Trusts and Divorce

The simplest trust has often occurred when a parent (or the will of a deceased parent) establishes a trust for the parent's child ' in this case, Wife ' and names an independent person, or even Wife as a trustee or co-trustee. The rights Wife may be granted in the trust agreement might expose the trust assets to divorce by letting your client, Husband, step into Wife's “trust” shoes and have her exercise those rights.

These types of trusts were traditionally structured to end with distributions of trust principal at specified ages, for example, principal may have been directed to be distributed to Wife by 1/3 at ages 25, 30 and 35. At these end points any protections that the trust afforded Wife will terminate as to the portion of the trust distributed to her. Thus, you might be able to assist Husband in reaching the assets distributed, or income earned on those distributed assets, for matrimonial settlement purposes, depending on state law and whether the trust assets are immune or not.

Protection from Divorce

So long as assets remain in the trust they have some measure of protection from divorce, but even that protection may prove ephemeral. For example, in these types of trusts, it is common for Wife to have been made a co-trustee or even sole trustee, and granted the right to distribute principal and/or income to herself in accordance with an “ascertainable standard,” the tax equivalent to a standard of living. If the Wife's right to distribute to herself was limited to an ascertainable standard, the principal of the trust might have avoided inclusion in her estate for tax purposes. If a power may be exercised only in accordance with an ascertainable standard relating to Wife's health, education, support, or maintenance, it is not treated as a general power of appointment for tax purposes. If it is not treated as a general power, it will not create exposure to the estate tax. IRC Sec. 2041(b)(1)(A). This tax paradigm, however, could undermine a significant portion of the protection the trust might have otherwise afforded in a matrimonial action. If Wife can make distributions to herself, how might the court consider this power in light of the pending matrimonial action?

'Health, Education, Maintenance and Support'

A common phrase used in trust documents where distributions are limited is to permit distributions to meet “health, education, maintenance and support” or “HEMS.” The assets of a HEMS trust might be susceptible to challenge, depending on state law, by arguing that the Wife's standard of living, the “maintenance and support” component of HEMS, should include payment of child support, perhaps even alimony. The meaning of “support” under the tax law is not limited to the bare necessities of life. It includes other reasonable living expenses, but it does not necessarily extend to all expenditures that might be considered customary in the decedent's position in life.” The ability to access the trust assets is greater where the trust provides that the trustee “shall pay,” rather than the discretionary “may pay,” to herself.

The traditional trust might give Wife the right to income. This could be done by including in the trust agreement a mandate that income must be distributed currently (often after she attains a specified age, say 18 or 21). This income right might expose the actual income, or an estimated income stream, to the reach of your client, Husband, in the matrimonial action by considering it a resource in setting maintenance for Wife, in setting child support, etc. Certainly, once the income is paid, or Wife has the right to it, it is an asset of Wife.

'Crummey' Power

The traditional heir's trust typically includes a demand power to assure that gifts to the trust qualify for the annual gift tax exclusion. The trust beneficiary, Wife, is given a period of time, typically 30-60 days, to demand the distribution of funds. This gives Wife the immediate right to the money given, so that the donor can realize a favorable gift tax result. This is done to preserve the parent/grantor's lifetime gift exemption of $1 million (but for the withdrawal right the donor would use up a portion of his/her lifetime gift exemption on each gift made to the trust). These powers are often referred to as “Crummey” powers after the case that first sanctioned them. Crummey v. Comm'r, 397 F2d 82 (9th Cir. 1968). Crummey powers may provide another mechanism of attack for a matrimonial practitioner. A Crummey power permits the beneficiary to demand a distribution of the amount given in a particular year to the trust, typically the annual gift exclusion ($13,000 in 2009) or a multiple of that if there are multiple donors. Can you use the existence of a Crummey power to Husband's advantage in a matrimonial action to expose trust assets? Certainly during the period when Wife has the power to withdraw trust money or assets, the amount she can withdraw is exposed. After the power lapses, the argument to advance is that Wife could have withdrawn the funds, but opted not to. Only by virtue of Wife's inaction have the funds remained in the trust. This line of argument cannot change the reality that the funds are gift assets that should be immune. Example: Wife's parents established a trust for Wife and contribute $13,000 each to the trust for Wife's benefit. The trust includes a Crummey power to qualify those gifts for the parent's annual gift exclusion. Wife signs a notice issued to her by the trustee acknowledging she has the right to withdraw the money (standard procedure for Crummey powers), but then does not withdraw the $26,000. Wife's parents have made gifts for more than a dozen years with no withdrawals. If Wife could have taken the $26,000, and a history of such gifts exists, does that impact the dynamic of the settlement negotiations?

'5 and 5 Power'

A final power often granted in many traditional heir trusts is a so called “5 and 5 power.” This is a right given to the beneficiary of a trust to demand in any year, a distribution that is the greater of 5% of the trust corpus, or $5,000. This measure is used to limit such demand rights because the rules for general powers of appointment exempt the lapse of a withdrawal power from having any estate and gift tax consequences to the extent that the value of the property that can be withdrawn does not exceed the above limits. Thus, Wife could be given the right to withdraw the greater of 5% of her trust, or $5,000 each year, and the remainder of her trust's assets would not be included in her estate. IRC Sec. 2041(b)(2) and 2514(e). The existence of such a power might provide another shoehorn into trust assets. Remember, many of the traditional trusts for a child, grandchild or other heirs, were written to address the client's concern that maximum access to the trust be permitted. This paradigm makes these trusts easier to pierce in a matrimonial action then the trusts described below. If Wife has the unfettered ability to withdraw 5% of the trust principal in each year, without any restriction, that amount of money could be argued to be available to her in each year in negotiating the financial aspects of the matrimonial case.

Status After Divorce

Apart from beneficiary status, will the Wife or her family members remain trustees or other fiduciaries after the divorce? If a trust was established to fund college for the children of the marriage, and Wife and her family control investment and distribution provisions of the trust, this could have a significant impact on later decisions that affect not only the children, but Husband as well. Therefore, the possible resignation or removal of trustees or successor trustees should be addressed in the divorce negotiation process if feasible. In some trusts, the draftsperson may have reserved to the grantor the power to remove and replace trustees and that power may trump any modifications of trustees you attempt during the divorce process. This power has been used more often since the IRS held that the power would not cause the assets of the trust to be taxable in the grantor's estate (Wife's parent in our example). Rev. Rul. 95-58, 1995-2 CB 191, 8/04/1995. 1686WDS.

Basic Insurance Trust

One of the most common trusts encountered by matrimonial practitioners, especially since 529 plans have replaced many of the common children or education trusts, is the irrevocable life insurance trust (“ILIT”). A typical insurance trust will generally be similar to the basic or traditional heir's trust discussed above, but there are commonly differences that could be significant in a matrimonial context.

ILITs tend to be formed by the husband and wife who are insured so they are more likely to include marital rather than immune assets.

If insurance will be purchased on Wife's life, Wife will typically create the ILIT (Wife is said to be the “grantor”) and often, Husband will be a co-trustee with certain powers and rights. This is quite different from the traditional heir's trust in which your client, Husband, is not named in any capacity.

A few ILITs include a “floating spouse” clause, which provides that the person married to the specified heir at the point at which a distribution is to be made will be a beneficiary. When this approach is used, even if Husband is named in the trust as both a co-trustee and beneficiary, the divorce may by terms of the trust, terminate both. The difficulties in enforcing any rights will be exacerbated, if not prevented, by such a clause. This could be significant if the trust has a cash value insurance policy with significant worth.

Another mechanism that some trust attorneys use is to include a clause in the ILIT that provides that if a divorce judgment is entered into between grantor and grantor's spouse, then the grantor's spouse will be deemed to have predeceased the grantor. This type of clause could similarly undermine later plans to use the insurance held in the particular trust to meet divorce obligations. If Wife is not then insurable (or insurable only at substantially increased rates) meeting her divorce insurance obligations to Husband could be costly or even impossible. It may be possible for the Husband to buy the policy from the trust to preserve favorable rates. This type of transaction, however, raises a host of issues.

State Law

Even if the ILIT is silent, some states' laws automatically terminate the divorced spouse's interests as a beneficiary in insurance on the then ex-spouse's life. If such a state law presumption was not overridden in the ILIT, the spouse will not be a beneficiary. Consequently, silence in this scenario, may not prove golden for your client.

The conclusion of this article will discuss GST Trusts, Grantor Trusts and Beneficiary Defective Trusts.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site, http://www.laweasy.com/, has information on matrimonial, investment and related matters. Richard A. Oshins is a member of the Las Vegas law firm of Oshins & Associates, LLC, where he concentrates in tax and estate planning with a substantial emphasis on multi-generational wealth planning particularly with regard to closely held businesses. He was a member in the Estate Planning Hall of Fame.

Wealthy taxpayers have commonly used trusts to achieve a variety of tax, estate, asset and divorce protection, and other goals. What might loosely be called “traditional” trusts, typically done by a parent or other benefactor for a child to safeguard funds for college, and the insurance trust, which is nearly ubiquitous in estate planning, have been the most common types of trusts. These trusts present a number of issues to matrimonial practitioners. More recently, grantor trusts, and variations of them such as self-settled domestic asset protection trusts (“DAPTS”) or dynasty trusts targeted to plan for the generation-skipping transfer (“GST”) tax, have become more common. These present more complex and thorny issues in a divorce context. Matrimonial practitioners need to have some understanding of common long-standing trust techniques and some of the new ones in order to advise clients through a divorce involving such trusts.

The following two-part discussion begins with the simplest of trusts and progresses through more sophisticated trust techniques, highlighting the issues that may arise at each phase. The simplicity of the progression below might be more understandable framework for non-estate planners forced to address these matters. Trusts can be assembled, like an erector set, in myriad ways, each with its own nuances. To simplify the discussion, assume that you, the reader, represent the husband (“Husband”), and that the wife is involved with the particular trust in question as beneficiary, grantor, etc. (“Wife”). The purpose of this article is to raise practical ideas and considerations for matrimonial practitioners to consider and not to provide an analysis of current matrimonial case law on these matters.

Traditional Heir's Trust

The simplest trust has often occurred when a parent (or the will of a deceased parent) establishes a trust for the parent's child ' in this case, Wife ' and names an independent person, or even Wife as a trustee or co-trustee. The rights Wife may be granted in the trust agreement might expose the trust assets to divorce by letting your client, Husband, step into Wife's “trust” shoes and have her exercise those rights.

These types of trusts were traditionally structured to end with distributions of trust principal at specified ages, for example, principal may have been directed to be distributed to Wife by 1/3 at ages 25, 30 and 35. At these end points any protections that the trust afforded Wife will terminate as to the portion of the trust distributed to her. Thus, you might be able to assist Husband in reaching the assets distributed, or income earned on those distributed assets, for matrimonial settlement purposes, depending on state law and whether the trust assets are immune or not.

Protection from Divorce

So long as assets remain in the trust they have some measure of protection from divorce, but even that protection may prove ephemeral. For example, in these types of trusts, it is common for Wife to have been made a co-trustee or even sole trustee, and granted the right to distribute principal and/or income to herself in accordance with an “ascertainable standard,” the tax equivalent to a standard of living. If the Wife's right to distribute to herself was limited to an ascertainable standard, the principal of the trust might have avoided inclusion in her estate for tax purposes. If a power may be exercised only in accordance with an ascertainable standard relating to Wife's health, education, support, or maintenance, it is not treated as a general power of appointment for tax purposes. If it is not treated as a general power, it will not create exposure to the estate tax. IRC Sec. 2041(b)(1)(A). This tax paradigm, however, could undermine a significant portion of the protection the trust might have otherwise afforded in a matrimonial action. If Wife can make distributions to herself, how might the court consider this power in light of the pending matrimonial action?

'Health, Education, Maintenance and Support'

A common phrase used in trust documents where distributions are limited is to permit distributions to meet “health, education, maintenance and support” or “HEMS.” The assets of a HEMS trust might be susceptible to challenge, depending on state law, by arguing that the Wife's standard of living, the “maintenance and support” component of HEMS, should include payment of child support, perhaps even alimony. The meaning of “support” under the tax law is not limited to the bare necessities of life. It includes other reasonable living expenses, but it does not necessarily extend to all expenditures that might be considered customary in the decedent's position in life.” The ability to access the trust assets is greater where the trust provides that the trustee “shall pay,” rather than the discretionary “may pay,” to herself.

The traditional trust might give Wife the right to income. This could be done by including in the trust agreement a mandate that income must be distributed currently (often after she attains a specified age, say 18 or 21). This income right might expose the actual income, or an estimated income stream, to the reach of your client, Husband, in the matrimonial action by considering it a resource in setting maintenance for Wife, in setting child support, etc. Certainly, once the income is paid, or Wife has the right to it, it is an asset of Wife.

'Crummey' Power

The traditional heir's trust typically includes a demand power to assure that gifts to the trust qualify for the annual gift tax exclusion. The trust beneficiary, Wife, is given a period of time, typically 30-60 days, to demand the distribution of funds. This gives Wife the immediate right to the money given, so that the donor can realize a favorable gift tax result. This is done to preserve the parent/grantor's lifetime gift exemption of $1 million (but for the withdrawal right the donor would use up a portion of his/her lifetime gift exemption on each gift made to the trust). These powers are often referred to as “Crummey” powers after the case that first sanctioned them. Crummey v. Comm ' r, 397 F2d 82 (9th Cir. 1968). Crummey powers may provide another mechanism of attack for a matrimonial practitioner. A Crummey power permits the beneficiary to demand a distribution of the amount given in a particular year to the trust, typically the annual gift exclusion ($13,000 in 2009) or a multiple of that if there are multiple donors. Can you use the existence of a Crummey power to Husband's advantage in a matrimonial action to expose trust assets? Certainly during the period when Wife has the power to withdraw trust money or assets, the amount she can withdraw is exposed. After the power lapses, the argument to advance is that Wife could have withdrawn the funds, but opted not to. Only by virtue of Wife's inaction have the funds remained in the trust. This line of argument cannot change the reality that the funds are gift assets that should be immune. Example: Wife's parents established a trust for Wife and contribute $13,000 each to the trust for Wife's benefit. The trust includes a Crummey power to qualify those gifts for the parent's annual gift exclusion. Wife signs a notice issued to her by the trustee acknowledging she has the right to withdraw the money (standard procedure for Crummey powers), but then does not withdraw the $26,000. Wife's parents have made gifts for more than a dozen years with no withdrawals. If Wife could have taken the $26,000, and a history of such gifts exists, does that impact the dynamic of the settlement negotiations?

'5 and 5 Power'

A final power often granted in many traditional heir trusts is a so called “5 and 5 power.” This is a right given to the beneficiary of a trust to demand in any year, a distribution that is the greater of 5% of the trust corpus, or $5,000. This measure is used to limit such demand rights because the rules for general powers of appointment exempt the lapse of a withdrawal power from having any estate and gift tax consequences to the extent that the value of the property that can be withdrawn does not exceed the above limits. Thus, Wife could be given the right to withdraw the greater of 5% of her trust, or $5,000 each year, and the remainder of her trust's assets would not be included in her estate. IRC Sec. 2041(b)(2) and 2514(e). The existence of such a power might provide another shoehorn into trust assets. Remember, many of the traditional trusts for a child, grandchild or other heirs, were written to address the client's concern that maximum access to the trust be permitted. This paradigm makes these trusts easier to pierce in a matrimonial action then the trusts described below. If Wife has the unfettered ability to withdraw 5% of the trust principal in each year, without any restriction, that amount of money could be argued to be available to her in each year in negotiating the financial aspects of the matrimonial case.

Status After Divorce

Apart from beneficiary status, will the Wife or her family members remain trustees or other fiduciaries after the divorce? If a trust was established to fund college for the children of the marriage, and Wife and her family control investment and distribution provisions of the trust, this could have a significant impact on later decisions that affect not only the children, but Husband as well. Therefore, the possible resignation or removal of trustees or successor trustees should be addressed in the divorce negotiation process if feasible. In some trusts, the draftsperson may have reserved to the grantor the power to remove and replace trustees and that power may trump any modifications of trustees you attempt during the divorce process. This power has been used more often since the IRS held that the power would not cause the assets of the trust to be taxable in the grantor's estate (Wife's parent in our example). Rev. Rul. 95-58, 1995-2 CB 191, 8/04/1995. 1686WDS.

Basic Insurance Trust

One of the most common trusts encountered by matrimonial practitioners, especially since 529 plans have replaced many of the common children or education trusts, is the irrevocable life insurance trust (“ILIT”). A typical insurance trust will generally be similar to the basic or traditional heir's trust discussed above, but there are commonly differences that could be significant in a matrimonial context.

ILITs tend to be formed by the husband and wife who are insured so they are more likely to include marital rather than immune assets.

If insurance will be purchased on Wife's life, Wife will typically create the ILIT (Wife is said to be the “grantor”) and often, Husband will be a co-trustee with certain powers and rights. This is quite different from the traditional heir's trust in which your client, Husband, is not named in any capacity.

A few ILITs include a “floating spouse” clause, which provides that the person married to the specified heir at the point at which a distribution is to be made will be a beneficiary. When this approach is used, even if Husband is named in the trust as both a co-trustee and beneficiary, the divorce may by terms of the trust, terminate both. The difficulties in enforcing any rights will be exacerbated, if not prevented, by such a clause. This could be significant if the trust has a cash value insurance policy with significant worth.

Another mechanism that some trust attorneys use is to include a clause in the ILIT that provides that if a divorce judgment is entered into between grantor and grantor's spouse, then the grantor's spouse will be deemed to have predeceased the grantor. This type of clause could similarly undermine later plans to use the insurance held in the particular trust to meet divorce obligations. If Wife is not then insurable (or insurable only at substantially increased rates) meeting her divorce insurance obligations to Husband could be costly or even impossible. It may be possible for the Husband to buy the policy from the trust to preserve favorable rates. This type of transaction, however, raises a host of issues.

State Law

Even if the ILIT is silent, some states' laws automatically terminate the divorced spouse's interests as a beneficiary in insurance on the then ex-spouse's life. If such a state law presumption was not overridden in the ILIT, the spouse will not be a beneficiary. Consequently, silence in this scenario, may not prove golden for your client.

The conclusion of this article will discuss GST Trusts, Grantor Trusts and Beneficiary Defective Trusts.

Martin M. Shenkman, CPA, MBA, JD, a member of this newsletter's Board of Editors, is an estate planner in New York City and Teaneck, NJ. His Web site, http://www.laweasy.com/, has information on matrimonial, investment and related matters. Richard A. Oshins is a member of the Las Vegas law firm of Oshins & Associates, LLC, where he concentrates in tax and estate planning with a substantial emphasis on multi-generational wealth planning particularly with regard to closely held businesses. He was a member in the Estate Planning Hall of Fame.