Cross-Border Alimony Trusts for Hong Kong Americans: Section 682 Trust Taxation After Divorce

The repeal of IRC § 682, effective for divorce or separation instruments executed after December 31, 2018, and for pre-2019 instruments modified after that date, has fundamentally altered the tax treatment of alimony trusts for Hong Kong-based American citizens and Green Card holders. This change, enacted under the Tax Cuts and Jobs Act (TCJA) of 2017, removed the long-standing rule that allowed a trust grantor to shift the tax burden on trust income paid to a former spouse from the grantor’s tax return to the recipient’s. For a US person resident in Hong Kong, where the territorial tax system does not offer a mirroring deduction for alimony paid, the loss of § 682 creates a structural mismatch: the grantor may still be taxable on trust income under the grantor trust rules (IRC §§ 671-679), while the former spouse receives distributions that are now tax-free to them but potentially subject to US gift tax or generation-skipping transfer (GST) tax consequences. The 2025 IRS examination priorities, as outlined in the IRS’s annual “Dirty Dozen” list and the Large Business & International (LB&I) division’s compliance campaigns, continue to target high-wealth individuals using trusts to shift income, including cross-border alimony arrangements. Hong Kong Americans who established alimony trusts before 2019 or who are considering post-divorce financial settlements must now navigate a landscape where the trust’s classification—grantor vs. non-grantor—and the source of the trust’s assets (US situs vs. foreign situs) determine the US tax outcome, with Hong Kong’s absence of an alimony deduction adding a layer of cross-border friction.

The Repeal of § 682: A Structural Shift for Alimony Trusts

The TCJA’s repeal of IRC § 682 applied to any divorce or separation instrument executed after December 31, 2018, and to any pre-2019 instrument that was “expressly modified” after that date to reflect the new law. For Hong Kong Americans, this means that alimony trusts created or modified after the effective date no longer benefit from the income-shifting mechanism that § 682 provided. Under the old regime, a trust that paid income to a former spouse pursuant to a divorce instrument was treated as two separate trusts: one for the spouse (taxable on the income distributed) and one for the grantor (taxable on retained income). The repeal collapses this structure, so that the grantor trust rules under IRC § 677—which treat the grantor as the owner of any portion of a trust whose income may be distributed to the grantor or the grantor’s spouse—now apply if the trust retains any connection to the grantor, such as a power to revoke or a retained beneficial interest.

The Grantor Trust Trap for Hong Kong Residents

For a US citizen living in Hong Kong, the grantor trust rules are particularly pernicious because the trust’s income is taxable to the grantor regardless of whether the income is distributed to the former spouse or accumulated in the trust. Under IRC § 677(a), the grantor is treated as the owner of any portion of a trust whose income, without the approval or consent of an adverse party, may be distributed to the grantor or the grantor’s spouse. After the repeal of § 682, a trust that pays alimony to a former spouse but retains a power in the grantor to alter the trust’s terms—a common feature in Hong Kong trust deeds drafted by offshore trustees—triggers grantor trust status for the entire trust. The result: the grantor reports all trust income on their US tax return (Form 1040), even if the income is physically paid to the former spouse in Hong Kong. The Hong Kong Inland Revenue Ordinance (Cap. 112) does not allow a deduction for alimony paid, per the territorial source principle (Section 12(1)(a) excludes personal expenses from deductions), so the grantor bears the full US tax burden without any offsetting Hong Kong tax benefit.

The Post-2018 Alimony Trust: A Case Study in Double Taxation

Consider a Hong Kong American who established a trust in 2020 to pay HKD 1,200,000 (approximately USD 153,600 at the 2024 average exchange rate of 7.82) per year to a former spouse residing in Hong Kong. The trust holds a portfolio of US dividend-paying stocks and Hong Kong-listed REITs. Under the pre-2019 rules, the former spouse would have reported the distributions as alimony income on their US tax return (Form 1040, Line 11), and the grantor would have deducted the same amount. Post-2018, the grantor is taxable on all trust income under IRC § 677, because the trust instrument likely gives the grantor a power to replace the trustee or veto distributions—a “power of appointment” that triggers grantor trust status under IRC § 674. The US dividends are subject to a 30% withholding tax if the trust is a foreign trust (as defined under IRC § 7701(a)(31)), but if the trust is a US trust with a Hong Kong trustee, the grantor must gross up the income on Form 1040 and claim a foreign tax credit for any Hong Kong profits tax paid—though Hong Kong’s territorial system typically exempts foreign-source dividends from tax, creating a mismatch in foreign tax credit availability.

Trust Classification: US vs. Foreign Trust for Hong Kong Americans

The classification of an alimony trust as either a US trust or a foreign trust under IRC § 7701(a)(30) and (31) determines the filing obligations, tax rates, and reporting requirements for the grantor and the former spouse. A trust is a US trust if (1) a US court can exercise primary supervision over its administration (the “court test”) and (2) one or more US persons have the authority to control all substantial decisions of the trust (the “control test”). For a Hong Kong American, this typically means that a trust with a Hong Kong trustee and a Hong Kong situs of assets fails the court test, making it a foreign trust. However, if the grantor retains a US-based investment advisor who makes all investment decisions, the control test may be satisfied, potentially reclassifying the trust as a US trust—a result that the IRS has scrutinized in recent examinations.

Foreign Trust Reporting: Form 3520 and Form 3520-A

A Hong Kong American who is the grantor of a foreign alimony trust must file Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts) if the trust makes distributions to the grantor or the former spouse, or if the grantor transfers assets to the trust. The penalty for failure to file Form 3520 is 35% of the gross value of the property transferred or distributed, per IRC § 6677. For the 2025 tax year, the IRS has indicated that Form 3520 will be a focus of the LB&I’s “High Wealth” compliance campaign, which targets individuals with assets over USD 10 million. Additionally, if the trust is a foreign trust with a US grantor, the trust itself must file Form 3520-A (Annual Information Return of Foreign Trust with a US Owner), which requires detailed disclosure of the trust’s income, assets, and beneficiaries. The trust’s Hong Kong trustee must appoint a US agent for service of process, or the IRS may assess a penalty of 5% of the trust’s gross assets per month (up to 30% total) under IRC § 6677(c).

The US-China Tax Treaty and Alimony Trusts

For Hong Kong Americans who are also tax residents of Mainland China or who have former spouses residing in Mainland China, the US-China Tax Treaty (Article 18, “Pensions, Annuities, Alimony, and Child Support”) provides that alimony paid by a resident of one Contracting State to a resident of the other Contracting State is taxable only in the recipient’s country of residence. However, this treaty applies only to “alimony and other similar payments” that are periodic and made under a written separation agreement or decree of divorce. For a Hong Kong American, the treaty does not apply to Hong Kong because the US-Hong Kong Tax Information Exchange Agreement (TIEA) does not include a provision on alimony. This means that a US citizen living in Hong Kong cannot rely on the treaty to shift the tax burden to the former spouse’s country of residence, reinforcing the grantor trust trap described above.

State Tax Considerations for Hong Kong Americans

While Hong Kong has no state-level income tax, a Hong Kong American who retains a domicile in a US state—such as New York, California, or Florida—may face state tax consequences on alimony trust income. New York and California, for example, follow federal law for alimony deductions (i.e., they conformed to the TCJA’s repeal of the alimony deduction for post-2018 agreements), but they may still tax trust income based on the grantor’s residence. Under New York Tax Law § 612(b)(20), a New York resident is taxable on all trust income if the grantor is a New York resident and the trust is a grantor trust for federal purposes. For a Hong Kong American who spends more than 183 days in New York City or maintains a permanent place of abode there, the state may assert residency and tax the trust income at the state’s top marginal rate of 10.9% (2024 rate). California’s Franchise Tax Board (FTB) takes a similar position under California Revenue and Taxation Code § 17731, which treats a grantor trust as a “wholly grantor trust” and taxes the grantor on all income. For Hong Kong Americans who have moved to Hong Kong but retain a US driver’s license, voter registration, or property, the state’s residency audit division may challenge their non-resident status and impose tax on the alimony trust income.

The “Safe Harbor” of a Non-Grantor Trust

One strategy to avoid the grantor trust trap is to structure the alimony trust as a non-grantor trust, where the grantor relinquishes all powers over the trust, including the power to revoke, amend, or direct distributions. Under IRC § 674, a trust is a grantor trust if the grantor retains any power to “dispose of the beneficial enjoyment” of the trust’s income or corpus, unless the power is held by an adverse party. For a Hong Kong American, this means appointing an independent Hong Kong trustee—such as a licensed trust company under the Hong Kong Trustee Ordinance (Cap. 29)—who has sole discretion over distributions, and ensuring that the grantor has no power to replace the trustee (a “reserved power” that triggers grantor trust status under IRC § 674(c)). If the trust is a non-grantor trust, the trust itself files Form 1041 (US Income Tax Return for Estates and Trusts) and pays tax on its income at the compressed trust tax rates (the 37% bracket begins at USD 15,450 of taxable income for 2024). Distributions to the former spouse are then taxed to the spouse under IRC § 662, but the spouse receives a deduction for the distribution (the “distributable net income” or DNI rule under IRC § 661). For a Hong Kong resident former spouse, this means the spouse must file a US tax return to report the distribution, but may be able to exclude it under the foreign earned income exclusion (FEIE) if the spouse is a US citizen living in Hong Kong and meets the physical presence test (330 days outside the US per year). The 2024 FEIE cap is USD 126,500 per tax year, so a distribution of HKD 1,200,000 (USD 153,600) would exceed the cap, leaving the excess USD 27,100 subject to US tax.

Practical Takeaways for Hong Kong Americans

• Review any alimony trust created before 2019 to determine whether it was “expressly modified” after December 31, 2018; if so, the trust is subject to the new rules and the grantor must file Form 3520 and Form 3520-A annually, with penalties of 35% of gross transfers for non-compliance.
• For post-2018 alimony trusts, ensure the trust instrument contains no retained powers by the grantor (e.g., no power to replace the trustee, no power to veto distributions) to avoid grantor trust status under IRC § 674; appoint an independent Hong Kong trustee licensed under the Trustee Ordinance (Cap. 29) to satisfy the “adverse party” requirement.
• A Hong Kong American grantor of a foreign alimony trust must file Form 3520-A by March 15 of the following tax year (with a 6-month extension available), and the trust’s Hong Kong trustee must appoint a US agent for service of process to avoid the 5% per month penalty under IRC § 6677(c).
• State residency remains a trap: retain no US driver’s license, voter registration, or property in a high-tax state like New York or California, and maintain a diary of time spent in the US to substantiate non-residency under the 183-day rule.
• The US-China Tax Treaty Article 18 does not apply to Hong Kong; a former spouse residing in Hong Kong cannot rely on the treaty to exempt alimony from US tax, so consider a lump-sum settlement (tax-free under IRC § 1041 if between spouses) instead of a trust to avoid ongoing US reporting and tax liability.

本文不構成稅務建議。涉及個人稅務情況請諮詢持牌會計師或稅務師。 This does not constitute tax advice. Consult a licensed CPA or tax advisor for your specific situation.