TRUST AND ESTATE PLANNING ISSUES IN DIVORCE

First Run Broadcast: January 19, 2017

Live Replay: July 24, 2017

1:00 p.m. ET/12:00 p.m. CT/11:00 a.m. MT/10:00 a.m. PT (60 minutes)

Martial separation and divorce are times fraught with emotion, but also fraught with financial

decisions that have a major estate, trust and tax implications. Transfers pursuant to divorce are

generally tax-free. But there are many complications, including the transfer of property over

time or where the value may not be known, the transfer and assumption of debts, the treatment of

income held in trust, and also complex issues of beneficiary designations in retirement plans and

insurance contracts. There are also issue related to health care choices, the sale or transfer of a

personal residence and family businesses. If not properly planned, these transfers can have

substantially adverse and often unanticipated consequences. This program will cover major

estate, trust and income tax issues in property settlement negotiations, in the division of assets

and debts, alimony and settlement payments, and more.

Estate, trust and income tax issues in martial separation and divorce

Treatment of income form and property held in trust on divorce

Traps surrounding beneficiary designations on retirement benefits and insurance

contracts

Opportunities for post-nuptial agreements to resolve lingering disputes

Issues related to the sale or transfer of personal residences

Income tax issues when property and debt are separated in divorce

Health care issues for children, including insurance for the divorcing spouse

Educational expenses for children over time

Speakers:

Jennifer A. Pratt is a partner in the Baltimore office of Venable, LLP, where she has assists

client with estate planning, charitable giving, and estate and gift tax controversy matters. She

has extensive experience with estate administration, the preparation of federal estate and gift tax

returns, as well as fiduciary income tax returns. Earlier in her career, she worked with a major

national bank and has particular expertise in adapting financial products to the estate planning

needs of clients. She has been named in the 2011 edition of “Maryland Super Lawyers Rising

Stars Edition.” Ms. Pratt received he B.A., summa cum laude, from the University of Baltimore,

her J.D., magna cum laude, from the University of Baltimore School of Law, and her LL.M. in

taxation from the University of Baltimore.

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Trust & Estate Planning Issues in Divorce Teleseminar

July 24, 2017 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: July 24, 2017 Seminar Title: Trust & Estate Planning Issues in Divorce Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

© Jeanne L. Newlon, Esquire, 2017. All rights reserved.14593113-v1

ESTATE PLANNING IN DIVORCE: SPECIFIC ISSUES

Presented by:Jennifer A. Pratt, Esquire

Venable LLP750 East Pratt Street, Suite 900

Baltimore, MD 21202Telephone: (410) 528-2883Facsimile: (410) 244-7742

japratt@venable.com

Materials Prepared by:Jeanne L. Newlon, Esquire

Venable LLP575 7th Street, N.W.

Washington, DC 20004Telephone: (202) 344-8553Facsimile: (202) 344-8300

jlnewlon@venable.com

-i-© Jeanne L. Newlon, Esquire, 2017. All rights reserved.14593113-v1

TABLE OF CONTENTS

Content Page Number

I. TAX TREATMENT OF TRANSFER OF CERTAIN ASSETS.........................................1

1. Retirement Plan Assets ............................................................................................1a. Division of Qualified Retirement Plans in Divorce.....................................1b. Transfer of Individual Retirement Accounts in Divorce .............................2c. Beneficiary Designations on Retirement Plan Assets..................................2

2. Residences................................................................................................................3a. Recognition of Gain on Transfer of Residence from One Spouse to Other 3b. Exclusion of Gain under Section 121 ..........................................................3c. Sale of Residence from One Spouse to the Other........................................4d. Payment of Mortgage...................................................................................5

3. Closely-Held Corporations ......................................................................................5

4. Stock Options and Deferred Compensation Plans ...................................................8

5. Charitable Remainder Trusts .................................................................................10

6. Life Insurance ........................................................................................................12a. Transfer of Policy by One Spouse to Other ...............................................12b. Insurance Payable to Spouse to Secure Support Obligations ....................13c. Insurance to Secure Support Obligation of Children.................................14d. Second-to-Die Insurance............................................................................15

II. USE OF TRUSTS IN DIVORCE......................................................................................16

1. Gift Tax Consequences ..........................................................................................16a. Gift Tax Marital Deduction under Section 2523 .......................................16b. Transfer for Full and Adequate Consideration under Section 2516 ..........17c. Trusts to Which Section 2702 Does Not Apply.........................................19d. Relinquishment of Support Rights.............................................................21e. Relinquishment of Enforceable Rights in Property ...................................24f. The “Harris” Rule ......................................................................................24

2. Estate Tax Consequences.......................................................................................25a. Inclusion of Trust Property in Transferor Spouse’s Estate........................25b. Inclusion of Property in Estate of Transferee Spouse................................27c. Estate Tax Deductibility ............................................................................28

3. Income Tax Consequences ....................................................................................29a. Grantor Trusts ............................................................................................29

i. General Rules.................................................................................29ii. Grantor Trusts in Divorce ..............................................................34

b. Nongrantor Trusts ......................................................................................36

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ESTATE PLANNING IN DIVORCE: SPECIFIC ISSUES

When a couple decides to divorce, the last thing they are thinking about is the tax consequences. In any event, the division of the property, support payments and the use of trusts to provide for such division and payments have tax consequences that should be considered before moving forward. This outline will discuss the tax treatment of the transferof certain assets often divided in divorce, including, retirement plan assets, residences, stock in a closely-held business, stock options and other deferred compensation, charitable remainder trusts and life insurance. The outline then will address the use of trusts in the divorce context.

I. TAX TREATMENT OF TRANSFER OF CERTAIN ASSETS

1. Retirement Plan Assets

Retirement plan assets, such as 401(k) plans, individual retirement accounts (IRAs), pension plans, profit-sharing plans and other deferred compensation plans, are often an important part of a client’s portfolio. Retirement plan assets may be a part of the divorce settlement or may not. In either case, it is important to properly plan for such assets.

a. Division of Qualified Retirement Plans in Divorce

A divorcing couple may have agreed upon a division of a retirement plan owned by one of the spouses. Generally, a qualified retirement plan, such as a 401(k) plan, may not be divided between a plan participant and his or her spouse as there is a spendthrift provisionthat applies to such plans.1 There is, however, an exception to the spendthrift protection if the division is made pursuant to a qualified domestic relations order (QDRO).2

A QDRO is a domestic relations order that “creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan.”3 A domestic relations order is a judgment, decree or order made pursuant to a state domestic relations law relating to the provision of child support, alimony payments or marital property rights of a spouse, former spouse, child or other dependent of the plan participant.4 In addition to the prior requirements, to qualify as a QDRO, the domestic relations order must also specify the name and last known mailing address of the participant and each alternate payee covered by the order, the amount or percentage of the participant’s benefits to be paid by the plan to each such alternate payee or the manner in which such amount or percentage is to be determined, the number of payments or period to which such order applies and the specific plan or plans

1 Section 401(a)(13)(A) and (B).2 Section 414(p).3 Section 414(p)(1)(A)(i).4 Section 414(p)(1)(B).

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to which such order applies.5 The order may not require the plan to provide any benefit or option not otherwise already provided under the plan.6 The order also may not require the plan to provide increased benefits determined on the basis of actuarial value.7 Finally, the order may not require the payment of benefits to an alternate payee which are already required to be paid to another alternate payee under a previously issued QDRO.8

The QDRO likely will provide that the spouse will receive a lump sum distribution from the plan in satisfaction of the divorce agreement. As retirement plan assets generally have not been subject to income tax, there is a question of whether such distribution is an assignment of income by the participant to the spouse. The tax law provides an exception to the assignment of income doctrine so long as the spouse will be subject to income tax on the distributions made to him or her.9 When receiving a lump sum distribution, however, the spouse can defer income tax consequences by rolling over the amount distributed to an individual retirement account as described in Section 408(a) or other qualified retirement plan described in Section 402(c)(8). In order to avoid the immediate income tax consequences of the distribution, the rollover must be accomplished within sixty days of the distribution.10

b. Transfer of Individual Retirement Accounts in Divorce

An individual may transfer his or her interest in an IRA to his or her spouse pursuant to the provisions of a divorce or separation agreement.11 A divorce or separation agreement is a decree of divorce or separate maintenance or a written instrument incident to such divorce.12 Thus, in order for one spouse to transfer his or her IRA to the other spouse, there must be an actual divorce or separate maintenance decree, not just a written separation agreement between the parties. Following the transfer of the IRA, the IRA will be considered to the IRA of the transferee spouse rather than that of the transferor spouse. Such transfer should not be in the form of a distribution, but rather as an actual transfer of the IRA itself from one spouse to the other.

c. Beneficiary Designations on Retirement Plan Assets

If the spouses decide to keep their separate retirement plan assets, it is very important that each spouse immediately review and likely change the beneficiary designations on those assets. Plan administrators are required to abide by the most recent beneficiary designation even if applicable state law may sever the rights of the spouse to such benefits upon divorce.13

5 Section 414(p)(2).6 Section 414(p)(3)(A).7 Section 414(p)(3)(B).8 Section 414(p)(3)(C).9 Section 402(e)(1)(A).10 Id.11 Section 408(d)(6).12 Section 71(b)(2)(A).13 Egelhoff v. Egelhoff, 532 U.S. 141 (2001); Kennedy v. Plan Administrator for DuPont Savings &

Investment Plan, 555 U.S. 285 (2009).

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2. Residences

Another asset that will be discussed during property settlement negotiations is the principal residence, as well as other residences of the parties. It is a simple act to prepare a Deed transferring all of the rights of one spouse in the principal residence to the other spouse. Before doing so, however, certain tax matters must be considered.

a. Recognition of Gain on Transfer of Residence from One Spouse to Other

If the parties agree to transfer the residence to one spouse, the transferor spouse will not recognize gain on the transfer of his or her interest in the residence if the transfer is incident to the divorce of the parties.14 A transfer is incident to divorce if the transfer occurs within 1 year after the date on which the marriage ceases or is related to the cessation of the marriage.15 A transfer is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation agreement as defined in Section 71(b)(2) and the transfer occurs not more than 6 years after the date on which the marriage ceases.16 Section 71(b)(2) provides that a divorce or separation agreement is a decree of divorce or separate maintenance or a written instrument incident to such divorce. If, however, there is a mortgage on the residence which is transferred to the transferee spouse and the amount of the mortgage exceeds the basis of the residence, then the transferor spouse will recognize gain to the extent that the mortgage exceeds the basis of the residence.17

b. Exclusion of Gain under Section 121

Section 121 excludes from gross income some portion up to all of the gain recognized on the sale of a principal residence. In order to qualify for such exclusion, the taxpayer must have owned and used the property as his or her principal residence for at least 2 of the 5 years leading up to the sale.18 The test for determining whether a residence is a principal residence of the taxpayer is a facts and circumstances test.19 In applying the test, the IRS will look at which residence the taxpayer uses a majority of the time during the year, the taxpayer’s place of employment, the principal place of abode of the taxpayer’s family members, the address listed on the taxpayer’s Federal and state tax returns, driver’s license, automobile registration and voter registration card, the taxpayer’s mailing address for bills and other correspondence, the location of the taxpayer’s checking and other bank accounts and the location of any religious or social organizations of which the taxpayer is a member.20

14 Section 1041(a).15 Section 1041(c).16 Treas. Reg. Section 1.1041-1T A-7.17 Section 1041(e).18 Section 121(a).19 Treas. Reg. Section 1.121-1(b)(1).20 Treas. Reg. Section 1.121-1(b)(2).

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An unmarried taxpayer may exclude up to $250,000 of gain on the sale of the principal residence.21 A married couple who files a joint return may exclude up to $500,000 of gain on the sale of the principal residence if either spouse has owned the residence as his or her primary residence for 2 of the last 5 years, both spouses have used the residence as their primary residence for 2 of the last 5 years and neither spouse has sold a primary residence within the last 2 years.22

As noted above, if one spouse transfers his or her interest in the residence to the other spouse, generally no gain will be recognized under Section 1041 so Section 121 does not apply. The issue though becomes what happens when the transferee spouse sells the entire residence at a later time. The transferee spouse may add the period of ownership and use of the couple prior to the divorce to the transferee spouse’s period of ownership.23 In addition, the transferee spouse may treat the residence as his or her principal residence during any period of ownership while he or she was granted use of the property under a divorce or separation instrument.24 Thus, the transferee spouse should be able to meet the use and ownership tests of Section 121 to exclude a portion of the gain on the sale of the residence.

The larger concern, however, is that the transferee spouse will only have an exclusion of $250,000. If the couple had sold the residence while still married, they would have beenable to exempt $500,000 of the gain from income tax. Depending upon the value of the residence and the potential gain on sale of the residence, the parties may wish to take into consideration the increased income tax consequences that result by not selling the residence before divorce. This may mean an additional cash payment by the transferor spouse to the transferee spouse.

c. Sale of Residence from One Spouse to the Other

The parties may agree that one of the spouses will purchase the other’s interest in a residence, whether it be the parties’ principal residence or some other residence. Such purchase will not cause the transferor spouse to recognize gain under Section 1041, unless any liability transferred with such residence exceeds the basis of such residence.25 If the transferee spouse gives back a note for a portion or all of the purchase price, the interest payments should be deductible by the transferee spouse as qualified residence interest if the note is secured by the residence.26

There may, however, be local transfer and recordation taxes on the transfer due to the fact that there is consideration for the transfer and the exception provided in most jurisdictions for a transfer between spouses may not apply. In Maryland, for example, a transfer of residential property between spouses and former spouses is exempt from transfer

21 Section 121(b)(1).22 Section 121(b)(2)(A).23 Section 121(d)(3)(A).24 Section 121(d)(3)(B). Section 71(b)(2) provides that a divorce or separation agreement is a decree of divorce or separate maintenance or a written instrument incident to such divorce. 25 Section 1041(e).26 Section 163(h).

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and recordation taxes, even if the property is transferred subject to a mortgage.27 In the District of Columbia, however, a transfer of real property between spouses for consideration is subject to transfer and recordation tax unless such transfer is pursuant to a decree of divorce or separate maintenance or pursuant to a written instrument incident to such divorce or separation.28

d. Payment of Mortgage

If one spouse transfers his or her interest in the residence to the other spouse, the transferor spouse can no longer claim that the residence is his or her primary residence. Thus, if there is a mortgage on the residence, the transferor spouse will not be entitled to an interest deduction for the payment of any interest on such mortgage under Section 163(h)(3). If, however, the couple has children who live in the residence, the transferor spouse may be able to treat the residence as a secondary residence and deduct the interest he or she is paying on the mortgage.29

If there are no children living in the residence, then the transferor spouse could provide for an increased payment of alimony and have the transferee spouse make the mortgage payments in full. The transferee spouse would be entitled to the full interest deduction under Section 163(h)(3) and the marital settlement agreement would provide for a deduction to the transferor spouse of the alimony payments.

3. Closely-Held Corporations

Often one of the assets of one or both of the parties in a marriage is stock in a closely-held corporation. If both parties own the stock, it is likely that they will not want to continue working together in the business. Furthermore, the corporation may be the source of cash to provide a lump sum payment to one of the spouses. One solution is to have the corporation redeem the stock of one of the spouses.

If both spouses own shares in the corporation, the parties can agree to have one of the spouse’s shares redeemed by the corporation. The redemption generally will be treated as a sale or exchange of the stock so long as the redeeming spouse terminates his or her entire interest in the corporation.30 If, however, the redemption satisfies a primary and unconditional obligation of the nonredeeming spouse to purchase the shares of the redeeming spouse, then the redemption could be treated as a constructive dividend, rather than a sale or exchange of the stock.31

27 Md. Code Ann. (Tax – Property) Section 12-108(c) and (d).28 D.C. Code Ann. Section 47-902(5) and (20).29 Section 163(h)(5)(A).30 Section 302(b).31 See Sullivan v. U.S., 244 F. Supp. 605 (1965), affirmed, 363 F. 2d 724 (1966), certiorari denied, 387 U.S. 905 (1967), rehearing denied, 388 U.S. 924 (1967); Rev. Rul. 69-608, 196-2 C.B. 43.See Hayes v. Comm’r, 101 T.C. 593 (1993), in which the Tax Court held that the redemption of the wife’s shares in a closely-held corporation was a constructive dividend to the husband because it satisfied the husband’s obligation to purchase his wife’s shares under the marital settlement agreement.

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The Treasury Regulations under Section 1041 allow the spouses to control the tax consequences of the redemption. If the redemption is made pursuant to a divorce or separation agreement or a valid written agreement between the transferor spouse and the nontransferor spouse that expressly provides that both spouses intend for the redemption to be treated as a redemption distribution to the transferor spouse and such agreement supersedes any other agreement concerning the purchase, sale, redemption or other disposition of such stock, then the property received in exchange for the redeemed stock shall be treated as a redemption and not a constructive divided to the nontransferor spouse.32 Section 1041 does not apply to the redemption, rather, Section 302 will apply to the stock of a C corporation and Section 1368 will apply to the stock of an S corporation.33

If, however, the divorce or separation agreement or other valid written agreement between the transferor spouse and the nontransferor spouse expressly provides that both spouses intend for the redemption to be treated as resulting in a constructive dividend to the nontransferor spouse and such agreement supersedes any other agreement concerning the purchase, sale, redemption or other disposition of the stock, then the redemption will be treated as a constructive dividend to the nontransferor spouse.34 As in the situation above where the redemption is not treated as a constructive dividend, Section 1041 does not apply and the parties must look to Section 302 for the stock of a C corporation and Section 1368 for the stock of an S corporation to determine the income tax consequences.35

In order for the above rules to apply, the divorce or separation agreement must be effective, or the valid written agreement must be executed by both spouses, prior to the date on which the transferor spouse or nontransferor spouse, as may be applicable, files such spouse’s first timely-filed (including extensions) Federal income tax return for the year that includes the redemption.36

The Treasury Regulations provide the following examples:

Example 1. Corporation X has 100 shares outstanding. A and B each own 50 shares. A and B divorce. The divorce instrument requires B to purchase A's shares, and A to sell A's shares to B, in exchange for $100x. Corporation X redeems A's shares for $100x. Assume that, under applicable tax law, B has a primary and unconditional obligation to purchase A's stock, and therefore the stock redemption results in a constructive distribution to B. Also assume that the special rule of Section 1.1041-2(c)(1) does not apply. Accordingly, under Section 1.1041-2(a)(2) and (b)(2), A shall be treated as transferring A's stock of Corporation X to B in a transfer to which section 1041 applies(assuming the requirements of Section 1041 are otherwise satisfied), B shall be treated as transferring the Corporation X stock B is deemed to

32 Treas. Reg. Section 1.1041-2(c)(1).33 Treas. Reg. Section 1.1041-2(b)(1).34 Treas. Reg. Section 1.1041-2(c)(2).35 Treas. Reg. Section 1.1041-2(b)(2).36 Treas. Reg. Section 1.1041-2(c)(3).

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have received from A to Corporation X in exchange for $100x in an exchange to which Section 1041 does not apply and Sections 302(d) and 301 apply, and B shall be treated as transferring the $100x to A in a transfer to which section 1041 applies.

Example 2. Assume the same facts as Example 1, except that the divorce instrument provides as follows: “A and B agree that the redemption will be treated for Federal income tax purposes as a redemption distribution to A.” The divorce instrument further provides that it “supersedes all other instruments or agreements concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption.” By virtue of the special rule of Section 1.1041-2(c)(1) and under Sections 1.1041-2(a)(1) and (b)(1), the tax consequences of the redemption shall be determined in accordance with its form as a redemption of A's shares by Corporation X and shall not be treated as resulting in a constructive distribution to B. See Section 302.

Example 3. Assume the same facts as Example 1, except that the divorce instrument requires A to sell A's shares to Corporation X in exchange for a note. B guarantees Corporation X's payment of the note. Assume that, under applicable tax law, B does not have a primary and unconditional obligation to purchase A's stock, and therefore the stock redemption does not result in a constructive distribution to B. Also assume that the special rule of Section 1.1041-2(c)(2) does not apply. Accordingly, under Sections 1.1041-2(a)(1) and (b)(1), the tax consequences of the redemption shall be determined in accordance with its form as a redemption of A's shares by Corporation X. See Section 302.

Example 4. Assume the same facts as Example 3, except that the divorce instrument provides as follows: “A and B agree the redemption shall be treated, for Federal income tax purposes, as resulting in a constructive distribution to B.” The divorce instrument further provides that it “supersedes any other instrument or agreement concerning the purchase, sale, redemption, or other disposition of the stock that is the subject of the redemption.” By virtue of the special rule of Section 1.1041-2(c)(2), the redemption is treated as resulting in a constructive distribution to B for purposes of Section 1.1041-2(a)(2). Accordingly, under Sections 1.1041-2(a)(2) and (b)(2), A shall be treated as transferring A's stock of Corporation X to B in a transfer to which Section 1041 applies (assuming the requirements of Section 1041 are otherwise satisfied), B shall be treated as transferring the Corporation X stock B is deemed to have received from A to Corporation X in exchange for a note in an exchange to which Section 1041 does not apply and Sections 302(d) and 301 apply, and B shall be

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treated as transferring the note to A in a transfer to which Section 1041 applies.37

4. Stock Options and Deferred Compensation Plans

Another type of property that may be the subject to a divorce settlement includes stock options and nonqualified deferred compensation. In Revenue Ruling 2002-22, the IRS ruled that an employee who transfers interests in nonstatutory stock options and nonqualified compensation to a spouse incident to divorce will not realize income on the transfer.38 The transferee spouse will realize income when he or she exercises the stock option or when the deferred compensation is paid or made available to the spouse.39

In the Ruling, prior to the divorce of A and B, the corporation by which A wasemployed issued nonstatutory stock options to A as part of A’s compensation. The stock options did not have a readily ascertainable fair market value at the time of issue within the meaning of Section 1.83-7(b) so A did not realize any income at the time of issuance. A also participated in two unfunded nonqualified deferred compensation plans managed by the corporation. Under one of the plans, A is entitled to payments based on the balance of the individual account. By the time of the divorce, A had accumulated an account balance in the plan of $100x. Under the other plan, A is entitled to receive single sum or periodic payments following separation from service based on a formula reflecting A’s years of service and compensation history with the corporation. At the time of A’s divorce, A had accrued the right to receive a single sum payment of $50x following A’s termination of employment with the corporation. A’s rights to the deferred compensation under both plans were not contingent on A’s performance of future services for the corporation.

Under applicable state law, stock options and unfunded deferred compensation plan rights earned by a spouse during marriage are marital property subject to equitable division between the spouses in the event of divorce. A and B entered into a property settlement agreement that was incorporated into the judgment of divorce under which A agreed to transfer to B 1/3 of the nonstatutory stock options, the right to receive deferred compensation payments under the account balance plan based on $75x of A’s account balance at the time of divorce and the right to receive a single sum payment of $25x from the corporation under the other deferred compensation plan upon A’s termination of employment with the corporation. Four years after the divorce, B exercises all of the stock options and receives stock in the corporation with a fair market value in excess of the exercise price of the options. Nine years after the divorce, A terminates A’s employment with the corporation and B receives a single sum payment of $150x from the account balance plan and a single sum payment of $25x from the other plan.

In reaching its conclusion, the IRS reviewed the application of Section 1041 and the assignment of income doctrine. Under Section 1041, a transferor spouse does not recognize gain or loss on the transfer of property to the transferee spouse if the transfer is incident to

37 Treas. Reg. Section 1.1041-2(d).38 Rev. Rul. 2002-22, 2002-1 C.B. 849.39 Id.

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divorce.40 Rather, the property is treated as being acquired by the transferee spouse by gift and the transferee’s basis in the property received is the adjusted basis of the transferor spouse.41 While Section 1041 provides for the nonrecognition of gain or loss on transfers between spouses, it does not address whether such transfers remain taxable to the transferor spouse under the assignment of income doctrine.

The assignment of income doctrine provides that income is taxed to the person who earns it and may not be shifted by assignment to another person.42 The doctrine, however, does not apply to every transfer of future income rights.43 Many courts specifically have concluded that transfer of income rights between divorcing spouses are not voluntary assignments and should not be subject to the doctrine.44 The IRS further stated that, to apply the assignment of income doctrine to transfers of property between divorcing spouses would “impose substantial burdens on marital property settlements involving such property and thwart the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible.”45

With respect to the stock options, the general rule is that, if property is transferred to a person in connection with the performance of services, the amount in excess of the fair market value of the property over the amount, if any, paid for the property is included in the gross income of such person in the first taxable year in which the rights of such person in such property are transferable or are not subject to substantial risk of forfeiture.46 Nonstatutory stock options may not have a readily ascertainable fair market value on the date they are granted. Thus, the holder of such options must include in his or her gross income the value of such option when he or she disposes of such option.47 The IRS stated that, while the transfer of nonstatutory stock options in connection with a divorce settlement may involve an arm’s length exchange for consideration, it would contravene the gift treatment under Section 1041(b) to include the value of such consideration in the transferor’s income under Section 83. Accordingly, the IRS ruled that the transfer of nonstatutory stock options between divorcing spouses is entitled to nonrecognition treatment under Section 1041 and that the transferee will realize income when the options are exercised. It further reasoned that the same conclusion would apply where the employee transfers a statutory stock option in connection with a divorce which does not cause realization of income on the transfer.48

Accordingly, Revenue Ruling 2002-22 concluded that the interests in nonstatutory stock options and nonqualified deferred compensation transferred by A to B are property within the meaning of Section 1041 and that the assignment of income doctrine does not

40 Section 1041(a).41 Section 1041(b).42 Lucas v. Earl, 281 U.S. 111 (1930).43 See, e.g., Rubin v. Comm’r, 429 F.2d 650 (2d Cir. 1970); Hempt Bros., Inc. v. U.S., 490 F.2d 1172 (3d Cir. 1974), cert. denied, 419 U.S. 826 (1974); Rev. Rul. 80-198, 1980-2 C.B. 113.44 See Meisner v. U.S., 133 F.3d 654 (8th Cir. 1998); Kenfield v. U.S., 783 F.2d 966 (10th Cir. 1986); Schulze v. Comm’r, T.C.M. 1983-263; Cofield v. Koehler, 207 F. Supp. 73 (D. Kan. 1962).45 Rev. Rul. 2002-22, 2002-1 C.B. 849.46 Section 83(a).47 Section 83(e); Treas. Reg. Section 1.83-7(a).48 Section 424(c)(4).

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apply to the transfers. A is not required to include in A’s gross income any income resulting from B’s exercise of the stock options four years after the divorce or on the payment of the deferred compensation to B nine years after the divorce. Rather, B must include in B’s gross income an amount determined under Section 83(a) as if B were the person who performed the services. Furthermore, B must include in B’s gross income the amount realized from the payments of deferred compensation in the year such payments are paid or made available to B. One important caveat to this ruling is that it does not apply to transfers of nonstatutory stock options, unfunded deferred compensation rights or future income rights to the extent such options or rights are unvested at the time of transfer or the transferor’s rights to such income are subject to substantial contingencies at the time of the transfer.

5. Charitable Remainder Trusts

As part of their estate plan, the divorcing couple may have created a charitable remainder trust (CRT). A CRT is a split-interest trust under which the grantor, another person or persons or both receive an annuity or unitrust income for a specified period of time and, at the end of such period, any property remaining in the CRT passes to one or more charitable organizations. This annuity or unitrust income may be an important asset to either or both of the spouses in the property settlement negotiation process. Thus, the spouses may wish to divide the CRT between the spouses so that each spouse may receive a portion of the annuity or unitrust interest.

The IRS has addressed the tax consequences of the division of a CRT between spouses in several private letter rulings. In Private Letter Ruling 200502037, A and B, while married, established a charitable remainder unitrust (CRUT). The CRUT provided for annual payments of a unitrust amount be made to A during his lifetime and, upon A’s death, to B for her lifetime if she survives A. A reserved the right to revoke B’s interest exercisable under A’s Will. Furthermore, B’s lifetime unitrust interest only takes effect upon A’s death if B pays any Federal or state estate tax due with respect to such interest upon A’s death. Following the death of the latter of A and B to survive, the property will pass to a charity as set forth in the CRUT.

Several years after the CRUT was created, A and B decided to divorce and entered into a property settlement agreement which was incorporated into the divorce decree. Under the agreement, A renounced his right to revoke and terminate B’s interest in the CRUT and the parties agreed to divide the CRUT into two separate Trusts – CRUT A and CRUT B. A was to become the sole non-charitable beneficiary of CRUT A and B was to become the sole non-charitable beneficiary of CRUT B. This allowed A and B to each receive the designated unitrust payment from the respective trusts.

The first issue addressed by the IRS in the Private Letter Ruling was the tax-exempt status of CRUT A and CRUT B. A CRUT generally is exempt from Federal income tax.49 A CRUT is a trust from which a fixed percentage (which is not less than 5 percent nor more than 50 percent) of the net fair market value of its assets, valued annually, is to be paid not less often than annually to one or more persons who are not charitable organizations, from

49 Section 664(c).

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which no amount other than the unitrust payment and certain qualified gratuitous transfers may be paid to or for the use of any person other than a charitable organization, following the termination of the unitrust payments, the remainder interest is to be transferred to or for the use of a charitable organization and with respect to each contribution of property to the trust, the value of the remainder interest in such property is at least 10 percent of the net fair market value of such property as of the date the property is contributed to the trust.50 As the CRUT in this case originally qualifies as a CRUT under Section 664(d)(2) and no provisions of original CRUT are changed in CRUT A and CRUT B other than the payee of the unitrust amount, the IRS ruled that CRUT A and CRUT B will continue to qualify as charitable remainder trusts under Section 664.

The second issue addressed by the IRS relates to the income tax consequences upon the division of the CRUT. In general, an individual must include in gross income gains derived from the sale or exchange of property.51 The amount of the gain required to be recognized is equal to the excess of the amount realized over the adjusted basis of the property.52 In order to be required to recognize such gain, the properties exchanged must be materially different.53 Properties will be materially different if the respective possessors enjoy legal entitlements that are different in kind or extent.54 In this case, prior to the divorce, A owned the entire unitrust interest in the CRUT and B had a future contingent interest in the unitrust interest. After the division of the CRUT, A’s interest decreased to a lower percent unitrust interest determined by reference to the 50 percent of the assets used to fund CRUT A and B’s interest becomes immediately possessory as to a percentage of the 50 percent of the assets used to fund CRUT B. Accordingly, because after the division of the CRUT, A’s interest decreases significantly and B’s interest increases significantly, A and B will enjoy legal entitlements that are materially different in kind or extent from those enjoyed prior to the division. Accordingly, gain or loss would generally be realized and recognized under Section 1001.

Section 1041(a), however, provides that no gain or loss is recognized on a transfer of property from an individual to a spouse if the transfer is incident to divorce. The transferee receives a basis in the transferred property equal to that of the transferor.55 The IRS ruled that Section 1041 should apply in this case as the division of the CRUT and the transfer of the unitrust interest from A to B is incident to the parties’ divorce. Therefore, neither of the parties will realize nor recognize gain on the division and transfer.

Other Private Letter Rulings addressing CRTs in divorce are as follows: Private Letter Ruling 201029002 (April 14, 2010); Private Letter Ruling 200902012 (October 16, 2008); Private Letter Ruling 200824022 (March 20, 2008); Private Letter Ruling 200616008 (January 12, 2006); Private Letter Ruling 200539008 (June 13, 2005); Private Letter Ruling

50 Section 664(d)(2).51 Section 61(a)(3).52 Section 1001(a).53 Treas. Reg. Section 1.1001-1(a); Cottage Savings Association v. Comm’r, 499 U.S. 554 (1991).54 Id. At 564-65.55 Section 1041(b).

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200524013 (March 2, 2005); Private Letter Ruling 200340022 (October 6, 2003); and Private Letter Ruling 200333013 (August 18, 2003).

6. Life Insurance

Another major asset of a divorcing couple is likely to be life insurance. Life insurance is obtained for a variety of reasons. While it generally is not a current usable asset of the couple, the divorcing couple may wish to utilize it as a way to secure payments required to be made under the divorce settlement agreement.

a. Transfer of Policy by One Spouse to Other

Under the divorce settlement agreement, the divorcing couple may decide that an existing insurance policy should be transferred by the insured spouse to the other spouse. In general, life insurance proceeds are not includible in the recipient’s gross income if the proceeds are received due to the death of the insured.56 If, however, the life insurance policy was transferred for valuable consideration, only a portion of the proceeds will be excludable from the recipient’s gross income.57 The amount that is excludible is equal to the sum of the actual value of the consideration paid for such policy plus the premiums and other amounts subsequently paid by the transferee.58 If the transferee’s basis in the insurance contact is the same as the basis of the transferor, such as in a gift of the insurance policy, then no portion of the insurance proceeds will be includible in the transferee’s gross income.59 Also, if the transfer is to the insured, a partner of the insured, a partnership in which the insured is a partner or a corporation in which the insured is a shareholder, then no portion of the insurance proceeds will be includible in the transferee’s gross income.60

If the uninsured spouse owns a policy on the insured spouse, Section 101(a)(2)(B)provides that the transfer is not a transfer for valuable consideration and therefore no portion of the insurance proceeds will be includible in the recipient’s gross income. There is no exception under Section 101 for the transfer of an insurance policy by the insured spouse to the other spouse.

Section 1041(a) provides that no gain or loss is recognized on a transfer of property from an individual to a spouse if the transfer is incident to divorce. The transferee receives a basis in the transferred property equal to that of the transferor.61 A transfer is incident to divorce if the transfer occurs within 1 year after the date on which the marriage ceases or is related to the cessation of the marriage.62 A transfer is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation agreement as defined in Section 71(b)(2) and the transfer occurs not more than 6 years after the date on which the

56 Section 101(a)(1).57 Section 101(a)(2).58 Id.59 Section 101(a)(2)(A).60 Section 101(a)(2)(B).61 Section 1041(b).62 Section 1041(c).

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marriage ceases.63 Section 71(b)(2) provides that a divorce or separation agreement is a decree of divorce or separate maintenance or a written instrument incident to such divorce. Therefore, the transfer of an insurance policy from the insured spouse to the other spouse pursuant to qualifying divorce or separation agreement should not result in any income tax consequences as, under Section 1041, the transferee spouse’s basis in the policy will be that of the transferor.

It is also important to remember that the “three-year rule” applies to the transfer of the policy by the insured to the other spouse. The “three-year rule” states that, if the decedent made a transfer, in trust or otherwise, of an interest in any property, or relinquished a power with respect to any property, within the 3-year period ending on the date of the decedent’s death that would otherwise have been included in the decedent’s gross estate for Federal estate tax purposes under Section 2036, 2037, 2038 or 2042, such property will be included in the decedent’s gross estate for Federal estate tax purposes.64 The death benefit under an insurance policy on the life of the decedent is includible in the decedent’s gross estate for Federal estate tax purposes if the decedent possessed at his death any of the incidents of ownership of the policy.65 An incident of ownership includes the power to change the beneficiary, to surrender or cancel the policy, to revoke an assignment, to pledge the policy for a loan or to obtain from the insurer a loan against the surrender value of the policy.66

b. Insurance Payable to Spouse to Secure Support Obligations

Generally, alimony and other support obligations negotiated during the divorce end upon the death of the obligor. However, the payee spouse may still need support either for himself or herself or for the children after such period. One method to provide for the payment of such support is to maintain a life insurance policy on the life of the obligor spouse.

If the obligor spouse wishes for the premium payments to qualify as alimony, the payee spouse must be the owner of the policy and his or her interest cannot be contingent, such as ceasing upon remarriage.67 The three-year rule of Section 2035 will apply to the transfer of an existing policy by the insured spouse to the payee spouse. Thus, the parties should consider having the payee spouse acquire a new policy on the life of the insured spouse to avoid the application of this rule.

The insurance proceeds received by the payee spouse upon the death of the insured spouse will likely be includable in the payee spouse’s gross income for Federal income tax purposes.68

63 Treas. Reg. Section 1.1041-1T A-7.64 Section 2035(a).65 Section 2042(2).66 Treas. Reg. Section 20.2042-1(c)(2).67 Auerbach v. Comm’r, 34 T.C.M. 948 (1975).68 Treas. Reg. Section 1.101-5.

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If the obligor spouse wishes to continue to own the policy rather than transferring it to the payee spouse or allowing the payee spouse to purchase a policy on the obligor’s spouse to satisfy the support obligation, the insurance proceeds will be includible in the obligor spouse’s estate upon his or her death for Federal estate tax purposes.69 The obligor spouse’s estate, however, may be entitled to a deduction to offset the amount of the insurance proceeds includible in his or her estate.

Section 2053(a)(3) allows for a deduction of claims against the taxable estate of the decedent. When such claim is based upon an agreement, such as a marital settlement agreement, such claim is only deductible to the extent it was made pursuant to a bona fide agreement for full and adequate consideration in money or money’s worth.70 In general, the release of marital rights, such as dower or curtesy or a statutory share of the estate, is not considered to be consideration in money or money’s worth.71 If, however, the transfer is made in the context of a marital property settlement that meets the requirements of Section 2516(1), such transfer will be considered to have been made for full and adequate consideration in money or money’s worth.72 To meet the requirements of Section 2516(1), the transfer to must occur pursuant to the agreement within the 3-year period beginning on the date that is one year before such agreement is entered into and must be in settlement of the transferee spouse’s marital or property rights.73 Thus, the receipt of the insurance proceeds by the payee spouse in settlement of the payee spouse’s marital rights should be deductible under Section 2053 by the obligor spouse’s estate.

It is important to note that the amount of the insurance may not be equal to the support obligation. In such a case, only the amount of insurance that is necessary to satisfy the support obligation will be deductible under Section 2053.

c. Insurance to Secure Support Obligation of Children

Another use of insurance is to provide a means to support the couple’s children following the death of the obligor spouse. If the obligor spouse owns the insurance policy that is being used to satisfy such obligation, a deduction will not be allowed under Section 2053. While Section 2516(2) provides that a transfer of property pursuant to a marital settlement agreement to provide a reasonable allowance for the support of issue of the marriage during minority is deemed to be a transfer for full and adequate consideration in money or money’s worth, Section 2053 does not recognize this as deducible for Federal estate tax purposes.74

One way to avoid this result is by having the insurance policy owned by an irrevocable trust. In general, property in an irrevocable trust will be includible in the decedent’s gross estate for Federal estate tax purposes if the decedent retained the use,

69 Section 2042(2).70 Section 2053(c)(1)(A).71 Section 2043(b)(1).72 Section 2043(b)(2).73 Section 2516.74 Sections 2043(b)(2) and 2053(e).

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possession, right to income or other enjoyment of the transferred property.75 The decedent will be deemed to have retained the use, possession, right to the income or other enjoyment of the transferred property if such property may be applied to discharge a legal obligation of the decedent.76 If, however, the transfer is deemed to be a bona fide sale for adequate and full consideration in money or money's worth, such property will not be included in the decedent’s gross estate for Federal estate tax purposes.77

As noted above, Section 2516 provides that where a married couple enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date that is 1 year before such agreement is entered into, any transfer of property or interest in property made pursuant to such agreement to provide a reasonable allowance for the support of issue of the marriage during minority is deemed to be a transfer made for full and adequate consideration in money or money’s worth.78 Therefore, the only portion of such insurance that should be includible in the obligor spouse’s estate for Federal estate tax purposes will be the excess of the fair market value of the insurance over the value of the consideration received therefor by the obligor spouse.79 This leaves open many questions when dealing with life insurance. Thus, it may be best to provide larger child support payments during the obligor spouse’s life that can be used to pay the insurance premiums to help ensure that the full proceeds are excludible from the obligor spouse’s estate for Federal estate tax purposes.

d. Second-to-Die Insurance

During the estate planning process, many couples invest in second-to-die insurance that insures the joint lives of the couple so that it does not become payable until the death of the latter of them to survive. Most often such insurance is purchased to provide a source of liquidity to pay estate taxes that become due upon the death of the surviving spouse. If the couple divorces and there is a second-to-die policy in place, several issues should be considered.

First, there is no way to know which spouse will die first. Therefore, the second-to-die policy, if retained, should not be relied upon as a means to provide liquidity upon the death of a spouse as both spouses have to pass away before the proceeds become available. Therefore, if estate tax liquidity is an issue for either spouse after the divorce, such spouse should consider investing in a single life policy on his or her life to provide for such liquidity. Of course, any such policy should be acquired and owned by an irrevocable trust so as to exclude the policy proceeds from such spouse’s estate for Federal estate tax purposes.

Second, if the policy is to be retained for the benefit of the children, for example, the policy should be reviewed prior to divorce to ensure that the divorce does not cause the policy to cease to exist. This generally will not be the result, but the policy may

75 Section 2036(a)(1).76 Treas. Reg. Section 20.2036-1(b)(2).77 Section 2036(a).78 Section 2516(2).79 Section 2043(a).

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automatically split into separate policies insuring the life of each spouse individually rather than jointly. If the policy is not automatically split, there may be a provision in the policy permitting a split of the policy upon divorce.

Finally, if the policy is to be maintained as a second-to-die policy, the divorcing couple will need to provide for the continued payment of the premiums. If they do not agree to be jointly liable for the premiums, there will need to be some planning to make sure that if the payor spouse dies first, the premiums can continue to be paid either from a liquidity source within the insurance trust or from contributions from the other spouse or other sources.

II. USE OF TRUSTS IN DIVORCE

Trusts are an important tool in structuring divorce settlements. They may be used so spouses no longer have to deal with each other with respect to support and property settlement payments. They also can be used to provide creditor protection for the spouse or children. A trust arrangement, however, may mean that the transferor spouse loses control over the assets and transfers more at one time than he or she may wish to transfer when an obligation has not come due. In all events, any trust must be structured properly to ensure the desired gift, estate and income tax consequences.

1. Gift Tax Consequences

Generally, when a spouse establishes a trust to hold property for the benefit of the other spouse pursuant to divorce negotiations, neither spouse intends for the transfer of the property to the trust to be treated as a gift. The gift tax rules, however, do not take into account the donative intent of the parties. A gift is a transfer of property for less than adequate and full consideration in money or money’s worth.80 If the transfer includes any consideration from the recipient, then the portion that is treated as a gift is equal to the amount by which the value of the property exceeded the value of the consideration received by the transferor.81 Thus, in the context of a transfer pursuant to a marital settlement, the issue is whether there is sufficient consideration for the transfer to the trust not to be treated as a gift.

a. Gift Tax Marital Deduction under Section 2523

Section 2523 provides a deduction for Federal gift tax purposes to transfers of property made to a donee who is the donor’s spouse at the time the gift is made.82 Thus, the parties must still be married at the time of the transfer for such transfer to qualify for the gift tax marital deduction. Transfer of property to a trust for the benefit of a spouse must meet the same requirements for the gift tax marital deduction as for the estate tax marital

80 Section 2512(b).81 Id.82 Section 2523(a).

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deduction. Thus, there are essentially two ways to transfer property in trust for the benefit of a spouse.

The first is through a power of appointment trust. In such trust, the donee spouse must be entitled to all of the income from the transferred property for his or her life payable at least annually and must have the power to appoint the donee spouse’s entire interest in the property to himself or herself or his or her estate, either by Will or during lifetime or both.83 In addition, no other person may have the power to appoint any part of such property to any person other than the donee spouse.84 No portion of the transferred property will be included in the donor spouse’s estate for Federal estate tax purposes.85

The second type of transfer is a qualified terminable interest property trust (“QTIP Trust”). In order to qualify as a QTIP Trust, all of the income of the trust must be payable to the donee spouse at least annually and the trust property may not be distributed to or for the benefit of a person other than the donee spouse.86 The donee spouse, however, may have a power to appoint the property remaining in the trust at the donee spouse’s death to any individuals or entities.87 In addition, the donor spouse must make an election on a timely filed Federal gift tax return to have the trust treated as a QTIP Trust.88

In either of the above options, the transferred property will be includible in the donee spouse’s estate for Federal estate tax purposes.89 Thus, the donee spouse should adequately plan for any possible estate tax that may be due on such property. One way to do this is to provide in the donee spouse’s estate plan that any estate tax will be paid out of the property in the trust. Section 2207A provides that, if any of the donee spouse’s estate includes property includible by reason of Section 2044, the donee spouse’s estate is entitled to recover the portion of the estate tax attributable to such property from the person receiving the property.90 The donee spouse, however, may waive such right of recovery by specific provision in his or her Will.91 It is important to review state law for such right of recovery instates that have an estate tax. For example, Maryland permits reimbursement from the property in the QTIP Trust.92

b. Transfer for Full and Adequate Consideration under Section 2516

While a trust that qualifies for the gift tax marital deduction may be useful in some circumstances, the donee spouse may not agree to have the property includible in his or her estate for Federal estate tax purposes or the parties may wish for the children to be

83 Section 2523(e).84 Id.85 Id.86 Section 2523(f)(2) and 2056(b)(7)(B)(ii).87 Id.88 Section 2523(f)(1).89 Sections 2044(a) and (b)(1)(B).90 Section 2207A(a)(1).91 Section 2207A(a)(2).92 Md. Code. Ann. (Tax – General) Section 7-308(b)(2)(i).

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beneficiaries of the trust along with the spouse. In either case, the gift tax marital deduction will not be available.

The Federal gift tax is not applicable to gifts made for full and adequate consideration in money or money’s worth.93 If, however, the transfer is made in the context of a marital property settlement that meets the requirements of Section 2516(1), such transfer will be considered to have been made for full and adequate consideration in money or money’s worth.94 To meet the requirements of Section 2516(1), the transfer must occur pursuant to the agreement within the 3-year period beginning on the date that is one year before such agreement is entered into and must be in settlement of the transferee spouse’s marital or property rights.95 The transfer to the trust may be made at anytime. However, the parties must actually be divorced at the time of the transfer.96

Another important consideration is that, while Section 2516 will cause a transfer to be treated as being made for full and adequate consideration, it only applies to transfers for the benefit of the spouse and the minor children.97 If there are other beneficiaries of the trust, even as remainder beneficiaries, there could be gift tax consequences to the donor spouse. This is especially an issue if the donor spouse is the remainder beneficiary. The issue is the application of Section 2702.

Section 2702 provides special rules to determine the amount of the gift when an individual makes a transfer in trust to or for the benefit of a member of such individual’s family and such individual or an applicable family member retains an interest in the trust.98 If Section 2702 applies, the amount of the gift is determined by “subtracting the value of the interests retained by the transferor or any applicable family member from the value of the transferred property.”99 If the interest retained by the transferor or an applicable family member is not a “qualified interest”, the retained interest will be deemed to have a zero value so that the entire value of the property transferred to the trust is treated as a gift.100

The transferees to which Section 2702 applies include the transferor’s spouse, any ancestor or lineal descendant of the transferor or the transferor’s spouse, any brother or sister of the transferor and any spouse of the foregoing individuals.101 An “applicable family member” includes the transferor’s spouse, an ancestor of the transferor or the transferor’s spouse and the spouse of any such ancestor.102 A “qualified interest” is an annuity interest, a unitrust interest and any noncontingent remainder interest if all other interests in the trust

93 Section 2512(b); Treas. Reg. Section 25.2511-1(g)(1).94 Section 2043(b)(2).95 Section 2516(1).96 See Estate of Hundley v. Comm’r, 52 T.C. 495 (1969), aff’d, 435 F.2d 1311 (4th Cir. 1971).97 Treas. Reg. Sections 25.2516-1 and 25.2516-2.98 Section 2702(a)(1); Treas. Reg. Section 25.2702-1(a).99 Treas. Reg. Section 25.2702-1(b).100 Id.101 Sections 2702(e) and 2704(c)(2).102 Section 2701(e)(2).

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consist of an annuity interest or a unitrust interest.103 Section 25.2702-4 provides all of the requirements for an interest to be a qualified interest.

There are several exceptions when Section 2702 will not apply. First, if the transfer is not a completed gift, Section 2702 will not apply.104 Transfers to qualified personal residence trusts (QPRTs) are not affected by Section 2702.105 Also, Section 2702 does not apply to transfers to charitable remainder trusts and charitable lead trusts.106

Most importantly in the divorce context, if the transfer is pursuant to a marital settlement agreement and meets the requirements of Section 2516, Section 2702 does not apply.107 Rather, the transferee spouse is deemed to have retained the remaining interests in the trust.108 This results in a gift by the payee spouse rather than the payor spouse and that may not be the desirable result. If the transfer does not meet the requirements of Section 2516, then the gift will be made by the payor spouse and the amount of the gift will be the full value of the property transferred.

c. Trusts to Which Section 2702 Does Not Apply

As noted above, there are several trust arrangements to which Section 2702 does not apply. One way is to have the payee spouse retain the remainder interest in the trust and then transfer such remainder interest to or for the benefit of the children after the divorce is final. This subsequent transfer is not part of the martial settlement agreement so the exception under Section 25.2702-1(c)(7) should not apply and the payee spouse will be making a gift of his or her remainder interest only. If, however, this subsequent transfer is part of an agreement or arrangement, the subsequent transfer will be treated as part of a series and Section 2702 will apply to the initial transfer.

Another way to avoid the application of Section 2702 is to provide the payee spouse with a “qualified interest” in the trust. A “qualified interest” is an annuity interest, a unitrust interest and any noncontingent remainder interest if all other interests in the trust consist of an annuity interest or a unitrust interest.109 Such interests must meet the requirements of the Treasury Regulations under Section 2702 in order to avoid the application of the zero value rule.

For an interest to be a qualified annuity interest, the interest holder must be irrevocably entitled to receive a fixed amount, at least annually.110 A withdrawal right is not a qualified annuity interest and the annuity amount to be paid may not be satisfied with a note or other debt instrument.111 A “fixed amount” includes either (i) a stated dollar amount

103 Section 2702(b).104 Treas. Reg. Section 25.2702-1(c)(1).105 Treas. Reg. Section 25.2702-1(c)(2).106 Treas. Reg. Sections 25.2702-1(c)(3) and (5).107 Treas. Reg. Sections 25.2702-1(c)(7).108 Id.109 Section 2702(b).110 Treas. Reg. Section 25.2702-3(b)(1)(i).111 Id.

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that is payable at least annually to the extent that the amount does not exceed 120 percent of the stated dollar amount payable in the previous year or (ii) a fixed fraction or percentage of the initial fair market value of the property transferred to the trust payable at least annually to the extent that the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage payable in the preceding year.112 Any income in excess of the annuity amount may be paid to or for the benefit of the holder of the qualified annuity interest.113 In the event that the property transferred to the trust is undervalued or overvalued, the trust agreement must provide for the repayment of the incorrect amount.114 In a short taxable year, the annuity amount must be prorated.115 Each annuity payment must be made no later than 105 days after the anniversary date.116 The trust agreement must prohibit anyone from making additional contributions to the trust.117

The requirements of a qualified unitrust interest are similar to those of a qualified annuity interest. For an interest to be a qualified unitrust interest, the interest holder must be irrevocably entitled to receive, at least annually, a fixed percentage of the net fair market value of the trust assets determined annually.118 A right of withdrawal is not a qualified unitrust interest and the annuity amount to be paid may not be satisfied with a note or other debt instrument.119 A “fixed percentage” is a fraction or percentage of the net fair market value of the trust assets determined annually payable at least annually, but only to the extent that the fraction or percentage does not exceed 120 percent of the fixed fraction or percentage payable in the previous year.120 Any income in excess of the annuity amount may be paid to or for the benefit of the holder of the qualified annuity interest.121 In the event that the property transferred to the trust is undervalued or overvalued, the trust agreement must provide for the repayment of the incorrect amount.122 In a short taxable year, the annuity amount must be prorated.123 Each annuity payment must be made no later than 105 days after the anniversary date.124

There also are rules applicable to both qualified annuity interests and qualified unitrust interests. Specifically, the interest must be payable in all events and may not be subject to any contingency, other than either the survival of the holder or, in the case of a revocable interest, the transferor’s right to revoke the qualified interest of the transferor’s spouse.125 No distributions may be made to any person other than the holder of the qualified annuity or unitrust interest during the term of such interest.126 The trust agreement must set

112 Treas. Reg. Section 25.2702-3(b)(1)(ii).113 Treas. Reg. Section 25.2702-3(b)(1)(iii).114 Treas. Reg. Sections 1.664-2(a)(1)(iii) and 25.2702-3(b)(2).115 Treas. Reg. Section 25.2702-3(b)(3).116 Treas. Reg. Section 25.2702-3(b)(4).117 Treas. Reg. Section 25.2702-3(b)(5).118 Treas. Reg. Section 25.2702-3(c)(1)(i).119 Id.120 Treas. Reg. Section 25.2702-3(c)(1)(ii).121 Treas. Reg. Section 25.2702-3(c)(1)(iii).122 Treas. Reg. Sections 1.664-3(a)(1)(iii) and 25.2702-3(c)(2).123 Treas. Reg. Section 25.2702-3(c)(3).124 Treas. Reg. Section 25.2702-3(c)(4).125 Treas. Reg. Section 25.2702-3(d)(2).126 Treas. Reg. Section 25.2702-3(d)(3).

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the term of the qualified annuity or unitrust interest based on the life of the holder, a specified term of years or the shorter of those periods.127 The trust agreement must prohibit the prepayment of the qualified annuity or unitrust interest.128

Thus, the parties can utilize a grantor retained annuity trust or a grantor retained unitrust and satisfy the requirements of a qualified interest which provide the appropriate income stream to the payee spouse. If the payor spouse has charitable intentions, the payor spouse could also establish a charitable remainder annuity trust or charitable remainder unitrust, ensuring that all of the requirements of Section 664 and the Treasury Regulations thereunder are met.

d. Relinquishment of Support Rights

Another way for a transfer to a trust to be treated as a transfer for full and adequate consideration for money or money’s worth is to structure the trust to provide for the support of the payee spouse. Most states impose obligations on spouses to provide financial support for each other and their minor children. Any payments made by one spouse that satisfy a support obligation are not treated as gifts for Federal gift tax purposes because the satisfaction of the obligation imposed by state law provides consideration for the transfer.

The obligation to support a spouse and minor children continues after divorce and often becomes an important point in divorce negotiations. One or both of the parties may waive these rights in a marital settlement agreement. The IRS has held that transfers made in relinquishment of support rights are treated as made for full and adequate consideration in money or money’s worth.

For example, in Revenue Ruling 77-314,129 the IRS addressed several situationsunder which a couple entered into a marital settlement agreement that contained a provision that A would transfer 100x dollars in cash to a trust upon issuance of a valid divorce decree in exchange for the surrender by B of the right to support. In each case, the divorce occurred more than 2 years after the marital settlement agreement became effective and the court had no ability to alter or invalidate the agreement. The situations addressed in the ruling were as follows:

Situation 1 – In Situation 1, A transferred 100x dollars to a trust. The trust agreement provided that all of the income is payable to B for life and, upon B’s death, the remaining principal is payable to A and B’s children. A and B’s children are adults; thus, A and B have no legal obligation to support them. The present value of the support right that B surrendered is 50x dollars at the date of A’s transfer. The present value of the right to trust income for B’s lifetime is 60x dollars as of the date of A’s transfer. The present value of the remainder is 40x dollars.

127 Treas. Reg. Section 25.2702-3(d)(4).128 Treas. Reg. Section 25.2702-3(d)(5).129 1977-2 C.B. 349.

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Situation 2 – The facts are the same as Situation 1 but that the trust agreement provides that 1/3 of the trust income is payable to an adult child of A and B and 2/3 of the trust income is payable to B. Upon B’s death, all income payments cease and the remaining trust principal is distributed to A and B’s children. The present value of the adult child’s right to income is 20x dollars and the present value of B’s right to income is 40x dollars. The provision of A and B’s child to receive income was part of the divorce negotiation because B wanted to provide income payments to the child.

Situation 3 – Finally, in Situation 3, all of the facts are the same as Situation 1 except that the trust agreement provides that, upon B’s death, the trust will terminate and the remaining principal in the trust will be distributed to one of A’s siblings. The present value of B’s income interest is 60x dollars. The present value of the remainder interest is 40x dollars. The value of B’s surrendered support right is 70x dollars, which exceeds B’s right to income by 10x dollars. B did not have any concern over who was the remainder beneficiary of the trust, only that B receive adequate income. B actually settled for a smaller monthly payment in order to avoid litigation over the amount of support to which B actually would have been entitled. B’s decision had nothing to do with any desire to provide more to third parties.

The IRS then reviewed the rules relating to gifts. Specifically, when property is transferred for less than adequate and full consideration in money or money’s’ worth, the value of the transferred property in excess of the consideration is deemed a gift.130 The relinquishment of dower or curtesy or other marital rights in the spouse’s property or estate is not considered to be consideration in money or money’s worth.131 However, the IRS pointed to Revenue Ruling 68-379132 which held that the surrender of a spouse’s right to support constitutes consideration in money or money’s worth. Following the decision in the Estate of Hundley,133 the Ruling also held that the transfer of property in exchange for the surrender of support rights pursuant to a legal separation agreement results in a taxable gift to the extent of the excess of the value of the transferred property over the value of the support rights.

In order to qualify as consideration, the IRS referred to Rohmer v. Comm’r134 in which the Tax Court stated that consideration must be bargained for in order to support a contract and not be treated as a gift. The IRS also cited Comm’r v. McLean,135 where the spouses failed to show that there was any agreement between them and that each spouse’s transfer in trust for the benefit of the other was made as consideration for the other spouse’s

130 Section 2512(b).131 Treas. Reg. Section 25.2512-8.132 1968-2 C.B. 414.133 52 T.C. 495 (1969), aff’d per curiam, 435 F.2d 1311 (4th Cir. 1971).134 21 T.C. 1099 (1954).135 127 F.2d 942 (5th Cir. 1942).

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reciprocal trust transfer. Therefore, both transfers were treated as gifts. Also, in Wiedemann v. Comm’r,136 pursuant to the provision of a divorce decree, the husband established a trust for the benefit of the wife, under which all of the net income was payable to the wife for life and, upon her death, to their adult daughter with a power of appointment in the daughter. The Tax Court held that the value of the remainder interest transferred to the adult daughter is taxable as a gift because the wife did not insist upon providing for the child. The IRS summarized that, merely because one spouse makes transfers to his adult children pursuant to a divorce settlement agreement that alone does not mean that such transfers are for consideration. The transferor spouse must show that such transfers are made at the insistence of the other spouse and for consideration in money or money’s worth. Accordingly, the IRS stated that Section 2512(b) is applicable where the donor spouse has not only received a valuable transfer but also has received it as an inducement for the transfer that would otherwise constitute a taxable gift. Each transfer or interest created must be examined separately to determine whether the donor spouse received consideration in money or money’s worth as an inducement for such transfer.

In the three situation described above, the IRS held as follows:

Situation 1 – In Situation 1, because the value of the trust income interest transferred by A exceeds the value of the support rights surrendered by B, A’s gifts are as follows: (1) 10x dollars to B (which is the excess of the value of B’s income interest over B’s support rights) and (2) 40x dollars to A and B’s children (which is the full value of the remainder interest).

Situation 2 – In Situation 2, B negotiated for a reduced income interest so that the adult child could receive some of the income. Therefore, the excess (10x dollars) of the value of B’s support rights (50x dollars) over the value of the income interest received by B (20x dollars) is excludible from the value of the child’s income interest as consideration in money or money’s worth. Thus, the amount of the gift to the child is 10x dollars [20x dollars - (50x dollars – 40x dollars)]. In addition, the full value of the remainder interest (40x dollars) is a gift to the adult child.

Situation 3 – In Situation 3, B’s income interest was adequately met by valuable consideration, thus, A did not make a gift to B of the value of the income interest. The remainder interest to A’s sibling, however, is a gift equal to the full present value of the gift (40x dollars). Even though the value of the support rights surrendered by B exceeded the value of the income interest B received by 10x, B’s motives of avoiding litigation and delay for releasing the excess value are not consideration. Therefore, B also has made a taxable gift to A of 10x dollars.

136 26. T.C. 565 (1956).

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The issue that Revenue Ruling 77-314 presents is how to value the support rights released by one spouse. Most states do not provide for a schedule or standards to determine support, particularly for that of spouses. Thus, the parties are going to need to obtain a valuation to determine what appropriate support would be. These valuations need to take into account probabilities, such as death or remarriage of the payee spouse, as support obligations generally end at that time, as well as the life expectancies of the minor children. Thus, using a trust to settle support rights can be a costly endeavor for the donor spouse who wishes to reduce the value of the taxable gift.

e. Relinquishment of Enforceable Rights in Property

Another part of the marital settlement process often involves a division of the marital assets. Many states provide for a specified division of the property. For example, in Maryland, the marital property is subject to equitable division by the court based upon a list of factors considered by the court in making the division.137 Some courts have held that the release of a spouse’s rights in such property upon divorce is more than the release of a marital right that would not qualify as full and adequate consideration under Section 2043(b)(1), but rather actual consideration.138

f. The “Harris” Rule

In 1943, Cornelia Harris divorced her husband, Reginald Wright. Prior to the filing of the divorce proceedings, Cornelia and Reginald entered into a marital settlement agreement dividing their assets between them. Reginald received $107,150 more than Cornelia under the agreement. The IRS argued that Cornelia made a gift of this amount to Reginald on the theory that there was no consideration for the transfer. The case went to the Tax Court, which held for Cornelia, but then the Second Circuit Court of Appeals reversed the decision in favor of the IRS. Cornelia appealed the case to the United States Supreme Court.

This is Harris v. Comm’r. In the case, the Supreme Court reversed the Second Circuit and held that the property settlement was not subject to gift tax. Had Cornelia and Reginald made a voluntary division of their property, the gift tax would apply. Here, the applicable state law required that the divorce court provide for a just and equitable

137 Md. Code Ann. (Family Law) Section 8-205(a)(1). Such factors include “(1) the contributions, monetary and nonmonetary, of each party to the well-being of the family; (2)the value of all property interests of each party; (3) the economic circumstances of each party at the time the award is to be made; (4) the circumstances that contributed to the estrangement of the parties; (5) the duration of the marriage; (6) the age of each party; (7) the physical and mental condition of each party; (8) how and when specific marital property or interest in property [] was acquired, including the effort expended by each party in accumulating the marital property or the interest in property [] or both; (9) the contribution by either party of property [] to the acquisition of real property held by the parties as tenants by the entirety; (10) any award of alimony and any award or other provision that the court has made with respect to family use personal property or the family home; and (11) any other factor that the court considers necessary or appropriate to consider in order to arrive at a fair and equitable monetary award or transfer of an interest in property [] or both.” Md. Code Ann. (Family Law) Section 8-205(b).138 See Estate of Glen v. Comm’r, 45 T.C. 323 (1966); Estate of Waters v. Comm’r, 48 F.3d 838 (4th Cir. 1995).

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disposition of the parties’ property. The Supreme Court ruled that such decree by the divorce court created rights and duties regarding Cornelia and Reginald’s property rather than a promise or agreement. Thus, the gift tax does not apply.139

The result of this case is the “Harris” rule, which states that, if a property settlement is the result of a divorce decree rather than an agreement between the parties, then there is consideration for the transfer which should not be subject to gift tax. If, however, the transfer is voluntary or based on a promise or an agreement, it is a gift subject to the gift tax. The IRS has agreed with this result.140

2. Estate Tax Consequences

One of the most important considerations in using trusts in satisfaction of the requirements in a marital settlement agreement is whether the property will be included in either the transferor or transferee spouse’s estates for Federal estate tax purposes and, if so, whether any portion of such amount qualifies for an estate tax deduction.

a. Inclusion of Trust Property in Transferor Spouse’s Estate

The three primary provisions that may apply to cause inclusion in the transferor spouse’s estate are Section 2036, Section 2037 and Section 2038.

Section 2036 provides that, if the transferor spouse has retained the possession or enjoyment of or the right to the income from the property transferred to the trust or has retained the right, either alone or in conjunction with any other person, to designate the persons who will possess or enjoy the property or the income therefrom, such property will be included in the transferor spouse’s estate for Federal estate tax purposes.141 If the transferor spouse transfers stock in a controlled corporation to the trust and retains the right to vote the transferred stock, the transferor spouse will be deemed to have retained the right to enjoy the transferred property.142 Section 2036 could apply, for example, where the transferor spouse retains the right to the income of the property transferred to the trust for a period of time before the spouse’s interest comes into being. It also could arise where the transferor spouse is required to transfer a portion of his or her business to a trust. In the latter case, the transferor spouse should consider recapitalizing the company into voting and non-voting shares and only transfer the non-voting shares to the trust.

Section 2037 applies when the transferor spouse if the possession or enjoyment of the transferred property can only be had by surviving the transferor spouse and the transferor spouse retains a reversionary interest in the transferred property, the value of which immediately before the transferor spouse’s death exceeds 5 percent of the value of the

139 Harris v. Comm’r, 340 U.S. 106 (1950).140 See Rev. Rul. 60-160, 1960-1 C.B. 374.141 Section 2036(a).142 Section 2036(b)(1). A “controlled corporation” is a corporation in which the transferor spouse owned, with the application of the attribution rules of Section 318, or had the right (either alone or in conjunction with any other person) to vote, stock possessing at least 20 percent of the total combined voting power of all classes of stock. Section 2036(b)(2).

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transferred property.143 A reversionary interest includes a possibility that the transferred property either may return to the transferor spouse or his or her estate or may be subject to a power of disposition by the transferor spouse.144

Section 2038 applies when the transferor spouse retained the right, whether exercisable alone or in conjunction with any other person, to alter, amend, revoke or terminate the trust to which the property was transferred.145 This is another likely power retained by the transferor spouse. The settlement agreement may require that the power to amend or revoke the trust be exercised only with the consent of the transferee spouse. However, that still causes the trust property to be includible in the transferor spouse’s estate for Federal estate tax purposes.

The transferor spouse can also retain one of the above interests or powers and then decide at a later time to release such interest or power. If the transferor spouse releases any of such interests or powers and then dies within 3 years of the date of release, the property still will be includible in the transferor spouse’s estate for Federal estate tax purposes.146

The Tax Court has specifically addressed includibility of trust property that is used to satisfy the transferor spouse’s support obligation. In Estate of Gokey v. Comm’r,147 Mr. and Mrs. Gokey had three children. Mr. Gokey created a trust for the benefit of Mrs. Gokey andthe children. Under the trust agreement, Mrs. Gokey was entitled to the income for her life with the remainder distributed equally among the children upon her death. In addition, Mr. Gokey created trusts for two of the three children, both of whom were minors at the time the trusts were created. Each trust agreement provided that, until each child reached the age of 21, the Trustee had the discretion to distribute the trust principal to the children for their support, care, welfare and education and the income of the trust could be distributed by the Trustee in the Trustee’s discretion in the best interests of the children. After each child reached the age of 21, all of the income was to be distributed to such child and the Trustee could distribute principal for such child’s support, care, welfare and education. At the time of Mr. Gokey’s death 8 years later, the two children were still minors.

The IRS stated that the value of the trusts for the two children and their remainder interests in the trust for Mrs. Gokey should have been included in Mr. Gokey’s estate due to the application of Section 2036. The IRS asserted that Mr. Gokey retained the possession or enjoyment of the right to the income in the trusts because the trusts could be used to discharge his legal obligation to support them while they were minors. Mr. Gokey’s estate argued that the trusts should not be subject to Section 2036 because the Trustees only had discretion to distribute trust property for the support of the children and that the inclusion of the word “welfare” created either an unascertainable standard or one that is much broader than support. The Tax Court agreed that, if the Trustees had discretion over the distributions, then Mr. Gokey would not have retained possession or enjoyment of the income within the

143 Section 2037(a).144 Section 2037(b).145 Section 2038(a)(1).146 Section 2035(a).147 72 T.C. 721 (1979).

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meaning of Section 2036. However, due to the application of state law, the Trustee did not have discretion but rather was required to make distributions that would discharge Mr. Gokey’s obligation to support his children. Therefore, the Tax Court held that the property in the trusts was includible in Mr. Gokey’s estate under Section 2036.

As alimony and child support both are granted to satisfy the transferor spouse’s obligation to support his or her spouse and minor children, when the transferor spouse transfers property to a trust to satisfy these obligations, the trust property will be included in the transferor spouse’s estate under Section 2036. If the obligation terminates during the transferor spouse’s lifetime, Section 2036 no longer will apply.148

When the transferor spouse does not survive until the termination of the support obligation, there may be other ways to avoid the application of Sections 2036, 2037 and 2038. For example, if the transfer is a “bona fide sale for adequate and full consideration in money or money’s worth”, Sections 2036, 2037 and 2038 do not apply.149 Thus, if the transferor spouse’s estate can show that the transferor spouse received consideration for the transfer of the property to the trust, the property will not be includible in his or her estate even if he retained one of the rights or powers listed in those Sections.

In the marital settlement context, the consideration is most often the relinquishment of one or more marital rights. The relinquishment of marital rights, however, is not consideration in money or money’s worth.150 Section 2043(b)(2) provides an exception to such rule where a transfer is made that meets the requirements of Section 2516(1). However, this exception is specifically limited in application to the Section 2053 deductibility of certain claims and expenses. Thus, a 2516 marital settlement agreement may not be enough to keep the property out of the transferor spouse’s estate for Federal estate taxes, but, as further explained below, may provide the authority for a deduction to offset the inclusion.

There may be other rights that are being waived that do constitute full and adequate consideration in money or money’s worth. As discussed above, the relinquishment of support rights may provide consideration.151 The settlement of certain property rights as required by state law may also provide consideration.152 Finally, the “Harris” rule may apply.

b. Inclusion of Property in Estate of Transferee Spouse

When property is held in trust for the benefit of the transferee spouse, there are two ways that the property may be includible in his or her estate for Federal estate tax purposes. First, if the transferor spouse’s transfer qualified for the gift tax marital deduction, the property in the trust remaining at the time of the transferee spouse’s death will be includible

148 See Priv. Ltr. Rul. 200408015.149 Sections 2036(a), 2037(a) and 2038(a)(1).150 Section 2043(b)(1).151 See Rev. Rul. 77-314, 1977-2 C.B. 349.152 See Estate of Glen v. Comm’r, 45 T.C. 323 (1966); Estate of Waters v. Comm’r, 48 F.3d 838 (4th Cir. 1995).

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in his or her estate under Section 2044.153 Second, if the transferee spouse is treated as the transferor, the property could be included in his or her estate for Federal estate tax purposes. As discussed above, this could occur where the transferee spouse does not receive the full value for his or her support rights. In this case, the transferee spouse is deemed to have made a gift either to the transferor spouse or a third party.154

c. Estate Tax Deductibility

The most likely provision to allow for an estate tax deduction is Section 2053. Specifically, Section 2053(a)(3) provides for an estate tax deduction for claims against the estate. The claim must be bona fide in nature rather than a transfer that essentially is donative.155 When the claim involves a family member, as would be the case in the enforcement of a marital settlement agreement, or a beneficiary of the decedent’s estate, certain factors are indicative of the bona fide nature of the claim, which include the following: (a) the underlying transaction occurs in the ordinary course of business, results from an arm’s length negotiation and is free of donative intent; (b) the nature of the claim is not related to an expectation or claim of inheritance; (c) the claim originates between the decedent and the family member or beneficiary and is substantiated with contemporaneous evidence; (d) the claimant’s performance is pursuant to the terms of an agreement between the decedent and the family member or beneficiary and the agreement can be substantiated; and (e) all amounts paid in satisfaction or settlement of the claim are reported, as appropriate, by each party for Federal income and employment tax purposes in a manner consistent with the reporting of such claim.156

In order for a claim against an estate to be deductible for Federal estate tax purposes when such claim is based upon a promise or an agreement, it must be based on adequate and full consideration in money or money’s worth.157 The promise or agreement must have been bargained for at arm’s length.158

Under the “Harris” rule,159 support payments and property transfers resulting from a divorce decree issued by a court are involuntary and therefore are not treated as gifts. Thus, such payments and transfers should be deductible under Section 2053. In addition, if a marital settlement agreement meets the requirements of Section 2516(1), then the property in the trust used to satisfy the obligations should be deductible under Section 2053(a)(3).160

The IRS has agreed with this result in Revenue Ruling 71-67, in which it held that a transferee spouse’s release of marital support rights and an obligation to support minor children are adequate consideration for purposes of Section 2053(c)(1)(A).161 The Eleventh

153 Section 2044(b)(1)(B).154 Rev. Rul. 77-314, 1977-2 C.B. 349.155 Treas. Reg. Section 20.2053-1(b)(2)(i).156 Treas. Reg. Section 20.2053-1(b)(ii).157 Section 2053(c)(1)(A); Treas. Reg. Section 20.2053-4(d)(5).158 Treas. Reg. Section 20.2053-4(d)(5).159 See Harris v. Comm’r, 340 U.S. 106 (1960); Treas. Reg. Section 20.2053-4.160 Section 2043(b)(2).161 Rev. Rul. 71-67, 1971-1 C.B. 271.

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Circuit Court of Appeals also permitted a deduction where the decedent’s estate was forced to satisfy a provision under a separation agreement to provide for the decedent’s sons.162 The court found that, because the decedent’s ex-wife agreed to unmodifiable alimony in an amount that was not sufficient to maintain her former lifestyle, there was consideration for decedent’s promise to establish a trust under his Will for his sons.

It is important to note that the entire amount includible in the decedent’s estate may not be deductible under Section 2053 even if any of the above requirements are met. This is particularly true if the obligation is no longer enforceable under state law. For example, in Estate of Nesselrodt v. Comm’r,163 an estate made a lump sum payment to the decedent’s ex-spouse to satisfy the remaining unpaid alimony installments. The court held that the estate was only entitled to a deduction equal to the present value of the future installment payments.

3. Income Tax Consequences

In creating a trust in the divorce settlement concept, the last item to consider is whether the trust will be treated as a grantor trust or a nongrantor trust for Federal income tax purposes. If the trust is treated as a grantor trust, the transferor spouse will be taxed on the income of the trust. If the trust is treated as a nongrantor trust, the trust (or the trust beneficiaries if a distribution is made) will be taxed on the income of the trust.

a. Grantor Trusts

i. General Rules

A grantor trust is a trust that is deemed, for Federal income tax purposes, to be owned, either in whole or in part, by the grantor of such trust or some other person. The rules for determining whether a trust is considered a grantor trust for Federal income tax purposes are set forth in Sections 671 through 679.

Section 673(a) provides that the grantor is treated as the owner of the trust if the grantor has retained a reversionary interest in the trust and the value of such interest exceeds five percent of the value of the trust.

Section 674(a) provides that the grantor is treated as the owner of a trust if the grantor or a nonadverse party or both control the disposition of the trust property without the consent of an adverse party. Section 672(a) defines an adverse party as any person having a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of a power. Section 672(b) defines a nonadverse party as any person who is not an adverse party. There are eight exceptions that, even though technically a power of disposition, will not cause the trust to be treated as a grantor trust under Section 674.

(1) Power to Apply Income to Support of Dependent – If the Trustee or the grantor or any other person has the authority to pay or apply the trust income

162 See Estate of Kosow v. Comm’r, 45 F.3d 1524 (11th Cir. 1995).163 T.C. Memo 1986-286; see also Estate of Van Horne v. Comm’r, 720 F.2d 1114 (9th Cir. 1983).

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to discharge the grantor’s legal obligation to support a dependent, the trust will not be treated as a grantor trust.164 If, however, income is actually distributed in a manner that discharges the grantor’s legal obligation to support a dependent, then the trust will be treated as a grantor trust.165 If the trust income (or principal) can be used to discharge the grantor’s legal obligation to support a beneficiary of the trust and the grantor passes away, the trust property will be included in the grantor’s estate for Federal estate tax purposes.166

(2) Power Affecting Beneficial Enjoyment Only After Occurrence of Event – A power to affect the beneficial enjoyment of the trust property that only arises after the occurrence of an event will not cause the trust to be treated as a grantor trust.167 If, however, the power is postponed for a period that, if such power were a reversionary interest, would cause the trust to meet the five percent test under Section 673, then the trust will be treated as a grantor trust.168 In other words, the power must be postponed for a long enough period of time that the value of such power is less than five percent of the value of the trust. Once the event occurs, however, the trust could become a grantor trust, unless the power has been relinquished.169

(3) Power Exercisable Only by Will – If the grantor only may exercise the power of disposition by Will, then the trust will not be treated as a grantor trust, unless the power is to appoint income that has been “accumulated for such disposition by the grantor or may be so accumulated in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party”.170 Thus, the grantor may retain a testamentary power of appointment over the trust principal without causing grantor trust status. However, such power of appointment could also cause the trust property to be included in the grantor’s estate for Federal estate tax purposes.171 In addition, if the grantor is able to appoint the trust principal to the grantor’s creditors or to the grantor’s estate, the power could be deemed to be a reversionary interest, in which case Section 677(a) may apply causing the trust to be treated as a grantor trust.172

(4) Power to Allocate Among Charitable Beneficiaries – A trust will not be treated as a grantor trust when the grantor or a nonadverse party or both have the power to make distributions to charitable beneficiaries.173 For example,

164 Section 674(b)(1).165 Sections 674(b)(1) and 677(b).166 Treas. Reg. Section 20.2036-1(b)(2).167 Section 674(b)(2).168 Id.169 Id.170 Section 674(b)(3).171 Section 2041.172 Treas. Reg. Section 1.674(b)-1(b)(3).173 Section 674(b)(4).

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the grantor can retain the right to designate the remainder beneficiaries of a charitable remainder trust and the trust will not be treated as a grantor trustunder Section 674. This should be distinguished from the power to add charitable beneficiaries discussed below.

(5) Power to Distribute Corpus Subject to Reasonably Definite Standard or to Advance Principal – The grantor or a nonadverse party or both may hold a power to distribute principal if the power is limited by a reasonably definite standard set forth in the trust agreement without causing the trust to be treated as a grantor trust.174 Examples of a reasonably definite standard include:

for the education, support, maintenance, or health of the beneficiary;

for the reasonable support and comfort; to enable the beneficiary to maintain his accustomed standard

of living; and to meet an emergency.175

Alternatively, a power to distribute principal for the “pleasure, desire, or happiness of a beneficiary” is not a reasonably definite standard. Furthermore, if the trust agreement provides that the trustee’s determination is conclusive with respect to the exercise or nonexercise of the power, the power will not be limited by a reasonably definite standard.176 It is important to note that, if the power is limited to a reasonably definite standard, the trust property should not be included in the grantor’s estate for Federal estate tax purposes.

Additionally, the power to make distributions to current income beneficiaries where such distributions are charged against those beneficiaries’ proportionate shares of the trust principal will not cause the trust to be treated as a grantor trust.177 With respect to such advances, the Trustee must treat the beneficiary’s share of the trust principal as a separate trust.178

If, however, the grantor or a nonadverse party or both retains one of the two powers above and anyone has the power to add beneficiaries to the trust, other than after-born or after-adopted children, then the trust will be treated as a grantor trust.179 The exception to this rule is that a beneficiary can be granted a power of appointment over his or her portion of the trust without causing the trust to be treated as a grantor trust.180

174 Section 674(b)(5)(A).175 Section 1.674(b)-1(b)(5)(i).176 Id.177 Section 674(b)(5)(B).178 Treas. Reg. Section 1.674(b)-1(b)(5)(ii).179 Section 674(b)(5).180 Treas. Reg. Section 1.674(d)-2(b).

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(6) Power to Withhold Income Temporarily – A trust will not be a grantor trust if income of the trust can be withheld from the income beneficiary, so long as such income must ultimately be distributed in any of the following ways:

to the beneficiary; to the beneficiary’s estate; to the beneficiary’s appointees subject to a broad limited or

special power of appointment; or on the termination of the trust, or with current principal

distributions, to the current income beneficiaries in shares irrevocably specified in the trust agreement.181

Even though the grantor could be one of the possible appointees under a broad limited or special power of appointment, such inclusion will not cause the trust to be treated as a grantor trust under Section 677.182 The exceptions under Section 674(b)(6) do not apply if the power to accumulate income is combined with a power in any person to add beneficiaries to the trust, other than after-born or after adopted children.183

(7) Power to Withhold Income During Disability of Beneficiary – If the grantor or a nonadverse party or both, without the consent of an adverse party, reserves the power to withhold income from a beneficiary during any legal disability or until the beneficiary reaches the age of twenty-one, the trust will not be treated as a grantor trust.184 This power is different from the power in Section 674(b)(6) in that such accumulated income may be distributed to other beneficiaries.185 Like Section 674(b)(6), however, the exception does not apply if the power to withhold income is combined with a power in any person to add beneficiaries to the trust, other than after-born or after adopted children.186

(8) Power to Allocate Between Principal and Income – The power to allocate receipts and disbursements between principal and income, no matter how broadly stated, does not cause the trust to be treated as a grantor trust.187

There is another exception to the application of Section 674(a) and that is in the case of an “independent Trustee”. If a Trustee or Trustees, “none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor” may “distribute, apportion, or accumulate income” or distribute principal “to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries”, the trust

181 Section 674(b)(6).182 Treas. Reg. Section 1.674(b)-1(b)(6)(i).183 Section 674(b)(6).184 Section 674(b)(7)(A) and (B).185 Treas. Reg. Section 1.674(b)-1(b)(7).186 Section 674(b)(7).187 Section 674(b)(8).

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will not be treated as a grantor trust.188 However, the exception does not apply if the power to withhold income is combined with a power in any person to add beneficiaries to the trust, other than after-born or after adopted children.189

If a nonadverse Trustee has the power to distribute or accumulate income subject to a reasonably definite standard, the trust will not be treated as a grantor trust. Such nonadverse Trustee may not be the grantor or a spouse living with the grantor. Again, the exception does not apply if the power to withhold income is combined with a power in any person to add beneficiaries to the trust, other than after-born or after adopted children.190

Under Section 675, a trust is treated as a grantor trust if any of the following administrative powers are present: (1) the grantor can deal with the trust principal for less than full and adequate consideration; (2) the grantor may borrow trust property without adequate interest or adequate security; (3) the grantor actually borrows trust property without adequate interest or adequate security; or (4) the grantor retains certain powers to vote stock, control investments or substitute property. Each power must be exercisable by the grantor or a nonadverse party without the consent of an adverse party.

Section 676 provides that the grantor is treated as the owner of a trust if the grantor or a nonadverse party has the power to revest trust property in himself or herself. The power to revest title of the trust assets in the grantor includes a power to revoke, terminate, alter, amend or appoint.191 If, however, such power is deferred and cannot be exercised until after the exercise of a certain event, then the trust may not be treated as a grantor trust.192 This will be the case if the trust would not be treated as a grantor trust under Section 673 if the grantor had retained a reversionary interest.193

Section 677 states that the grantor is treated as the owner of a trust if the grantor or a nonadverse party or both may, without the approval of an adverse party, distribute or hold for future distribution trust income to the grantor or the grantor’s spouse. The powers of distribution or withholding under Section 677 include the following:

(1) the discretion to distribute or the actual distribution of the trust income to the grantor or the grantor’s spouse;194

(2) the discretion to hold or accumulate or the actual holding and accumulation of trust income for future distribution to the grantor or the grantor’s spouse;195 or

(3) the discretion to apply or the application of the trust income to pay premiums on insurance on the life of the grantor or the grantor’s spouse.196

188 Section 674(c)(1) and (2).189 Section 674(c).190 Section 674(d).191 Treas. Reg. Section 1.676(a)-1.192 Section 676(b).193 Id.194 Section 677(a)(1).195 Section 677(a)(2).196 Section 677(a)(3).

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Under Section 678, a trust can be deemed to be a grantor trust as to an individual other than the grantor where such individual has a power to appoint trust principal or income to himself or herself or had such a power that has been released but, after the release, such individual has control that, if the grantor, would cause the trust to be treated as a grantor trust.197

Finally, under Section 679, if a U.S. person establishes a foreign trust with one or more U.S. beneficiaries, the trust will be treated as a grantor trust.198

ii. Grantor Trusts in Divorce

In the divorce context, the grantor trusts rules may apply for several reasons. First, the transferor spouse may retain a reversionary interest in the trust. If the actuarial value of that reversion is more than 5% of the transferred property at the time of the transfer, then the trust will be treated as a grantor trust.199 The transferor spouse may wish to control the disposition of the property in the trust at the end of the spouse’s interest. This could be a power over beneficial enjoyment causing the application of Section 674(a). Also, if the grantor’s spouse is an income beneficiary of the trust, Section 677(a)(1) may cause the trust to be treated as a grantor trust to the transferor spouse.

A grantor is also treated as holding any powers that are held by the grantor’s spouse at the time of the creation of the power or by a person who becomes the grantor’s spouse after the creation of the power.200 If, however, the parties are legally separated pursuant to divorce decree or decree of separate maintenance at the time the power is created, then the parties are not considered married and the powers will not be deemed to be those of the grantor.201 If, for example, the transferor spouse creates a trust that provides for income to the transferor spouse’s children for a specified period of time and the remainder to the transferee spouse, the Section 673 reversionary interest provisions may apply if the parties were still married when the trust was created because the determination of whether Section 673 applies is made at the time the property is transferred. Also, where a trust is created that provides the transferee spouse with distributions of income, it is possible that Section 677(a)(1) or (a)(2) will apply if the parties were married at the time the trust was created. This is more likely where there is a mandatory distribution of income.

There is, however, an exception to this rule. This exception is found in Section 682(a).

Under Section 682(a), if spouses are divorced or legally separated under a divorce decree or decree of separate maintenance or separated under a written separation agreement, any income that one of the spouses receives or is entitled to receive from a trust will be included in the receiving spouse’s income rather than the income of the transferor spouse. If,

197 Section 678(a)(1) and (2).198 Section 679(a)(1).199 Section 673(a).200 Section 672(e)(1).201 Section 672(e)(2).

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however, the income is distributable to satisfy the transferor spouse’s child support obligation, then such income is not part of the transferee spouse’s income.

Section 682(a) does not apply in situations where Section 71 applies.202 Section 71 provides that gross income includes any amounts received as alimony or separate maintenance.203 Alimony or separate maintenance payments includes any payment in cash if such payment is received by a spouse under a divorce or separation agreement, such agreement does not designate such payment as being excludible from the payee spouse’s gross income and deductible by the payor spouse under Section 215, the payee spouse and the payor spouse are not members of the same household at the time the payment is made and the payor spouse does not have any liability for the payments after the death of the payee spouse.204 A divorce or separation agreement includes a decree of divorce or separate maintenance or a written instrument incident to such decree, some other decree requiring a spouse to make payments for the support or maintenance of the other spouse or a written separation agreement.205 Payments for child support under such agreement are not includible in the payee spouse’s gross income.206 Thus, Section 682(a) applies, for example, to a trust created before the parties divorced or separated.207 It is designed to “produce uniformity as between cases in which, without Section 682, the income of a so-called alimony trust would be taxable to the husband because of his continuing obligation to support his wife or former wife, and other case in which the income of a so-called alimony trust is taxable to the wife or former wife because of the termination of the husband’s obligation.”208

The following examples illustrate the application of Section 682:

Example 1 - Upon the marriage of H and W, H irrevocably transfers property in trust to pay the income to W for her life for support, maintenance, and all other expenses. Some years later, W obtains a legal separation from H under an order of court. W, relying upon the income from the trust payable to her, does not ask for any provision for her support and the decree recites that since W is adequately provided for by the trust, no further provision is being made for her. Under these facts, Section 682(a), rather than Section 71, is applicable. Under the provisions of Section 682(a), the income of the trust which becomes payable to W after the order of separation is includible in her income and is deductible by the trust. No part of the income is includible in H's income or deductible by him.

Example 2 - H transfers property in trust for the benefit of W, retaining the power to revoke the trust at any time. H, however, promises that if he revokes the trust he will transfer to W property in the value of

202 Treas. Reg. Section 1.682-1(a)(2).203 Section 71(a).204 Section 71(b)(1).205 Section 71(b)(2).206 Section 71(c)(1).207 Treas. Reg. Section 1.682-1(a)(2).208 Treas. Reg. Section 1.682-1(a)(3).

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$100,000. The transfer in trust and the agreement were not incident to divorce, but some years later W divorces H. The court decree is silent as to alimony and the trust. After the divorce, income of the trust which becomes payable to W is taxable to her, and is not taxable to H or deductible by him. If H later terminates the trust and transfers $100,000 of property to W, the $100,000 is not income to W nor deductible by H.209

b. Nongrantor Trusts

If the trust is not taxed as a grantor trust for Federal income tax purposes, then the trust will be subject to tax under the general rules relating to the income taxation of trusts. Thus, the trust will be liable for the income tax unless the income is distributed to one or more of the beneficiaries. The trust may either be a simple trust, under which all of the income is required to be distributed to one or more of the beneficiaries, or a complex trust, which includes all other nongrantor trusts. This outline will not review the complexities of the income taxation of nongrantor trusts. The rules are set forth in Sections 641 through 668.

209 Treas. Reg. Section 1.682-1(a)(4).

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Speaker Contact Information

TRUST AND ESTATE PLANNING ISSUES IN DIVORCE

Jennifer Pratt

Venable LLP - Baltimore

(o) (410) 528-2883

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Missia H. Vaselaney

Taft Stettinius & Hollister LLP - Cleveland, Ohio

(o) (216) 706-3956

mvaselaney@taftlaw.com