Alimony Trust Planning
By Shauna Dell, Manager, Tax & Business Services
Use of Alimony Trusts
Alimony trusts are generally utilized in situations where there is sufficient wealth to obtain economic and tax benefits that outweigh the costs of administering the trust. The adversarial relationships associated with divorce can be overcome through the use of a trust vehicle. In essence, using a trust for divorce purposes can provide economic protection; achieve income and estate tax planning goals, and set aside assets for children.
An alimony trust may be utilized in circumstances where either spouse is concerned about the handling of lump-sum settlements particularly if the funds are squandered causing either spouse to be exposed to continual requests for support. Also, the recipient spouse may be concerned with the paying spouse’s ability to meet his or her financial obligations. Hence it is important that the trust agreement be properly drafted and funded with assets that minimize risks associated with the funding spouse’s ability to pay the recipient spouse.
Using Alimony Trusts to Hold Illiquid Assets
An alimony trust can be used to hold title to illiquid assets for which spouses cannot agree on the valuation and or terms of a partnership agreement or shareholder restriction that prohibits a transfer to a party other than the existing owner.
Using an Alimony Trust to Obtain Beneficial Income Tax Results
An alimony trust is established pursuant to a divorce decree which stipulates that the recipient spouse receive distributions from the trust that satisfies obligations imposed by the divorce decree. The grantor retains control over the trust income and corpus and the trust assets may revert back to the grantor.
Taxation of Alimony Trusts
The tax consequences of using alimony trusts depends on the terms of the trust agreement. The normal trust rules determine who is taxed on the trust income that is fixed in the divorce decree. Transfers of property encumbered with liabilities, and multiple beneficiaries complicate the planning. As such, planners need to be very knowledgeable about the trust taxation rules, local law and the tax implications associated with the use of alimony trusts.
The contributing spouse, the grantor, is not taxed on the trust’s income pursuant to the grantor trust rules under IRC Sec.682 (a). Also, the grantor is not allows a deduction for alimony paid. The trust is generally taxed as a complex trust pursuant to IRC Sec. 641-685 and subject to the applicable trust filing requirements. The recipient spouse, however, is taxed on the distributions pursuant to trust rules of Subchapter J. If the divorce decree agreement provides that distributions or any part thereof is payable as support to the grantors minor children, the grantor is taxed on the applicable portion under the grantor trust rules.
Using Alimony Trusts to Pay Deemed Child Support
When a child leaves the home, then the payments are deemed to be child support as opposed to alimony. As such child support payments are not deductible by the paying spouse nor are they taxable to the child. The trust payments would only be taxable to the grantor when deemed to be child support. Using the trust to make payments results in tax treatment similar to alimony. The trust agreement should therefore specify the amount of trust distributions that represent child support to ensure the recipient is not taxed.
Using Trusts to Minimize Estate Taxes
An alimony trust should be structured to exclude marital property from the transferring spouse’s estate in addition to fulfilling an alimony obligation. It can also be structured to exclude property from the receiving spouse’s gross estate thereby passing property to the children with minimal if any transfer tax.
Property in an alimony trust is excluded from the transferring spouse’s estate only if the transferring spouse does not have the following:
- Retained interest in the property;
- Retained life estate;
- No reversionary interest;
- Power to revoke, alter, amend or terminate the trust;
- General Power of appointment; and
- Exercise or release any powers pursuant to IRC Sec. 2035 within three years of death
With a properly drafted trust agreement, the receiving spouse is treated for income tax purposes as the owner of the trust assets. As income shifts to the receiving spouse, the economic benefits are fulfilled and as long as the grantor does not retain any prohibited powers, the corpus will pass to the children at a low gift tax cost if any.