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Revisiting the Tax Consequences of the Alimony Trust

Posted on September 6, 2016 by Vitale, Katrina

A. Introduction



In the United States, it is predominantly state law that addresses family law rights, including alimony rights. Alimony has evolved over the past century with recent trends toward scrutiny of its application.1 Demands for alimony reform are at their height, with New York being the most recent state to introduce a formula for calculation of alimony, which took effect January 25.2 Several states have bills under legislative review, including Connecticut, Louisiana, and Florida.3 Alimony reform legislation was passed recently in New Jersey,4 and reform efforts continue. The trend signifies that this is the time to reassess how alimony is awarded and what other tools may be available to serve the interests of parties in the process of separation and divorce.

In states that recognize alimony, spousal support, or separate maintenance rights (collectively referred to as alimony),5 the laws vary significantly.6 For example, in Texas, spousal maintenance is reserved for limited circumstances in which there is either criminal family violence or an inability to meet "minimum reasonable needs" resulting from a marriage of at least 10 years in length or involving the disability of a dependent spouse or child.7 New Jersey has no limitations on who may seek an alimony award, but there are 13 nonexclusive factors for judicial discretion in making a determination.8

The general principle is that a financially dependent spouse or former spouse in a marriage of relative length may be entitled to a form of alimony based upon the marital laws of the state.9 Many states view the right of alimony as being linked to the lifestyle enjoyed by the parties during marriage.10 Alimony may be payable for a set number of years, and in some states it may be permanent. Generally, the obligation of alimony is payable in cash from earnings of the payer that have already been taxed as income to the payer.11

Under federal law, there are tax consequences linked to payment and receipt of alimony. The payee must report the funds as income assuming all requirements of section 71(b) are met, and the payer can take a tax deduction under section 215 for payments made.12

In situations in which the payer is making or has the ability to make payments from an investment asset within his gross estate, that payer might want to consider an estate planning alternative to remove the asset from his estate and to avoid income on the growth. That will matter when the payer has a higher net wealth that may pose estate tax implications or is in a higher income tax bracket that could otherwise be avoided by proper tax planning. For that reason, and if carefully drafted, an alimony trust can be beneficial to the payer as a tax savings. A payee might also favor this method of payment as security for ongoing payments, whether there be concern about the payer's future compliance with the alimony obligation or for reasons relating to a future disability, untimely demise, or other risk.

In light of the current focus on alimony reform, this article reevaluates and explores the use of the alimony trust when economically feasible and what we can learn from its development over time and through litigation. Additional concepts to be discussed include issues arising with drafting and improving the alimony trust's viable use by legal practitioners and state courts.

B. Alimony Trust Described



1. What is the alimony trust? The alimony trust is a vehicle that is generally established for the payment of a support obligation of one spouse or former spouse to another and that may provide a security fund for payment of the obligation beyond the lifetime of the payer spouse, also known as the obligor spouse. Under the code, the term "alimony" does not soundly fit within the concept of the "alimony trust." Instead, the alimony trust in some ways conflicts with the federal qualifications for alimony. For example, the alimony trust often allows for some form of security payment beyond the lifetime of the payer, which is inconsistent with the code.13

In general, the alimony trust is an alternative to alimony paid by a spouse or former spouse, and the tax consequences vary. In the case of alimony, the funds are paid from the income or assets of the obligor spouse. The payer will have first included the funds in his gross income, and upon receipt the payee must report the funds as income assuming all requirements of section 71(b) are met. Upon payment, the payer can then deduct the payments on his federal return.14

If the payer transfers funds to an alimony trust, the income distributed to the payee is not usually characterized as gross income to the payer, and a deduction by the payer is not allowed.15 Instead, the income distributed to the payee will be characterized as income to the payee under section 682(a) and will not be treated as income to the payer.16

2. When was the alimony trust introduced? The alimony trust was not traditionally a popular tool for payment of a support obligation, but it began to receive more attention after the Tax Reform Act of 1984.17 However, cases addressing the alimony trust date to 1935, when the Supreme Court affirmed a holding that the income paid to a former wife under an alimony trust constituted income to the payer.18 Much of the case law reveals confusion about the concepts of double taxation and income shifting while making efforts to reconcile these concepts with the changing language of section 71. State and federal courts have continued to struggle with the reconciliation of alimony and traditional trust concepts for decades.

3. How has the alimony trust been used in the past? The alimony trust has been used most often for shifting taxable income from the payer to the payee in situations involving high net worth individuals.19 However, until TRA 1984, there was confusion about the realization of income by the payee spouse. Also, it was generally a more viable tool for cases in which assets were available to be transferred irrevocably to the spouse or with remainder interests for their children and without a right of reversion retained by the payer.

Generally speaking, litigated cases involving alimony trusts have originated with an alimony trust created by the parties -- represented by attorneys or otherwise -- through an agreement rather than by any court order or adjudication.20 That is not to say that some state courts could not find authority to direct the creation of such a trust. It is possible to hypothesize circumstances in which a court may want to direct the creation of that type of trust, which is discussed below along with future expansion of the alimony trust.

4. The evolution of law involving the alimony trust. Many reported decisions involving alimony trusts have focused on the income reporting aspects. The income-shifting aspect of the alimony trust was upheld as federally constitutional in 1950.21 A similar argument by a payee spouse failed in Fairbanks. After the demise of her former husband who placed assets, including stock, into trust for her in accordance with a divorce settlement, she took distributions from the trust but failed to report the income derived.22

The ongoing struggle was made apparent when the Sixth Circuit held that distributions to a former spouse under an alimony trust from the income of tax-exempt bonds were not income to the payee23 after the IRS issued a recommendation to interpret the section 71 reference in section 682(b) as being limited to the determination of the correct tax year of the beneficiary of a section 71 trust and not to the applicability of the source of income rules of subchapter J.24 Under prior law, a payee spouse was taxed on periodic payments "attributable to property transferred in trust or otherwise."25 No distinction was made as far as distribution from principal or from tax-exempt income.26 The distributions were characterized as income to the payee regardless of the source of the payments.

The Supreme Court once again addressed the tax attributes of an alimony trust in 1962 when it held that the transfer of appreciated property to an alimony trust could be a taxable event.27 A complete transfer in satisfaction of the payer's obligation for support would be deemed taxable.28 Moreover, if there was a gift of the remainder interest (or reversion) in the payer, the trust would not receive a cost basis in the property.29 Further, any distributions from the trust to a former spouse were treated as income to that former spouse under section 71, regardless of whether the distribution came from income or principal. However, under circumstances in which the divorce was not final, the distributions were treated as income to the payee spouse only if disbursed from income of the trust rather than principal.30

Congress addressed allocation of tax involved in the alimony trust when it codified section 682 in 1984.31 The legislative history makes clear that the intention in establishing the separate provision under the code was to distinguish the tax effect of alimony under section 71 from the tax effect of payments from the alimony trust. The IRS later discussed the distinction in the regulations, stating that "section 682(a) applies to a trust created before the divorce or separation and not in contemplation of it."32 Thus, section 682(a) presupposes that there is a termination of the payer spouse's alimony obligation. The IRS has stated that this section, if applicable, requires, in taxable income of the payee spouse under an alimony trust, inclusion of amounts paid, credited, or required to be distributed to the payee only to the extent they are includible in the taxable income of a trust beneficiary under section 641 through section 665 (the subchapter J provisions).33

5. The need for review of the tax code to reconcile sections 682 and 71. "Before the [1984] changes in [section] 71, the entire distribution from a trust was required to be included in the recipient-spouse's income as alimony. Under the post-[1984] rule, the recipient-spouse is entitled to the usual treatment under subchapter J as the beneficiary of a trust."34 The payee spouse is likewise treated as the beneficiary of a trust as so treated under the subchapter J provisions.35 The question then becomes: Does the trust instrument terminate any alimony obligation and create an alimony estate rather than supplant a preexisting alimony obligation? If so, the payee will be taxed only to the extent of disbursements from income rather than principal.

However, the IRS explains, if the payments are made through a trust in accordance with specific terms in discharge of an alimony obligation under a court order, divorce decree, or a written instrument incident to divorce, section 71 applies.36 Following that rationale, section 71 will treat all disbursements as alimony requiring inclusion in the payee spouse's income of the full amount of the periodic payments received from the property in trust, regardless of whether it is out of trust income.37 That includes payments from principal, as well as tax-exempt income.38 What appears to be missing is the link under section 71 to any trust connection. The regulations discuss the difference between an alimony trust under section 682 and an alternative trust for alimony under section 71. An earlier version of this section allowed for character as alimony "periodic payments . . . attributable to property transferred, in trust or otherwise, in discharge of" a legal obligation imposed on the husband and arising out of "the marital or family relationship."39 Yet, the code today lacks any such connection. That calls into doubt the IRS's interpretation under the existing regulations and the reliability of tax treatment under section 71.

The application of section 682 and its distinction from section 71 remain to be explored. However, with careful drafting, estate planning options are available to divorce and estate practitioners under section 682 that allow for innovative trust planning.

C. Applications of the Alimony Trust



1. Recognizing an opportunity to use the alimony trust. There are several primary reasons for establishing an alimony trust including: shifting of tax consequences, reduction in size of estate, security of ongoing payments, terms for self-automated termination of alimony, and terms otherwise in avoidance of the six-year rule and the alimony recapture rule.

To begin, the alimony trust allows a payer spouse to shift income to the payee spouse by transferring to the trust income-producing assets. In this way, the payer, who may otherwise be in a higher tax bracket, may take advantage of lowering his tax bracket by effectively assigning the asset income to the payee under a section 682 qualified alimony trust, even if the trust is revocable.

If the income-producing asset is irrevocably transferred to the trust, the payer may also accomplish the task of removing the asset from his gross estate. That can be important for those whose assets might otherwise be subject to a sizable estate tax. While that would appear to be an effective estate planning tool, it remains uncertain how the disposition of property upon transfer to the trust will be treated: Will it be treated as a gift or a transfer incident to divorce? Will it be coupled with the estate tax? The code and regulations give rise to conflicting interpretations. Those issues are left open for interpretation and creative presentation. However, the client must be warned about the uncertainty.

Another consideration for invoking section 682 alimony trust planning is for the benefit of the payee spouse who has concern about the payer's compliance with an alimony obligation. The payee may prefer to have the alimony payable with the security of an inalienable asset in accordance with the terms of a trust and thus prefer an arrangement that will have more teeth than a direct pay arrangement. In the case of an irrevocable alimony trust, there is added security to that payment method.

Another reason for considering a section 682 alimony trust is to establish automatic termination of alimony upon specific events with built-in protections rather than reliance upon vague terms of a marital settlement agreement. The payer can establish terms for reversion of the remainder of the trust or can identify alternate beneficiaries to meet his estate planning goals without the contingency of the assets automatically reverting back to his estate. In some cases that can avoid probate of an unintended reversionary interest.

Another benefit of the section 682 alimony trust is that the six-year rule and alimony recapture rules do not apply to these alimony trusts. Under section 1041, property transferred between spouses or incident to divorce is not taxable. However, Congress has said that when you front-load alimony in years one and two after separation, you'll need to recapture the excess payments in year three under section 71(f). What you look for is whether the alimony payments in year one exceed the average payments in years two and three by more than $15,000 and whether the alimony payments in year two exceed the payments in year three by more than $15,000. For example, if a payer establishes a three-year trust that generates $25,000 income annually and is distributed to a former spouse, the ex-spouse would report all the income without the recapture otherwise imposed on the payer. Thus, there is a recapture of income to the payer.

In a practical sense, the parties could otherwise treat the payments as equitable distribution in nature with neither claiming the receipt as income or taking a deduction for the payment. However, that has other implications under the family laws of some states and in some circumstances can invite a spouse to return to court to readdress an alimony request when the payments have not been treated as alimony. When structured into a section 682 qualified alimony trust, there are no such recapture implications otherwise assumed in a direct alimony payment arrangement.

Finally, establishing an alimony trust with funding from a loan may allow the payer to deduct interest payments on the loan. While generally interest on loans is nondeductible as a personal expense,40 when structured into a qualified section 682 alimony trust, the trustee may take deductions on interest that is disbursed to the payee spouse under the terms of the trust.41 That is based on a reading of the regulations that would apply the subchapter J provisions to the section 682 alimony trust.42 This could result in tax savings otherwise unavailable to the individual payer.

In consideration of the viable planning tools available to the payer in establishing a qualified section 682 alimony trust, thoughtful attention should be given to their appropriate use.

2. Alternatives to the alimony trust and possible consequences. The primary alternative to an alimony trust is direct payment of support from the financial resources of the payer spouse. That includes direct payment or wage execution, the tax consequences of which have been addressed above. In practice the payment of alimony is taxed to the payer when received as income, so the code allows for a deduction upon transfer of the payment as alimony to the payee.43 In cases of high wealth that may include investment income, the payer is placed in a higher tax bracket by holding onto the income-producing asset, first receiving income from an income-producing asset before transferring it to the payee spouse.44 In that case, direct payment may not be a favorable alternative. The direct payment arrangement lacks the security favored by the payee. It may also implicate unfavorable results in which the alimony recapture rules or six-year transfer rules are applicable.

Another alternative to the alimony trust is to offer an asset or lump sum in lieu of alimony payment. In that case, the total projected alimony to be paid over time is calculated, and this figure will be reduced by the loss of tax effect and the time value of money. This alternative may be characterized as equitable distribution and therefore would not effectively be deductible by the payer spouse. While it may be viewed as a viable tool to reduce the size of the payer's gross estate because of the application of section 1041, it may also have the effect of overpayment of an alimony obligation when the state laws governing alimony may have otherwise allowed for an earlier termination or reduction of the obligation. When termination of the alimony obligation can result in some states that allow for termination or reduction of alimony upon a payee spouse's cohabitation or remarriage, this option is lost in a lump sum payment arrangement.45

A third alternative is the creation of a trust that does not otherwise qualify for section 682 tax treatment, automatically implicating the benefits of the subchapter J provisions. Here, the payer spouse may retain tax benefits arising from the income shifting of some income-producing assets placed into the trust. However, as discussed above, there are flaws in this option that can create unfavorable tax treatment on all disbursements to the payee spouse.

Those alternatives may be beneficial options when section 682 estate planning is not otherwise acceptable. The tax attributes and loss of some preferable tax treatment should be taken into consideration.

3. Distinguishing the alimony-insurance alternative trust. It is important to avoid confusion of the alimony trust discussed in this article with the trust alternative created solely for protecting an alimony payment. One common mistake is for the family law practitioner to refer to this alternative as an alimony trust. The terminology should be carefully avoided when one is drafting settlement agreements when the intention is to establish a trust to protect the alimony rather than pay the alimony.

To place the issue in context, the obligation to provide alimony is often accompanied by an obligation to protect the ongoing support of the spouse, whether as ordered by the state court or by agreement of the parties. The contingent events being protected by the alimony-insurance alternative trust may include disability or death of the payer. Generally speaking, the alimony can be secured with an appropriate disability or life insurance policy that is determined to cover the period of alimony that would otherwise be payable to a dependent spouse for the duration of the payer spouse's disabling event or premature demise.

However, circumstances arise in which the ability to secure disability or life insurance on the life of the payer is not an option. That often arises when a spouse suffers from a health condition that renders the insurance premiums cost-prohibitive to secure the alimony obligation.

A payer may have an option to protect an alimony obligation with an alternate form of trust, referred to as the "alimony insurance-alternative trust." That is not an alimony trust and should not be confused with one. This option can be established by transferring assets to a living trust that ultimately distributes the assets to the payee spouse upon the contingency of the payer's unforeseen disability or untimely demise. If the assets are irrevocably transferred to the trust without a retained or reversionary interest, it may receive preferable estate tax treatment compared with establishing a revocable trust.46

However, this alternative to disability or life insurance is generally available only when the payer spouse has a level of assets that meets the level of projected alimony and those assets can be allocated as a resource for the trust. It should also carefully take into consideration a reduction in distribution for an alimony term that is subject to a declining basis and alternate distribution for an alimony term that is subject to termination upon the payee's death or remarriage.

D. Planning and Pitfalls



1. Key terms of the alimony trust. An alimony trust like any other "living" or inter vivos47 trust must take into consideration for whose benefit the trust is being established, both during the lifetime of the payer and payee, as well as any remainder beneficiaries. Should an alternate beneficiary be established to address contingencies -- such as death of the payee or a change in events -- assumed by the purpose for the alimony trust? That is one important area in which the input of other professionals, as will be discussed below, comes into play. It is crucial to assess future events. Too often alternate distributions are overlooked when appropriate planning can address the parties' discernible goals.

The alimony trust must also address who will serve as the trustee to administer the trust. Should the trustee be an individual in being at the time of the creation of the trust or should it be a corporate trustee? How will any successor trustee be selected? Should designation of a remainder beneficiary be avoided? Those are all concepts that should be explored with the parties taking into consideration input from both estate attorneys and family law attorneys, as well as tax and corporate trust professionals.

Will the trust be irrevocable or revocable? One goal that can be met in creating a properly drafted alimony trust is that of removing the assets of the trust from the estate of the payer.48 The subchapter J provisions must be carefully reviewed to avoid inclusion of assets in the estate of the payer if the intention is for removal based upon estate planning goals. This will necessarily require the attention of the estates attorney and a tax professional.

Regardless of whether the alimony trust is revocable or irrevocable, the 1984 changes to the code make clear that the income can be shifted to the payee spouse when that spouse is entitled to receive an amount of income from "any trust." The code states:


    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.49

Deductions for payments under this section are not allowed for the payer.50 They will not otherwise be treated as child support despite the language of section 71(c).

Thus, the beneficiary, and not the settlor, is taxed on the distributions.51 That is true even if: (1) the grantor (payer) retains broad powers under the trust or (2) the income is made available to discharge the payer's obligation to support the payee.52 It is important to recognize that the beneficiary is taxed only on amounts that she "is entitled to receive," while a grantor might under other circumstances be taxed on the income of a revocable trust or a trust wherein the grantor retains power to make distributions of income to other beneficiaries.53 In those cases, the beneficiary is not in certain terms entitled to receive any disbursements from the trust.54

Also, a post-death receipt of trust funds that can be characterized as alimony arrearages will be reportable as income on the estate return and taxable to the payee's beneficiaries under passthrough distributable net income rules rather than being treated as a beneficiary of the decedent's estate.55 Those considerations must also be taken into account.

Finally, there must be consideration for terminology to address modification of any revocable alimony trust. Alternatively, if the choice is an irrevocable alimony trust, one must anticipate contingencies that could otherwise affect the underlying intent of the trust, such as cohabitation or remarriage of the payee. If the alimony trust is to be revocable, how is it to be modified? What court should have jurisdiction over the review? Should it be the state probate court or the family court? Is the family court equipped to handle the nuances of trust administration and possible reformation or termination issues?

Those questions will typically depend on the circumstances and will need to be fully explored with the parties while involving other professional input. These issues require attention from the outset of any alimony trust planning.

2. Common mistakes in drafting alimony trusts. When properly drafted, an alimony trust is an ideal alternative for a dependent spouse who seeks to continue relying on the support of a former spouse. However, an alimony trust that fails to undergo appropriate review by the family law and estate lawyers risks litigation over its terms. Coordination of trust planning and guidelines for funding the trust will help avoid disputes when the trust is designed to allow for distributions to a dependent spouse.

One common mistake in drafting the alimony trust is lack of negotiation about key terms. Although the prospect of agreeing on essential terms might appear to be difficult, the failure to reach a negotiated agreement is certain to invite litigation, which can come with costs that far exceed the burden of timely efforts to close on all essential terms.

Another misconception about the alimony trust is that the payer will have an available tax deduction. Most family law practitioners are adapted to the general principle that alimony will be taxable to the recipient under section 61 and the payments thereof will be deductible by the payer spouse under section 215,56 as long as the statutory requirements are met.57 Thus, under section 61(a)(8) and section 71(a), alimony and separate maintenance payments are specifically included in gross income. The amount of the alimony or separate maintenance that is included by the recipient as income is allowed as a deduction under section 215 from the gross income of the payer.

However, the rules governing the alimony trust alter the tax implications substantially; payments released under the alimony trust will generally not be treated as alimony at all.58 Rather, the distributions will be treated as income to the beneficiary, who is also the dependent spouse, while the payments will not be deductible by the payer. So the funds paid to the beneficiary from an alimony trust will be taxable to the extent payments are made from trust income.59 Under some circumstances, disbursements from the principal of the alimony trust can also be treated as income to the payee, such as when a payment from both income and principal is made in accordance with a term for payment "out of trust income if possible and, if not, out of corpus."60 Section 71 does not generally apply to payments made from a trust under current law. Instead, section 682 must be carefully considered as it applies to alimony trusts.

Another common area for mistakes involves overlooking the inclusion of trust assets in the estate of the payer when a complete relinquishment is not otherwise met under the code.61 The attorney must avoid reversion or retained interests when tax reduction may be a goal of the payer. The principal added to the alimony trust could be treated as a complete relinquishment of interest if properly drafted under the subchapter J provisions.62 On the other hand, when any incidence of ownership is retained by the payer spouse, the tax treatment will be viewed as an asset of the payer's estate until it is transferred to the trust irrevocably, which typically does not happen until after the payer's demise. In that situation the asset is included in the payer's estate, and all exclusion potential is lost.

To summarize, the common areas overlooked in preparing the alimony trust are careful consideration of negotiable terms applicable to the unique facts of each case, neglect of the intricate details of the subchapter J provisions, and failure to carefully consider the loss of a deduction under section 215 for payment of alimony. All of these mistakes can be avoided with proper trust planning and involvement of the key professionals discussed below.

E. Consulting With Other Professionals



1. Attorney as the scribner. Generally, the estate lawyer will be primarily responsible for drafting of the alimony trust. The estate lawyer is familiar with the preparation and administration of similar legal instruments, including inter vivos trusts, testamentary trusts, revocable and irrevocable trusts, and irrevocable life insurance trusts. However, the need for such alimony trust drafting generally does not arise in the estate-planning context, but it usually arises in the context of a pending divorce. Therefore, the divorce attorney must be able to spot the issue.

Given the hybrid nature of the alimony trust, it is crucial for the divorce lawyer to consult with a qualified estate lawyer. While not a guarantee to produce an alimony trust immune from attack, the combination of legal expertise in the two fields can create a draft that will work rather than run the risk of limited analysis or oversight of key concepts. The family lawyer offers valuable input on the rights and obligations of parties with respect to the state law applicable to alimony and its modification or termination. One should fully explore those underlying rights and obligations when drafting an alimony trust to avoid an unknown or unforeseen loss of payer or payee rights.

The attorney must continue to oversee the drafting of an alimony trust to ensure compliance with ethical obligations of competence and diligence.63 It is important that both attorneys have a full understanding of the resulting draft and its implications. While that may appear to be an obvious duty, it should be emphasized.

2. Input of accountants or other tax experts. Tax treatment of the alimony trust will be determined based on the trust terms. Drafting techniques can also affect the taxable estate of the grantor and the beneficiary. A qualified accountant or another tax expert offers needed perspective relative to tax and financial implications of the alimony trust and not limited to legal aspects on which the attorney will focus. Also, the accountant or tax expert should be regularly updated on changes in tax law that will prove useful during the course of drafting and from one case to another.

Tax law involves complexities that are rapidly changing and vary from one situation to another, not to mention exceptions within exceptions that can be buried in the code and regulations. To complicate matters, a combination of authority dictates the tax benefits and burdens in the trust and estate area. Filing and reporting requirements and deadlines also must be met, currently including Form 104164 to be filed by the trustee and Form 104065 to be filed by the beneficiary in recognition of income received. If overlooked, that could be financially devastating for the client and give rise to a legal malpractice claim against the attorney. It is imperative that tax expertise be consulted in alimony trust planning. Because the primary purpose in preparing the alimony trust is to meet the financial goals of the client, tax experts should be involved throughout the alimony trust planning and drafting process.

3. Input of corporate trustees. In all trust situations the trustee plays a crucial role in administering the terms of the trust and carrying out the grantor's known intentions. An alimony trust is no different. Anticipating practical implications of trust administration involving the future trustee will offer a more fully developed perspective for application of the trust.

The input of a corporate trustee is beneficial at the drafting stages because it routinely confronts administrative issues in carrying out the terms of a given trust. That does not necessarily mean that a designated trustee must be consulted, although that type of input may be preferred. At the very least, the input of an experienced corporate trustee can produce a more developed draft for implications not anticipated by the scribner or unwary parties to the alimony trust.

From another viewpoint, failure to consult a corporate trustee can lead to interpretation issues when, for example, a term of the alimony trust cannot be implemented because of practical considerations such as inclusion of a trust term that conflicts with the standard procedures of the trust department that is anticipated to administer the trust. The time involved in revising a conflicting term in an active trust can be unwieldy compared with revising it in the drafting stages. The benefit gained from anticipatory review can help avoid future legal and practical problems.

F. Future Changes and Applications



1. Areas of improvement. One issue that can present a problem with the alimony trust is that there is no deduction for payments by the payer. This can be a problem for the payer who agrees to a revocable alimony trust, whereas the payer in an irrevocable alimony trust may have the tax benefit of removing the asset from his estate and the deduction not otherwise being the goal. When the payer transfers assets to the trust -- and to the extent distributions are later paid from principal to meet the obligation (and therefore failing to meet a tax-shifting goal) -- the payer is not allowed a deduction, whereas that payment outside the trust would have allowed for a deduction, having been previously characterized as income.

Other than avoiding underfunding an alimony trust, a possible alternative to the inflexibility of nondeductible corpus payments would be legislation that would allow a tax deduction for payments disbursed from principal, and not from income, while meeting all other section 71(b) requirements. The effect is to treat the payment as alimony from the hands of the payer. This is rationally based on the principle that the funds transferred to the trust might have a reversionary interest and thus are not wholly removed from the estate of the payer. That is especially true when the trust is revocable or otherwise subject to modification.

For now, however, negative consequences can be avoided with a properly funded trust whereby distributions are made from income on the trust corpus without tapping into the principal. In that way, the corpus can be preserved for the intended beneficiaries of the payer according to the terms of the trust and without invasion by the payee.

Another way to avoid negative consequences necessitates reconciliation between sections 682 and 71 regarding the tax-altering treatment of child support. In the 1961 Supreme Court decision United States v. Lester, the Court held that support payments specifically designated as child support were not deductible by the payer and were not includible in the gross income of the payee spouse.66 No payment would be presumed to be child support unless specifically so designated,67 and there would be no determination "by inference or conjecture."68 Once a payment (or portion of the payment) is expressly earmarked for children's support, it would be nondeductible to the payer even though he actually supports the children in addition to making the payment. Support payments that can be characterized as child support cannot be treated as alimony under section 71, yet if the parties specifically designate a portion of support in a section 682 alimony trust, the parties can alter that characterization. Those sections should be amended to allow for consistency. One option for reconciling the sections is to amend section 682 so that it is consistent with the Lester rule as it implicates alimony trusts.

Section 682 can also be improved by adding clear language for an exception from the six-year rule and the alimony recapture rules. Practitioners are at risk in relying on the regulations that otherwise suggest such an exception exists. Given the language of section 71, practitioners should remain cautious in counseling their clients before relying on the regulations.

Another aspect of section 682 that requires clarification includes the below-market interest rules of section 7872. Clarification is needed to determine the extent to which those rules could apply to short-term trusts in which the payer retains a reversionary interest. That issue is left open in the language of section 682 and the subchapter J provisions and remains a trap for the unwary.

2. Expanded use. One can expect that the alimony trust will receive more attention from divorce and estate lawyers based on the current focus on alimony reform and the viable, alternative tax planning offered by section 682. Thus, the alimony trust is a more attractive tool for the payer today. With our growing population living longer, there is an added interest today to secure payments from an obligor. This alternative offers the payee a more secure interest in ongoing payments without interruption.

3. Development of the law. As the plain language of section 682 reveals, trust income can be allocated to a spouse who receives the income distribution of a qualified alimony trust, thereby shifting the income otherwise tied to assets in the name of the other spouse. Although the code requires clarification for consistent application, the alimony tax planning tool of section 682 is an option for those who wish to combine their tax planning with their alimony obligations upon separation or divorce. Attentive attorneys take advantage of this unique tax planning device to serve client goals on multiple levels when resolving family matters. However, it is perhaps an underused tool by the state courts.

In the same manner that the state courts have the power to allocate an equitable distribution of assets, they have the power to direct the use of an alimony trust to serve the purposes of removing income derived from assets and allocate those assets to the other spouse as an alternative to assessing section 71 alimony. State courts likewise have the power to direct the use of an alimony trust to ensure payment of alimony through secure means to a dependent spouse, as an alternative to direct payment, "under a decree of divorce or of separate maintenance." What is missing is the artful lawyering to establish the claim in the appropriate circumstances. An option overlooked from many viewpoints, the alimony trust is yet another alternative for review as legislators, practicing attorneys, and clients seek answers for alimony reform.

G. Conclusion



As alimony reform reaches the forefront of family-related litigation, the time is ripe to revisit alimony trust legislation. In appropriate circumstances the alimony trust is a viable tool for both divorce and estate lawyers and is given more favorable tax treatment today compared with its pre-1984 tax treatment. The lawyer practicing family law must recognize the opportunity for use of an alimony trust when feasible, advocate the effective use of the alimony trust upon which state courts may rely, work with estate lawyers to carefully frame out key terms, and rely on the input of other qualified professionals -- such as tax professionals and corporate trustees -- to meet client goals.

Properly used, the alimony trust can offer tax advantages for both parties to a divorce and to offer security for a payee spouse. Attention to its use and improvement is essential to the development of alimony trust law.


FOOTNOTES

1See Laura W. Morgan, "Current Trends in Alimony Law: Where Are We Now?" 34 Family Advocate 8 (Winter 2012).

2 N.Y. Dom. Rel. section 240.

3 Most recently, Florida passed an alimony reform bill and sent it to Gov. Rick Scott (R) for his signature. In Connecticut and Louisiana, multiple variations of alimony reform bills have been introduced since February 2014.

4 N.J. Stat. section 2A:34-23.

5See supra note 1.

6Id.

7 Texas Fam. Code Ann. section 8.051.

8 N.J. Stat., supra note 4.

9See supra note 1.

10See N.J. Stat., supra note 4; Fla. Stat. section 61.08; 13 Del. C. section 1512; 23 Pa. C.S. section 3701; N.C. Gen. Stat. section 50-16.3A; and Conn. Gen. Stat. section 46b-82.

11 In the case of a cash-based individual, the income is taxed upon actual or constructive receipt of cash or its equivalent as compared with the accrual-based individual, who is taxed when all events have occurred that fix the right to receive the income and that income can be determined with reasonable accuracy. See section 446; reg. section 1.446-1(c)(2)(ii); and reg. section 1.451-1(a).

12 Those attributes include the following: Payments are made in cash or equivalent; payment is made under a divorce decree or written separation instrument; payer and payee are not members of the same household; the instrument does not specify payments as "not alimony"; there is no liability to make payments for any period after the death of the payee; the payer and payee do not file a joint tax return; payments made "on behalf of" the payee spouse must be evidenced by a writing; and the payment will be subject to recapture rules. Section 71; reg. section 1.71-1T(b).

13 There can be no requirement to make any payment for any period after the death of the payee spouse because that contingency would remove the payment from qualification as alimony. See section 71(b)(1)(D).

14See section 215.

15See section 215(d).

16See section 682(a).

17 Internal Revenue Code of 1954, ch. 736, 68A Stat. 1, 19.

18Douglas v. Willcuts, 296 U.S. 1 (1935).

19See Fairbanks v. Commissioner, 343 U.S. 915 (1952); Laughlin's Estate v. Commissioner, 167 F.2d 828 (1948); Johnson v. United States, 70 F. Supp. 517 (W.D. Ky. 1947); Burton v. Commissioner, 1 T.C. 1198 (1943); and Fitch v. Commissioner, 43 B.T.A. 773 (1941).

20See id.

21See Mahana v. United States, 340 U.S. 847 (1950).

22See court cases, supra note 19.

23Ellis v. United States, 416 F.2d 894 (6th Cir. 1969).

24In Re: Mary C. Ellis v. United States, 1968 WL 16476 (AOD June 21, 1968).

25 IRC 1954, supra note 17.

26See reg. section 1.71-1(c)(2).

27United States v. Davis, 370 U.S. 65 (1962).

28See Rev. Rul. 57-507, 1957-2 C.B. 511.

29See Spruance v. Commissioner, 60 T.C. 141, 155 n.7 (1973).

30 IRC of 1954, supra note 17.

31 Section 682.

32 Reg. section 1.682(a)-1.

33Id.

34Alimony Trusts, U.S. Tax Rep. P 6824 (2014).

35 Reg. section 1.682(b)-1.

36Id.

37Id.

38Alimony Trusts, supra note 34.

39 Roland L. Hjorth, "Tax Consequences of Post-Dissolution Support Payment Arrangements," 51 Wash. L. Rev. 233 (1976) (citing section 71(d)).

40See section 262(a).

41See section 661(a).

42See reg. section 1.682(b)-1.

43See sections 71 and 215.

44 Section 61(a).

45See, e.g., N.J. Stat., supra note 4.

46See sections 67-679.

47 An inter vivos or living trust is a transfer of property into a trust during an individual's lifetime. Black's Law Dictionary 821 (1990).

48See sections 671-679.

49 Section 682(a). Section 682 assumes that the husband is the grantor of the alimony trust and the wife is the beneficiary. The code and regulations make clear that the section is to be gender neutral in application. See section 7701(a)(17); reg. section 1.682(a)-1.

50See section 215.

51 Section 682.

52See reg. section 1.682(b)(1).

53Id.

54Id.

55See section 71 and 682; Kitch v. Commissioner, 103 F.3d 104 (10th Cir. 1996), reh'g denied.

56 Alimony became deductible in arriving at adjusted gross income in 1976, thereby eliminating the requirement that a taxpayer seeking a tax benefit for a payment must itemize deductions with a reduced tax benefit. Section 74; section 215.

57 TRA 1984 introduced four significant changes in whether a payment can be characterized as alimony: (1) the requirement that payments be allocated as and for support in order to qualify as alimony was eliminated; (2) payments must terminate upon the death of the payee spouse, and the divorce or separation instrument expressly provides for that termination; (3) payments that exceed $10,000 in any given year are deductible only if some payments must be made in at least six post-separation years; and (4) if payments are structured to be made in each year within the six-year post-separation period, a reduction in payments of more than $10,000 when comparing any later year in the period with any earlier year will result in the payer of alimony being deemed to have income for the year in which the reduction occurs.

58 Some states have considered that issue and after struggling to some extent with the concept have ultimately concluded that alimony paid under an alimony trust is not to be treated as alimony under the state and federal tax scheme. See Ky. Rev. Stat. section 141.096 (1948) (repealed 1954).

59 Reg. section 1.71-1(c)(2).

60See reg. section 1.682(b)(1).

61See sections 671-679.

62See id. An argument can otherwise be made under section 1041 that the transfer of property between spouses or to a former spouse "incident to a divorce" should result in no gain or loss recognized. See section 1041. Incident to a divorce means within one year of cessation of the marriage or regarding the cessation of the marriage. However, the alternate argument is that the funding of a trust for the benefit of a former spouse with a contingency that might allow for recovery of the funds by the payer is not a transfer to a spouse at all in the case of a revocable or reversionary trust. Even if irrevocably transferred to the trust by a complete relinquishment of an interest in the assets, the transfer by its nature is to a trust subject to the trust terms, rather than an outright transfer to a spouse or former spouse under section 1041. However, an argument can be made under that section that the transfer should not be treated as a gift within one year of the cessation of the marriage to avoid immediate gain if one can still show that it was "related to the cessation of the marriage." See section 1041(a)(2) and (c)(2). Reg. section 1.1041-1T provides that the transfer will be deemed related to the cessation if it is made in accordance with a divorce or separation instrument and it occurs not more than six years after the date on which the marriage ceases.

63See American Bar Association, "Model Rules of Professional Conduct," Rules 1.1, 1.3 (2016).

64See section 6012(a)(4). Form 1041 is used to report the income, deductions, gains, and losses of a trust. The trustee must file a tax return on Form 1041 if the trust estate has gross income of $600 or more during a tax year. See reg. section 1.641(a)(2); and reg. section 1.61-1(a).

65See section 6012(a)(1)(A). Depending on the circumstances, Form 1040, Form 1040A, or Form 1040EZ will be used to report income distributed from a trust when the taxable year gross income equals or exceeds the applicable exemption amount plus any applicable basic standard deduction.

66United States v. Lester, 366 U.S. 299 (1961).

67Id.

68 "K-6192 Payment for Support of Husband's Minor Children -- Under Pre-'85 Decrees," Federal Tax Coordinator, 1997 WL 521096 (2014).


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