Taxation of Trusts After Divorce: Grantor Trusts, Section 682 and International Considerations

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1 Taxation of Trusts After Divorce: Grantor Trusts, Section 682 and International Considerations Leigh-Alexandra Basha McDermott Will & Emery LLP Richard Franklin McArthur Franklin PLLC Justin T. Miller BNY Mellon May 2016

2 Support Trusts in Lieu of Alimony Advantages Minimize need for future interaction Protect ownership interest in a closely held family business Protect support from death Provide professional asset management Benefit from gift, estate or generation skipping transfer ( GST ) tax savings Protect support from financial insolvency or bankruptcy 2

3 Professional Athletes NBA NFL Average annual salary $5.15M $1.9M Average career length 4.8 Years 3.5 Years Players who are broke within 2 to 5 years into retirement 60% 78% Sources: National Basketball Players Assn. (2011); National Football League Players Assn. (2011); Pablo Torre, How (and Why) Athletes Go Broke, Sports Illustrated (March 23, 2009) 3

4 Support Trusts in Lieu of Alimony Moneyed Spouse No upfront income tax deduction Not taxed on distributed trust income (IRC 682) Non-Moneyed Spouse Payment stream for term of years or life Taxed on distributed trust income (IRC 682) Distributions in excess of income treated as principal (i.e., not taxable) End of Trust Term Assets revert back to moneyed spouse or distributed outright, or in trust, for descendants 4 See PLRs and

5 Support Trusts in Lieu of Alimony Front-Loaded Support May front-load payments with decreasing amounts over time With alimony under IRC 71, excessively high or front-loaded payments in the first three post-separation years are subject to recapture or being taxed to payor in the third post-separation year Anti-Lester Rules May reduce payments based on childhood events With alimony under IRC 71(c)(2), support payments do not qualify if reductions in such payments are tied to certain childhood events Child Support IRC 682 does not apply to amounts for support of minor children Moneyed Spouse subject to tax 5

6 Support Trusts in Lieu of Alimony Income for a 10-Year Term ($250k Per Year) MONEYED SPOUSE $5M SUPPORT TRUST NON- MONEYED SPOUSE Total Receipts $2.5M Assets Remaining in Trust at End of 10-Year Term Revert Back 7% Growth: $6.4M 10% Growth: $9.0M 6

7 Support Trusts in Lieu of Alimony Gift Value (= $2.7M) Income for a 10-Year Term ($250k Per Year) MONEYED SPOUSE $5M SUPPORT TRUST NON- MONEYED SPOUSE Assets Remaining in Trust at End of 10-Year Term 7% Growth: $6.4M 10% Growth: $9.0M Total Receipts $2.5M WEALTH TRANSFER TRUST 7 Assumes April 2016 rates. Rev. Rul

8 IRC Section 682 (a) Inclusion in gross income of wife There shall be included in the gross income of a wife who is divorced or legally separated under a decree of divorce or of separate maintenance (or who is separated from her husband under a written separation agreement) the amount of the income of any trust which such wife is entitled to receive and which, except for this section, would be includible in the gross income of her husband, and such amount shall not, despite any other provision of this subtitle, be includible in the gross income of such husband 8

9 Divorce: Tax Consequences 1041 Rules Do Not Apply When NRA Spouse Is Involved General Rule: transfers between spouses incident to divorce are income tax free and transferee spouse takes a carry over basis Incident to Divorce means that a transfer of property either (1) occurs within 1 year of the date on which the marriage ceases, or (2) is related to the cessation of the marriage. Usually it is related if it is pursuant to the divorce agreement and occurs not more than 6 years after the date on which the marriage ceases Except if transferee spouse is an NRA, then taxable gain will be recognized on the transfer and NRA spouse gets a basis stepped up to FMV 9

10 Divorce: Sourcing Rules Generally Sourcing: important when gain recognized on transfer to NRA because it determines taxing jurisdiction General Rules: Interest: sourced based on residence of the payor Dividends: sourced based on residence of the payor Personal Services: sourced based on where services are performed Rents: sourced based on location of rental property Royalties: sourced based on location of use of intangible property Real Estate Gains: sourced based on situs of the real property Capital Gains: sourced based on where property was sold Inventory: sourced based on place of sale, i.e., where title passes 10 Residual Rule: sourced based on residence of seller

11 Divorce: U.S. Tax Consequences for Each Type of Couple Property Settlement to Which I.R.C May Apply RECIPIENT SPOUSE TREATED AS TAX-FREE GIFT I.R.C. 1041(b) U.S. Citizen Resident Alien (non-u.s. Citizen) DEEMED EXCHANGE I.R.C. 1041(d) NRA TRANSFEROR SPOUSE U.S. Citizen - No Income Tax (a), (b). - No Gift Tax, Unlimited Marital Deduction before divorce or 2516 for non-gift treatment (if applicable), after divorce (3 year window). - No Income Tax (a), (b). - No Gift Tax (i.e., deemed transfer for adequate consideration) if 2516 applies. - If 2516 does not apply (i.e., transfer outside 3 year period), then no gift tax on first $148,000 (Gift Allowed to Non-Citizen Spouse), Then Taxable U.S. Gift Tax on Assets Transferred Over $147,000 Pursuant to Divorce Agreement. Taxable Transfer (d). - No Gift Treatment (i.e., deemed exchange), and Taxed to Transferor Spouse as if exchanged property for FMV. Recipient Spouse takes FMV basis in property received. 11

12 Divorce: U.S. Tax Consequences for Each Type of Couple Property Settlement to Which I.R.C May Apply RECIPIENT SPOUSE TREATED AS TAX-FREE GIFT I.R.C. 1041(b) U.S. Citizen Resident Alien (non-u.s. Citizen) DEEMED EXCHANGE I.R.C. 1041(d) NRA TRANSFEROR SPOUSE U.S. Resident (non-u.s. Citizen) - No Income Tax (a), (b). - No Gift Tax, Unlimited Marital Deduction or 2516 for non-gift treatment (if applicable). - No Income Tax (a), (b). - No Gift Tax if 2516 applies. - If 2516 does not apply, then no gift tax on first $148,000 (Gift Allowed to Non-Citizen Spouse), Then Taxable U.S. Gift Tax on Assets Transferred Over $148,000 Pursuant to Divorce Agreement. - Consider Domicile of Transferor Spouse. - Taxable Transfer (d). - No Gift Treatment (i.e., deemed exchange), and Taxed to Transferor Spouse as if exchanged property for FMV. - Recipient Spouse takes FMV basis in property received. 12

13 Divorce: U.S. Tax Consequences for Each Type of Couple Property Settlement to Which I.R.C May Apply RECIPIENT SPOUSE TREATED AS TAX-FREE GIFT I.R.C. 1041(b) U.S. Citizen Resident Alien (non-u.s. Citizen) DEEMED EXCHANGE I.R.C. 1041(d) NRA TRANSFEROR SPOUSE NRA - No Income Tax (a), (b). - No Gift Tax, Unlimited Marital Deduction or 2516 for non-gift treatment (if applicable). But Recipient Spouse May Have to Report Gift on Form 3520 (if determined to be gift) because might not be a gift if 2516 applies, or less than $100,000 - No Income Tax (a), (b). - No Gift Tax if 2516 applies. - If 2516 does not apply, then no gift tax on first $148,000 (Gift Allowed to Non-Citizen Spouse), Then Taxable U.S. Gift Tax on Assets Transferred Over $148,000 Pursuant to Divorce Agreement. - But $148,000 only applies to U.S. situs property (real estate and TPP). - Gift/Transfer of non-u.s. situs property via Divorce Agreement is not subject to U.S. Gift Tax. - Recipient May Have file Form Taxable Transfer (d). - No Gift Treatment (i.e., deemed exchange) I.R.C. 1041(d), and Taxed to Transferor Spouse as if exchanged property for FMV. - Recipient Spouse takes FMV basis in property received. - But Transferor Spouse only owes U.S. income tax on deemed sale of U.S. source income assets. See general sourcing rules above. 13

14 Divorce: U.S. Tax Consequences for Each Type of Couple Special Note I.R.C. Section 2516 Gift Tax Savings Provision Section 2516 provides where a husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within a 3-year window beginning on the date 1 year before such agreement is entered into and ends 2 years after, then any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable child support, shall be deemed to be transfers made for a full and adequate consideration in money or money s worth (i.e., not a gift). 14

15 Example 1 of Section 1041 and Section 2516 Husband, a U.S. Citizen, and Wife, an NRA, get divorced. Pursuant to a divorce agreement, H transfers appreciated stock to his NRA spouse as part of the divorce settlement. As a result, he will have to pay tax on the inherent gain in the stock as if he sold it (i.e., deemed sale treatment). Assuming the transfer took place immediately after the agreement took effect, then section 2516 would provide for deemed sale/exchange treatment and this transfer would not result in any adverse U.S. gift tax consequences, but there would be gain/loss consequences to H. 15

16 Example 2 of Section 1041 and Section 2516 However, what happens if H is an NRA too? In that case, 1041(d) states that the non gain/loss recognition treatment of 1041 is inapplicable. Thus, the transfer of appreciated stock would result in a deemed sale and H would need to refer to the applicable U.S. income sourcing rules to determine if U.S. tax was owed on the deemed sale transaction. Assuming the transfer took place within the 3 year period provided in section 2516, then there would be deemed sale/exchange treatment and this transfer would not result in any adverse U.S. gift tax consequences. 16

17 Example 3 of Section 1041 and Section 2516 H, a U.S. citizen, and W, a green card holder, divorce in 2011 and sign the divorce agreement on January 1, Pursuant to a divorce agreement, H transfers appreciated stock worth $1 million (basis of $250,000) to his Green Card Holder spouse as part of the divorce settlement 5 years after the divorce agreement was finalized (i.e., on January 1, 2016). - Because the transfer was incident to divorce, H will not have to pay income tax on the inherent gain in the stock as if he sold it (i.e., deemed sale treatment) because his spouse is a U.S. resident. - However, because the transfer took place outside of the 3 year period provided in section 2516, then there would not be deemed sale/exchange treatment and this transfer would be considered a gift for U.S. transfer tax purposes. 17

18 Divorce: U.S. Tax Consequences for Trust 682(a) provides special exception from usual grantor trusts rules Support trusts are normally grantor trusts because the donor spouse usually retains some interest in, or power over the trust. Grantor trust rules provide that the grantor/donor spouse is subject to tax directly on the trust s taxable income regardless of any distributions from the support trust to the donee spouse. 682 provides an exception : If the spouses are divorced from each other or are separated under a decree of separate maintenance or under a written separation agreement the donee spouse (i.e., Wife) is required to include in gross income the amount of the income of any trust which she is entitled to receive, and which would otherwise be includible in the gross income of the donor spouse (i.e. Husband). The exception does not apply to the income of the trust which is payable for the support of minor children. 18

19 Example of Section 682 Under Section 682, the income is taxed to Wife so you look to the source rules. You could have good results if the Wife is a non-resident alien and there s non-u.s. situs assets generating the income for income tax purposes. EXAMPLE 1: H, a U.S. citizen, and W, an NRA who lives in a treaty country, get divorced. H has a support trust that generates capital gain from US traded stock portfolio of $100,000 in year 1, which is paid to W. H is not taxed. Under 682 W should be taxed, but because she is an NRA (did not reside in the U.S. more than 183 days), the gain on that stock is not subject to U.S. income tax (non situs asset). 19

20 Example of Section 682 EXAMPLE 2: H, an NRA, and W, a U.S. citizen, get divorced. H has all foreign assets are in a revocable trust (support trust) that generates income, which is paid to W. Normally there would not be any U.S. income tax b/c non U.S. situs assets. However under 682, there will be income tax on the assets going to the U.S. Wife because she is taxed on a world-wide basis. Furthermore, if it is a foreign trust, Wife may have to file the Form

21 Questions?

22 Disclosure This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. Pursuant to IRS Circular 230 we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. 22