New Tax Act Creates Trap for Family Law Attorneys and Their Clients

Upon divorce, most clients find their estate planning documents do not meet their needs. A happily married couple generally have aligned interests, both wanting to save estate taxes and provide for each other and their children. Accordingly, they may create trusts benefiting each other and then their children. In many situations, the trust may be a grantor trust which means that, under the tax law, the creator (“the grantor”) is responsible for paying income tax on trust income. A revocable trust is an example of a grantor trust. Unfortunately, upon divorce, interests diverge.

While a spouse may create a trust for the benefit of the other spouse for estate tax planning or for asset protection purposes, the following example illustrates the income tax issues of certain transfers. The asset protection and estate tax issues are outside the scope of this particular blog.

Gator transfers 10 million to a trust for the benefit of his wife, Alberta, who has a right to all income and discretionary distributions of principal. At Alberta’s death, the assets may be held further for Gator or distributed directly for the benefit of their children and their descendants. Alberta  can create a similar trust for Gator and, provided the trusts are not “reciprocal” trusts, the assets may not be included in either of their estates for estate tax purposes.

Because a spouse is the beneficiary of each trust, the trusts are grantor trusts for income tax purposes. Thus, income from the trust that Gator created for Alberta is taxed to Gator and the income from the trust that Alberta created for Gator is taxed to Alberta.

Assume that the trust Gator creates for Alberta is very successful. Gator will pay income taxes on those earnings. While Gator and Alberta are married, it generally does not matter whether Gator or Alberta pays the income tax as Gator and Alberta file a joint return.

What happens if Gator and Alberta divorce? As Alberta is no longer a “spouse”, then does the trust continue to be a grantor trust (assuming that no other provisions make the trust a grantor trust)? If the trust is no longer a grantor trust, then Gator is relieved from paying income taxes on the trust for the benefit of Alberta. This would be good news because once divorced, Gator will NOT want to pay income tax on a trust that benefits Alberta.

The tax law states that “a grantor shall be treated as holding any power or interest held by any individual who was the spouse at the time of the creation of such power or interest. Unfortunately, Alberta WAS a spouse at the time of the creation of the trust. It is unclear as to whether the current tax law would serve to sever the grantor trust provision if the parties divorce AFTER the creation of the trust.

Fortunately, Section 682 of the Internal Revenue Code (the “Code”) provides that, in such a grantor trust, IF there is a divorce, the income will be included in Alberta’s income and Gator would NOT be taxed on such income. Thus, upon divorce, Section 682 overrides the grantor trust law noted above.

Unfortunately, the 2017 Tax Act (the “Act”) REPEALS Section 682 of the Code as of 12. 31. 18. Starting in 2019, who will pay income tax on the trust Gator created for Alberta? Practitioners and clients have to interpret the current grantor trust rules and currently it is unclear as to whom is taxable on those amounts after 12.31.18. Grandfathering rules are provided and hopefully  the Internal Revenue Service (the “Service”) will clarify, either through a ruling or regulations, this issue.

ADVICE: In any dissolution proceeding or preparation and review of a prenuptial agreement, the repeal of Section 682 of the Code must be considered if grantor trusts have been created. If the grantor spouse is found to be liable for income taxes, then a clause should be included in any agreement that the ex-spouse benefiting from the trust must reimburse the grantor for the income taxes. Consider having this reimbursement part of alimony as the client could use the case law and court supervision over alimony. Attorneys should also consider decanting or trust modification. For a well written in-depth article on the Act’s repeal of Section 682 of the Code and other family law changes,  see “Alimony, Prenuptial Agreements, and Trusts under the 2017 Tax Act by George D. Karibjanian, Esquire, Richard S. Franklin, Esquire and Lester B Law, Esquire (Copyright @ 2018 by BNA 800.372.1033).

WORD OF THE WEEK: Reciprocal Trusts are trusts that are created at the same time to benefit each spouse. The Service can “unwind” reciprocal trusts.

For example, Bill creates a trust for his wife, Susan, providing income to Susan and principal to benefit his children. At Susan’s death, she can appoint trust assets for the benefit of Bill and the children. Ideally the trust is not included in Bill’s estate for estate tax purposes.

At the same time, Susan creates a trust for Bill, providing income to Bill and principal to benefit his children. At Bill’s death, he can appoint trust assets for the benefit of Susan and the children. Again, the trust is not included in Susan’s estate for estate tax purposes.

At either Bill’s or Susan’s death, the Service can argue that these trusts are “reciprocal” because, in effect, Bill and Susan have merely transferred assets and have “retained” an interest in the trust. Thus, the trust that Susan created for Bill may be included in Bill’s estate and vice versa. The relevant factor is that the trusts created by Bill and Susan placed each of them in the same objective economic position as they would have been in if each had created his or her own trust with himself or herself, rather than the other, as life beneficiary.

The reciprocal trust can be avoided by careful drafting. Read the case of United States v. Grace for the seminal case on reciprocal trusts.

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