During happy days, one spouse (call him or her the “Donor Spouse”) sets up an irrevocable trust for the benefit of the other spouse (call him or her the “Donee Spouse”). Under Code §672(e)(1)(A), a grantor of a trust is treated as holding any power or interest in a trust that is held by an individual who was the spouse of the grantor at the time of the creation of such power or interest. This typically results in grantor trust status for the trust since the Donor Spouse is treated as having retained rights to income and principal in the trust - with the Donor Spouse being taxable on some or all of the trust income.
Fast forward, and the happy couple is not so happy. They divorce, but the trust lives on. Since the testing under Code §672(e)(1)(A) of the spousal relationship that gives rise to the grantor trust status looks to the time of the creation of the trust, not the status in any later tax year, the Donor Spouse continues to be taxable to the Donor Spouse after the divorce. This is typically an unexpected and unwanted surprise to the Donor Spouse.
Previously, Code §682 remedied this circumstance by providing the Donee Spouse would be taxable on the income. Even then, it was not a perfect solution, with some income potentially remaining taxable to the Donor Spouse, such as capital gains.
In the 2017 Tax Act, special rules allowing shift of alimony tax consequences to a payee spouse were repealed. As part of that repeal, Code §682 was removed from the Code. This presents at least two major issues.
First, what happens to trusts that were formed prior to the repeal of Code §682? Notice 2018-37 has answered this question. It indicates that regulations will be issued to provide that former Code §682 will continue to apply to those older trusts, so the Donee Spouses will remain taxable thereunder. However, this applies only to spouses divorced or legally separated under a divorce or separation instrument executed on or before December 31, 2018, unless that instrument is modified after that date and the modification provides that the changes made by the 2017 tax act apply to the modification.
The second major issue is what happens to trusts for spouses whose divorce or separation occurs after December 31, 2018? Without Code §682, Donor Spouses should remain taxable on those trusts under the grantor trust rules because Code §672(e)(1) continues to apply. Ramifications for persons setting up spousal trusts, either during the marriage or providing for them in prenuptial or postnuptial agreements, is to consider these issues and perhaps to come up with a way to terminate the grantor trust treatment to the Donor Spouse upon divorce if that is the desired arrangement. One way perhaps may be to terminate the trust upon divorce - as to who the assets will be payable can be worked out with regard to the other tax and planning consequences to such a termination or having such a termination provision in existence (e.g., provisions relating to the qualification for and termination of QTIP trust status). Another might be to trigger a mandatory reimbursement provision for the taxes to the Donor Spouse from the trust, or other Donee Spouse assets (again, subject to other applicable tax and planning considerations).
The Notice does request comments on whether guidance is needed regarding the continued application of the grantor trust provisions after divorce or separation. Perhaps Treasury is thinking about instituting its own regulatory relief to the application of the grantor trust rules after divorce or separation, but the Notice provides no indication that is on the table.
Notice 2018-37 (4/12/2018)
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