The Tax Cuts and Jobs Act has created significant ramifications in the divorce context, particularly on the income tax front. Here are 7 areas impacted by the new tax laws – including taxation of trust income.
By Sharon L. Klein, Family Wealth Strategist, Trusts & Estates Attorney
On December 22, 2017, the Tax Cuts and Jobs Act (the Tax Act) was signed into law. The Tax Act has created significant ramifications in the divorce context, particularly on the income tax front. Here is what family law practitioners must know about how the new tax laws could affect their divorcing clients.
1. Taxation of Trust Income Under the New Tax Laws Has Dramatically Changed
The Tax Act repeals Internal Revenue Code (IRC) § 682, which deals with the taxation of trust income following divorce.
For estate planning purposes, individuals can create irrevocable trusts for the benefit of family members. Using the federal gift tax exemption, which at $11.4 million per person for 2019 is an all-time high, they can move assets up to that amount into those irrevocable trusts without a federal gift tax consequence. Property transferred to the trusts (and the appreciation on that property) is removed from the individuals’ taxable estates when they die because they will no longer own those assets at death. 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%, significant estate tax savings can be garnered through the use of these irrevocable trusts. Although the trust creator – known as the grantor – does not own the assets after they are transferred to the trust, he can remain responsible for paying the trusts’ income and capital gains taxes (a so-called “grantor trust”). Having a grantor assume the tax liability that otherwise would be payable by the trust or trust beneficiaries is a popular planning tool, essentially allowing these trusts to grow tax-free for the trust beneficiaries because someone else is paying those taxes. Although the tax payments are in effect gifts to the trust by the grantor, they are not treated as gifts by the Internal Revenue Service. Accordingly, practitioners often purposely include provisions in trusts that will trigger grantor trust status.
Additionally, under IRC § 677(a)(1) (the so-called spousal unity rule), a grantor is treated as the owner of any portion of a trust if the income from the trust may be distributed to the grantor or the grantor’s spouse. Under IRC § 672(e)(1), a grantor is treated as holding any power or interest held by an individual who was the grantor’s spouse at the time the power or interest was created. Accordingly, the trust remains a grantor trust even if the grantor and the grantor’s spouse subsequently divorce. If, after a divorce, trust income was payable to a grantor’s spouse, in the absence of relief, the grantor would continue to be taxed on the income and the ex-spouse would receive the income tax-free. IRC § 682 prevented that result by providing that the income distributed to a spouse after a divorce is taxable to the recipient. The Tax Act repeals § 682 with regard to divorce or separation agreements signed in 2019 or thereafter. Note that the repeal is keyed to the date of the divorce or separation agreement, not the date of the trust agreement. Accordingly, the grantor spouse will be liable to pay the income tax on trust income from grantor trusts potentially created years before a divorce, even though the ex-spouse will be receiving that income.
Collaboration between estate and matrimonial attorneys will be key in investigating any possible techniques to potentially change grantor trust status, being mindful of potential adverse tax consequences, for example, in jeopardizing a trust that qualified for the marital deduction. With that caveat, possibilities might include terminating the trust upon divorce, decanting or otherwise modifying a trust in favor of other beneficiaries, and equalizing with other assets, or including a reimbursement provision or other equalization mechanism in a separation agreement for the taxes payable by the grantor spouse. The tax impact of every trust created during the marriage should be carefully considered when negotiating a divorce settlement or presenting evidence to a court.
The Tax Act changes regarding the repeal of IRC § 682 are permanent, and do not sunset.
Issue Does Not Arise for Trusts Created After Divorce
Pursuant to IRC §1041(a)(2), no gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse, or a former spouse if the transfer is “incident to the divorce.“ Of course, if a trust is created incident to a divorce after a couple is divorced, the problem created by the repeal of §682 never arises. A transfer of property is incident to the divorce if the transfer:
i. Occurs within 1 year after the date on which the marriage ceases, or
ii. Is related to the cessation of the marriage (IRC §1041(a)(2)).
A transfer of property is treated as related to the cessation of the marriage if the transfer:
1. Is pursuant to a divorce or separation instrument, and
2. Occurs not more than 6 years after the date on which the marriage ceases (Temp. Reg. §1.1041-1T(b).
Any transfer not made pursuant to a divorce or separation instrument and any transfer occurring more than 6 years after the cessation of the marriage is presumed to be not related to the cessation of the marriage. This presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage (for example, if there were legal or business impediments to the transferor disputes concerning the value of the property owned at the time of the cessation of the marriage, and the transfer was effected promptly after the impediment was removed).
Transfers to which §1041(a) applies are treated as gifts; the basis of the transferee in the property is the adjusted basis of the transferor immediately before the transfer (with a couple of exceptions).
Note that § 1041 does not eliminate gain; it defers an immediate gain on transfer, postponing gain recognition until the gain actually is realized. Accordingly, it is critical for advisors to factor in the impact of potential future embedded gains when negotiating settlement agreements.
2. Alimony Payments Have Lost their Tax Deductible Status: Courts Begin to Deal with Impact
Until 2019, alimony payments were characterized as taxable income to the recipient and deductible by the payer1. With the spouse paying alimony likely to be in a higher income tax bracket than the recipient spouse, the recipient spouse potentially was able to pay taxes on the alimony at a lower rate. The paying spouse received the benefit of a deduction at a higher tax bracket. This bracket play often resulted in overall tax savings between the parties.
Under the Tax Act, alimony payments made pursuant to a divorce or separation agreement signed after December 31, 2018 are no longer treated as taxable income to the recipient, and alimony payments cannot be deductible by the payer. Divorce or separation agreements signed before January 1, 2019 will be grandfathered. However, since a prenuptial agreement is likely not included in the definition of “divorce or separation agreement,” a prenuptial agreement signed before January 1, 2019 probably will not be grandfathered if the divorce decree that incorporates its terms is issued after December 31, 2018. All prenuptial agreements signed before January 1, 2019 must be reviewed in light of these changes. A report prepared by the Family Law Section of the American Bar Association describes the unfairness to a couple who entered into a prenuptial agreement with alimony provisions based on the assumption that the alimony deduction would be available: “…the parties who agreed to pay alimony on the assumption that it would be tax-deductible will now be required to pay the amount agreed upon without that benefit and the party receiving the alimony will receive a windfall.” Reopening a prenuptial agreement to revisit the issue may be undesirable for fear other items may also be revisited.
In Wisseman v. Wisseman,2 the New York Supreme Court, Duchess County, considered the impact of the new tax laws on a maintenance award determined under prior law, where the divorce was not finalized before December 31, 2018. Since the maintenance was no longer deductible to the husband, he argued that the award should be reduced by his tax rate, 22%. The wife argued the award should be reduced by her tax rate, 12%, which is what she would have paid in taxes under prior law, had the maintenance been taxable to her. The court determined to reduce the award by 12%: “the net result of which is application of the guidelines as intended by the New York State Legislature prior to the federal change in the relevant tax law, impacted only by a reduction concomitant with the wife’s tax bracket and what she would have been obligated to include as taxable income.”
For state purposes, some states have decoupled from the federal treatment of alimony payments. Accordingly, alimony can be subtracted from federal adjusted gross income in computing state taxable income. This is the case, for example, in New York3 and New Jersey.4
The new tax law changes regarding the taxation of alimony payments are permanent, and do not sunset.
3. The New Tax Laws Have Suspended the Personal Exemption
Before 2018, an exemption per child could be taken only by one parent, and was a negotiated benefit. The new law eliminates personal exemptions for dependents beginning December 31, 2017 and ending December 31, 2025.
4. The Tax Act Has Also Suspended Miscellaneous Itemized Deductions
Before 2018, miscellaneous itemized deductions, including fees related to tax advice incident to a divorce, were deductible to the extent they exceeded 2% of the taxpayer’s adjusted gross income. Those fees will no longer be deductible beginning December 31, 2017 and ending December 31, 2025.
5. Education Expenses Under the New Tax Laws
The new tax laws allow for distributions from 529 Plans to be used for qualified education expenses, not only for college, but also for tuition expenses for elementary, middle, and high school, up to $10,000 per year. Educational funding is often an element in marital agreements.5
6. Child Tax Credit Increased
The annual child tax credit, which typically is available to the custodial parent, has been increased from $1,000 to $2,000.
7. Possible Higher Valuations for Closely-Held Businesses
Lower corporate tax rates could potentially increase the valuation of closely-held businesses, increasing the strain on liquid assets to divide in a divorce. This highlights the importance of credit solutions to potentially provide liquidity to buy out a spouse not involved in the business, avoiding splitting up the business.
The Bottom Line: Collaboration is Key Under the New Tax Laws
Clients can benefit when matrimonial, trusts & estates, accounting, and investment professionals partner to integrate considerations that cross disciplines. Advisors will be well-served in taking a collaborative approach to ensure they effectively represent clients by considering the many nuanced factors in this arena.
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1IRC Sections 71(a) and 215(a)
2Wisseman v. Wisseman, 63 Misc. 3d 819, 97 N.Y.S.3d 823 (N.Y. Sup. Ct. 2019)
3N.Y. Tax Law § 612(w)
4N.J.S.A. § 54A:3-2
5Note that, at the state level, 529 Plan distributions for educational expenses below the college level may not be considered qualified distributions.
Sharon L. Klein is President of Family Wealth, Eastern US Region, for Wilmington Trust, where she also heads the National Matrimonial Advisory Solutions Group. She is a Fellow of the American College of Trust and Estate Counsel and a member of its Family Law Task Force, she chairs the Domestic Relations Committee of Trusts & Estates magazine, and is a member of the New York City Bar Association’s Matrimonial Committee. 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. www.wilmingtontrust.com/divorce
This article 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. 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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