Trusts and Divorce

If the client's state law does not permit a perpetual trust, the client might then establish the trust in a state that does permit perpetual trusts, e.g., Delaware. That may raise further complications as to jurisdiction over the trust, and/or of having to apply a different state law to interpret the trust. Many of the states that have tax and property laws conducive to maximizing gift and GST planning benefits, also have laws that are more protective of trust assets from claimants, including those in matrimonial actions. Thus, the laws of the jurisdiction selected to maximize Wife's tax benefits may inadvertently (or perhaps intentionally) make it more difficult for you to obtain any access or even consideration of those trust assets for Husband in the matrimonial action.

Since one goal of a GST exempt trust is to protect assets from all transfer taxes after funding, for as long as possible, such a trust is unlikely to mandate distributions at any specified age or time. Thus, reaching assets in the manner that you might have in the traditional heir's trust, is unlikely to be successful.

GST exempt trusts often make distributions discretionary with an independent trustee to preserve assets inside the tax protective envelope of the trust for as long as feasible. This will make it more difficult to reach the trust assets under any theory. This approach contrasts sharply with the traditional heir's trust or the irrevocable life insurance trust (ILIT) in that the likelihood of an ascertainable standard or “5 and 5″ power is small or nonexistent.

Limited Power of Appointment

It is common in GST exempt trusts to provide a limited power of appointment to the child/heir, Wife, so that she can designate how her heirs will inherit the remaining trust assets following her death. It is permissible to give the Wife a power to designate who will enjoy the property after her so long as she cannot exercise this power in favor of herself, her estate, her creditors, or the creditors of her estate. IRC Sec. 2041(b)(1). If the decedent can appoint the trust assets to the children of the marriage, such a power may present a sliver of opportunity to argue for a post-death mandate to appoint assets to minor children.

Example: Assume that Wife's insurance trust included a provision removing Husband, your client, and the children as beneficiaries in the event of divorce. If Wife is no longer insurable, the only option to protect your client and the children in the event of Wife's death may be to convince a court to dictate how the power of appointment should be exercised. But even if you could prevail on such a theory, this avenue may be precluded by another trust drafting technique. Some asset protection trusts, which include limited powers, mandate that power is not exercisable if the exercise is forced by a court or other proceeding.

Because the maximum amount that can be given during the grantor's lifetime to a GST exempt trust before incurring a substantial gift and GST tax is $1 million (as a completed gift for gift tax purposes, even though the GST exemption is $3.5 million), other techniques are commonly combined with GST trusts to leverage greater wealth into the GST trust's protective envelope. Matrimonial practitioners may thus face very substantial amounts of wealth protected by these techniques.

Grantor Trust

The technique of structuring trusts to be “grantor trusts” is increasingly common. This technique can have significant matrimonial implications. When a trust is characterized as a grantor trust, the income of the trust is reportable on the income tax return of the grantor who established the trust. This characteristic has substantial estate planning benefits in that it will enable the assets inside the trust not only to grow outside of the grantor's estate, which a more traditional trust can do, but also allows them to grow without reduction by income taxes. How can this impact divorce?

Example: Assume a parent sets up a trust for a daughter that was structured as a grantor trust. Now daughter divorces your client. The fact that parent continues to pay the income tax on the trust makes the value of the assets, and earnings, of that trust even more valuable. So for example, if you have to evaluate the economic benefit to the daughter of some presumed distributions from the trust, those distributions can be made whole and do not have to be netted by an assumed income tax during parent's lifetime.

A common mechanism for Wife's parent to create grantor trust status is for the parent to reserve the right to substitute assets of the trust for other assets of equivalent value. If the trust holds assets of particular importance to your client, Husband, e.g., the family house, vacation home, etc., Wife's parent, who is holding a power of substitution, can at anytime pull that asset from the trust. IRC Sec. 675(4)(C); Rev. Rul. 2008-22.0

Self-Settled Trust

An increasingly popular trust-planning technique is a self-settled trust established in a jurisdiction that has modified its laws to permit such trusts. These include Delaware, South Dakota, Nevada, Alaska. A self-settled trust is a trust that the taxpayer, e.g., Wife, establishes for herself, funds with assets from which she remains a beneficiary, but over which her creditors should have no reach. Hence, these types of trusts are referred to as domestic asset protection trusts (“DAPT”).

These trusts are often established with several characteristics that raise a host of difficulties for you as Husband's matrimonial counsel:

• The jurisdictions typically have laws favorable to grantors (the Wife, in this case).
• An institutional trustee in that jurisdiction is often used as a sole or co-trustee.
• Distributions are often totally discretionary and often in the purview of an independent institutional trustee.

Because the maximum amount that can be given to a DAPT before incurring a substantial gift and GST tax, is $1 million (as a completed gift for gift tax purposes), other techniques are commonly combined with the DAPT to leverage greater wealth into the DAPT protective envelope. If the DAPT is structured solely as an asset protection mechanism, larger transfers may be planned. DAPTs are generally structured to be grantor trusts (see above). The client, after establishing and funding the DAPT will often sell substantial assets she owns to the DAPT. Because the DAPT is a grantor trust, no gain is recognized for income tax purposes on the sale. The DAPT gives Wife back a note for the purchase price. Now, to the extent that the assets she sold to the trust appreciate faster than the interest rate on the note, all that growth is also removed from her estate. While this is a potentially beneficial estate tax technique, it might also prove rather difficult to pierce from a matrimonial perspective. Some of the factors to consider in evaluating the situation might include:

Were there initial gifts of assets made to the trust? Were these marital or separate assets? If marital assets were transferred, as contrasted with immune assets, how will this impact the result?

If the sale was for fair value, it could not have a negative impact on the matrimonial estate. Was the property sold properly appraised? How does state law view discounts in matrimonial valuations? If state law looks askance at discounts in a matrimonial valuation, will similar concepts be applicable to a pre-divorce sale?

What was the source of the payment of income taxes due on trust earnings? Were marital resources used to pay income tax on a grantor trust DAPT that holds immune assets? If so, is that sufficient to taint the trust assets as marital?

Was Husband aware of and a party to the plan? What if Husband participated in the plan and was fully aware of it? Was Husband represented by his own counsel?

Even if there is a theory to reach or at least count or consider DAPT assets, if the trust is irrevocable, distributions are discretionary to an independent trustee, etc., what practical objective will be achievable?

Beneficiary Defective Trust

There is a variation of the DAPT ' or self-settled trust ' concept discussed above that can be even more difficult to pierce in a divorce action. One name by which this variation is known, is a Beneficiary Defective Inheritor's Trust (“BDIT”). The following list describes how this trust differs from a typical DAPT. These differences should make the BDIT trust assets more difficult to reach than those in a self-settled trust.

Someone other than Wife establishes a perpetual trust. This could be, for example, Wife's parent. This technique is used by some estate planners because many of the estate tax rules that can operate to pull trust assets back into a taxpayer's estate arguably do not apply if the trust is set up by a third party.

Example: Wife gives assets to a trust, but retains the right to enjoy the assets transferred (e.g., the income, or the right to live in a house that was transferred). The full value of those assets will be included in her estate. This approach, however, should eliminate any argument that you might have for Husband that Wife somehow used marital funds to establish the trust. Wife could not have used the funds because she did not establish the trust.

One of the unusual strategies employed to make a BDIT successful is to assure that it is a grantor trust for income tax purposes as it applies to the beneficiary, the Wife in our paradigm, and not to Wife's parents who established the trust. Grantor trust status is important so that if more significant assets are sold to the BDIT no capital gains or tax on the income triggered on the sale will be realized. The mechanism to accomplish this objective is the careful use of the annual demand or Crummey powers discussed in Part One of this article. The tax law provides that if a person other than the grantor can vest the entire principal of the trust in herself, she will be treated as the owner of the trust for income tax purposes so long as the donor is not taxed on the income (e.g., Wife's parent). So, for example, if Wife's parent makes an annual gift to the trust, and Wife is provided a Crummey power of withdrawal over each of the gifts, the trust will be a grantor trust as to Wife, even though she did not establish the trust or make transfers to it. As with the trust discussions above and in Part One, if Wife utilized non-marital funds to pay the income tax on the BDIT's income, and if Wife made no gifts to the BDIT (which she should not) there may be no hook whatsoever to reach or even consider BDIT assets.

The key estate planning benefit of this grantor trust status, as with the DAPT, is that Wife can sell valuable assets, such as interests in a family business or a family limited partnership owning various family investment assets, to the BDIT and not trigger capital gains. If the assets were sold at fair market value, supported by an independent appraisal, it will be difficult for you as Husband's counsel to find a basis to pierce the BDIT. However, if the sales price of the assets was not at fair value (e.g., no appraisal, or an inadequate appraisal), then perhaps it can be argued that the transaction was a dissipation of the marital estate prior to the divorce.

Conclusion

Trust planning is extremely varied and often designed to achieve specific estate or income tax goals, rather than divorce objectives. When evaluating the ability to reach assets in a divorce action, an evaluation of the estate planning techniques is essential, and to the creative matrimonial practitioner the results may be surprising.

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. Web site: www.laweasy.com. Richard A. Oshins is a member of the Las Vegas law firm of Oshins & Associates, LLC.

The first part of this article addressed the Traditional Heir's Trust and Basic Insurance Trust. The conclusion herein discusses the Generation Skipping Trust (GST) Trust, Grantor Trust and Beneficiary Defective Trust. The same assumption that applied in Part One, i.e., you, the reader, represent the husband (“Husband”), and that the wife is involved with the particular trust in question as beneficiary, grantor, etc. (“Wife”).

GST Trust

Some trusts are established to last as long as permissible, perhaps forever if state law permits. Multi-generational trusts are often intended to protect gift tax and GST tax advantages for as long a time as feasible. Achieving this goal often leads to a number of drafting and structural characteristics that may further impede your efforts to have consideration given to the trust in a matrimonial action.

If the client's state law does not permit a perpetual trust, the client might then establish the trust in a state that does permit perpetual trusts, e.g., Delaware. That may raise further complications as to jurisdiction over the trust, and/or of having to apply a different state law to interpret the trust. Many of the states that have tax and property laws conducive to maximizing gift and GST planning benefits, also have laws that are more protective of trust assets from claimants, including those in matrimonial actions. Thus, the laws of the jurisdiction selected to maximize Wife's tax benefits may inadvertently (or perhaps intentionally) make it more difficult for you to obtain any access or even consideration of those trust assets for Husband in the matrimonial action.

Since one goal of a GST exempt trust is to protect assets from all transfer taxes after funding, for as long as possible, such a trust is unlikely to mandate distributions at any specified age or time. Thus, reaching assets in the manner that you might have in the traditional heir's trust, is unlikely to be successful.

GST exempt trusts often make distributions discretionary with an independent trustee to preserve assets inside the tax protective envelope of the trust for as long as feasible. This will make it more difficult to reach the trust assets under any theory. This approach contrasts sharply with the traditional heir's trust or the irrevocable life insurance trust (ILIT) in that the likelihood of an ascertainable standard or “5 and 5″ power is small or nonexistent.

Limited Power of Appointment

It is common in GST exempt trusts to provide a limited power of appointment to the child/heir, Wife, so that she can designate how her heirs will inherit the remaining trust assets following her death. It is permissible to give the Wife a power to designate who will enjoy the property after her so long as she cannot exercise this power in favor of herself, her estate, her creditors, or the creditors of her estate. IRC Sec. 2041(b)(1). If the decedent can appoint the trust assets to the children of the marriage, such a power may present a sliver of opportunity to argue for a post-death mandate to appoint assets to minor children.

Example: Assume that Wife's insurance trust included a provision removing Husband, your client, and the children as beneficiaries in the event of divorce. If Wife is no longer insurable, the only option to protect your client and the children in the event of Wife's death may be to convince a court to dictate how the power of appointment should be exercised. But even if you could prevail on such a theory, this avenue may be precluded by another trust drafting technique. Some asset protection trusts, which include limited powers, mandate that power is not exercisable if the exercise is forced by a court or other proceeding.

Because the maximum amount that can be given during the grantor's lifetime to a GST exempt trust before incurring a substantial gift and GST tax is $1 million (as a completed gift for gift tax purposes, even though the GST exemption is $3.5 million), other techniques are commonly combined with GST trusts to leverage greater wealth into the GST trust's protective envelope. Matrimonial practitioners may thus face very substantial amounts of wealth protected by these techniques.

Grantor Trust

The technique of structuring trusts to be “grantor trusts” is increasingly common. This technique can have significant matrimonial implications. When a trust is characterized as a grantor trust, the income of the trust is reportable on the income tax return of the grantor who established the trust. This characteristic has substantial estate planning benefits in that it will enable the assets inside the trust not only to grow outside of the grantor's estate, which a more traditional trust can do, but also allows them to grow without reduction by income taxes. How can this impact divorce?

Example: Assume a parent sets up a trust for a daughter that was structured as a grantor trust. Now daughter divorces your client. The fact that parent continues to pay the income tax on the trust makes the value of the assets, and earnings, of that trust even more valuable. So for example, if you have to evaluate the economic benefit to the daughter of some presumed distributions from the trust, those distributions can be made whole and do not have to be netted by an assumed income tax during parent's lifetime.

A common mechanism for Wife's parent to create grantor trust status is for the parent to reserve the right to substitute assets of the trust for other assets of equivalent value. If the trust holds assets of particular importance to your client, Husband, e.g., the family house, vacation home, etc., Wife's parent, who is holding a power of substitution, can at anytime pull that asset from the trust. IRC Sec. 675(4)(C); Rev. Rul. 2008-22.0

Self-Settled Trust

An increasingly popular trust-planning technique is a self-settled trust established in a jurisdiction that has modified its laws to permit such trusts. These include Delaware, South Dakota, Nevada, Alaska. A self-settled trust is a trust that the taxpayer, e.g., Wife, establishes for herself, funds with assets from which she remains a beneficiary, but over which her creditors should have no reach. Hence, these types of trusts are referred to as domestic asset protection trusts (“DAPT”).

These trusts are often established with several characteristics that raise a host of difficulties for you as Husband's matrimonial counsel:

• The jurisdictions typically have laws favorable to grantors (the Wife, in this case).
• An institutional trustee in that jurisdiction is often used as a sole or co-trustee.
• Distributions are often totally discretionary and often in the purview of an independent institutional trustee.

Because the maximum amount that can be given to a DAPT before incurring a substantial gift and GST tax, is $1 million (as a completed gift for gift tax purposes), other techniques are commonly combined with the DAPT to leverage greater wealth into the DAPT protective envelope. If the DAPT is structured solely as an asset protection mechanism, larger transfers may be planned. DAPTs are generally structured to be grantor trusts (see above). The client, after establishing and funding the DAPT will often sell substantial assets she owns to the DAPT. Because the DAPT is a grantor trust, no gain is recognized for income tax purposes on the sale. The DAPT gives Wife back a note for the purchase price. Now, to the extent that the assets she sold to the trust appreciate faster than the interest rate on the note, all that growth is also removed from her estate. While this is a potentially beneficial estate tax technique, it might also prove rather difficult to pierce from a matrimonial perspective. Some of the factors to consider in evaluating the situation might include:

Were there initial gifts of assets made to the trust? Were these marital or separate assets? If marital assets were transferred, as contrasted with immune assets, how will this impact the result?

If the sale was for fair value, it could not have a negative impact on the matrimonial estate. Was the property sold properly appraised? How does state law view discounts in matrimonial valuations? If state law looks askance at discounts in a matrimonial valuation, will similar concepts be applicable to a pre-divorce sale?

What was the source of the payment of income taxes due on trust earnings? Were marital resources used to pay income tax on a grantor trust DAPT that holds immune assets? If so, is that sufficient to taint the trust assets as marital?

Was Husband aware of and a party to the plan? What if Husband participated in the plan and was fully aware of it? Was Husband represented by his own counsel?

Even if there is a theory to reach or at least count or consider DAPT assets, if the trust is irrevocable, distributions are discretionary to an independent trustee, etc., what practical objective will be achievable?

Beneficiary Defective Trust

There is a variation of the DAPT ' or self-settled trust ' concept discussed above that can be even more difficult to pierce in a divorce action. One name by which this variation is known, is a Beneficiary Defective Inheritor's Trust (“BDIT”). The following list describes how this trust differs from a typical DAPT. These differences should make the BDIT trust assets more difficult to reach than those in a self-settled trust.

Someone other than Wife establishes a perpetual trust. This could be, for example, Wife's parent. This technique is used by some estate planners because many of the estate tax rules that can operate to pull trust assets back into a taxpayer's estate arguably do not apply if the trust is set up by a third party.

Example: Wife gives assets to a trust, but retains the right to enjoy the assets transferred (e.g., the income, or the right to live in a house that was transferred). The full value of those assets will be included in her estate. This approach, however, should eliminate any argument that you might have for Husband that Wife somehow used marital funds to establish the trust. Wife could not have used the funds because she did not establish the trust.

One of the unusual strategies employed to make a BDIT successful is to assure that it is a grantor trust for income tax purposes as it applies to the beneficiary, the Wife in our paradigm, and not to Wife's parents who established the trust. Grantor trust status is important so that if more significant assets are sold to the BDIT no capital gains or tax on the income triggered on the sale will be realized. The mechanism to accomplish this objective is the careful use of the annual demand or Crummey powers discussed in Part One of this article. The tax law provides that if a person other than the grantor can vest the entire principal of the trust in herself, she will be treated as the owner of the trust for income tax purposes so long as the donor is not taxed on the income (e.g., Wife's parent). So, for example, if Wife's parent makes an annual gift to the trust, and Wife is provided a Crummey power of withdrawal over each of the gifts, the trust will be a grantor trust as to Wife, even though she did not establish the trust or make transfers to it. As with the trust discussions above and in Part One, if Wife utilized non-marital funds to pay the income tax on the BDIT's income, and if Wife made no gifts to the BDIT (which she should not) there may be no hook whatsoever to reach or even consider BDIT assets.

The key estate planning benefit of this grantor trust status, as with the DAPT, is that Wife can sell valuable assets, such as interests in a family business or a family limited partnership owning various family investment assets, to the BDIT and not trigger capital gains. If the assets were sold at fair market value, supported by an independent appraisal, it will be difficult for you as Husband's counsel to find a basis to pierce the BDIT. However, if the sales price of the assets was not at fair value (e.g., no appraisal, or an inadequate appraisal), then perhaps it can be argued that the transaction was a dissipation of the marital estate prior to the divorce.

Conclusion

Trust planning is extremely varied and often designed to achieve specific estate or income tax goals, rather than divorce objectives. When evaluating the ability to reach assets in a divorce action, an evaluation of the estate planning techniques is essential, and to the creative matrimonial practitioner the results may be surprising.

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. Web site: www.laweasy.com. Richard A. Oshins is a member of the Las Vegas law firm of Oshins & Associates, LLC.