When most family lawyers consider the impact of trusts in divorce, they are usually thinking about whether a divorcing spouse will get access to trust assets, either directly or indirectly. While that is very important, the focus of this podcast will be how recent changes in the law have impacted the income tax consequences of trusts after divorce.
This special Family Lawyer Magazine Podcast features Sharon Klein – the president of Family Wealth, Eastern US Region, for Wilmington Trust – discussing what family lawyers must know about how the new tax laws affect trust income after divorce.
My name is Diana Shepherd, and I’m the Editorial Director of Family Lawyer Magazine. My guest today is Sharon Klein, who is here to discuss “What Family Lawyers Must Know About the New Tax Laws for Trust Income Following Divorce”. Sharon heads Wilmington Trust’s National Divorce Advisory Solutions Group. Beginning her career as a trusts & estates attorney, Sharon has over 25 years’ experience in the wealth advisory arena and is a nationally recognized speaker and author. Thank you for joining us today, Sharon!
Sharon Klein: Thank you so much! It’s a pleasure to be here.
Diana: Let’s dive right in. Trusts are often very difficult to untangle in divorce. Some recent changes to the law have added some additional wrinkles, right?
Sharon: Yes, that’s exactly right. When most family law attorneys consider the impact of trusts in divorce, they are usually thinking about whether a divorcing spouse will get access to trust assets, either directly or indirectly. While that, of course, is very important, what I want to focus on today are the recent changes in the law that have had a significant impact to the income tax consequences of trusts after divorce, which I think many people might not be aware of.
How recent are these changes? And when did they become effective?
The changes were enacted by the Tax Cuts and Jobs Act, which was signed into law on December 22, 2017. These changes apply to divorce or separation agreements signed beginning this year. So beginning January 1, 2019, the changes came into effect. These are federal changes that affect everyone.
How have the income tax consequences of trust changed in the divorce context?
Let me respond to that question by asking you a question. Do you think a client would be surprised to learn that he’s responsible for paying the income taxes on trust distributions made to an ex-spouse from a trust that he set up during the marriage – and that his “beloved” ex-spouse will enjoy those trust distributions, completely tax-free, forever? On his dime?
Oh, no! I would think the client would be very surprised to learn that. So yes – absolutely yes!
I had kind of guessed that that might be your response, and you’re 100% correct! Unfortunately, that is exactly the result that may occur as a consequence of these recent changes to the law.
Sharon, that couldn’t be the result the trust creator intended, could it?
No, indeed, not! That is what’s known as a horrendous result, and clearly not intended. It might be helpful if we take a look at how we get to that unintended result, Diana.
For estate planning purposes, people can create irrevocable trusts for the benefit of family members. And when they move assets to fund those irrevocable trusts, they remove the assets from their taxable estates when they die, because they don’t own the assets anymore at death – they’ve transferred them into the trust. With the current top federal estate tax bracket at 40%, and with many states imposing their own estate taxes, which can be as high as 16%, we’re talking about significant possible estate tax savings when you create these irrevocable trusts.
But here is the kicker: although the trust creator (also known as the grantor) doesn’t own the trust assets anymore when he transfers them to the trust, and they’re out of his estate for estate tax purposes, he can remain responsible for paying the trust‘s income and capital gains taxes. If you create a trust, and you remain responsible for paying the income tax generated by the trust, that is what is known as a “grantor trust.” In other words, the creator of the trust, or the grantor, does not own assets for estate tax purposes, but does own the trust for income tax purposes. Why, you might ask, would anyone want to do that? Why would anyone want to give assets away but remain on the hook for paying the income taxes? Because that is perfect estate planning! It’s a very popular planning tool, because it allows the grantor, in effect, to make gifts to the trust in the amount of the income tax payments: Because if the grantor didn’t pay the taxes, the trust would be saddled with that liability. Really, paying the trust‘s taxes is a gift to the trust by the grantor, but the IRS doesn’t consider it a gift. So estate practitioners often purposely include provisions in trusts that will trigger this so-called grantor trust status, which effectively allows these trusts to grow tax-free for the beneficiaries because somebody else is paying the taxes. And tax-free growth is the most powerful estate planning technique of them all.
Under a section of the Internal Revenue Code – Section 677(a)(1) – a grantor is treated as the owner of a trust for income tax purposes if income may be distributed to the grantor’s spouse. Under another code section, Section 672(e)(1) – the so-called “spousal unity rule” – a grantor is treated as holding any interest held by grantor’s spouse at the time the interest was created. That means if a trust was created while the parties were married, and trust income may have been distributed to the grantor’s spouse, that trust will likely be a grantor trust. Because you look to the time the trust is created to determine grantor trust status, that trust will remain a grantor trust even if the grantor and the grantor’s spouse subsequently divorce. In other words, after a divorce, the grantor would be liable to pay the taxes attributable to trust income that is paid to the grantor’s ex-spouse, and the ex-spouse would receive the distributions tax-free. As we said, a horrendous result.
Until December 31 of 2018, Internal Revenue Code Section 682 prevented that result by providing that the income distributed to an ex-spouse after a divorce is taxable to the recipient and not the grantor. That rule saved the day. The problem is that the protection of Code Section 682 has ended. The Tax Cuts and Jobs Act, signed into law at the end of December 2017, repealed Section 682 for divorce or separation agreements executed after December 31, 2018. So, for divorce or separation agreements signed January 1 of this year and going forward, Section 682 is repealed. And while many of the Tax Cuts and Jobs Act changes sunset after 2025, repeal of Section 682 is permanent and does not sunset.
Which trusts are affected by this change in the law?
That’s an excellent question, Diana! All trusts created during a marriage are potentially affected – all of them. It’s very important to note that the effective date of the repeal of Section 682 is keyed to the date the divorce or separation agreement is signed, not the date the trust was executed. That means that, beginning this year, if a couple gets divorced, and one spouse created a trust at any point during the course of the marriage (could be five years ago, 10 years ago, more than that), and from that trust the other spouse could receive income, the trust will generally be a grantor trust, and the spouse who created the trust will continue to be liable to pay the taxes on all future distributions received by his or her ex-spouse. This really is a big deal! It affects some of the staple techniques of marital estate planning, like lifetime marital trusts, and there’s another very popular technique now called the Spousal Limited Access Trust (or SLAT), and it also affects a number of other trusts that are routinely created as part of the estate planning process.
This really does sound like a very big deal! Has there been any push to remedy the unintended consequences of this change to the law?
Yes. The IRS did request comments regarding the application of these grantor trust rules, in light of the repeal of Section 682. Those comments had to be submitted by July last year. There were comments submitted by the American College of Trusts and Estates Counsel (or ACTEC), which is the preeminent national organization of trusts and estates attorneys. It’s equivalent to the American Academy of Matrimonial Lawyers on the trusts and estates side. I’m actually delighted to be an ACTEC Fellow. And by the way, ACTEC and AAML have just created sister committees to focus on issues just like this, which are issues about the intersection between the matrimonial and trusts and estates practices. I’m pleased to be an inaugural member of the ACTEC family law committee, which will look at issues just like this.
ACTEC submitted two sets of comments in response to the IRS’s requests for comments. In the first set of comments, ACTEC suggests terminating the application of the spousal unity rule (which I mentioned is that rule in Section 672(e) of the Code, which says that a grantor is treated as holding any interest held by the grantor‘s spouse at the time the interest was created). The ACTEC comments basically say that the spousal unity rule makes no sense after a divorce when the couple is no longer a spousal unit – and if the spousal unity rule doesn’t apply after divorce, that would basically solve the problem.
The second set of comments submitted by ACTEC says that tying the repeal of Section 682 to the date the divorce or separation agreement is signed, and not the date a trust was executed, unfairly applies repeal to trusts that were irrevocable on the date the Tax Cuts and Jobs Act was enacted. ACTEC recommends that the protection of Section 682 continue to apply to the income of trusts that were irrevocable on the date the law changed (which is December 22, 2017) because that is the basis on which those trusts were created. Whether either of the ACTEC comment letter suggestions will be adopted is yet to be seen.
What should Family Law practitioners do in the meantime?
I think the short answer to that is that family law practitioners should take action. If trusts have been created during a marriage, and a couple is contemplating divorce or is in the process of getting divorced, it will be key to collaborate with a client‘s other advisors in investigating any techniques that potentially could change grantor trust status. You have to be very careful to do that without triggering any adverse tax consequences, so it’s critical to include the right advisors in that discussion. With that caveat, possibilities might include terminating the trust on divorce and paying it outright to one spouse and equalizing with other assets, or perhaps using a technique to modify the trust provisions to eliminate the spouse as a beneficiary of that trust and, again, equalizing with other assets. Another solution might be to include a reimbursement provision or other equalization mechanism in the marital agreement for the taxes that will continue to be payable by the grantor spouse after a divorce.
Sharon, how can you help family lawyers who have divorce cases that involve trusts?
If any family law practitioners are working with someone getting divorced and there are trusts involved, I can help them look at these issues, parse through the alternatives, and also consider other tax free opportunities they can leverage to get to the result they want. For example, under Code Section 1041(a)(2), no gain or loss is recognized on a transfer of property to a spouse or a former spouse if that transfer is “incident to the divorce”. To be incident to a divorce and for the transfer to have no income tax consequences, a property transfer needs to satisfy one of two tests: either the transfer occurs within one year after the date on which the marriage ceases (so if you’re within that one year period, you satisfy the test of incident to the divorce), or if you are outside that period, the transfer must be “related to the cessation of the marriage“. To be related to the cessation of the marriage requires satisfying a two-pronged test. The first prong is that the property transfer is pursuant to a divorce or separation agreement, and the second prong is that the transfer occurs not more than six years after the marriage ceases. Of course, if a trust is created incident to a divorce (after a couple is divorced, when they’re no longer married), the problem created by the repeal of Section 682 never arises because the trust was not created during the marriage. One caveat in this situation: these tax-free transfers under Section 1041(a) are treated as gifts for income tax purposes. That means that the basis of the property in the hands of the recipient is the same as the basis of the transferor. So if the person transferring the property has a zero basis, the person receiving the property will have a zero basis too, and a gain will be incurred when that property is sold. In other words, Section 1041 does not eliminate gain: it defers an immediate gain on transfer, postponing gain recognition until the gain is actually realized, making it critical for Family Law practitioners to factor in the impact of potential future embedded gains when negotiating settlement agreements.
Do you have any final tips for family lawyers on this topic?
I do, so I’m very glad that you asked! I think that the lesson to learn from this is that clients will benefit when matrimonial attorneys, trusts and estates attorneys, accounting and investment professionals partner to integrate considerations that cross disciplines. For example, if a family lawyer says “I’ll finish with the divorce, and then I’ll send my client to a new investment advisor and trusts and estates attorney,” it will be too late to address issues like the Section 682 problems we’ve been discussing today. As we’ve seen, those types of issues need to be resolved before the divorce is finalized. There are so many other nuanced issues that require the input of a team of advisors [that] I think advisors would be well-served by taking a collaborative, team-based approach to ensure they most effectively represent their clients.
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My guest today has been Sharon Klein, president of Family Wealth, Eastern US Region, for Wilmington Trust. She is a Fellow of the American College of Trusts & Estates Counsel, she chairs the Domestic Relations Committee of Trusts & Estates magazine, and is a member of the New York City Bar Association’s Matrimonial Committee. To learn more about how Sharon and her team can help ensure that your clients won’t suffer negative consequences as a result of the Tax Cuts and Jobs Act, visit Wilmington Trust’s dedicated divorce solutions resource page: www.wilmingtontrust.com/divorce
This podcast is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Professional advice always requires consideration of individual circumstances. The information in this podcast has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly-owned subsidiary of M&T Bank Corporation (M&T).
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