Divorce and separation can be a very stressful time on many levels, including from a taxation standpoint. One of the issues that generally arises is whether alimony will be required, meaning one spouse providing financial support for the other spouse following the divorce or separation. Trust and estate law provides an avenue to fund a specific type of trust known as an Alimony Trust with the purpose of providing such financial support. This article will take a closer look at alimony trusts, including its general structure as well as its tax implications.
Generally, an alimony trust is setup with its own trust agreement, similar to that of standard trusts, as part of the final settlement involving two spouses. The payor spouse transfers investments such as stocks or rental property that generate income into a trust. The other spouse is known as the recipient spouse and is also the beneficiary for the trust. A third-party professional trustee can act as an intermediary between the two spouses to keep the asset management structured in an agreed upon way. When active, the recipient spouse will receive distributions of all of the income from the trust as alimony for the agreed upon time period. When the term expires or the recipient spouse passes away, the remaining assets or principal can be used in a wide variety of ways depending on the terms of the trust agreement: New trusts can be formed for the benefit of children or grandchildren, the assets can be donated to a charitable organization, or the assets can even be returned to the payor spouse.
Alimony trusts can be of benefit to both spouses. For example, if the recipient spouse is concerned about the risk of not being paid due to the payor spouse becoming bankrupt or insolvent, an alimony trust sets aside the assets before such an event occurs. Another example would be when the payor spouse is a business owner who would need to sell an interest in the business to fund regular alimony payments. In this scenario, a portion of equity in the business would be used to fund the trust with the recipient spouse receiving the applicable portion of income from the business on a yearly basis for the term prescribed in the final agreement. When the term ends, the share of the business reverts back to the payor spouse.
The recipient spouse will report and pay tax on the trust income received under Section 682 of the Internal Revenue Code (IRC) as the income beneficiary of the trust instead of reporting the income as alimony. For this reason, the payor spouse is not allowed to claim an alimony deduction for the income generated in the trust. In addition, there is also the risk of overfunding or underfunding the trust relative to the terms of the settlement. In the case of underfunding an alimony trust, the payor spouse may elect to personally guarantee any shortfall of alimony payments and regain the ability to deduct such amounts on the tax return, but leaves the potential to be taxed on the income from the trust if any part of the guaranteed payments are derived from the trust assets. Should an alimony trust be overfunded and the payments decrease over time, the payor spouse would not be subject to the potential penalty of recapturing alimony payments made during the first three years following the divorce or separation.
Alimony trusts, while a useful option in the right circumstances, can add another complex layer in the already difficult process of divorce and separation. Should you have any questions or need assistance in setting up an alimony trust, please contact your L&B professional.