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ESTATE & INCOME TAX PLANNING ISSUES IN DIVORCE
First Run Broadcast: November 4, 2015
Live Replay: May 18, 2016
1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (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. Thus 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 tax issues in martial separation and divorce
Income tax issues when property and debt are separated in divorce
Traps surrounding beneficiary designations on retirement benefits and insurance
contracts
Treatment of income form and property held in trust on divorce
Opportunities for post-nuptial agreements to resolve lingering disputes
Issues related to the sale or transfer of personal residences
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.
Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth
Management in New York City, where she works with clients and their advisors to help develop
estate, gift, tax, and wealth transfer planning strategies. Earlier in her career she was a vice
president in the estate planning department of U.S. Trust Company. She also practiced law with
Weil, Gotshal & Manges in New York City. Ms. Christerson is the author of the monthly
newsletter “Tax Topics." She received her B.A. from Sarah Lawrence College, her J.D. from
New York Law School and her LL.M. in taxation from New York University School of Law.
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Estate & Income Tax Planning Issues in Divorce Teleseminar May 18, 2016 1:00PM – 2:00PM
1.0 MCLE GENERAL CREDITS
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CERTIFICATE OF ATTENDANCE
Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: May 18, 2016 Seminar Title: Estate & Income Tax 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, 2011. All rights reserved.
ESTATE PLANNING IN DIVORCE: SPECIFIC ISSUES
Materials prepared by:
Jeanne L. Newlon, Esquire
Venable LLP
575 7th Street, N.W.
Washington, DC 20004
Telephone: (202) 344-8553
Facsimile: (202) 344-8300
Presented By:
Jennifer A. Pratt, Esquire
Venable LLP
750 East Pratt Street, Suite, 900
Baltimore, MD 21202
Telephone: 410-528-2883
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© Jeanne L. Newlon, Esquire, 2011. All rights reserved.
TABLE OF CONTENTS
Content Page Number
I. TAX TREATMENT OF TRANSFER OF CERTAIN ASSETS .........................................1
1. Retirement Plan Assets ............................................................................................1
a. Division of Qualified Retirement Plans in Divorce .....................................1
b. Transfer of Individual Retirement Accounts in Divorce .............................2
c. Beneficiary Designations on Retirement Plan Assets ..................................2
2. Residences................................................................................................................3
a. Recognition of Gain on Transfer of Residence from One Spouse to Other 3
b. Exclusion of Gain under Section 121 ..........................................................3
c. Sale of Residence from One Spouse to the Other ........................................4
d. 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 ........................................................................................................12
a. Transfer of Policy by One Spouse to Other ...............................................12
b. Insurance Payable to Spouse to Secure Support Obligations ....................13
c. Insurance to Secure Support Obligation of Children .................................14
d. Second-to-Die Insurance ............................................................................15
II. USE OF TRUSTS IN DIVORCE ......................................................................................16
1. Gift Tax Consequences ..........................................................................................16
a. Gift Tax Marital Deduction under Section 2523 .......................................16
b. Transfer for Full and Adequate Consideration under Section 2516 ..........17
c. Trusts to Which Section 2702 Does Not Apply.........................................19
d. Relinquishment of Support Rights .............................................................21
e. Relinquishment of Enforceable Rights in Property ...................................24
f. The “Harris” Rule ......................................................................................24
2. Estate Tax Consequences .......................................................................................25
a. Inclusion of Trust Property in Transferor Spouse’s Estate ........................25
b. Inclusion of Property in Estate of Transferee Spouse ................................27
c. Estate Tax Deductibility ............................................................................28
3. Income Tax Consequences ....................................................................................29
a. Grantor Trusts ............................................................................................29
i. General Rules .................................................................................29
ii. Grantor Trusts in Divorce ..............................................................34
b. Nongrantor Trusts ......................................................................................36
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© Jeanne L. Newlon, Esquire, 2011. All rights reserved.
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 transfer
of 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 provision
that 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 been
able 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 was
employed 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 or 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 in
states 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 situations
under 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 and
the 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 trust
under 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).
Round up
April 15th is just behind us, leaving many taxpayers a little less flush after paying off the balance of their 2014
income tax obligations. In honor of “Tax Day,” we wanted to mention a few bills that the House of
Representatives passed on April 16th, mostly along party lines: H.R. 622, the “State and Local Sales Tax
Deduction Fairness Act of 2015,” and H.R. 1105, the “Death Tax Repeal Act of 2015.” Although it is unclear
if and when the Senate might take up these bills, it matters not: President Obama has promised to veto both
of them if they end up on his desk. Here’s what the bills would do:
• H.R. 622, the “State and Local Sales Tax Deduction Fairness Act of 2015.” This bill would make
permanent a taxpayer’s ability to deduct state and local sales taxes in lieu of state and local income
taxes (taxpayers must itemize their deductions to take advantage of this provision, and typically live in
states without an income tax). The bill has no offsets to pay for it, and the Joint Committee on Taxation
(JCT) projects its cost at about $42 billion over 10 years. The vote was 272 to 152, with 238
Republicans and 34 Democrats in favor of the bill, and 151 Democrats and one Republican against it.
Comments. Although there is bipartisan support for this provision (it expired – again – at the end of
2014), most Democrats opposed the bill because it had no “pay-fors” and would have added to the long-
term deficit. This is the same objection that Democrats have had to other Republican attempts to make
permanent certain other popular “extenders” – temporary provisions that Congress regularly renews at
one- to two-year intervals, including the now-expired charitable IRA rollover provision. Republicans view
the sales tax deduction as a simple question of tax fairness that should be made permanent so that
taxpayers know what to expect. (Note that extenders are generally easier to pass than permanent
provisions because they are viewed as less costly from a budget perspective: revenue estimators must
assume that temporary provisions actually expire, no matter how improbable that is as a matter of tax
policy.)
2015-04
04/24/15 Tax Topics
Blanche Lark Christerson Managing Director, Senior Wealth Planning Strategist
Tax Topics 04/24/15 2
• H.R. 1105, the “Death Tax Repeal Act of 2015.” This bill would repeal the estate tax and generation-
skipping transfer tax (GST) as of the Act’s enactment, although distributions from qualified domestic
trusts (QDOTs) would still be subject to estate tax for 10 years after the bill’s enactment (QDOTs are
trusts for non-citizen surviving spouses, and postpone estate tax at the first spouse’s death). The gift tax
would remain, with a 35% tax rate and a $5 million exclusion, annually indexed for inflation. Lifetime
gifts into trusts would be treated as taxable gifts unless the trust was a “grantor trust” (grantors are
responsible for paying the income taxes of such trusts). The JCT projects the bill’s cost at about $269
billion over 10 years. The vote was 240 to 179, with 233 Republicans and 7 Democrats in favor of the
bill, and 176 Democrats and 3 Republicans against it.
Comments. The Death Tax Repeal Act is essentially the same as the estate tax and GST repeal that
took effect in 2010, with one notable exception: it does not have the modified carryover basis regime that
also took effect in 2010 and generally passed along a decedent’s built-in capital gains to heirs, subject to
a limited basis step-up of $1.3 million, plus an additional $3 million for property passing to a surviving
spouse. (Repeal was itself retroactively repealed in late 2010; estates of 2010 decedents could opt out
of the estate tax in favor of the modified carryover basis regime.) In other words, the Death Tax Repeal
Act not only eliminates transfer tax at death, but retains the stepped-up basis rules that eliminate built-in
capital gains on a decedent’s appreciated property. (Retention of these rules could account for a good
deal of the bill’s projected cost.)
Not surprisingly, the Administration has stated that it “strongly opposes” the bill. This position is
consistent with various proposals in Mr. Obama’s Fiscal Year 2016 Budget, including: 1) reverting to the
2009 transfer tax regime in 2016: $3.5 million estate tax exclusion and GST exemption, $1 million gift tax
exclusion, and top estate and gift tax and GST rate of 45%; and 2) treating most transfers of appreciated
property – whether by lifetime gift or at death – as deemed sales that trigger capital gains tax.
It goes without saying that the estate tax – or “death tax,” as the bill refers to it – is a true hot-button item
that engenders fierce debate: on one side, are those who feel passionately that death should not be a
“taxable event” and that it is wrong to tax the family farm or business, or a lifetime of savings; on the
other side, are those who feel just as passionately that eliminating the estate tax would create a monied
aristocracy, exacerbate wealth inequality and deficits, and be a boon to the wealthiest of the wealthy.
However one comes out on the issue, it is a fact that the nearly 100 year-old federal estate tax now
affects fewer and fewer people: the inflation-indexed $5 million exclusion means that in 2015, an
individual can protect $5.43 million from gift and estate tax ($10.86 million per married couple);
according to the Center on Budget and Policy Priorities, this means that the federal estate tax only
affects about 2 out of every 1,000 decedents (0.20%). This exclusion, along with the current basis step-
up rules, mean that many estates pass free of both federal estate tax and any built-in income tax liability
(note that state estate tax/inheritantance tax might still apply, and that the basis step-up rules don’t apply
to assets such as retirement accounts).
One way of looking at Mr. Obama’s proposals (more robust transfer taxes and what amounts to a capital
gains tax at death) and the Death Tax Repeal Act is that they represent two extremes: the possibility of
property being taxed twice at death, or not at all. Does either approach have a chance of currently being
enacted? No. But after the 2016 elections? That’s a different question.
Right now, both parties are basically at a stalemate – at least as to anything remotely ideological – and
are trying to score political points while setting the stage for the 2016 elections. The most obvious
change these elections will bring is a new occupant of the White House. As to Congress, the current
House of Representatives has 244 Republicans, 188 Democrats and 3 vacancies; the current Senate
has 54 Republicans, 44 Democrats and 2 Independents, both of whom caucus with the Democrats. In
Tax Topics 04/24/15 3
2016, the entire House is up for re-election, of course, as is one-third of the Senate. Of that one-third,
10 are Democrats, three of whom are retiring (Barbara Boxer (CA), Barbara Mikulski (MD) and Harry
Reid (NV)); the other 24 seats are currently held by Republicans (note that Marco Rubio (FL) is running
for President and is not running for re-election). Although the gap between the number of Republicans
and Democrats in the Senate is much narrower than the gap in the House, Democrats have their work
cut out for them if they hope to retake control of both houses of Congress.
What the looming 2016 elections presumably mean for tax legislation is that while the current Congress
will need to address certain provisions – such as the 50+ extenders that expired at the end of 2014,
including the sales tax deduction – major legislation that requires bipartisan cooperation seems unlikely
until at least 2017, assuming it happens.
Nightmare on Elm Street Imagine the following scenario: Dad is a very successful insurance broker. He has deferred compensation
arrangements with Company, pension benefits and a 401(k); he also has life insurance, and an IRA. He
marries Wife in 1990, and names her as sole beneficiary of some of these assets, and as co-beneficiary of
others. (We’ll assume that Son, presumably from a prior marriage, is the other co-beneficiary). Dad
divorces Wife in 2006. Pursuant to his divorce decree, Dad agrees to keep $1 million of insurance on his life
for Ex-Wife’s benefit. Dad dies in 2009, never having changed any of his beneficiary designations.
Son, Dad’s executor, and Ex-Wife both present claims to Company regarding the deferred compensation
and pension benefits payable at Dad’s death. Son says that under the divorce settlement agreement, Ex-
Wife waived any rights or expectancy interests in these assets; Ex-Wife insists that she didn’t. Company
files an interpleader action, and asks the local district court to decide who gets the property: Dad’s estate or
Ex-Wife? The District Court finds for Ex-Wife, who “never had any claims against her former husband to waive” [italics in original]; her claims didn’t arise – against Company – until Dad’s death, since Dad could
have changed the beneficiary designations at any time after his divorce, but didn’t. New York Life Insurance Company v. Smoot and Smoot, Southern District Court of Georgia, CV 209-047, 11/30/09.
Act II begins with Son going back to the same District Court to get reimbursed from Ex-Wife for the estate
tax dollars attributable to the $5.4 million worth of property she received (Son received $2.2 million from
Dad’s estate and Dad’s former business partner received about $100,000). Son argues that Ex-Wife owes
nearly $1 million of the nearly $1.5 million in estate taxes that Son has already paid to the IRS from Dad’s
estate. (In the meantime, Ex-Wife pointed out that because Dad was required to maintain $1 million worth of
life insurance coverage for her benefit, part of what she received was a legitimate claim on the estate, and
therefore deductible; the IRS agreed and reduced the estate tax bill.)
Back in the District Court, Son makes two arguments for why Ex-Wife should pay her share of tax: 1) the tax
law allows the executor to recover tax from beneficiaries of life insurance policies (IRC Sec. 2206, for tax
mavens); and 2) the tax apportionment clause in Dad’s will says that “[a]ll transfer, estate, inheritance,
succession and other death taxes which shall become payable by reason of my death…shall be charged
against and paid by the recipient of such property or from the property to be received.”
Ex-Wife argues that she is not liable for the $350,000+ of tax attributable to the non-life insurance assets she
received (i.e., the deferred compensation, the IRA, the 401(k) and the annuity, none of which are covered
under IRC Sec. 2206) for two reasons: 1) Georgia (where this all took place) does not provide for a right of
contribution for taxes; and 2) even if there were such a right, her divorce from Dad makes the terms of his
will inapplicable to her.
Tax Topics 04/24/15 4
The District Court again agrees with Ex-Wife. It says that it doesn’t even need to consider Ex-Wife’s first
argument, since Georgia law is quite clear in stating that “[a]ll provisions of a will made prior to a testator’s
final divorce…in which no provision is made in contemplation of such event shall take effect as if the former
spouse had predeceased the testator.” Because the tax apportionment clause is a “provision” like any other,
it doesn’t apply to Ex-Wife: she and Dad divorced after he executed his will, and his will didn’t contemplate
divorce; Ex-Wife is therefore treated as having predeceased Dad. While this may be an unintended
outcome of Georgia’s probate code, that statute is unambiguous, and also applies to the tax apportionment
clause. Son appears to be caught “in a gap between the two systems” – having to pay the taxes on his
father’s estate and being precluded from collecting tax because of Georgia’s probate code; this outcome, the
court says, is “inescapable.” Smoot v. Smoot, Southern District Court of Georgia, No. 2:13-cv-0040, 3/31/15.
Comments. Wow. Not only does Ex-Wife get the property that still names her as beneficiary, she also
doesn’t have to pay any estate tax on it! So what might have been done differently to prevent this outcome?
Although it is true that Georgia law does not have a default provision that allocates estate taxes to
beneficiaries, that would not have mattered if Dad had simply updated his beneficiary designations after his
divorce to name someone other than Ex-Wife.
As a practical matter, many states have laws that would at least have mitigated this result: an ex-spouse
may be barred from taking property via a “stale” beneficiary designation, and default tax apportionment laws
may require beneficiaries to pay their pro rata share of estate tax, subject to a contrary provision in the
decedent’s will (or revocable trust). Yet while state law may come to the rescue and preclude a now ex-
spouse from taking, say, life insurance or an annuity, it will not necessarily work with respect to retirement
accounts, which are typically governed by federal law (ERISA).
But rather than having to litigate a matter or hope that state law is on the decedent’s side, wouldn’t it be
better to regularly check planning documents – including beneficiay designations – to make sure that they
still accomplish their desired purpose? This is especially true if there has been a major life event, such as
marriage, divorce, death, or the birth of a child. Judging by the number of cases dealing with ex-spouses
and “stale” beneficiary designations, however, such periodic planning checks don’t happen nearly enough.
May 7520 rate
The IRS has issued the May 2015 applicable federal rates: the May 7520 rate is 1.8%, a 0.20% (20 basis
points) decrease from April’s 2.0% 7520 rate. The May mid-term rates are: 1.53% (annual) and 1.52%
(semiannual, quarterly and monthly). The April mid-term rates were: 1.70% (annual), 1.69% (semiannual
and quarterly), and 1.68% (monthly).
Blanche Lark Christerson is a managing director at Deutsche Asset & Wealth Management in New York
City, and can be reached at [email protected].
The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank AG or any
affiliate thereof (collectively, the “Bank”). Any suggestions contained herein are general, and do not take into account an individual’s
specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. No
warranty or representation, express or implied, is made by the Bank, nor does the Bank accept any liability with respect to the
information and data set forth herein. The information contained herein is not intended to be, and does not constitute, legal, tax,
accounting or other professional advice; it is also not intended to offer penalty protection or to promote, market or recommend any
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PROFESSIONAL EDUCATION BROADCAST NETWORK
Speaker Contact Information
ESTATE & INCOME TAX PLANNING ISSUES IN DIVORCE
Jennifer A. PrattVenable LLP – Baltimore, Maryland(o) (410) [email protected]
Blanche Lark ChristersonDeutsche Asset & Wealth Management - New York City(o) (212) [email protected]