Taxation of Trusts on Divorce: Interception of Section 682 in Divorce. Presented to ABA RPTE Section Meeting. May 12, Boston, Massachusetts

Transcription

1 Taxation of Trusts on Divorce: Interception of Section 682 in Divorce Presented to ABA RPTE Section Meeting May 12, 2016 Boston, Massachusetts By Leigh-Alexandra Basha Partner/Private Client Group McDermott Will & Emery 500 North Capitol Street, N.W. Washington, D.C C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx

2 I. Introduction a. Backdrop i. In 2011, the U.S. Census Bureau estimated that approximately 21 percent of all married-couple households in the United States had at least one foreignborn spouse. 1 Also, it determined that over 4.1 million households are of mixed nativity, meaning one spouse was not born in the United States. 2 ii. Of these 4.1 million households, 39% of foreign-born spouses are not naturalized U.S. citizens, meaning that 1.6 million households in the United States need to address the estate and gift planning issues and pitfalls that come with planning for a non-citizen spouse. 3 iii. While many of the income and gift tax rules protect divorcing spouses who are U.S. persons, unexpected results can occur when the recipient s spouse is a non-resident alien. This presentation will examine the tax consequences of divorce by looking at section 1041, which is the income tax rule and section 2516, which is a gift tax provision, and finally section 682 which deals with shifting the income tax of a support trust, all in the context of a divorcing international couple. II. Tax Consequences of Divorce a. Overview and Section 1041 Rules Do Not Apply When Non-Resident Alien ( NRA ) Spouse Involved i. Generally, the U.S. tax rules provide that asset transfers between spouses incident to a divorce are tax-free. 4 The transfer is treated as a gift for U.S. income tax purposes. 5 If the spouses are both U.S. citizens, then there are no U.S. income or gift tax consequences. 6 However, special rules apply where one spouse is either (1) a U.S. tax resident (but non-u.s. citizen) or (2) is an NRA of the United States. 7 ii. For U.S. tax purposes, incident to divorce means that a transfer of property either (1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. 8 Generally, a transfer is related to the cessation of the marriage if it is 1 Luke J. Larsen and Nathan P. Walters, Married-Couple Households by Nativity Status: 2011, U.S. Census Bureau: American Community Survey Briefs, September 2013, at 3. 2 Id. 3 See id. 4 Unless otherwise noted, all Section references are to the Internal Revenue Code of 1986, as amended (the Code ) and the Treasury Regulations promulgated thereunder. I.R.C Id. 6 See I.R.C. 1041(a), 2516, and See I.R.C. 1041(a), I.R.C. 1041(c). C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 2

3 pursuant to a divorce or separation agreement and occurs not more than 6 years after the date on which the marriage ceases. 9 iii. iv. Also of note, section 1041 cannot be used to avoid recognition of the gain by transferring the right to receive the income already earned. However, when an income-producing asset is transferred between spouses, the right to receive future income is transferred together with the underlying asset, such that the recipient spouse is responsible for paying taxes on that income. There is a similar rule that applies for transfers of the income interest in trusts set up by the transferor spouse as well, that would require the transferee spouse to pick up the income tax liability associated with income that the transferee spouse receives as spousal support. 10 Importantly, for income tax-free treatment of section 1041(a) to apply, the recipient spouse cannot be an NRA. 11 When the spouse who receives property incident to divorce is an NRA, then taxable gain will be recognized on the transfer. 12 The spouse making the transfer will be taxed on the gain (the difference between the fair market value of the property transferred and his or her adjusted tax basis in the property). The rationale behind this rule is that there is little chance that gain will ever be reported (and tax paid) in the case of a recipient NRA spouse on property transferred to him or her (unlike transfers to U.S. tax resident spouses). v. When the recipient spouse is a U.S. citizen, then the U.S. gift tax will not apply because gifts made between spouses are entitled to the unlimited marital deduction. The key is that the recipient of the gift must be a U.S. citizen. This is because, if the recipient spouse is not a U.S. citizen, then the unlimited federal gift tax marital deduction does not apply. This is so even if the recipient is a U.S. income tax resident (i.e., has a green card or meets the substantial presence test). Instead, any gifts to a non-u.s. citizen spouse have an annual exclusion amount which, for 2016, is $148, This is the amount that can be gifted to a non-u.s. citizen spouse gift tax free. III. Section 2516: Certain Property Settlements Treated as Sales/Exchanges for U.S. Gift Tax Purposes a. The U.S. gift tax treatment for [c]ertain property settlements is governed by section Sometimes, this treatment can be either consistent, or inconsistent, with the treatment of transfers to spouses (or former spouses) under section 1041 (which is an income tax rule). b. Under section 2516, for U.S. gift tax purposes, where a husband and wife (either 9 See Treas. Reg T(b), Q&A-7; PLR See I.R.C I.R.C. 1041(d). 12 See I.R.C. 1041(d). This rule only applies in the case of a U.S. person transferring property to an NRA. 13 Rev. Proc C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 3

4 U.S. person or non-resident alien) enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date 1 year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), 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 allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money s worth (i.e., not a gift). c. As this rule illustrates, the U.S. tax treatment of transfers to a spouse in divorce for U.S. income tax purposes and U.S. gift tax purposes are governed by different rules. Section 1041 provides the income tax treatment for transfers, and section 2516 provides the rule for the U.S. gift tax treatment for transfers. Additionally, unlike section 1041, section 2516 applies to all spouses transferring assets whether U.S. persons or NRAs. Thus, the dichotomy involved does produce interesting consequences that are better illustrated in the examples and chart included below. IV. Examples of Section 1041 and Section 2516 a. Example 1: H (U.S. citizen) and W a nonresident alien (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. b. Example 2: However, what happens if H is an NRA too? In that case, section 1041(d) states that the non-gain/loss recognition treatment of section 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. Similar to Example 1, 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 to H. i. Deemed Sale of Stock No U.S. Income Tax Generally: As detailed in paragraph 4. below, generally capital gains relating to the sale of personal property assets (which stock would be) are taxable only by the residence country of the seller. Thus, if an NRA is deemed to sell stock, then generally the sale will give rise to non-u.s. source income and the NRA transferor spouse will not recognize income in the United States even though that spouse cannot avail himself or herself of section 1041(a). 14 ii. Additional Caveat Special Rules: There is a special rule where certain NRAs are not subject to day-counting for the periods of time that they live 14 See I.R.C. 865(a). Stock in a corporation is intangible personal property. C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 4

5 in the United States (e.g., exempt visa categories of A, G, etc.). These NRAs that spend more than 183 days in the United States during a calendar year are subject to U.S. income tax on deemed sales of their U.S. situs capital assets. Thus, if the appreciated stock in the example is U.S. stock and the NRA in question is one of these special NRAs, then that NRA will be subject to U.S. tax at a rate of 30% on the gain from the deemed sale. 15 c. Example 3: H (U.S. citizen) and W (U.S. green card holder) divorce in 2011 and signed the divorce agreement on January 1, Pursuant to the 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). As a result, and because the transfer was incident to divorce, he 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. As a result, H would owe U.S. gift tax on the amount of the gift ($1 million) over the current annual exclusion gift amount ($14,000 per person per year) and not the amount over the current $148,000 non-citizen spouse transfer amount because W would no longer be considered H s noncitizen spouse at the time of the transfer. V. Sourcing Rules Generally for U.S. Income tax Purposes a. The sourcing of various types of income is important for U.S. citizens, U.S. tax residents, and NRAs because the sourcing of the income determines who has taxing jurisdiction over income earned. For NRAs the rules are especially important, as the sourcing rules are critical for determining whether income from a trade or business is effectively connected income (ECI), which is subject to graduated income tax rates, and, for certain nonbusiness income (such as FDAP), whether the 30% withholding regime on U.S. source income applies (unless a lower treaty rate is applicable). 16 The following are the general U.S. sourcing rules that may apply to different income streams: i. Interest: Generally sourced based on residence of the payor. 17 ii. Dividends: Generally sourced based on residence of the payor. 18 iii. Personal Services: Generally sourced based on where services are performed. 19 iv. Rents: Generally sourced based on location of rental property See I.R.C. 871(a)(2); 7701(b)(3)(D). 16 See I.R.C. 871; 864(c). 17 See I.R.C. 861(a)(1), 862(a)(1); But see U.S. Model, 2006, Art. 11 (under which interest is generally taxed based on the residence of the beneficial owner). 18 See I.R.C. 861(a)(2), 862(a)(2). But see U.S. Model, 2006, Art. 10 (which reduces the maximum rate on dividends imposed by the payor s resident country to 15%). 19 See I.R.C. 861(a)(3), 862(a)(3). U.S. Model, 2006, Arts , See I.R.C. 861(a)(4), 862(a)(4); U.S. Model, 2006, Art. 6. C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 5

6 v. Royalties: Generally sourced based on location of use of intangible property. 21 vi. Real Estate Gains: Generally sourced based on situs of the real property. 22 vii. Capital Gains: Generally sourced based on where property was sold. 23 viii. Inventory: Generally sourced based on place of sale, i.e., where title passes. 24 ix. Residual Rule: Generally sourced based on residence of seller. 25 b. When examining sourcing rules, the practitioner should always consider the effects of an applicable tax treaty. The United States has tax treaties for income, gift, and estate tax with many jurisdictions. Thus, an advisor should always consider the effects of an applicable treaty on both (1) the allocation of the source of income and (2) the modification of the applicable tax rate that may apply. VI. Basis Considerations Low Basis, BIG Problem (Potentially) a. Basis is the original cost of property, adjusted for certain factors such as depreciation. When property is sold, basis is the determinative factor in determining the taxpayer s calculation of U.S. income tax payable. The taxpayer pays taxes on a capital gain (or takes a capital loss) that equals the amount realized on the sale minus the sold property s basis. b. When a divorce involves an NRA, then the parties should be very cautious about which assets they agree to keep, give, or take in the property settlement. This is because the basis of the assets in assets transferred to the NRA spouse transferee may result in the gain being triggered in those assets depending on the status of the transferor spouse as a U.S. person (or not). Thus, (1) the U.S. person status of the spouses, (2) the basis of the asset, (3) which spouse will ultimately be responsible for the tax due, and (4) the source of the gain/income must be considered upon divorces involving an NRA spouse. c. In property settlement agreements, the parties should agree to provide all necessary basis information to the other party who is receiving the asset and will be responsible for payment of the U.S. tax due. The parties should agree to provide access to all records that will permit proof to the IRS of the cost or adjusted basis of each asset. VII. Basis of Asset Received in Divorce Settlement Matters for NRA Spouse a. If the rules of section 1041 apply giving tax-free treatment to the transferorspouse, then an asset received per a property settlement will be taken by the 21 See I.R.C. 861(a)(4), 862(a)(4). But see U.S. Model, 2006, Art. 12(1) (under which royalties are taxed based on the residence of the beneficial owner). 22 See I.R.C. 861(a)(5), 862(a)(5); U.S. Model, 2006, Art. 13(1). 23 See I.R.C. 863, 865(a); 26 C.F.R ; But see U.S. Model, 2006, Art. 13(6). (under which capital gains are taxable based on the residence of the seller). 24 See I.R.C. 861(a)(6), 862(a)(6), 865(b); U.S. Model, 2006, Art. 13(3). 25 See I.R.C. 865(a); U.S. Model, 2006, Art. 21. C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 6

7 transferee-spouse with what is called a carry-over basis (the transferee takes over the transferor s basis in the property). This carry- over basis rule applies to all property received by way of gift. Since the rules of Section 1041 do not apply when property is transferred to an NRA spouse, then this carry-over basis rule would not apply when the recipient is a NRA. The recipient spouse should be viewed as releasing marital rights or other valuable consideration in exchange for the property received from the other spouse, with the result that the recipient will take a basis equal to the fair market value of the property received. 26 b. Divorces involving couples when one is either an NRA or a U.S. tax resident (but non-u.s. citizen) require extra care and attention to detail for many reasons, the main one being the special rules that apply (as depicted by the table herein and examples provided above) relating to divorce settlements. c. Of note, section 1041 refers to individuals and does not specifically define terms in its provisions. Thus, any terminology referenced should refer to the definitions of section 7701 of the Code for reference. VIII. Summary of I.R.C Rules As Applied to U.S. Citizens, U.S. Tax Resident (non- U.S. Citizens), and NRAs a. As a reminder, no gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) (1) a spouse, or (2) a former spouse, but only if the transfer is incident to the divorce. 27 If section 1041(a) applies, then the property shall be treated as acquired by the transferee by gift, and the basis of the transferee in the property shall be the adjusted basis of the transferor. 28 Incident to divorce means that a transfer of property either (1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. 29 Also, there is a special rule where the transferee spouse is an NRA (see above). 30 b. The table on the following page looks to summarize the impact of these rules for U.S. tax purposes when considering a divorce between a mixed marital couple. c. The U.S. gift tax treatment for [c]ertain property settlements is governed by section Sometimes, this treatment can be either consistent, or inconsistent, with the treatment of transfers to spouses (or former spouses) under section 1041 (which is an income tax rule). The U.S. tax treatment of transfers to a spouse in divorce for U.S. income tax purposes and U.S. gift tax purposes are governed by different rules. Section 1041 provides the income tax treatment for transfers, and section 2516 provides the rule for the U.S. gift tax 26 See I.R.C I.R.C. 1041(a). 28 I.R.C. 1041(b). 29 I.R.C. 1041(c). 30 I.R.C. 1041(d). C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 7

8 treatment for transfers. Additionally, unlike section 1041, section 2516 applies to all spouses transferring assets whether U.S. persons or NRAs. Thus, the dichotomy involved does produce interesting consequences (see chart on next page). IX. Interception of Section 682 in Divorce a. An intentionally defective grantor trust (a support trust ) is normally a grantor trust because the grantor/donor spouse usually retains some interest in, or power over the trust. Grantor trust rules provide that the 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 31. b. Section 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 (the code uses term 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 (ther code uses ther term husband ) 32. c. This section addresses the treatment of income of an estate or trust in case of divorce. The main objective of this provision is to protect the husband when wife is a beneficiary of a support trust so, the husband does not pay the income tax on it, but the wife will pay the income tax on the portion that is considered spousal support. It does carve out child support so that is not taxable to the wife 33. d. Under Section 682(b) the wife is considered a beneficiary. For purposes of computing the taxable income of the estate or trust and the taxable income of a wife to whom subsection (a) applies, such wife shall be considered as the beneficiary 34. e. Additionally, section 7701 establishes an equal application of the provision to wife and husband 35. It should be noted that this section should also apply to same sex couples. f. It may be better than alimony because alimony has restrictions and a support trust may have more flexibility (e.g., it can front end load the payments and alimony cannot). The use of this section could be advisable if the donor spouse has creditors or might have a decrease in income (e.g., an athlete). The residue of the trust usually reverts to the grantor or is paid to children or trusts for their benefit. 31 I.R.C I.R.C I.R.C I.R.C. 682 (b). 35 I.R.C C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 8

9 X. Examples of Section 682 Under section 682, the income is taxed to wife and so one must look to the source rules. There could be good results if the wife is a non-resident alien and there is non-u.s. situs assets generating the income for U.S. income tax purposes. a. Example 1: H (U.S. citizen) and W (NRA) who lives in a treaty country get divorced. The support trust generates capital gains from US traded stock portfolio of $100,000 which is paid to W. As a result, H is not taxed because of section 682, and W is not taxed because under the sourcing rules, the gains are non situs. If a U.S. person has a NRA spouse and the support trust is generating capital gain in the U.S. that is being paid to her, she should be taxed on it under section 682, but because she is a foreign person and does not reside in the U.S. more than 183 days, the gain on that stock is not subject to U.S. income tax. XI. b. Example 2: H is an NRA who has a revocable trust funded with all non US situs assets. His spouse, W, is a U.S. resident and they are divorcing. If the trust assets are non U.S. situs and the trust is set up by an NRA normally there would not be any U.S. income tax generated. However, with W, a U.S. tax resident, receiving distributions under section 682, there will be income tax on the assets going to the U.S. wife, so now the U.S. wife has to pick up U.S. income tax because she is taxed on a world-wide basis. Furthermore, if it is a foreign trust, she may have to file the Form 3520 reporting a distribution from a foreign trust. Conclusion. Given the increasing number of mixed nationality/residency couples and the high number of divorces in the U.S., practitioners should pay attention to the unusual tax ramifications that can occur under U.S. tax law. The rules applicable to purely domestic couples often have opposite results when one or both spouses are either an NRA or a non U.S. citizen. C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 9

10 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) DEEMED EXCHANGE I.R.C. 1041(d) TRANSFEROR SPOUSE U.S. Citizen Resident Alien (non-u.s. Citizen) NRA U.S. Citizen Resident Alien (non-u.s. Citizen) NRA - 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, Unlimited Marital Deduction or 2516 for non-gift treatment (if applicable). - 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 (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. - 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. - 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), and Taxed to Transferor Spouse as if exchanged property for FMV. Recipient Spouse takes FMV basis in property received. - 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. - 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 in V. above. C:\Users\lbasha\Documents\ABA RPTE Boston - Special Rules in Divorce Outline and Chart Embedded (v4).docx 10