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Practical Considerations in Representing the (Un)Happily Married (Pt. 2 of 3)

Aug 22, 2023 | General Estate Planning, Podcasts, T&E Administration, T&E Litigation

“Practical Considerations in Representing the (Un)Happily Married” is a three-part special:

  • Part 1, posted August 15, 2023
  • Part 2, posted August 22, 2023 (this podcast)
  • Part 3, posted August 29, 2023

“Practical Considerations in Representing the (Un)Happily Married,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. Estate planners often encounter challenging issues when representing married couples, ACTEC Fellow Sharon Klein of New York City will address practical considerations in representing once happily married couples who may now be headed towards divorce, and whether trust assets will be accessible by a former spouse as a result of the divorce.

In Part 2 of this three-part series, Sharon will discuss an important step in analyzing whether trust assets could be on the table in the divorce proceedings, which is the review and consideration of the history of the trust administration. Welcome, Sharon.

Introduction and Recap of Part One

Sharon Klein: Thanks so much, Travis, and I’m delighted to be back here for Part 2 of this three-part series addressing the question of whether trust assets are reachable in divorce. I want to start off by emphasizing my opening remarks in Part 1 of the series, that is to determine whether trust assets are accessible in divorce. The key question is generally whether the interests of the beneficiary spouse is a property interest that can be considered an asset under the relevant state’s law.

So, in Part 1, as you know, we examined what to look for in the governing trust document to see if trust assets are vulnerable in divorce. In this Part 2, as Travis mentioned, we’re going to examine what to look for in terms of the history of how the trust has been administered. And then, in Part 3, we’ll explore tax traps, creative planning techniques, and practice tips.

So, assuming you listened to Part 1 of the series, you know how important it is to review the trust document. As I mentioned then, when all else fails, read the instructions. And the instructions are the trust document. But, once you have done a thorough job reviewing the trust document, that’s only half the picture. The other half of the picture is to look at what actually happened, to consider the history of the trust administration, which of course, is the subject of this Part 2 of the podcast series.

Courts Consider the History of Trust Distribution

A court can consider the history of trust distributions to identify any patterns and consider whether couples have used trust funds to support their lifestyle. If they have used trust funds to support their lifestyle, it’s more likely that those funds are going to be reachable in divorce. If the distributions have been irregular and uneven, it’s less likely that they’ll be reachable in divorce.

A leading case in this arena is a case coming out of New Jersey, Tannen v. Tannen. And in that case, a wife’s parents established an irrevocable trust for their daughter’s sole benefit. The trustees, in their sole discretion, could make distributions for the wife’s health, support, maintenance, education, and general welfare, as they determined would be in her best interest, after taking into account her other financial resources. So, you kind of have a mish-mosh there of broad and ascertainable standards of distribution.

The trust had paid for certain marital expenses, including real estate taxes on the marital home, home improvements, and private school for the children. And the lower court imputed a $4,000 monthly trust distribution to the wife, but the Appellate Division reversed. And, at the Appellate level, the court’s driving inquiry was whether the wife’s interest was an asset held by her. In other words, we get back to that fundamental question – was it a property interest?

They also asked whether she had control over the trust income generation or the ability to tap the income source. The court noted there was no history of distributions directly to the wife and pointed to the settlor’s stated intent in the trust document. And, as I noted in Part 1 of this podcast series, the settlor’s intent is very important to the court. And, in this case, the settlor’s intent was evidenced by a provision that the wife shouldn’t be permitted under any circumstances to compel distributions of income or principal prior to the time of final distribution.

The settlor’s intent was also evidenced by the fact that the trust contained a spendthrift provision, which I previously described, prohibits a beneficiary from transferring their interests in the trust and provides that a beneficiary’s interest will not be subject to that person’s debts or liabilities.

The court also interpreted the fact that the wife had yet to receive a distribution from the trust, which had been in existence for seven years, as evidence that the wife did not have control over the trust or access to the income. And the court concluded that the trust assets would not be included in the marital estate or used to reduce the wife’s claim to alimony or child support.

So, the history, as well as the trust distributions, are very important. On the other hand, I should mention that although the trust was not taken into account for division purposes or alimony and child support in the Tannen case, sometimes courts have treated alimony and child support differently. And if a divorcing spouse receives distributions on a regular basis, courts have considered those distributions and the expectancy that they will continue when calculating alimony and child support. Particularly if the distributions have funded a couple’s lifestyle.

I would also like to point out here that an important lesson, I think, to be learned from many of the cases in this arena is that although trusts afford great protection in divorce – and, of course, trusts are advisable for a myriad of other tax and planning reasons – nothing really replaces a well-drafted prenuptial agreement. And the combination of trusts and prenuptial agreements is a very powerful one. In other words, establishing trusts to protect assets and then disclosing them in the prenuptial agreement.

Prenuptial Agreements Protecting Trust Assets

And, where people do have prenups and trusts are involved – which, as I mentioned, I think is a great combination – and they disclose their trust interests in the prenup, which generally you need to do to have an enforceable prenup, it’s typically advisable to have comprehensive disclosure.

So, where people disclose trusts, a common mistake that I see in prenups is people admitting that their trust interests are their separate property. So, why is that a mistake? Because, recall, the crux of the issue as to whether a trust interest is reachable in divorce, is whether that interest is a property interest at all. That’s the foundational question. Because if the trust interest is a property interest, even if it’s a separate property interest, it may be subject to a claim for appreciation. But, if it’s not property, if it’s purely a discretionary trust interest, there might not be a basis for any claim. So, it might be a big mistake to describe a discretionary trust interest as separate property.

And the implications become particularly stark when you, for example, consider you might have one spouse running a family business that’s in a trust. And the business interests may have wildly appreciated during the course of the marriage, but you could argue that there can’t be any claim against a purely discretionary trust because that’s not a property interest susceptible to division. But if you had admitted that the trust was a separate property interest, the trust may be subject to a claim for appreciation.

Some attorneys I know actually create a category in their prenups called, “Trust Interests,” and they specifically disclose the trust interests and they specifically say that they are not property interests. So, a practice tip right there.

Trusts Created During the Marriage

Now, particularly in the context of trusts created during a marriage, by parties to the marriage, a very common question is whether marital assets transferred into an irrevocable trust during the marriage, lose their character as marital property. In other words, once they’re transferred to a trust, are they off the marital balance sheet? There have been many cases that have held that where an irrevocable trust is set up for the benefit of third parties by spouses, and neither spouse is a trustee, neither spouse has a beneficial interest, neither spouse has any control over the trust assets, that a court may not dispose of it. Even if one or both of the spouses created or funded it.

However, then you get a case like the Yerushalmi case coming out of New York, where the Appellate Division of the New York Supreme Court found that a residence that had been transferred to a trust was still marital property. So, the parties, in that case, had created a QPRT, a Qualified Personal Residence Trust, which is a very common estate planning technique where a home is transferred to a trust, and the trust creator reserves the right to live there for a term. And at the end of the term, the residence goes to other beneficiaries.

And if you would’ve asked me, “Is this home included in the marital balance sheet?” I would’ve said, “Of course not, duh, the parties don’t own it, it’s owned by the trust.” And that, actually, is exactly what the Supreme Court said. They said the marital residence was not a marital asset because it was owned by the QPRT and not the parties.

However, the Appellate Division reversed and said that since the marital residence was purchased by the parties during their marriage using marital funds, it was presumed to be marital property. And, according to the court, the fact that title had been transferred to the QPRT – and I’m quoting the court, “Allegedly for estate planning purposes, while the parties continued to reside there was, under the circumstances, insufficient to rebut the presumption.”

Now, the holding of that case was shocking to me, and I’m sure all of you listeners out there are shocked as well, right? A perfectly legitimate estate planning technique disregarded, shocking. In any event, apparently, what happened there is that under the particular facts of that case, it would’ve been inequitable for the residences to be off the marital balance sheet. So, the court seemingly backpedaled to the result that they wanted.

And the moral here, and I think it applies in many other cases – where, as a trust and estates attorney, you may be scratching your head at the results – the moral is that while legitimate estate planning should, and thankfully is often respected, at the end of the day, the family court is a court of equity. And planning is not going to stop a matrimonial attorney from at least trying to poke holes in the planning, to tell a story, to show vulnerability, and convince a court of equity why trust assets should be considered.

Now, in support of my theory that at the end of the day, a court of equity is just trying to be fair, consider another New York case where a residence and a QPRT were also an issue and the court reached a completely different result. In the Villi case, the court respected the QPRT and said that the residence was off the marital balance sheet. According to the court, what the parties accomplished by transferring their home to the trust was akin to the making of the gift of the home to the wife’s son, who was the ultimate beneficiary, subject only to the condition that both parties could reside in the home during their lifetimes. So said the court, “The home no longer constitutes marital property.”

Conclusions

The lesson? At the end of the day, while legitimate estate planning should be respected, be aware that matrimonial attorneys may try to persuade the court to consider the equities of a situation. And something that trust and estates attorneys might think is ironclad planning might not be so ironclad to a family court judge.

Travis Hayes: Thank you, Sharon, for educating us on issues relating to the accessibility of trust assets in a divorce. Stay tuned for the final part of ACTEC’s ongoing series on this topic.

 

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