Warn Clients About Change in Taxation of Trust Income After Divorce

This article reprint was published in the July 2019 issue of Trusts & Estates magazine. The 2017 Tax Cuts and Jobs Act (the Tax Act) altered the way that income from certain trusts is taxed in the event of a divorce. Practitioners should carefully consider the tax impact of every trust created during a marriage in the event the parties get divorced in the future. If a couple is in the process of getting divorced, existing trusts should be reviewed and amended to change the tax consequences, if possible and appropriate, or the tax implications should be factored into the divorce settlement negotiations or presented in evidence to a court. 

An individual can create irrevocable trusts for the benefit of family members, moving the assets transferred to those trusts out of the trust creator’s estate for estate tax purposes, while remaining responsible for paying the trusts’ income and capital gains taxes. Creating a so-called “grantor trust” (a trust considered owned by the grantor for income tax purposes) is a popular planning tool because it allows the grantor, in effect, to make gifts to the trust in the amount of the income tax payment, which otherwise would be payable by the trust or trust beneficiaries.  Accordingly, practitioners often purposely include provisions in trusts that will trigger grantor trust status, allowing these trusts effectively to grow tax-free for the beneficiaries. 

Additionally, under Internal Revenue Code (IRC) Section 677(a)(1), a grantor is treated as the owner of any portion of a trust if income may be distributed to the grantor or the grantor’s spouse. Under IRC Section 672(e)(1) (the so-called spousal unity rule), a grantor is treated as holding any power or interest held by an individual who was the grantor’s spouse at the time the power or interest was created. Accordingly, if a trust was created while the parties were married and trust income may have been distributed to the grantor’s spouse, that trust likely will be a grantor trust and will remain a grantor trust even if the grantor and the grantor’s spouse subsequently divorce. That is, after a divorce, the grantor would be liable to pay the taxes attributable to trust income that was paid to the grantor’s ex-spouse, and the ex-spouse would receive the income tax-free. Until Dec. 31, 2018, IRC Section 682 prevented that result by providing that the income distributed to a spouse after a divorce is taxable to the recipient and not the grantor. That protection has ended. The Act, signed into law on Dec. 22, 2017, repealed Section 682 for divorce or separation agreements executed after Dec. 31, 2018.

The Tax Act changes regarding the repeal of Section 682 are permanent and don’t sunset. 

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