'I DIG IT' Divorce

The wonderful tax actonym IDIGT (pronounced: “I dig it”) stands for an Intentionally Defective Irrevocable Grantor Trust. Selling assets to an irrevocable trust has become the favorite leisure activity of the ultra-wealthy, not only because it makes for great conversation on the golf course, but also because it can provide an incredible array of tax and asset protection benefits. However, rather than extol the benefits of this technique, here are some issues to consider when Junior gets divorced and Junior's Ex wants to Dig It too.

Fiduciaries

Who are the fiduciaries of the trust? Some IDIGTs are structured with an institutional trustee. This is the ideal arrangement in this context. Others have a family member; some have both a family member and institution. Unfortunately, many parents insist on naming Junior as a fiduciary of his own trust. The Ex will carefully evaluate what powers Junior has in endeavoring to share in the IDIGT nectar. If Junior is an investment adviser making investment decisions, that position might not provide much leverage for the Ex. If, however, Junior were a trustee and had broader powers, that position might open the door to attack the trust. Moreover, if Junior were given the power to distribute to himself, the Ex may have even more opportunity to gain access to the trust.

Distribution Standards

What distribution standards does the trust agreement provide? Having an independent institutional trustee with sole discretion to make distributions might be best. It would be difficult for a court to compel an institution to make a distribution to Junior to fund divorce obligations when the trust agreement itself does not obligate the institutional trustee to do anything. At the other extreme, many clients proceed AMA (not against medical advice, Against My Attorney's Advice) and insist that the trust give Junior the right to distribute to himself pursuant
to an ascertainable standard (to make payments or distributions to maintain his lifestyle). Ouch! Might the Ex get her toe in that door? After all, if Junior can maintain his lifestyle from the trust, the Ex could argue that standard should include paying for his lifestyle with the Ex. Safer trusts continue for life or in perpetuity. But many benefactors compare that to controlling from the grave and prefer to pay out the trust to Junior at some specified age. According to Murphy's Law that distribution birthday is usually just prior to the Ex's filing, so she might end up getting some of Junior's trust birthday presents.

Actual Distributions

What distributions have actually been made? Though it may be odd for tax authorities actually to consider reality, you need to account for exactly what that trust has been paying for. Shocking as it might seem, some trusts, especially when Uncle Joe or Aunt Jane is a trustee, pay for stuff the trust instrument never authorized. The Ex could ask for the trust check register and bank statements and demonstrate that the trust has basically been making regular distributions to Junior for a decade to support his ne'er-do-well habits. Furthermore, a court might consider that a pattern it will use to justify a result that is more supportive to the Ex than Junior and his family might have anticipated.

Look Under the Hood

What does that IDIGT own anyhow? In many cases mom sells interests in the family business or real estate LLCs to the trust (i.e., after having an appraiser confirm the 80% discount). What does that have to do with divorce? What does the operating agreement for the LLC provide for? Some operating agreements mandate certain minimum distributions in order to qualify gifts of LLC interests for the annual gift tax exclusion. Others might contain a mandated distribution requirement pegged to the approximate state and federal income tax rate of the members to avoid phantom income. This is done when a member might have to report income on her tax return but the cash distribution is not sufficient to pay the tax. This type of clause is often negotiated by unrelated minority partners. If the operating agreement mandates distributions and there is a history of cash flow (e.g., rental stream), the Ex's attack may have a different result from the one in which the operating agreement has no requirements for distributions, and has harsh restrictions on transferability. If cash flow has to end up in the trust, then Junior may lose the belt and have to rely only on his trust suspenders (yes, Brooks Brothers sells them in plaid). If the trust has some of the problems described above, that could be trouble for Junior's matrimonial negotiations.

Really Look Under the Hood

What does that LLC actually do? What do the tax return and financial data for the LLC show? Does the LLC provide Junior with a car, cell phone, travel and entertainment and other goodies? Might discovery of those perks enable the Ex to torpedo the entire structure on the basis that Junior was using and abusing it all? What about compensation? Might Junior have taken no compensation from the family Widget LLC and instead let all profits flow through the LLC to the trust in an attempt to characterize all economic benefits as passive return on immune assets? Might the court believe that Junior should have been paid a fair wage from the LLC for running the Widget business? Might that fair wage look like something that should be considered for alimony and child support?

Smell Test

Tax courts love applying what is really a smell test (but of course disguised in more sophisticated language). Might a matrimonial court apply a smell test to Junior's trust? If Junior and all involved with the trust disregarded all the formalities, might that increase the Ex's success in piercing the entire structure of the trust, LLCs and all? Assume Junior was named manager and operated the LLC but ignored many LLC formalities (undocumented loans, personal expenses, etc.), and this conduct was coupled with a trust that was not operated in conformity with the governing legal documents (e.g., did not pay the note pursuant to its terms from the family business it purchased, did not issue Crummey powers if required, had a blank Schedule A, did not have appropriate documentation for the purchase of assets). What level of disregard would persuade a court to dismiss the shield the structure might otherwise provide against the Ex? After all, if Junior and the other fiduciaries disregarded many or even most formalities, why should the court respect the entities as against the Ex if Junior himself did not respect them?

Conclusion

Not all IDIGTs were created equal, and certainly not all are operated like the pristine trusts and LLCs of textbook case studies. Depending on the terms of the governing instruments (trust, underlying entity, sale document, etc.) and the actuality of how the entire structure was operated, there will be a wide range of potential divorce consequences to such structures. While the intent of many such plans is to protect assets from a child or other heir's future divorce, the effectiveness of the structure will depend on the details of the documents and operation. The devil truly is in the details, especially in a divorce challenge to an IDIGT.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available on www.laweasy.com, and co-authored Estate Planning after the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics, available from the AICPA on www.cpa2biz.com.

The wonderful tax actonym IDIGT (pronounced: “I dig it”) stands for an Intentionally Defective Irrevocable Grantor Trust. Selling assets to an irrevocable trust has become the favorite leisure activity of the ultra-wealthy, not only because it makes for great conversation on the golf course, but also because it can provide an incredible array of tax and asset protection benefits. However, rather than extol the benefits of this technique, here are some issues to consider when Junior gets divorced and Junior's Ex wants to Dig It too.

Fiduciaries

Who are the fiduciaries of the trust? Some IDIGTs are structured with an institutional trustee. This is the ideal arrangement in this context. Others have a family member; some have both a family member and institution. Unfortunately, many parents insist on naming Junior as a fiduciary of his own trust. The Ex will carefully evaluate what powers Junior has in endeavoring to share in the IDIGT nectar. If Junior is an investment adviser making investment decisions, that position might not provide much leverage for the Ex. If, however, Junior were a trustee and had broader powers, that position might open the door to attack the trust. Moreover, if Junior were given the power to distribute to himself, the Ex may have even more opportunity to gain access to the trust.

Distribution Standards

What distribution standards does the trust agreement provide? Having an independent institutional trustee with sole discretion to make distributions might be best. It would be difficult for a court to compel an institution to make a distribution to Junior to fund divorce obligations when the trust agreement itself does not obligate the institutional trustee to do anything. At the other extreme, many clients proceed AMA (not against medical advice, Against My Attorney's Advice) and insist that the trust give Junior the right to distribute to himself pursuant
to an ascertainable standard (to make payments or distributions to maintain his lifestyle). Ouch! Might the Ex get her toe in that door? After all, if Junior can maintain his lifestyle from the trust, the Ex could argue that standard should include paying for his lifestyle with the Ex. Safer trusts continue for life or in perpetuity. But many benefactors compare that to controlling from the grave and prefer to pay out the trust to Junior at some specified age. According to Murphy's Law that distribution birthday is usually just prior to the Ex's filing, so she might end up getting some of Junior's trust birthday presents.

Actual Distributions

What distributions have actually been made? Though it may be odd for tax authorities actually to consider reality, you need to account for exactly what that trust has been paying for. Shocking as it might seem, some trusts, especially when Uncle Joe or Aunt Jane is a trustee, pay for stuff the trust instrument never authorized. The Ex could ask for the trust check register and bank statements and demonstrate that the trust has basically been making regular distributions to Junior for a decade to support his ne'er-do-well habits. Furthermore, a court might consider that a pattern it will use to justify a result that is more supportive to the Ex than Junior and his family might have anticipated.

Look Under the Hood

What does that IDIGT own anyhow? In many cases mom sells interests in the family business or real estate LLCs to the trust (i.e., after having an appraiser confirm the 80% discount). What does that have to do with divorce? What does the operating agreement for the LLC provide for? Some operating agreements mandate certain minimum distributions in order to qualify gifts of LLC interests for the annual gift tax exclusion. Others might contain a mandated distribution requirement pegged to the approximate state and federal income tax rate of the members to avoid phantom income. This is done when a member might have to report income on her tax return but the cash distribution is not sufficient to pay the tax. This type of clause is often negotiated by unrelated minority partners. If the operating agreement mandates distributions and there is a history of cash flow (e.g., rental stream), the Ex's attack may have a different result from the one in which the operating agreement has no requirements for distributions, and has harsh restrictions on transferability. If cash flow has to end up in the trust, then Junior may lose the belt and have to rely only on his trust suspenders (yes, Brooks Brothers sells them in plaid). If the trust has some of the problems described above, that could be trouble for Junior's matrimonial negotiations.

Really Look Under the Hood

What does that LLC actually do? What do the tax return and financial data for the LLC show? Does the LLC provide Junior with a car, cell phone, travel and entertainment and other goodies? Might discovery of those perks enable the Ex to torpedo the entire structure on the basis that Junior was using and abusing it all? What about compensation? Might Junior have taken no compensation from the family Widget LLC and instead let all profits flow through the LLC to the trust in an attempt to characterize all economic benefits as passive return on immune assets? Might the court believe that Junior should have been paid a fair wage from the LLC for running the Widget business? Might that fair wage look like something that should be considered for alimony and child support?

Smell Test

Tax courts love applying what is really a smell test (but of course disguised in more sophisticated language). Might a matrimonial court apply a smell test to Junior's trust? If Junior and all involved with the trust disregarded all the formalities, might that increase the Ex's success in piercing the entire structure of the trust, LLCs and all? Assume Junior was named manager and operated the LLC but ignored many LLC formalities (undocumented loans, personal expenses, etc.), and this conduct was coupled with a trust that was not operated in conformity with the governing legal documents (e.g., did not pay the note pursuant to its terms from the family business it purchased, did not issue Crummey powers if required, had a blank Schedule A, did not have appropriate documentation for the purchase of assets). What level of disregard would persuade a court to dismiss the shield the structure might otherwise provide against the Ex? After all, if Junior and the other fiduciaries disregarded many or even most formalities, why should the court respect the entities as against the Ex if Junior himself did not respect them?

Conclusion

Not all IDIGTs were created equal, and certainly not all are operated like the pristine trusts and LLCs of textbook case studies. Depending on the terms of the governing instruments (trust, underlying entity, sale document, etc.) and the actuality of how the entire structure was operated, there will be a wide range of potential divorce consequences to such structures. While the intent of many such plans is to protect assets from a child or other heir's future divorce, the effectiveness of the structure will depend on the details of the documents and operation. The devil truly is in the details, especially in a divorce challenge to an IDIGT.

Martin M. Shenkman, CPA, MBA, PFS, JD, a member of this newsletter's Board of Editors, is an estate and tax practitioner and expert witness in Paramus, NJ. He provides a free planning newsletter that is available on www.laweasy.com, and co-authored Estate Planning after the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics, available from the AICPA on www.cpa2biz.com.