Marriage, Divorce and Asset Protection
“Marriage, Divorce and Asset Protection,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Susan Snyder, ACTEC Fellow from Chicago. We’ll be hearing today from Sharon Klein, ACTEC Fellow of New York City, giving us three tips for asset protection in the context of marriage and divorce. Welcome Sharon.
Thanks, Susan. I appreciate being here. And as you mentioned, I’m going to give people three tips for asset protection. Two tips for before the marriage and one tip after the marriage in the context of divorce.
First of all, people might not realize, but they have a very important asset to negotiate a prenuptial agreement with the Deceased Spousal Unused Exemption (DSUE) amount. And that amount is, of course, portable and the portability of that amount makes it a very valuable asset to consider when negotiating a prenuptial agreement. As we know, the exemption amounts this year are at all-time highs at $11.4 million, and to the extent one spouse doesn’t use the whole exemption amount, they could port it to the surviving spouse. And that ported exemption amount can be a great asset with which to negotiate a premarital agreement.
So, for example, take a husband and a wife who are in that position, negotiating a premarital agreement. Let’s assume he has assets totaling $24 million and she only has assets of $1 million, which would pass to her heirs, other than her husband, leaving $10.4 million of the Deceased Spousal Unused Exemption amount, or DSUE, based on the 2019 $11.4 million amount.
Generally, where you had a couple where one spouse was much wealthier than the other spouse, in my case the husband, he generally wouldn’t ask for any financial consideration from his wife, because of the imbalance of the assets tilted in his favor. However, consider if the wife in this example predeceases her husband, and her executor, who could be the husband, elects to use portability; then her $10.4 million DSUE amount would pass to him. Assuming he also dies in 2019, with the top 40 percent federal estate tax rate and his $11.4 million exemption amount, having her additional exemption amount to shield estate taxes in his estate could save his heirs about $4 million in estate taxes. So that’s real money and very important for the non-moneyed spouse even if she didn’t think she had an asset to negotiate with, she actually has a very valuable asset. And, of course, the wealthiest spouse would also view that asset as an important asset with which to negotiate.
Of course, in order to get the ported amount that requires that a federal estate tax return be filed [Form 706], and in order to prevent a recalcitrant executor from spitefully refusing to file, the requirements to file the 706 or the estate tax return should be documented in the prenuptial agreement because the individual who files the federal estate tax return is not the surviving spouse; it’s the executor who may or may not be the surviving spouse. So, very important to document that obligation in the premarital agreement.
Asset Protection Trust
Another great technique to use pre-marriage is the asset protection trust, which is an irrevocable trust created in a jurisdiction that sanctions those types of trusts. So, in many jurisdictions, it’s not possible for a person to create a trust for himself or herself, and have it protected from creditors. In several jurisdictions including Delaware, it’s possible for an individual to create a trust for himself or herself and protect it from that individual’s creditors and remain a beneficiary. So, for example, in Delaware the settlor can continue to receive current income distributions, receive an annual unitrust payment of up to 5 percent, and retain the ability to receive income or principal in the discretion of an independent trustee.
The reason to do this is that there are many obstacles to overcome in order to pursue a claim against the Delaware asset protection trust. For example, the claim needs to be brought in the Delaware Court of Chancery; there’s a four-year statute of limitations; the creditor has to prove by clear and convincing evidence that the trust was a fraudulent transfer as to that particular creditor. And there are a very limited number of creditors who can pursue a claim against a Delaware asset protection trust.
So, in the family context, a spouse, a former spouse or a minor child who has a claim from an agreement or court order for alimony, child support or a property division can try to pursue a claim against the Delaware asset protection trust. But importantly, a future spouse cannot generally assert a claim against such a trust. So, if a client or a client’s children create such a trust, it can protect the assets from claims of future spouses way down the road. And of course, then you don’t need the financial disclosure that’s ordinarily required for an enforceable prenuptial agreement.
When you’re doing a trust like this, most practitioners recommend having an independent corporate trustee who has broad discretion to make distributions to a class of beneficiaries instead of predicating distributions on an ascertainable standard, since a court would be much less likely to find such a discretionary interest reachable in divorce. Some practitioners that I heard are also recommending putting a provision in the document, which requires a beneficiary’s spouse to waive marital rights to trust assets each time that beneficiary becomes eligible to receive a principal distribution as a prerequisite for making that distribution. I actually reviewed a trust agreement this week that contained a provision in it which said that the trustee can only make distributions to a beneficiary if the beneficiary’s spouse has signed a marital agreement that the trustee approves of. So, a couple of interesting practical tidbits to make sure that those documents are as divorce-proof as possible.
Estate Taxes, Marriage and Divorce Agreements
Susan, the final tip I want to give is in the context of divorce. So after marriage, and it deals with a recent change to the tax law that was enacted as part of the Tax Act on December 22, 2017, and it deals with the taxation of trust income following divorce. So ordinarily, as we know, when a grantor creates a so-called grantor trust there is substantial income tax savings associated with that technique. The grantor continues to be liable to pay the taxes associated with the trust, even though he or she has irrevocably given away the assets. And the reason to do that is, of course, it’s great estate planning, because to the extent the grantor pays the taxes associated with the trust, the trust beneficiaries are relieved of that tax obligation. There are a number of powers that you could put in a trust in order to trigger grantor trust status. Additionally, under Section 677(a)(1) of the Internal Revenue Code, a grantor is treated as the owner of any portion of a trust if the income from the trust can be distributed to the grantor or the grantor spouse (ACTEC Comments on Guidance in Connection with the Repeal of Section 682 – July 2, 2018).
Under the so-called spousal unity rule, which is Internal Revenue Code Section 672(e)(1), a grantor is treated as holding any power or interest held by an individual who was the grantor’s spouse at the time the power or interest was created. So, let’s just repeat that. A grantor holds any interest held by the grantor’s spouse, if that person was the spouse at the time the interest was created, which means that if the couple subsequently gets divorced, the spousal unity rule continues to apply and the trust continues to be a grantor trust, meaning the grantor would still be liable to pay the income taxes associated with distributions to a beloved ex-spouse, which is, of course, a horrendous result. So, Section 682 of the Internal Revenue Code used to come to the rescue. And that section of the code provided that, after a divorce, the ex-spouse would have to include the income in her income; it would be taxable to her not to the grantor. So that saved the day and made it a result that everyone surely had anticipated.
The problem is that the Tax Act of 2017 repeals section 682 for divorce or separation agreements executed after December 31, 2018. That means that if the divorce or separation instrument is executed after that date, section 682 does not apply to trusts created when the grantor and the spouse were married. So note the effective date is tied to the divorce or separation agreement, not to the date the trust was created; which means if trusts were created before January 1, 2019, and they could have been created any time a decade ago or more, if the divorce or separation agreement is signed after January 1 of 2019, those trusts will be caught and section 682 will not apply, and the grantor will continue to be taxed on distributions to an ex-spouse.
So how do you fix that? Well, there are a number of techniques people can consider, being mindful of the fact that if it’s a trust for which the marital deduction was granted, you want to be scrupulously careful not to jeopardize that. But with that backdrop, seeing whether maybe you could distribute the assets outright to a spouse, an ex-spouse, and equalize with other assets; perhaps you can decant the trust to beneficiaries other than the spouse, the ex-spouse, and then equalize with other assets as well. Or perhaps the best way to deal with it is in a marital agreement, when you could factor in the increased tax liability of the grantor and make the grantor whole either with a reimbursement provision or again equalization, with some other assets. But this is where it’s key for matrimonial attorneys to partner and collaborate with trusts and estates attorneys, because it’s going to be very important to identify old trusts that were created during the marriage to evaluate and deal with the future tax impact.
Thanks, Sharon. Thank you for those great tips on asset protection, pre-marriage, for married couples and divorcing couples.
If you have ideas for a future ACTEC Trust & Estate Talk topics, please contact us at ACTECpodcast@ACTEC.org.