from the ILIT, causing a forfeiture of income rights on remarriage, cohabitation, etc., upon which events the ILIT benefits then pass to the insured’s ultimate beneficiaries. If the ‘three year transfer of ownership’ rule is triggered, the ILIT trustee can then be directed to transfer some or all of the death benefit paid to the decedent insured’s estate in order to pay estate taxes. If the ILIT is used, then the premiums paid by the insured, or contributions of the annual premium amount to the ILIT to enable the trustee’s payment of the annual premium, will not be deductible by the insured.

Alimony Trusts: Often illiquid or closely held business interests are the centerpiece of the contested divorce litigation. The spouses cannot agree on the value of the interest, or the interest is subject to a restrictive stock voting agreement or LLC operating agreement. An alimony trust can be used to hold the illiquid asset for the beneficiary-spouse when the spouses cannot agree on the value of the illiquid business interest, such as a partnership or LLC interest which is a pass-through entity for income tax reporting purposes. The income from the closely held business entity passes to the alimony trust, and then distributed to the beneficiary-spouse. Unlike a QTIP trust the alimony trust can impose conditions on the distribution of income to the beneficiary-spouse, and it can be for a fixed period of time, unlike the QTIP trust which must continue for that beneficiary’s life. The settlor-spouse is not taxed under the grantor trust rules of the tax code, which can help the grantor-spouse if he/she is subject to the phase-out of other deductions and credits or must contend with the net investment income 3.8% surtax, all of which are tied to the settlor-spouse’s reportable income. IRC 682(a). Nor, however, is the settlor-spouse entitled to deduct the amounts that are paid by the alimony trust to the beneficiary-spouse. The alimony trust is taxed as a complex trust with distributions from the trust taxable to the beneficiary-spouse. IRC 641-685. Often the children of the marriage, maybe children who are working in the family business or who are expected to work in the family business at a later date, are named as the remainder beneficiaries of the alimony trust.

Estate planners can add value to divorce settlements given their basic knowledge of income tax traps and the IRS’s byzantine retirement plan distribution rules. Even more value can be added if a divorce settlement uses various estate planning trusts with independent trustees to fulfill disparate spousal expectations and to address the mutual distrust of the spouses who leave their marriage.