January 4, 2024
When Divorce and Grantor Trusts Collide
Currently, many married couples are encouraged to establish a trust for their spouse as part of their sophisticated estate plans. They are prompted to utilize their federal transfer tax exemption while it is large, since come 2026, if Congress does not act in the interim, their individual exemptions are set to drop from close to $14 million to about $6 million. Thus, the adage to ‘use it before you lose it’ comes to mind to avoid federal transfer taxes.
As a result, many married individuals are starting to heed that advice and consider the adoption of estate planning trusts for their spouse. Some of these trusts are: (i) spousal lifetime access trusts (SLATs); (ii) grantor retained annuity trusts (GRATs); (iii) irrevocable life insurance trusts (ILITs); and (iv) qualified personal residence trusts (QPRTs). All these irrevocable trusts are candidates that use one spouse’s available federal transfer tax exemption amount. Funding these trusts entails use of the trust creator’s currently large federal transfer tax exemption, so no gift tax is actually paid, but the trust shifts wealth from the creator’s taxable estate. While these trusts work well to save federal gift and estate taxes, often overlooked is the effect of a future divorce when the irrevocable trust is established for one’s spouse.
PROPERTY DIVISIONS: The first problem encountered is that the irrevocable trust might be ignored by a divorce court when the marital estate is divided. With an irrevocable trust, technically speaking, neither spouse ‘owns’ the trust’s assets — the trustee does, but not the spouse. While some divorce courts will identify that distinction and treat the trust and its assets as a separate and thus not considered in the court’s division of the marital estate, other divorce courts, exercising their equitable powers, will simply ignore the fact that an irrevocable trust owns the assets and will nonetheless include the assets in the divisible marital estate, especially if the trust was funded with assets that were acquired during the course of the spouse’s marriage, or when the trust’s income or assets are regularly used to sustain the couple’s lifestyle. Consequently, these estate planning trusts that are established by one spouse for the other’s benefit while married and are intended to be used, in part, for their creditor protection features, may not be respected when the trust’s creator and the trust’s beneficiary are later in a divorce. A post-nuptial agreement between the spouses as to how the trust will be addressed in a future divorce might guide the divorce judge, but post-nuptial agreements in Michigan are much harder to enforce in Michigan than one would imagine.
GRANTOR TRUST: Perhaps as an even bigger surprise to the trust’s creator are the income tax consequences that are associated with many of these estate planning trusts that are created for the creator’s spouse. Under the Tax Code the trust’s creator is treated as the owner of any portion of the trust if the trust’s income may be distributed to the creator’s spouse [IRC 677(a)(1)]. And under the so-called spousal unity rule the trust’s creator is treated as holding any interest in the trust that is held by an individual who was the creator’s spouse at the time the trust was created. [IRC 672(e)(1)].
Consequently, if the trust’s creator was married at the time that their spouse’s interest in the trust was created, the creator is taxed on the trust’s income, even though none of the income is available to the creator to pay that income tax liability. This is not much of a problem while the couple is happily married. It becomes a nightmare if the couple are divorced. The trust creator’s grantor trust income tax obligation is determined at the time their spouse’s interest in the trust was initially created, and that liability to pay the trust’s income tax continues to apply even if there is a subsequent divorce between the trust’s creator and his or her spouse. In short, after a divorce, the trust’s income will continue to be payable to the former spouse, tax-free, in the absence of any tax relief provided by the Tax Code. Divorce is an unpleasant experience to begin with. It is doubly unpleasant if the trust’s creator continues to pay the income tax liability on the trust’s income distributions to their ex-spouse.
FORMER TAX RELIEF: Prior to the 2017 Tax Act, there was relief for the trust’s creator. Under the prior Tax Code, the trust ceased to be taxed as a grantor trust to its creator after a divorce [IRC 682]. Unfortunately, that Tax Code section was repealed with the enactment of the 2017 Tax Act, starting in 2019. Moreover, the repeal of section 682 is keyed to the date of the divorce or separation agreement, not the date of the trust instrument. As a result of the repeal of IRC 682, the trust’s creator will continue to be liable to pay the tax on the grantor trust’s income, even those trusts that were created years before the divorce. Consequently, an ILIT, a GRAT, a QPRT, or a SLAT created during a happy marriage that name a spouse as a beneficiary are all grantor trusts that will cause this income tax burden faced by the trust’s creator post-divorce — income tax liability but no access to the income with which to pay the tax.
SOLUTIONS: It is often difficult to work around these grantor trust rules if there is a future divorce. How the trust instrument is written can prevent the trust from either being classified as a grantor trust or from a former spouse receiving tax-free income from the trust at the expense of the trust’s creator. Some of these strategies include the following:
- Adverse Party Consent: For the trust created for a spouse to not be classified as a grantor trust, any distribution to the spouse-beneficiary must be subject to the consent of another trust beneficiary who possesses an adverse interest in the trust to the spouse. If the trust is not a grantor trust to begin with, then its creator will not be taxed on the trust’s income after the divorce. An example would be where the trust document requires a child of the couple who is named as the remainder beneficiary of the same trust to provide their consent before distribution from the trust to their parent can be made.
- Marriage Contingency: Another approach to address the problem of the trust’s creator paying the income tax liability on income distributed to their former spouse is to name the spouse as trust beneficiary, but then make any distribution to the spouse contingent on remaining married to the trust creator. This might work for a SLAT, a GRAT, or a QPRT.
- Floating Spouse: Another way to avoid the frustration of the trust’s creator paying the income tax liability for income that is distributed to their former spouse is for the trust instrument to avoid expressly naming the spouse as the trust’s beneficiary and instead use an adjustable definition of the income beneficiary, called the floating-spouse concept. The trust instrument would thus describe the trust beneficiary using a word formula, but not by name. An example would be rather than say ‘all income shall be paid to my wife, Mary Smith for her lifetime’, the trust instrument instead provides that the trustee ‘may pay trust income to the person to whom I am married at the time of the distribution.’ If there is a divorce, and the trust’s creator is no longer married, then no distribution is made to the ex-spouse.
- Trust Director: It might be possible to name a trust director, (also sometimes called a trust protector) to hold the power to amend the trust to remove trust beneficiaries, including the trust creator’s spouse if there is a divorce.
- Terminate the Trust: While this sounds a bit more draconian, the trustee might be given the power to terminate and distribute the trust’s assets to the current beneficiaries, which would presumably include the ex-spouse. While terminating the trust defeats the purposes for the trust, the trust then ceases to exist as a grantor trust and thus its creator no longer has any income tax liability.
- Trust Decanting: If it is a discretionary distribution trust for the spouse, the trustee might decant the trust’s assets to a new trust created by the trustee where the former spouse is removed as a beneficiary, or his or her interests in the new trust are dramatically altered. If the decanting of the trust assets in response to a divorce is contemplated, it would be wise for the trust instrument to contain its own decanting power conferred on the trustee and not rely upon Michigan’s two decanting statutes, both of which require notice to be provided to the trust beneficiary.
- Divorce Settlement Agreement: If the trust is expected to continue beyond the divorce, it may be possible to include in the divorce settlement agreement that the beneficiary spouse who continues to be entitled to receive distributions from the grantor trust agrees to timely reimburse the creator for his or her income tax liability resulting from the trust. Of course, this is just one more entanglement between former spouses that most divorcing couples try to completely avoid if possible.
Final Thoughts: While married couples are currently encouraged to adopt irrevocable trusts with the thought of using their large available federal transfer tax exemption while it remains available, i.e., the ‘use it before you lose it’ philosophy, thought also needs to be given to the potential divorce and income tax repercussions associated with these sophisticated estate planning trusts, as most of these trusts will be classified as grantor trusts.