Creating an Alimony Trust:A Good Tax Planning Tool?by Sue K. Varon, Esq. and Martin S. Varon, CPA, CVA, JDsvaron@armvaluations.com, mvaron@armvaluationsEstablishing a trust prior to divorce mayserve to accomplish several desiredresults. One type of trust, provided forunder IRC Section 682, is commonlyknown as an alimony trust. Pursuant toSection 682(a) this trust must be created priorto divorce or separation, not in contemplationof it. These trusts are primary used for clientswith significant financial resources, who couldfund the corpus of the trust.Economic protection benefits afforded bythe alimony trust would be accomplished ineach of the following situations:• One spouse may not have a goodtrack record when it comes tohandling financial responsibilities.The recipient may be a spendthrift orhave an expensive addiction, with thepotential of dwindling away a lumpsum settlement. This could leave thedoor open for later pleas for additionalfunds from the more financially stableformer spouse.• In contrast, the funding spouse maybe the financially irresponsible partyor may be involved in an unstablebusiness venture, leaving the recipientspouse concerned about the likelihoodof not receiving future support orinstallment payments in accordancewith a settlement agreement.• If a significant part of the maritalestate is comprised of stock in a closelyheld business that will ultimately bedivided, the spouse who is activelyinvolved in the business will wantto prevent the other spouse frominterfering with the operation of thebusiness by exercising voting rightsthat accompany stock ownership.A solution may involve transferringthe stock to a trust for the recipientspouse’s benefit.IRC Section 682 specifies rules applicableto alimony trusts. A specified sum is set asideto be paid to the former spouse. The amountin excess of the specified sum (interest on theprincipal) reverts back to the person fundingthe trust. The recipient of the specified sumis taxed on the amount received, just as shewould be taxed on alimony payments. Once34<strong>Fall</strong> <strong>2009</strong>
Husband transfers the principal amount to the trust, he nolonger pays tax on the earnings. However, he does not get adeduction for the funds transferred to the trust.Example 1:Husband and Wife have decided to divorce. Wife willhave primary physical custody of the parties’ two minorchildren. Husband agrees to pay child support in theamount of $1,200 per month for each child until each childis 18 years old, for a total of $2,400 monthly. When the firstchild reaches the age of 18 years, Husband will pay $1,200per month in child support. If Husband pays $2, 400 directlyto Wife, he does not get a tax deduction nor does Wifeinclude the amount in her income. Instead, Husband canfund an alimony trust with a sufficient amount to produce aminimum of $28,800 annually ($2,400monthly child support multiplied by12 months), with the trust setting outthe requirement that the trustee payWife $2,400 monthly so long as bothchildren are under 18 andthe amount to be reduced to$1,200 monthly when onechild reaches the age of 18years. The trust would alsoprovide that any annualtrust income in excess of$28,800 is to be paid toHusband. Wife will not betaxed on trust income that isspecifically classified as childsupport in the divorce decreeor separation agreement.Example 2:Husband agrees to payWife monthly alimony in theamount of $1,000 for 5 years.Instead of making monthlypayments directly to Wife,he sets up an alimony trustwith Wife as the beneficiary,funding it with enoughassets to generate $12,000a year for a total of $60,000over the next 5 years ($1,000/mo x 12 months x 5 years).Each year Wife will pay taxon $12,000 that she receivesannually; $12,000 per yearis excluded from Husband’sgross income (receiving thesame benefit as if he hadthe alimony deduction).However, Husband willhave the additional benefitof enjoying the increase inthe trust principal (the amount earned on the principal inexcess of the $12,000 paid to Wife). Further, if Husbandis responsible for the total of $60,000 over 5 years, hecould create the trust with a corpus well below $60,000 ofprincipal at the inception of the trust. Because the trust ispaying out $1,000 the first month, the remaining corpuscontinues to earn interest income. Thus, the time value ofmoney concept reduces the amount of corpus needed toinitially fund the trust to satisfy the alimony obligation.Alimony trusts are governed by section 682(a) ofthe Code and, in terms of deduction and inclusion,produce results similar to those under regular alimonyarrangements. Trust distributions are excluded fromtransferring spouse’s gross income (giving Husband/transferring spouse the same benefit as if the amount wasincluded in his income and then deducted as alimony), arenot subject to alimony recapture, can continue after therecipient spouse/trust beneficiary’s death and are taxable tothe recipient/trust beneficiary spouse (with the exceptionnoted below).Section 682 sets out specific requirements for thealimony trust. The trust applies to people who aredivorced or legally separated pursuant to a divorce degree,separate maintenance decree or separation agreement.Trust distributions paid to the recipient/beneficiaryspouse (Wife) are includable in her gross income anddeductible from payor/Husband’s gross income. Thereis one notable exception. When amounts are specificallydesignated as child support in the divorce decree orseparation agreement, those distributions are treated as ifthey were received by the payor/Husband and then paiddirectly by him to the recipient/Wife. As a drafting tip,when a trust will make both child support and non-childsupport distributions, it is imperative that the trust termsspecifically designate the character of the distributions(child support or alternative support) to avoid taxconsequences to the recipient/Wife.Clearly, the alimony trust is not appropriate for allclients. However, it is a good planning vehicle for clientswho have sufficient assets to fund a settlement, particularlywhere either of the parties is concerned about the otherspouse’s financial stability. FLRMartin S. Varonmvaron@armvaluations.comSue K. Varonsvaron@armvaluations.comAlternative Resolutions Methods, Inc.770-801-7292www.armvaluations.com35<strong>Fall</strong> <strong>2009</strong>