Recent NJ Case Upholds Protection of Trust

Courts have disregarded corporations when shareholders have used the corporation as a personal pocket book or disregarded the corporate form. They have extended the corporate veil-piercing to limited partnerships under certain conditions, and there has been discussion of extension of the concept to limited liability companies. Perhaps it can be argued that similar veil-piercing principles can be applied to trusts. Canter v. Lakewood of Voorhees, A-1795-10, New Jersey Law Journal, 205 N.J.L.J. 117, July 4, 2011. According to the court in Canter, “[v]eil-piercing may apply when a partner's actions exceed the bounds of N.J.S.A. 42:2A-27b, which creates a “safe harbor” for activities such as being a shareholder or general partner, consulting with a general partner, or being the partnership's contractor, agent or employee. ' It may also apply where the limited partner dominates the partnership and uses it to perpetuate fraud or injustice.” If an ex-spouse/beneficiary serves as a co-trustee and completely disregards the formalities of a trust, but foists it as a barrier in the divorce, that might be comparable to the Canter arguments.

Some factors, which practitioners might consider in the analysis, and which many trusts inadequately address, might include:

• Does the trust have its own bank account? Are funds commingled?
• Has the trust made disbursements that were not legitimate trust expenditures?
• If the trust holds assets, such as insurance, are the correct persons listed as trustees on the insurance company records? In some instances, insurance companies might not update their records from the initial trustees.
• Have appropriate gift tax returns been filed?
• Have assets been properly transferred to the trust? Too often, tax returns may reflect that a trust owns an interest in a business entity but the requisite entity documents (e.g., assignments, operating agreements) have never been completed.
• Have appropriate Form 1041 income tax returns been filed? Were the Form K-1s properly issued? Were the appropriate or required schedules (e.g., a split-dollar loan statement) attached?
• Annual demand or “Crummey” powers are rights included in many trusts that afford the beneficiary the opportunity to withdraw gifts made to the trust each year up to the amount of the annual gift exclusion (see Part One of this article in last month's issue). The purpose of this is to qualify gifts to the trust for the annual gift exclusion. Practitioners should ascertain whether the trustees issue these notices in conformity with the requirements of the trust.
• Have distributions from the trust followed the mandates contained in the trust instrument? For example, if a trust mandates that only income can be paid out to the ex-spouse/beneficiary, were distributions limited to that criteria? What if the trust provides that a particular beneficiary has an income (or other) interest, but distributions are not made consistent with that right?

What quantum of disregard of trust formalities is tolerable before a court should prevent the ex-spouse/beneficiary from using the trust as a shield? While it seems clear that the more trust formalities that are respected, the more likely it should be that a court would respect the trust, there are no bright line rules. Another issue that will undoubtedly arise, is what happens when the bank account was formed and Crummey powers issued the week after the Complaint was filed?

Spendthrift Trusts Are Not Always Bullet-Proof

A spendthrift clause is an almost ubiquitous trust provision that seeks to prevent the trust beneficiary from alienating, pledging or assigning the assets or income of the trust. It is an important component of the asset protection benefits many trusts endeavor to provide.

Exceptions to spendthrift trusts are recognized for specific types of claims in some states. For instance, if the state in which a particular case is heard has adopted the Restatement (Third) on Trusts, a different result may be reached from that of the Tannen court. The Restatement Third states that “the interest of a beneficiary in a valid spendthrift trust can be reached in satisfaction of an enforceable claim against the beneficiary for (a) support of a child, spouse, or former spouse ' ” Ch. 12, Section 59, Page 395.

“A spendthrift trust can protect the income and principal interests of its beneficiaries from claims of their creditors, but that principal or income must be properly [emphasis added] held in trust.” Restatement (Third) on Trusts, Ch. 12, Section 58, Page 361. If the trust formalities have not been properly adhered to, perhaps it can be argued that the assets the ex-spouse/beneficiary are trying to protect with the trust should not shielded by the Trust.

Conclusion

The Tannen case was a victory for the estate-planning bar in that a trust, which was not the poster-child for ideal planning, was upheld as protecting gifted assets from a former spouse's claim for support. All practitioners, when counseling clients about prenuptial agreements, should learn lessons from Tannen. They should guide their clients to inform any potential benefactors to gift or bequeath wealth in the form of an appropriate crafted trust so that a challenge like that made in Tannen, or worse, can be avoided. Most importantly, practitioners should exercise caution. The intersection of matrimonial law and sophisticated estate planning is extraordinarily complex, the dollars are large, emotions are high, and malpractice risks significant.

Matrimonial lawyers are likely to face these issues in the future as the current $5 million gift exemption has motivated substantial numbers of wealthy taxpayers to shift wealth now, before Congress acts to limit the $5 million exemption. This has accelerated the trend of wealth transfers. The result will be an increasing number of cases requiring the analysis of trust owned wealth to resolve divorce matters. With the growing wealth concentration in trusts, courts will be pressed to find other ways to reach trust assets if the results of not doing so will create a hardship on the ex-spouse and certainly on minor children. Practitioners confronted by a trust that seems impenetrable might consider some of the possible alternate lines of attack suggested in this article.

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. Ira S. Herman, CPA, is the Trust and Estate Practice Director for J.H. Cohn LLP, Accountants and Consultants. Judson M. Stein is a partner at the law firm of Genova, Burns & Giantomasi in Newark, NJ. Martin D. Hauptman, a partner in Hauptman and Richmond, PA and a CPA, is an estate-planning and taxation attorney. Carl Soranno is a member of Brach Eichler, LLC, Roseland, NJ.

This article concludes last month's overview and discussion of the impact on trusts arising from a recent New Jersey case, Tannen v. Tannen , 416 N.J. Super. 248 (App. Div. 2010), aff'd, — N.J. —, — A.3d —-, 2011 WL 6090130 (2011) (Tannen).

How Was the Trust Operated and Maintained?

Practitioners must analyze the operations of the trust. Advice of estate planning counsel and a CPA specializing in trust income tax planning and compliance are essential to carry out this task properly. Consider whether the trust has historically been operated and maintained in accordance with its terms. If the trustee did not bother with the most basic indicia of an independent and valid trust, e.g., the establishment of a trust bank account, perhaps the court can be convinced that the ex-spouse/beneficiary should not be permitted to hide behind the shield of a trust he himself disregarded, in an effort to prevent his wife and children from having the benefit of the assets of that trust considered in determining support and maintenance.

Courts have disregarded corporations when shareholders have used the corporation as a personal pocket book or disregarded the corporate form. They have extended the corporate veil-piercing to limited partnerships under certain conditions, and there has been discussion of extension of the concept to limited liability companies. Perhaps it can be argued that similar veil-piercing principles can be applied to trusts. Canter v. Lakewood of Voorhees , A-1795-10, New Jersey Law Journal , 205 N.J.L.J. 117, July 4, 2011. According to the court in Canter, “[v]eil-piercing may apply when a partner's actions exceed the bounds of N.J.S.A. 42:2A-27b, which creates a “safe harbor” for activities such as being a shareholder or general partner, consulting with a general partner, or being the partnership's contractor, agent or employee. ' It may also apply where the limited partner dominates the partnership and uses it to perpetuate fraud or injustice.” If an ex-spouse/beneficiary serves as a co-trustee and completely disregards the formalities of a trust, but foists it as a barrier in the divorce, that might be comparable to the Canter arguments.

Some factors, which practitioners might consider in the analysis, and which many trusts inadequately address, might include:

• Does the trust have its own bank account? Are funds commingled?
• Has the trust made disbursements that were not legitimate trust expenditures?
• If the trust holds assets, such as insurance, are the correct persons listed as trustees on the insurance company records? In some instances, insurance companies might not update their records from the initial trustees.
• Have appropriate gift tax returns been filed?
• Have assets been properly transferred to the trust? Too often, tax returns may reflect that a trust owns an interest in a business entity but the requisite entity documents (e.g., assignments, operating agreements) have never been completed.
• Have appropriate Form 1041 income tax returns been filed? Were the Form K-1s properly issued? Were the appropriate or required schedules (e.g., a split-dollar loan statement) attached?
• Annual demand or “Crummey” powers are rights included in many trusts that afford the beneficiary the opportunity to withdraw gifts made to the trust each year up to the amount of the annual gift exclusion (see Part One of this article in last month's issue). The purpose of this is to qualify gifts to the trust for the annual gift exclusion. Practitioners should ascertain whether the trustees issue these notices in conformity with the requirements of the trust.
• Have distributions from the trust followed the mandates contained in the trust instrument? For example, if a trust mandates that only income can be paid out to the ex-spouse/beneficiary, were distributions limited to that criteria? What if the trust provides that a particular beneficiary has an income (or other) interest, but distributions are not made consistent with that right?

What quantum of disregard of trust formalities is tolerable before a court should prevent the ex-spouse/beneficiary from using the trust as a shield? While it seems clear that the more trust formalities that are respected, the more likely it should be that a court would respect the trust, there are no bright line rules. Another issue that will undoubtedly arise, is what happens when the bank account was formed and Crummey powers issued the week after the Complaint was filed?

Spendthrift Trusts Are Not Always Bullet-Proof

A spendthrift clause is an almost ubiquitous trust provision that seeks to prevent the trust beneficiary from alienating, pledging or assigning the assets or income of the trust. It is an important component of the asset protection benefits many trusts endeavor to provide.

Exceptions to spendthrift trusts are recognized for specific types of claims in some states. For instance, if the state in which a particular case is heard has adopted the Restatement (Third) on Trusts, a different result may be reached from that of the Tannen court. The Restatement Third states that “the interest of a beneficiary in a valid spendthrift trust can be reached in satisfaction of an enforceable claim against the beneficiary for (a) support of a child, spouse, or former spouse ' ” Ch. 12, Section 59, Page 395.

“A spendthrift trust can protect the income and principal interests of its beneficiaries from claims of their creditors, but that principal or income must be properly [emphasis added] held in trust.” Restatement (Third) on Trusts, Ch. 12, Section 58, Page 361. If the trust formalities have not been properly adhered to, perhaps it can be argued that the assets the ex-spouse/beneficiary are trying to protect with the trust should not shielded by the Trust.

Conclusion

The Tannen case was a victory for the estate-planning bar in that a trust, which was not the poster-child for ideal planning, was upheld as protecting gifted assets from a former spouse's claim for support. All practitioners, when counseling clients about prenuptial agreements, should learn lessons from Tannen. They should guide their clients to inform any potential benefactors to gift or bequeath wealth in the form of an appropriate crafted trust so that a challenge like that made in Tannen, or worse, can be avoided. Most importantly, practitioners should exercise caution. The intersection of matrimonial law and sophisticated estate planning is extraordinarily complex, the dollars are large, emotions are high, and malpractice risks significant.

Matrimonial lawyers are likely to face these issues in the future as the current $5 million gift exemption has motivated substantial numbers of wealthy taxpayers to shift wealth now, before Congress acts to limit the $5 million exemption. This has accelerated the trend of wealth transfers. The result will be an increasing number of cases requiring the analysis of trust owned wealth to resolve divorce matters. With the growing wealth concentration in trusts, courts will be pressed to find other ways to reach trust assets if the results of not doing so will create a hardship on the ex-spouse and certainly on minor children. Practitioners confronted by a trust that seems impenetrable might consider some of the possible alternate lines of attack suggested in this article.

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. Ira S. Herman, CPA, is the Trust and Estate Practice Director for J.H. Cohn LLP, Accountants and Consultants. Judson M. Stein is a partner at the law firm of Genova, Burns & Giantomasi in Newark, NJ. Martin D. Hauptman, a partner in Hauptman and Richmond, PA and a CPA, is an estate-planning and taxation attorney. Carl Soranno is a member of Brach Eichler, LLC, Roseland, NJ.