Monday, April 23, 2018
The Tax Cuts and Jobs Act (TCJA) constituted a major overhaul of the tax Code for both individuals and businesses. In previous posts, I have examined some of those provisions. In particular, I have taken a look at the new I.R.C. §199A and its impact on agricultural producers and cooperatives. Recently the IRS Commissioner told the Senate Finance Committee that it would take “years” to finish writing all of the rules needed to clarify the many TCJA provisions and provide the interpretation of the IRS. But, recently the IRS did clarify how “alimony trusts” are to work for divorces entered into before 2019.
The alimony tax rules and “alimony trusts”, that’s the focus of today’s blog post.
Tax treatment of alimony. For divorce agreements entered into before 2019, “alimony or separate maintenance payment” is taxable to the recipient and deductible to the payor. I.R.C. §71. What is an alimony or separate maintenance payment? It’s any payment received by or on behalf of a spouse (or former spouse) of the payor under a divorce or separate maintenance agreement that meets certain basic requirements: 1) the payment is made in cash (checks and money orders) pursuant to a decree, court order or written agreement; 2) the payment is not designated as a payment which is excludible from the gross income of the payee and non-deductible by the payor; 3) for spouses legally separated under a decree of divorce or separate maintenance, the spouses are not members of the same household at the time payment is made; 4) the payor has no liability to continue to make any payment after the payee’s death and the divorce or separation instrument states that there is no such liability. I.R.C. §71(b)(1). It’s also possible that a settlement requiring or allowing the paying spouse to make payments directly to third parties for the benefit of the other spouse (such as for medical treatment, life insurance premiums or mortgage payments, for example) can result in the payments being treated as alimony as long as they do not benefit the paying spouse or property owned by the paying spouse.
It is possible, however, to specify in a separation agreement or divorce decree that such payments escape taxation in the hands of the recipient (and not give rise to a deduction in the hands of the payor-spouse). Conversely, child support and property settlements are tax neutral – neither party pays tax nor gets a deduction. I.R.C. §71(c).
Another rule specifies that if the payor owes both alimony and child support, but pays less than the total amount owed, the payments apply first to child support and then to alimony. If the separation agreement does not specify separate alimony and child support payments, general “family support” payments are treated as child support for tax purposes, unless the alimony qualifications are met.
Planning point. This tax treatment raises an interesting planning point. In general, when the higher income spouse makes payments to the lower-income spouse, the payments should be structured as alimony because the deduction can be available to the spouse in the higher tax bracket and, concomitantly, the income will be taxable to the spouse in the lower tax bracket. If the spouse making payments is not in the higher income tax bracket (perhaps because of high levels of tax-exempt income such as disability payments), it makes more sense to structure the payments as child support or as a property settlement, or simply specify in the agreement that the alimony is not taxable to the recipient.
What about trusts? During marriage, one spouse may have created an irrevocable trust for the benefit of the other spouse. In that situation, I.R.C. §672(e)(1)(A) makes the trust a “grantor” trust with the result that the income of the trust is taxed to the spouse that created the trust. If the couple later divorces, the trust remains. It’s an irrevocable trust. The divorce doesn’t change the nature or tax status of the trust – the spouse (now ex-spouse) that created the trust must continue to pay tax on trust income. That’s probably both an unexpected and unhappy result for the spouse that created the trust. That’s why (at least through 2018) I.R.C. §682(a) provides that the spouse that didn’t create the trust is taxed on the trust income, except for capital gain. Capital gain income remains taxable to the spouse that created the trust. In essence, then, the “payee” spouse is considered to be the trust beneficiary. I.R.C. §682(b).
Reversing tax treatment of alimony. Under the TCJA, for agreements entered into after 2018, alimony and separate maintenance payments are not deductible by the payor- spouse, and they are not included in the recipient-spouse’s income. Title I, Subtitle A, Part V, Sec. 11051. This modification conforms alimony tax provisions to the U.S. Supreme Court’s opinion in Gould v. Gould, 245 U.S. 151 (1917). In that case, the Court held that alimony payments are not income to the recipient.
Under the TCJA, income that is used for alimony payments is taxed at the rates applicable to the payor spouse rather than the recipient spouse. The treatment of child support remains unchanged.
Impact on “alimony trusts.” However, the TCJA also struck I.R.C. §682 from the Code as applied to any divorce or separation instrument executed after 2018, and any divorce or separation agreement executed before the end of 2018 that is modified after 2018 if the modification provides that the TCJA amendments are to apply to the modification.
With the coming repeal of I.R.C. §682, what will happen to “alimony trusts” that were created before the repeal? IRS has now answered that question. According to IRS Notice 2018-37, IRB 2018-18, regulations will be issued stating that I.R.C. §682 will continue to apply to these trusts. That means that the “beneficiary” spouse will continue to be taxed on the trust income. But, the IRS points out that this tax treatment only applies to couples divorced (or legally separated) under a divorce or separation agreement executed on or before December 31, 2018. The only exception is if such an agreement is modified after that date and the modification says that the TCJA provisions are to apply to the modification.
What happens to “alimony trusts” executed after 2018? The spouse that creates the trust will be taxed on the trust income under the “grantor trust” rules. That’s because I.R.C. §672(e)(1) will continue to apply. Some taxpayers finding themselves in this position may want to terminate grantor trust treatment in the event of divorce. A qualified terminable interest property (QTIP) trust may be desired. Another approach may be to have a provision drafted into the language of the trust that says that the spouse creating the trust will be reimbursed for any tax obligation post-divorce attributable to the trust.
The IRS is requesting comments be submitted by July 11, 2018.
The TCJA changed many tax Code provisions. The alimony rules are only a small sample of what was changed. If you haven’t done so already, find a good tax practitioner and get to know them well. Tax planning for 2018 and beyond has already begun.