Understanding Alimony and Support Agreements
Everything you want to know but were afraid to ask
Jeffrey S. Freeman, JD, LL.M.
FREEMAN TAX LAW
2051 VILLA ROAD STE. 105 BIRMINGHAM, MI 48009
EMAIL: [email protected]
Alimony and Support Agreements under the Tax Cuts and Jobs Act of 2017
Jeffrey S. Freeman, JD, L.L.M. and Sandra Kouzy, Law Clerk
Overview of the Tax Cuts and Job Acts of 2017
On December 22, 2017 President Trump signed into law the “Tax Cuts and Jobs Act” (P.L. 115-97), (“TCJA 2017”) a sweeping tax reform law that entirely changes the tax landscape in the United States.
This comprehensive tax overhaul dramatically changed the rules governing the taxation of individual taxpayers for tax years beginning before 2026, providing new income tax rates and brackets, increasing the standard deduction, suspending personal deductions, increasing the child tax credit, limiting the state and local tax deduction, temporarily reducing the medical expense threshold, and, changing the law regarding the taxation of alimony payments among many other changes.
For businesses, the legislation permanently reduces the corporate tax rate to 21%, repeals the corporate alternative minimum tax, imposes new limits on business interest deductions, and makes a number of changes involving expensing and depreciation. The legislation also provides a new deduction for non-corporate taxpayers with qualified business income from pass-throughs. Finally, this legislation also makes significant changes to the tax treatment of foreign income and taxpayers, including the exemption from U.S. tax for certain foreign income and the deemed repatriation of offshore income.1
Alimony is a payment to or for a spouse or former spouse under a divorce or separation instrument. It doesn’t include voluntary payments that aren’t made under a divorce or separation instrument.
For divorces and separation agreements entered into prior to December 31, 2018, alimony is deductible by the payer, and the recipient must include it in income.
Under the TCJA of 2017, amounts paid as alimony or separate maintenance payments under a divorce or separation agreement executed, or modified, after December 31, 2018 won’t be deductible by the payer. Such amounts also won’t be includible in the income of the recipient.
To be considered alimony, a payment must meet certain requirements.
Spouse or former spouse
Unless otherwise stated, the term “spouse” includes former spouse.
Divorce or separation instrument
The term “divorce or separation instrument” means:
● A decree of divorce or separate maintenance or a written instrument incident to that decree,
● A written separation agreement, or
● A decree or any type of court order requiring a spouse to make payments for the support or maintenance of the other spouse. This includes a temporary decree, an interlocutory (not final) decree, and a decree of alimony pendente lite (while awaiting action on the final decree or agreement).
Payments under a divorce decree can be alimony even if the decree’s validity is in question. A divorce decree is valid for tax purposes until a court having proper jurisdiction holds it invalid.
An amendment to a divorce decree may change the nature of your payments. Amendments aren’t ordinarily retroactive for federal tax purposes. However, a retroactive amendment to a divorce decree correcting a clerical error to reflect the original intent of the court generally will be effective retroactively for federal tax purposes.
A court order retroactively corrected a mathematical error under your divorce decree to express the original intent to spread the payments over more than 10 years. This change is effective retroactively for federal tax purposes.
Your original divorce decree didn’t fix any part of the payment as child support. To reflect the true intention of the court, a court order retroactively corrected the error by designating a part of the payment as child support. The amended order is effective retroactively for federal tax purposes.
Amendments on treatment of alimony received
Alimony and separate maintenance payments you receive aren’t included in your income if you entered into a divorce or separation agreement before 2019 and the agreement is changed after December 31, 2018, to expressly provide that alimony received isn’t included in your income.
Deducting alimony paid
Generally you can deduct alimony you paid, whether or not you itemized deductions on your return. However, you can’t deduct alimony paid under an agreement that is executed after 2018. You must use Form 1040 to deduct alimony you paid. You can’t use Form 1040NR. The Taxpayer will enter the amount of alimony paid on Schedule 1 (Form 1040), line 31a. In the space provided on line 31b, enter your recipient’s SSN or ITIN. If a Taxpayer paid alimony to more than one person, they will enter the SSN or ITIN of one of the recipients. Show the SSN or ITIN and amount paid to each other recipient on an attached statement. Enter your total payments on line 31a. If you don’t provide your spouse’s SSN or ITIN, you may have to pay a $50 penalty and your deduction may be disallowed.
Reporting alimony received
Report alimony you received as income on Schedule 1 (Form 1040), line 11, or on Schedule NEC (Form 1040NR), line 12. You can’t use Form 1040NR-EZ. Note. Don’t include in income alimony you receive under an agreement executed after 2018, or an agreement executed before 2019 if the agreement is changed after 2018 to expressly provide that alimony received isn’t included in your income. You must give the person who paid the alimony your SSN or ITIN. If you don’t, you may have to pay a $50 penalty.
Withholding on nonresident aliens
Another issue that the TCJA of 2017 requires us to consider, is what specifically needs to be done in the situation where a Taxpayer is paying an ex-spouse that is a Non-Resident Alien? If the Taxpayer is a U.S. citizen or resident alien and they pay alimony to a nonresident alien
The following rules apply to alimony regardless of when the divorce or separation instrument was executed. Not all payments under a divorce or separation instrument are alimony.
A payment that is specifically designated as child support or treated as specifically designated as child support under your divorce or separation instrument isn’t alimony. The amount of child support may vary over time. Child support payments aren’t deductible by the payer and aren’t taxable to the payee.
Generally, there is no recognized gain or loss on the transfer of property between spouses, or between former spouses if the transfer is because of a divorce. You may, however, have to report the transaction on a gift tax return under certain circumstances9. If you sell property that you own jointly to split the proceeds as part of your property settlement, there may be tax consequences to both parties10.
Transfer Between Spouses
Generally, no gain or loss is recognized on a transfer of property from you to (or in trust for the benefit of): your spouse, or your former spouse, but only if the transfer is incident to your divorce. This rule applies even if the transfer was in exchange for cash, the release of marital rights, the assumption of liabilities, or other consideration.
The term “property” includes all property whether real or personal, tangible or intangible, or separate or community. It includes property acquired after the end of your marriage and transferred to your former spouse. It doesn’t include services.
Health savings account (HSA)
If there is transfer of an interest in an HSA to a spouse or former spouse under a divorce or separation instrument, it isn’t considered a taxable transfer. After the transfer, the interest is treated as your spouse’s HSA.
Archer medical savings account (MSA)
If there is transfer of an interest in an Archer MSA to your spouse or former spouse under a divorce or separation instrument, it isn’t considered a taxable transfer. After the transfer, the interest is treated as your spouse’s Archer MSA.
Individual retirement arrangement (IRA)
The treatment of the transfer of an interest in an IRA as a result of divorce is similar to that just described for the transfer of an interest in an HSA and an Archer MSA.11
Incident to divorce
A property transfer is incident to your divorce if the transfer: Occurs within 1 year after the date your marriage ends or Is related to the end of your marriage. A divorce, for this purpose, includes the end of your marriage by annulment or due to violations of state laws.
Related to end of marriage
A property transfer is related to the end of your marriage if both of the following conditions apply. The transfer is made under your original or modified divorce or separation instrument. The transfer occurs within 6 years after the date your marriage ends.
Unless these conditions are met, the transfer is presumed not to be related to the end of your marriage. However, this presumption won’t apply if you can show that the transfer was made to carry out the division of property owned by you and your spouse at the time your marriage ended. For example, the presumption won’t apply if you can show that the transfer was made more than 6 years after the end of your marriage because of business or legal factors which prevented earlier transfer of the property and the transfer was made promptly after those factors were taken care of.
If you transfer property to a third party on behalf of your spouse (or former spouse, if incident to your divorce), the transfer is treated as two transfers. A transfer of the property from you to your spouse or former spouse. An immediate transfer of the property from your spouse or former spouse to the third party. You don’t recognize gain or loss on the first transfer. Instead, your spouse or former spouse may have to recognize gain or loss on the second transfer.
For this treatment to apply, the transfer from you to the third party must be one of the following.
● Required by your divorce or separation instrument.
● Requested in writing by your spouse or former spouse.
● Consented to in writing by your spouse or former spouse. The consent must state that
both you and your spouse or former spouse intend the transfer to be treated as a transfer from you to your spouse or former spouse subject to the rules of Internal Revenue Code section 1041. You must receive the consent before filing your tax return for the year you transfer the property.
Transfers in trust
If you make a transfer of property in trust for the benefit of your spouse (or former spouse, if incident to your divorce), you generally don’t recognize any gain or loss.
● However, you must recognize gain or loss if, incident to your divorce, you transfer an installment obligation in trust for the benefit of your former spouse. For information on the disposition of an installment obligation, see Pub. 537, Installment Sales.
● You also must recognize as gain on the transfer of property in trust the amount by which the liabilities assumed by the trust, plus the liabilities to which the property is subject, exceed the total of your adjusted basis in the transferred property.
You own property with a fair market value of $12,000 and an adjusted basis of $1,000. You transfer the property in trust for the benefit of your spouse. The trust didn’t assume any liabilities. The property is subject to a $5,000 liability. Your recognized gain is $4,000 ($5,000 − $1,000).
Exceptions to nonrecognition rule
The Non-Recognition Rule doesn’t apply in the following situations: a) Your spouse or former spouse is a nonresident alien b) Certain transfers in trust can be excluded from this favorable non-recognition treatment c) Certain stock redemptions under a divorce or separation instrument or a valid written agreement that are taxable under applicable tax law, as discussed in Treasury Regulations section 1.1041-2.
Grandfathering Can Preserve Old Alimony Rule for Certain Divorces
The TCJA of 2017 incorporates grandfathering rules. The repeal of IRC § 71 and § 215 applies to any “divorce or separation instrument” executed after December 31, 2018. This means that for any divorce or separation agreement that is in effect before January 1, 2019, the repeal of § 71 and § 215 does not apply (the “Grandfathering Exception”).12 For example, if a divorce decree is issued before January 1, 2019, then, irrespective of the new law, the Old Alimony Rule continues to apply.
Are Prenuptial Agreements Covered Under the Grandfathering Exception?
As stated above, the Old Alimony Rule is an “opt-out” rule, meaning if the decree specifically states that it is not to apply, then it does not apply. Under current law, one way to ensure that the Old Alimony Rule would apply is to specifically provide for the Old Alimony Rule in a prenuptial agreement. Likewise, if the parties wish to elect out of the Old Alimony Rule, the parties would mandate this in a prenuptial agreement. Keep in mind that the Old Alimony Rule has been established as part of the law during the entire career of most every practicing divorce and tax lawyer. This is a known matter — it was not “sneaking up” on an unsuspecting alimony recipient.
Suppose that, prior to January 1, 2019, parties engage in a prenuptial agreement and specifically reference that the Old Alimony Rule is to apply. The question is now as to the status of the election for the Old Alimony Rule. As stated above, if a decree is issued prior to January 1, 2019 that implements the Old Alimony Rule, the repeal of § 71 and § 215 does not apply as to the alimony payments under that decree. The decree, in this instance, must be a “divorce or separation agreement” for purposes of the 2017 tax act.
Is, however, a prenuptial agreement deemed to be a “divorce or separation agreement” for purposes of the 2017 tax act? If it is, then the alimony provisions under a prenuptial agreement mandating the Old Alimony Rule would fall within the Grandfathering Exception even if the parties were not divorced prior to January 1, 2019.
The analysis begins with § 71(b)(2), which defines a “divorce or separation agreement” as, (1) a decree of divorce or separate maintenance or rewritten instrument incident to such a decree, (2) a written separation agreement, or, (3) a decree requiring a spouse to make payments for the support or maintenance of the other spouse.13 The definition includes decrees (which denotes issuance by a court) and a written separation agreement, which is an agreement to provide for the rights of a married couple who are then separating. Unfortunately, it does not appear that the definition encompasses prenuptial agreements. Presumably this is because a prenuptial agreement is not a court decree or a document where the actions and remedies are to take effect currently — rather, a prenuptial agreement forms a contractual relationship between the parties to provide for the enforcement of certain marital and other rights upon a future event, i.e., a separation or the termination of the marriage.
Suppose that, prior to January 1, 2019, a couple entered into a prenuptial agreement that imposes the Old Alimony Rule for alimony payments. Because the definition of a “divorce or separation agreement” seemingly does not include prenuptial agreements, such agreements would not be included within the Grandfathering Exception. Thus, even though the parties entered into the prenuptial agreement prior to January 1, 2019, if the divorce decree that incorporates the prenuptial agreements provisions is issued after December 31, 2018, the 2017 tax act prevents the application of the Old Alimony Rule because § 71 and § 215 would not be part of the law at time that the transfer obligation ripens (i.e., the alimony payment)!
It is imperative, then, that the advisers and clients review existing prenuptial agreements and determine whether the prenuptial agreement requires the application of the Old Alimony Rule. If this is the case, the advisers and clients need to consider the options and ramifications if a divorce were to occur.
The 2017 tax act includes an additional change related to alimony; it repeals IRC § 682 regarding the taxability of certain trust income as a result of a divorce.15 As innocuous as this change may appear to be, it could have major ramifications for a divorced individual who previously created an irrevocable trust for the benefit of his or her former spouse during their marriage.
‘Grantor Trusts’ and the Definition of ‘Spouse’ for Certain Trusts
When an individual creates an irrevocable trust (said individual is customarily referred to as the “grantor” of the trust), a provision is often included in the trust that causes the trust income and expenses to be reported for income tax purposes by the grantor and not by the trust. This is colloquially referred to as a “grantor trust.” Often, the inclusion of these provisions is intentional, as they allow for a “free gift” by the grantor to the trust in the amount of the income taxes paid by the grantor instead of the trust. An example of such a provision is found in § 675(4)(C), which applies “grantor trust” treatment if the grantor retains the right, at any time, to withdraw trust assets and substitute in their place other assets of equivalent value (the “Substitution Power”).
Another “grantor trust” provision is found in § 677(a)(1), which provides that the grantor is to be treated as the owner of any portion of a trust (and therefore taxed on the trust income) if the income from the trust may be distributed to the grantor or the grantor’s spouse.
Throughout the “grantor trust” provisions of the Code, some terms are defined in a way that they don’t mean what you might think they should mean. “Spouse” is one of those terms. Under § 672(e)(1)(A), a grantor is treated as holding any power or interest of the grantor’s spouse, which is defined as any individual who was the spouse of the grantor at the time of the creation of such power or interest. For the definition of “spouse,” the only time frame that is critical is the moment that the spouse’s interest was created, i.e., upon the creation of the trust. For the “grantor trust” rules, if a person is a “spouse” at that time, that person remains the “spouse” even if such spouse and the grantor subsequently divorce — there is no continuing review of the marital status of the parties.
Stated differently, based on this definition, if the trust income is required to be paid to the grantor’s spouse, the trust is a “grantor trust” as to the grantor, and the grantor — and not the grantor’s spouse — is taxed on the income regardless of whether the grantor and the spouse remain married during the duration of the trust.
With many married couples, “spousal trusts” exist within their respective estate plans. In advanced estate plans, spouses may use irrevocable trusts created for the benefit of the other spouse, with the trust qualifying for the gift tax marital deduction as “qualified terminable interest property” (QTIP). These trusts, called “inter-vivos QTIP trusts” were, and remain currently, a cornerstone of creative estate planning techniques.
Another type of spousal trust became very popular in 2012 when individuals were seeking ways to use their available estate and gift tax exemption before the end of the year for fear of a “sunset” of the then newly- increased exemption amount (which was $5.12 million at the time) and a reversion back to the 2001 exclusion threshold of $1 million (the “use it or lose it” paradigm). In order to utilize the exemption without sacrificing assets within the marital relationship, many clients created a trust called a “spousal lifetime access trust,” or SLAT. The typical SLAT would be a taxable gift by one spouse (the “grantor”) to the SLAT that would provide the other spouse (the “donee spouse”) with discretionary distributions of trust income and principal. The SLAT may also be a “sprinkle” trust by including the descendants into the class of individuals who could receive discretionary distributions of trust income and principal, with a direction that the needs of the spouse are to be considered before any distributions are to be made to the descendants (referred to as a “Preference Clause”). The effect of a SLAT is to utilize gift tax exemption while allowing the assets to technically remain within the “marital unit.”
When it comes to divorce, trusts may play an important role. Sometimes, instead of having alimony paid directly to the recipient, the payor may be required to establish a trust for the benefit of the recipient that would provide the recipient with trust income in lieu of requiring the payor to pay recurring alimony payments. These trusts are often referred to as “alimony trusts.” Interestingly, alimony trusts are not always created as a result of the divorce — if, for example, the donor had previously created an inter-vivos QTIP Trust, the court decree may reduce or eliminate the alimony requirement on account of the income that the recipient receives from the trust.
Alimony Trusts and § 682 — the Shifting of Taxability
As stated above, a trust created by a grantor that requires the income to be distributed to, or gives the trustee the discretion to pay the income to, the donee spouse would be a “grantor trust” as to the grantor under§ 677(a)(1) because the income was, or could be, paid to the donee spouse. The income taxation was not an issue because the spouses were part of the “marital unit.”
However, upon a divorce, because § 677(a)(1) only looks to the marital status at the time of the “creation” of the power or interest, the “grantor trust” provisions remain applicable. As a result of the divorce, because the parties are no longer part of a “marital unit,” not only does the grantor lose the benefit from the trust income, but the grantor is also taxed on such trust income. Under these circumstances, the donee spouse receives the trust income and would not be required to report any trust taxable income or expenses on her/his income tax return because the trust is a “grantor trust” as to the grantor. The end result is that the donee spouse receives the trust income free of income tax.
To avoid this seemingly harsh result, Congress enacted § 682 to shift the taxability away from the grantor. Generally, if trust income is distributed to a married person from a trust created by her/his spouse, then, upon a divorce and irrespective of any other income tax provision, § 682(a) taxes the income to the recipient (except as to any income specifically determined to be allocated for child support).
Suppose that A is married to B. During the marriage, for estate planning purposes, A irrevocably transfers property to a trust that A created for B. Under the trust, B is to receive all of the income for her/his lifetime. Some years later, B obtains a divorce from A under a court decree. Acknowledging that B receives sufficient income from the trust, the court does not award any alimony to B. Because A and B were married at the time that A created the trust, A would be taxed on the trust income under § 677(a)(1) notwithstanding the fact the income is paid to B. This would seem logical and non-controversial because, as a married couple, A and B are the equivalent of one “marital unit,” so together, they receive and are taxed together on the income. However, upon divorce, even though A and B cease to be one “marital unit,” the “grantor trust” rules of § 677(a) (1) still apply to tax all trust income to A even though B receives such trust income.
For this reason, § 682 comes to A’s rescue and taxes the trust income to B. 18By its design, § 682 is designed to match tax implications to economic reality.
2017 Tax Act and § 682 Repeal — Re-Shifting of Taxability
IRC Section § 682 is repealed as of January 1, 2019
At the start of January 1, 2019, the income taxability of certain alimony trusts is determined under other Code provisions, such as the “grantor trust” rules. However, the Grandfathering Exception described above should be applicable in that it applies to all of the § 11051 provisions of the 2017 tax act and not just to the provisions affecting § 71 and § 215. Although it is not clearly stated in the 2017 tax act, presumably, if a trust is referenced in a pre-January 1, 2019, divorce decree as paying its income in lieu of alimony, the income tax treatment under § 682 should continue to apply.
Recall that in the above example, § 682 taxes the trust income to B. This treatment applies so long as the divorce occurred before January 1, 2019. Based on the wording of the Grandfathering Exception, § 11051 of the 2017 tax act applies to any divorce or separation instrument executed after December 31, 2018. If the divorce decree references that the trust income is in lieu of a higher alimony (or any alimony) payment, then, because the decree was issued prior to 2019, § 682 should still apply even after December 31, 2018.
Timing, then, is everything!
Suppose in the prior example that the divorce decree is executed after December 31, 2018; § 682 would not be applicable and other income tax provisions would determine the trust’s income taxability.
What if, in December 2018, in an effort to resolve the open issues between the parties and expedite the issuance of a final divorce decree, A creates and funds a trust that pays all of the income to B? The parties agree that the divorce decree should reference the trust and state that the income paid to B is in lieu of alimony. The divorce decree, however, is not issued until January 4, 2019. Under these facts, because it was created during the marriage, the trust would be a “grantor trust” as to A pursuant to § 677(a)(1) and, upon the issuance of the divorce decree, the trust remains a “grantor trust” because after January 1, 2019, § 682 does not exist.
An interesting anomaly concerning § 682 is the fact that § 682(a) applies even if a trust is not specifically created pursuant to a property settlement agreement or a decree of divorce or separate maintenance. To invoke § 682(a), the divorce decree is not required to reference the trust — the only requirement is that income is required to be paid, or used for the benefit of, the donee spouse.
Recall that the Grandfathering Exception only applies to any divorce or separation instrument executed after December 31, 2018, which means that § 682 applies to any divorce or separation instrument executed prior to January 1, 2019. Although the Congressional Conference Report did not give a specific reason for the grandfathering, it is likely that the exception is provided because the alimony payments were a factor in the particular settlement.
What happens, though, when the decree fails to mention the source of payments in lieu of alimony, i.e., payments already coming to a spouse under an existing trust?
Suppose that, in the above example, the alimony trust created by A is not referenced in the 2018 divorce decree. Should the Grandfathering Exception apply? Technically, there was a divorce decree and the decree was entered prior to January 1, 2019; however, the decree appears to be mutually exclusive from the trust because there is no reference whatsoever to the trust in the decree. Given that § 682 governs the taxability of the trust in 2018, should this trust fall within the Grandfathering Exception, or does the lack of a specific reference to the trust in the divorce decree now subject A to the “grantor trust” rules under § 677(a) (1) even though it was obvious to the parties, but not stated in any manner in the decree, that the trust income was in lieu of alimony? The answer to this is unclear, and, technically, guidance is needed on this issue as well as to provide clarification as to the applicability of the Grandfathering Exception to all trusts subject to § 682.
What about SLATs — does § 682 apply to them? The answer is more ominous than with income trusts. As stated above, the typical SLAT is not an income trust but is a discretionary trust. In other words, all distributions to the donee spouse are at the discretion of the trustee and the donee spouse has no entitlement to any distributions. Pursuant to § 677(a)(1), § 677(a) applies to trusts where income may (as opposed to shall) be distributable to a spouse (“...whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be...distributed to the grantor or the grantor’s spouse”). This means that a SLAT would be a grantor trust as to the grantor.
As further described above, with an income trust for a donee spouse, upon a divorce, § 682 applies to shift the income taxation to the recipient. However, the language of § 682(a) is specific as to the distributions — the section provides, in pertinent part, as follows:
There shall be included in the gross income of a wife who is divorced or legally separated under a decree of divorce or of separate maintenance (or who is separated from her husband under a written separation agreement) the amount of the income of any trust which such wife i s entitled to receive. ..(emphasis added)
In a discretionary trust, such as a SLAT, the donee spouse has no entitlement to receive any distributions — all distributions are at the Trustee’s discretion. In this instance, the SLAT would continue to be a “grantor trust” as to the grantor. This would appear to be surprising news for any grantor who created a discretionary trust for donee spouse, such as those grantors who created SLATs in 2012, and become divorced from the donee spouse after December 31, 2018.
Any Recourse for the Grantor — Modification? Decanting? Death on Divorce Clause?
Section 682 applies to certain trusts regardless if they are referenced in the divorce decree. If a trust is not so referenced, as of January 1, 2019, such trusts are governed under other provisions of the Code, which, because spouses are involved, reverts to the “grantor trust” provisions.
Ordinarily, when an individual creates a “grantor trust,” it is possible to “toggle” the taxability on-and-off by relinquishing a power. For example, if a trust is a “grantor trust” on account of the inclusion of the Substitution Power, the grantor can “turn off” the “grantor trust” provisions by renouncing the Substitution Power. However, from the above analysis, § 677(a)(1) cannot be “turned off” — it remains in effect for as long as the grantor remains alive during the trust term. Similar to the news of the tax treatment of SLATs, this too would appear to be surprising news for any grantor who created an income trust for donee spouse and then became divorced from the donee spouse after December 31, 2018.
Unfortunately, courtesy of the power of § 677(a)(1), if a divorce occurs after 2018 there may be few options, if any, to switch the income taxability to the donee spouse (to reflect economic reality).
Under any trust other than an inter-vivos QTIP trust, one way to disable § 677(a)(1) is to modify the trust so that the income provisions are outside the scope of § 677(a)(1). For example, if the trust provides for a “trust adviser,”21 the adviser could amend the income distribution provision so as to negate the applicability of § 677(a)(1) by requiring income distributions to the spouse to be approved by an adverse party. If the trust does not provide for a trust adviser, the trust could possibly be judicially or non-judicially reformed or could be “decanted” to provide for one. However, the question arises as to whether such a change by the trust adviser, if the law provides that the trust adviser is a fiduciary, would be a breach of fiduciary duty as to the donee spouse in her/his capacity as the income beneficiary of the trust.
These suggested strategies are probably not possible with an inter-vivos QTIP because these changes could be considered to be a restriction on the donee spouse’s income interest. Such a restriction could thereby disqualify the trust for the gift tax marital deduction under § 2523(f).
Alternatively, if the QTIP election is not invalidated, upon implementation of such a strategy, it may cause the entire trust to be immediately subject to transfer taxation pursuant to § 2519.
Taking another approach, for those decrees that are issued before January 1, 2019, but fail to reference the particular trust, would it be possible for the decree to be amended after December 31, 2018, and have the amendment act to bring the trust within the Grandfathering Exception? There is no current answer to this question — the next likely step would be to request guidance from the Internal Revenue Service in the form of a private letter ruling request.
If the trust is a discretionary trust, such as a SLAT, whereby distributions can be made for any one or more of the spouse or the grantor’s descendants, it may be possible for the trustee to effect distributions only to the descendants. This way, even though the trust would remain a “grantor trust” under § 677(a)(1), the income would benefit the descendants and not the ex-spouse. However, this might not be feasible if the trust contains a Preference Clause, as the ex-spouse could object that her/his needs must be considered before any distributions can be made to the descendants.
One final thought on this topic:
When creating a spousal trust, a fairly common — but certainly not universal — boilerplate clause involves divorce. Such a clause — referred to as “death on divorce” clause — is a legal fiction providing that, in the event of a divorce and for all purposes of the trust, the donee spouse will be “deemed” to have then died and all of the donee spouse’s interests in the trust will then terminate. The only spousal trust where a “death on divorce” is not possible is in an inter-vivos QTIP trust because, in order to qualify for the gift tax marital deduction, the trust must continue unimpeded for the spouse’s lifetime, and a “death on divorce” clause prevents this from occurring. If any other form of spousal trust contains a “death on divorce” clause, upon the divorce the spouse’s income interest ends, which thereby terminates the applicability of § 677(a)(1) and, with it, “grantor trust” status based on the spouse’s interest in the trust. Of course, the trust could still be a “grantor trust” based on other provisions, such as the Substitution Power, but, even in those situations, the grantor is not being taxed on income payable to the donee spouse.
What if a trust does not contain a “death on divorce” clause; can it be added? If the trust is not an inter-vivos QTIP trust, there are several potential ways to add the clause, such as a trust modification proceeding, decanting (if permissible within the particular jurisdiction) or modification by a trust adviser (if authorized in the trust and/or under the governing law). Of course, at the time of a divorce, the parties could agree upon the termination of the spousal interest in the trust.
As illustrated above, there are extremely complicated tax implications of a divorce even without the changes implemented by the 2017 tax act, and such new changes provide further layers of issues.
This is a perfect example of why the estate planning adviser should be a part of any divorce planning. The changes brought about by the 2017 tax act is the perfect impetus for the family law and estate planning advisers to meet with the client to review the entire estate plan in light of a potential divorce, even if a divorce is not even remotely then contemplated.
Grandfathering Exception Might Still Work for “Some” Trusts
If a couple is seeking a divorce and trust income is involved in the settlement, the couple and counsel should work to satisfy the requirements of the Grandfathering Exception. The decree should reference any trust created by the grantor that provides that the income is payable to the donee spouse.
If the decree fails to reference a particular trust where the trust income is payable to a recipient in lieu of divorce, the only possible way to fall within the Grandfathering Exception is to seek a clarification and amendment to the divorce decree specifically referencing the trust income as a means of satisfying an alimony obligation.
As for other trusts that are not “alimony trusts,” while the decree can be revised to reference such trusts, it is unknown whether that change will be retroactively accepted within the Grandfathering Exception.
Formal guidance from either Treasury, the IRS, or both, is needed on these § 682 grandfathering points. Additional spousal trusts must be reviewed to determine whether such trusts are “grantor trusts” and, if so, whether the spousal interest continues after the divorce.
Finally, with respect to many of the tax law changes created under the 2017 tax act, there is a “sunsetting” of such provisions, meaning that the changes expire after a certain date and the law reverts back to the 2017 law. The provisions regarding alimony and divorce, however, do not sunset — these changes are permanent (or as permanent as tax law changes can be) and their pain will be enduring.
These and all other issues pertaining to a divorce or other marriage termination should be discussed over the next few months with matrimonial and estate planning counsel.
Get Creative with Property Settlements and Gifts
Since Property Settlements are not taxable to the receiving Spouse and because the federal gift tax doesn’t apply to most transfers of property between spouses, or between former spouses because of divorce, there may be some ways to structure divorce settlements using property rather than alimony.
Make Sure that Exceptions to Gift Tax Apply Before Transfers are Made
The transfer of property to a spouse or former spouse isn’t subject to gift tax if it meets any of the following exceptions.
- It is made in settlement of marital support rights.
- It qualifies for the marital deduction.
- It is made under a divorce decree.
- It is made under a written agreement, and you are divorced within a specified period.
- It qualifies for the annual exclusion.
Settlement of marital support rights
A transfer in settlement of marital support rights isn’t subject to gift tax to the extent the value of the property transferred isn’t more than the value of those rights. This exception doesn’t apply to a transfer in settlement of dower, curtesy, or other marital property rights.
A transfer of property to your spouse before receiving a final decree of divorce or separate maintenance isn’t subject to gift tax. However, this exception doesn’t apply to:
- Transfers of certain terminable interests, or
- Transfers to your spouse if your spouse isn’t a U.S.citizen.
Transfer under divorce decree
A transfer of property under the decree of a divorce court having the power to prescribe a property settlement isn’t subject to gift tax. This exception also applies to a property settlement agreed on before the divorce if it was made part of or approved by the decree.
Transfer under written agreement
A transfer of property under a written agreement in settlement of marital rights or to provide a reasonable child support allowance isn’t subject to gift tax if you are divorced within the 3-year period beginning 1 year before and ending 2 years after the date of the agreement. This exception applies whether or not the agreement is part of or approved by the divorce decree.
The first $15,000 of gifts of present interests to each person during 2018 isn’t subject to gift tax. The annual exclusion is $152,000 for transfers to a spouse who isn’t a U.S. citizen provided the gift would otherwise qualify for the gift tax marital deduction if the donee were a U.S. citizen. A gift is considered a present interest if the donee has unrestricted rights to the immediate use, possession, and enjoyment of the property or income from the property.
Are Divorce Legal Fees Tax Deductible under the TCJA of 2017?
Under the prior law, taxpayers who itemized their deductions were eligible to claim certain deductions under IRC § 67, if their itemized deductions exceeds 2% of adjusted gross income. TCJA eliminated the miscellaneous itemized deductions for the tax years 2018 through 2025. The personal and dependency exemptions worth $4,050 each in 2017 have also been eliminated from 2018 to 2025. State and local tax deductions, including property tax, have been limited to $10,000 per year. Many taxpayers (as many as 2/3 of those who itemized their deductions) will lose the benefit of their itemized deductions in 2018 due to these limitations and caps. Taxpayers who claim the standard deduction in 2018, instead of itemizing, will not be able to deduct legal fees.
Under the TCJA of 2017 litigants in a divorce can’t deduct legal fees and court costs for getting a divorce. In addition, you can’t deduct legal fees paid for tax advice in connection with a divorce and legal fees to get alimony or fees you pay to appraisers, actuaries, and accountants for services in determining your correct tax or in helping to get alimony.
Other Nondeductible expenses
Under the TCJA of 2017, Taxpayers can’t deduct the costs of personal advice, counseling, or legal action in a divorce. These costs aren’t deductible, even if they are paid, in part, to arrive at a financial settlement or to protect income-producing property. You also can’t deduct legal fees you pay for a property settlement. However, you can add it to the basis of the property you receive. For example, you can add the cost of preparing and filing a deed to put title to your house in your name alone to the basis of the house.
Finally, you can’t deduct fees you pay for your spouse or former spouse, unless your payments qualify as alimony under the Old Alimony Rule. (See Payments to a third party under Alimony, earlier.) If you have no legal responsibility arising from the divorce settlement or decree to pay your spouse’s legal fees, your payments are gifts and may be subject to the gift tax.
Although we have focused on the federal tax aspects, the results are magnified when state law is considered.
Consider a divorce where the parties reside in Florida, which has no state income tax. Suppose that the payor accepts a new position in the District of Columbia, which imposes a state income tax (which, for purposes of this example, is deemed to be 8%).24 If the Old Alimony Rule is not applicable, the payor’s payment of $60,000 of alimony is subject to D.C. taxes, which causes further out-of-pocket costs to the payor.
Result Under the New Alimony Rule
Isolating only the D.C. income taxes (and disregarding the federal taxes), the total out-of-pocket cost to the payor is approximately $65,200 ($60,000 ÷ (1 – 8%)). In other words, the payor would have to earn $65,200 to effectively pay $60,000. Even though the payor would have been subject to the D.C. income tax if she/he hadn’t been required to pay alimony, the tax would have been paid from the funds creating the tax. With the funds being paid as alimony, the payor receives zero benefit from the funds and must pay the income tax from other funds.
Result Under Old Alimony Rule
Now consider if the Old Alimony Rule applies — the payor would be able to offset the alimony paid as a deduction against the income, so the impact of the D.C. income tax is neutralized.
About Freeman Tax Law and Jeffrey S. Freeman, J.D., LL.M.
Freeman Tax Law is a boutique law firm based in Birmingham, Michigan that specializes exclusively in tax matters. During the past 25 years, Mr. Freeman has represented thousands of clients in both civil and criminal tax controversies throughout the years.
Mr. Freeman has resolved complex tax controversies for his clients before the IRS and in the Federal Court system, U.S. Tax Court, State Tax Courts, and the U.S. Bankruptcy Court. He has skillfully handled offshore bank account disclosures (i.e., OVDP, Streamlined, Transitional and OVDP opt outs), complex international tax compliance issues for corporations and individuals, audits with various taxing authorities, the settlement of tax liabilities with the IRS (Offer in Compromise), negotiation of installment agreements, removal of tax liens and levies, sales tax and payroll trust fund tax assessments, innocent spouse relief claims and the removal of penalties and interest for his clients. In addition, Mr. Freeman routinely advises his clients through various life cycle events such as divorce, and has served as Court Appointed Receiver before the Oakland County Family Court and has testified in Federal Court.
Mr. Freeman holds a Masters of Law in Taxation (LL.M.) from Georgetown University Law Center in Washington, D.C. and Juris Doctor (J.D.), Cum Laude, from the Michigan State University College of Law and a Bachelor of Arts in Accounting, with honor, from Michigan State University where he was a member of the Beta Gamma Sigma Business Honor Society and the Phi Kappa Phi Academic Honor Society. Further, he is a member of the Taxation Section of the American Bar Association, the Oakland County Bar Association and Michigan Bar Association, where he served as a past chair of the Tax Practice and Procedure Committee.
With national recognition for his work and commentary, Jeff has appeared on the Frank Beckman Show, Fox News Detroit, and has been quoted in various news publications such as the Detroit News, Detroit Free Press, Crain’s Business, and Detroit Business. Over the years, he has authored numerous articles for various professional journals.