Recent NJ Case Upholds Protection of Trust

Overview of Tannen and Its Implications

For matrimonial practitioners to understand the essence of the Tannen decisions and similar cases they may confront, the distinction between a “support” and a “discretionary” trust needs to be clarified. A “support” trust is one that directs the trustee to make distributions to support the beneficiary. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” A “discretionary” trust is one that grants the trustee the discretion to determine if, when and how much to distribute from the trust. As a generalization, if a trust were characterized as a pure support trust, the court might be inclined to enforce the beneficiary's interests in the trust in a matrimonial action. If the trust is a pure discretionary trust, the courts would be hard pressed to find an interest to enforce, and the trust should not be reachable. In reality, many trusts are combinations of the two standards, and that makes the decision process murkier.

The significance of the Tannen decision is the rejection of the Restatement Third of Trusts that a discretionary trust can be enforced as a support trust (based on the notion that the trustee must act in the best interests of the beneficiary). Instead, the decision reaffirmed that New Jersey will follow the Restatement Second of Trusts position that a purely discretionary trust will be honored as giving the trustee unfettered discretion to distribute or not distribute, regardless of the support needs of the beneficiary. This is important in areas far beyond matrimonial disputes. It is important in debtor/creditor situations, and also very important in the area of asset protection for trust beneficiaries who may otherwise qualify for governmental benefits such as Medicaid.

There is a distinction between third-party-funded discretionary trusts (which should be effective against creditors) and self-funded (or self-settled) discretionary trusts (which should not be effective against creditors unless the trust was formed in Delaware, Nevada, South Dakota, Alaska or a limited number of other states that have enacted asset protection trust legislation).

In Tannen, there was an aspect of self-funding in that the ex-spouse/beneficiary conveyed the marital home (which had been titled to her) to the trust. The decision does not address that fact. While effective with regard to the assets that were funded by the ex-spouse/beneficiary's parents, the ex-spouse/beneficiary conveyed the marital home to the trust. Consequently, the court should have considered whether the trust should not have been effective with regard to the marital home and whether there is a quantum of self-funding that might warrant treating the trust as entirely ineffective, not only as to the assets that are self-funded, but as to all assets.

Situs ' Which Jurisdiction Is Used and Which Should Govern

Another lesson from Tannen is that greater care should be exercised to plan proactively to use a purely discretionary trust in a jurisdiction that has adopted the Restatement Second of Trusts view. Ideally, the client should have the situs of the trust planned from inception to be in a jurisdiction with more favorable laws.

The choice of jurisdiction raises a host of issues. What if the trust were formed in New York and the parties at the time of divorce reside in New Jersey? Which state law governs? Depending on the facts involved, the intentions of the grantor may not be honored and may be subject to the forum state's choice of law provisions and the discretion of the court subjecting the trust to unpredictable results.

Many sophisticated trusts are intentionally designed to have a situs and governing law in Delaware, Nevada, Alaska, or South Dakota, which states have tax, property, trust and other laws that were enacted to be very favorable to trusts. In most instances, this will include the
designation of an institutional trustee in the desired state. But even with this and other precautions, there is a question of whether the Full Faith and Credit clause of the Constitution may apply to prevent application of these more favorable laws to a grantor domiciled in another state.

Tannen

Does Not Mean a Slam Dunk

Some matrimonial attorneys will be lulled into concluding that any trust should provide protection in the event of a divorce, certainly one that appears to be discretionary in nature. However, the analysis is much more complex than that. Practitioners who merely assume a discretionary trust cannot be pierced may well miss a significant opportunity for their client if their analysis of the trust and surrounding circumstances is too superficial. While Tannen is an important case, it addresses only a small part of the issue when dealing with trusts.

What Rights Does the Ex-Spouse/Beneficiary Have Under the Trust Instrument?

Practitioners should begin the trust review process by evaluating the ex-spouse/beneficiaries rights and powers under the trust instrument. If they significantly exceed the control and access which the spouse/beneficiary had in Tannen, there may well be a basis to distinguish Tannen (or whatever cases are applicable in your jurisdiction).

The analysis of the ex-spouse/beneficiary rights should not be limited only to what distributions he or she actually received. The Appellate Division, in Tannen at 263, quoted Aronson v. Aronson, 245 N.J. Super. 354 (App. Div. 1991), as follows: “The issue is not actual receipt of funds but access to them. So long as the spouse has the ability to tap the income source ' whether he or she actually obtains the cash in hand is inconsequential.”

The trust document discussed in Tannen included a restriction preventing the beneficiary from forcing a distribution. This provision was influential in the court's reaching its decision: “(C) Notwithstanding any other provision in this Trust Agreement to the contrary, it is the express intention of the Grantors in creating this Trust that the beneficiary shall not be permitted, under any circumstances, to compel distributions of income and/or principal prior to the time of final distribution.” Tannen at 256.

Other factors that might be relevant to consider:

1. Crummey or annual demand powers (see also below) provide the ex-spouse beneficiary the right to withdraw gifts made to the trust. Crummey v. Comm'r, 397 F2d 82 (9th Cir. 1968). If the beneficiary had the unfettered right during the marriage to withdraw 100% of the gift transfers made to the trust, should that affect the shield afforded by the trust? While most, or perhaps all, estate planners might argue it should not, this issue was not addressed in Tannen. What if the Crummey power existed for 10 years prior to the marriage and only one year during the marriage? There is a more complex structure for many Crummey powers that is intended to avoid the release of a general power, called a “hanging power.” This technique results in a potentially significant portion of the annual gifts remaining in limbo (“hanging”) and hence reachable during such period by the beneficiary holding the power.

Example: In year one, Mom makes a gift of $13,000 to the trust and the ex-spouse/beneficiary is given the right to withdraw up to $13,000 (the annual gift exclusion). However, nothing is withdrawn. At the end of year one, $5,000 of the $13,000 gift lapses, but the remaining $8,000 hangs until it can lapse at the rate of the greater of $5,000 or 5% of the trust corpus. For trusts that have received annual gifts over many years, the amount “hanging” that the ex-spouse can reach could be significant.

2. If the trust holds stock in an S corporation, the trust may be characterized as a Qualified Subchapter S Trust (QSST) to preserve the corporation's tax-favored status. A QSST must currently distribute (or be required to distribute) all of its trust accounting income to the income beneficiary. This means that any income, as determined under the trust instrument and local law, received by the trust must be actually distributed (or be required to be distributed) at least annually. Such a trust may afford no protection over income, but perhaps might afford some protection over corpus. In contrast, a grantor trust, or an Electing Small Business Trust (ESBT) that too can hold S corporation stock, are not required to make distributions.

3. A Florida court evaluated the consequences of a trustee's abdicating certain fiduciary responsibilities and other powers, and the beneficiary serving as trustee, on the ability of creditors to reach a third-party settled trust and upheld the trust. While favorable to trusts, the holding does not rule out such challenges from succeeding with different facts. Miller v. Kresser, 2010 Fla. App Lexis 6152 (Fla. 4th DCA 2010).

There are a host of other factors that may arise depending on the structure of the trust.

Rights Might Be Inferred Under the Reciprocal
Trust Doctrine

In some instances, parents will establish trusts for their children and name the sister as sole trustee of her brother's trust, and the brother as sole trustee of his sister's trust. Clearly, the brother has no rights as trustee over his trust. But might there be another line of attack? The reciprocal trust doctrine is a legal doctrine recognized in the tax law for more than four decades. It addresses the establishment of similar trust and unwinding or uncrossing them. U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008. Might there be merit to an argument that if brother has sole discretion over an identical trust for sister, he could force her to distribute what he wishes to him by refusing to distribute to her? Might a matrimonial court be persuaded by the similar concepts that have convinced courts to unravel mirror-image trusts for tax purposes?

The conclusion of this article will address how the Trust was operated and maintained, and whether spendthrift trusts are always bullet-proof.

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, which is available on www.laweasy.com. Ira S. Herman, CPA, is the Trust and Estate Practice Director for J.H. Cohn LLP, Accountants and Consultants. Judson M. Stein, a partner at the law firm of Genova, Burns & Giantomasi in Newark, NJ, concentrates his professional practice in matters of estate planning, estate administration, business law, and transactional matters. Martin D. Hauptman, a partner in Hauptman and Richmond, PA and a CPA, is an estate-planning and taxation attorney. Carl Soranno, a member of Brach Eichler, LLC, Roseland, NJ, has focused his legal practice on counseling and representing a wide range of clients with complex commercial business matters as well as matters involving divorce, equitable distribution, alimony, spousal support and marital property settlements.

When trusts are involved between divorcing spouses, matrimonial practitioners are faced with a number of issues concerning the assets of the trust. Among these issues important to the matrimonial practitioner is whether the wealth held in the trust is part of the marital estate subject to distribution, or if not, whether the assets are available to provide support to a former spouse and the children born of the marriage. While the laws differ from state to state ' and the law continues to evolve ' there are valuable general lessons for the matrimonial lawyer and other matrimonial practitioners. This two-part article discusses a recent landmark New Jersey case that addressed whether, for purposes of determining alimony, it was appropriate to impute income to a party based on her beneficial interest in a discretionary support trust. Tannen v. Tannen , 416 N.J. Super. 248 (App. Div. 2010), aff'd, — N.J. —, — A.3d —-, 2011 WL 6090130 (2011) ( Tannen ). The key terms, “discretionary” and “support,” are discussed below. This case is likely to be cited in future cases when other state courts have to address this issue.

The Case

The Tannen case involved a less-than-optimal trust for a host of reasons, most notably, that the grantor/parents remained trustees. It is unusual for the person forming and funding an irrevocable trust, the grantor, to serve as a trustee (other than in a revocable living trust). This and other provisions raise other tax concerns that were not addressed by the case. Further, the court did not have to address a range of ancillary issues that may prove critical to the resolution of how trusts should be treated in other matrimonial cases. These matters are discussed below, and in Part Two of this article.

Overview of Tannen and Its Implications

For matrimonial practitioners to understand the essence of the Tannen decisions and similar cases they may confront, the distinction between a “support” and a “discretionary” trust needs to be clarified. A “support” trust is one that directs the trustee to make distributions to support the beneficiary. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” A “discretionary” trust is one that grants the trustee the discretion to determine if, when and how much to distribute from the trust. As a generalization, if a trust were characterized as a pure support trust, the court might be inclined to enforce the beneficiary's interests in the trust in a matrimonial action. If the trust is a pure discretionary trust, the courts would be hard pressed to find an interest to enforce, and the trust should not be reachable. In reality, many trusts are combinations of the two standards, and that makes the decision process murkier.

The significance of the Tannen decision is the rejection of the Restatement Third of Trusts that a discretionary trust can be enforced as a support trust (based on the notion that the trustee must act in the best interests of the beneficiary). Instead, the decision reaffirmed that New Jersey will follow the Restatement Second of Trusts position that a purely discretionary trust will be honored as giving the trustee unfettered discretion to distribute or not distribute, regardless of the support needs of the beneficiary. This is important in areas far beyond matrimonial disputes. It is important in debtor/creditor situations, and also very important in the area of asset protection for trust beneficiaries who may otherwise qualify for governmental benefits such as Medicaid.

There is a distinction between third-party-funded discretionary trusts (which should be effective against creditors) and self-funded (or self-settled) discretionary trusts (which should not be effective against creditors unless the trust was formed in Delaware, Nevada, South Dakota, Alaska or a limited number of other states that have enacted asset protection trust legislation).

In Tannen, there was an aspect of self-funding in that the ex-spouse/beneficiary conveyed the marital home (which had been titled to her) to the trust. The decision does not address that fact. While effective with regard to the assets that were funded by the ex-spouse/beneficiary's parents, the ex-spouse/beneficiary conveyed the marital home to the trust. Consequently, the court should have considered whether the trust should not have been effective with regard to the marital home and whether there is a quantum of self-funding that might warrant treating the trust as entirely ineffective, not only as to the assets that are self-funded, but as to all assets.

Situs ' Which Jurisdiction Is Used and Which Should Govern

Another lesson from Tannen is that greater care should be exercised to plan proactively to use a purely discretionary trust in a jurisdiction that has adopted the Restatement Second of Trusts view. Ideally, the client should have the situs of the trust planned from inception to be in a jurisdiction with more favorable laws.

The choice of jurisdiction raises a host of issues. What if the trust were formed in New York and the parties at the time of divorce reside in New Jersey? Which state law governs? Depending on the facts involved, the intentions of the grantor may not be honored and may be subject to the forum state's choice of law provisions and the discretion of the court subjecting the trust to unpredictable results.

Many sophisticated trusts are intentionally designed to have a situs and governing law in Delaware, Nevada, Alaska, or South Dakota, which states have tax, property, trust and other laws that were enacted to be very favorable to trusts. In most instances, this will include the
designation of an institutional trustee in the desired state. But even with this and other precautions, there is a question of whether the Full Faith and Credit clause of the Constitution may apply to prevent application of these more favorable laws to a grantor domiciled in another state.

Tannen

Does Not Mean a Slam Dunk

Some matrimonial attorneys will be lulled into concluding that any trust should provide protection in the event of a divorce, certainly one that appears to be discretionary in nature. However, the analysis is much more complex than that. Practitioners who merely assume a discretionary trust cannot be pierced may well miss a significant opportunity for their client if their analysis of the trust and surrounding circumstances is too superficial. While Tannen is an important case, it addresses only a small part of the issue when dealing with trusts.

What Rights Does the Ex-Spouse/Beneficiary Have Under the Trust Instrument?

Practitioners should begin the trust review process by evaluating the ex-spouse/beneficiaries rights and powers under the trust instrument. If they significantly exceed the control and access which the spouse/beneficiary had in Tannen, there may well be a basis to distinguish Tannen (or whatever cases are applicable in your jurisdiction).

The analysis of the ex-spouse/beneficiary rights should not be limited only to what distributions he or she actually received. The Appellate Division, in Tannen at 263, quoted Aronson v. Aronson , 245 N.J. Super. 354 (App. Div. 1991), as follows: “The issue is not actual receipt of funds but access to them. So long as the spouse has the ability to tap the income source ' whether he or she actually obtains the cash in hand is inconsequential.”

The trust document discussed in Tannen included a restriction preventing the beneficiary from forcing a distribution. This provision was influential in the court's reaching its decision: “(C) Notwithstanding any other provision in this Trust Agreement to the contrary, it is the express intention of the Grantors in creating this Trust that the beneficiary shall not be permitted, under any circumstances, to compel distributions of income and/or principal prior to the time of final distribution.” Tannen at 256.

Other factors that might be relevant to consider:

1. Crummey or annual demand powers (see also below) provide the ex-spouse beneficiary the right to withdraw gifts made to the trust. Crummey v. Comm'r , 397 F2d 82 (9th Cir. 1968). If the beneficiary had the unfettered right during the marriage to withdraw 100% of the gift transfers made to the trust, should that affect the shield afforded by the trust? While most, or perhaps all, estate planners might argue it should not, this issue was not addressed in Tannen. What if the Crummey power existed for 10 years prior to the marriage and only one year during the marriage? There is a more complex structure for many Crummey powers that is intended to avoid the release of a general power, called a “hanging power.” This technique results in a potentially significant portion of the annual gifts remaining in limbo (“hanging”) and hence reachable during such period by the beneficiary holding the power.

Example: In year one, Mom makes a gift of $13,000 to the trust and the ex-spouse/beneficiary is given the right to withdraw up to $13,000 (the annual gift exclusion). However, nothing is withdrawn. At the end of year one, $5,000 of the $13,000 gift lapses, but the remaining $8,000 hangs until it can lapse at the rate of the greater of $5,000 or 5% of the trust corpus. For trusts that have received annual gifts over many years, the amount “hanging” that the ex-spouse can reach could be significant.

2. If the trust holds stock in an S corporation, the trust may be characterized as a Qualified Subchapter S Trust (QSST) to preserve the corporation's tax-favored status. A QSST must currently distribute (or be required to distribute) all of its trust accounting income to the income beneficiary. This means that any income, as determined under the trust instrument and local law, received by the trust must be actually distributed (or be required to be distributed) at least annually. Such a trust may afford no protection over income, but perhaps might afford some protection over corpus. In contrast, a grantor trust, or an Electing Small Business Trust (ESBT) that too can hold S corporation stock, are not required to make distributions.

3. A Florida court evaluated the consequences of a trustee's abdicating certain fiduciary responsibilities and other powers, and the beneficiary serving as trustee, on the ability of creditors to reach a third-party settled trust and upheld the trust. While favorable to trusts, the holding does not rule out such challenges from succeeding with different facts. Miller v. Kresser, 2010 Fla. App Lexis 6152 (Fla. 4th DCA 2010).

There are a host of other factors that may arise depending on the structure of the trust.

Rights Might Be Inferred Under the Reciprocal
Trust Doctrine

In some instances, parents will establish trusts for their children and name the sister as sole trustee of her brother's trust, and the brother as sole trustee of his sister's trust. Clearly, the brother has no rights as trustee over his trust. But might there be another line of attack? The reciprocal trust doctrine is a legal doctrine recognized in the tax law for more than four decades. It addresses the establishment of similar trust and unwinding or uncrossing them. U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008. Might there be merit to an argument that if brother has sole discretion over an identical trust for sister, he could force her to distribute what he wishes to him by refusing to distribute to her? Might a matrimonial court be persuaded by the similar concepts that have convinced courts to unravel mirror-image trusts for tax purposes?

The conclusion of this article will address how the Trust was operated and maintained, and whether spendthrift trusts are always bullet-proof.

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, which is available on www.laweasy.com. Ira S. Herman, CPA, is the Trust and Estate Practice Director for J.H. Cohn LLP, Accountants and Consultants. Judson M. Stein, a partner at the law firm of Genova, Burns & Giantomasi in Newark, NJ, concentrates his professional practice in matters of estate planning, estate administration, business law, and transactional matters. Martin D. Hauptman, a partner in Hauptman and Richmond, PA and a CPA, is an estate-planning and taxation attorney. Carl Soranno, a member of Brach Eichler, LLC, Roseland, NJ, has focused his legal practice on counseling and representing a wide range of clients with complex commercial business matters as well as matters involving divorce, equitable distribution, alimony, spousal support and marital property settlements.