Proactive Trust Planning to Protect Your Clients

Planning for trusts has evolved substantially over the years. “Modern” trusts are more comprehensive, flexible and protective than those that were more typically completed only a few short years ago. Understanding the characteristics of modern trust drafting is critical to achieving better protection for clients. But this planning can extend well beyond just planning new trusts. Even existing irrevocable trusts that might have been created in a less optimal manner may be improved. And it may be feasible to bring back into a protective trust structure gifts and bequests that were made out of trust. The IRS and the Obama administration have taken a less-than-favorable view of some of the planning techniques. Practitioners need to be aware of these risks so that they can encourage clients to act quickly when advisable.

Are Trust Assets Reachable?

Whether a trust is reachable in a divorce proceeding will depend on a number of trust characteristics. If a trust is deemed a “support” trust, which directs the trustee to make distributions to support the beneficiary, it may be reachable. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” Support trusts may have to rely on a spendthrift provision for any protection from claimants. In contrast, a “discretionary” trust gives the trustee the power to determine if, when, and how much to distribute from the trust. A pure support trust might be easier to reach in a matrimonial action. A pure discretionary trust may be more difficult to reach, because the trustee does not have to exercise the discretion given. While these generalities provide useful constructs, reality is much more complex because many trusts are actually a blend of the two principals, and all of this is compounded by the differences in state law.

In 2011, a New Jersey case held that the trust could not be counted for purposes of determining alimony. It was not 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). See, Shenkman, Martin M. et al., “Recent NJ Case Upholds Protection of Trust,” The Matrimonial Strategist , Feb. 2012. In a recent Florida case, the court permitted the former spouse of a beneficiary to access distributions as they were made from a discretionary trust. Berlinger v. Casselberry, Case No. 2D12-6470 (Fla. 2d DCA Nov. 27, 2013).

Although the trust in the Tannen case was not pierced, the costs incurred were likely substantial, and it is not fully clear that the conclusion was correct; the trust in Berlinger was pierced. Why accept this level of risk? With modern trust drafting and planning options, the risks to which the beneficiaries in Tannen, Berlinger and scores of other cases were subjected may be avoided.

Modern Trust Provisions

When planning a trust, or correcting a problematic existing trust (see below), consider counseling clients to incorporate each of the following provisions or mechanisms to provide a greater level of protection from a future matrimonial action.

Independent Trustee

It has become more common to name institutional trustees for a host of reasons. Having an institutional trustee imbues a trust with independence, which can be helpful. Also, institutional trustees have processes and procedures that greatly enhance the likelihood that trust formalities will be followed. This can be vital to the trust's being respected in a challenge. This is something few individual trustees tend to do. When an institutional trustee is vested with distribution decisions, the distribution will likely be the result of a documented formal process of consideration by a distribution committee.

Discretionary Distribution Standard

Whenever possible, and even in light of the Berlinger case above, discretionary distribution standards should always be favored. Permitting an independent trustee, ideally an institutional trustee, to make distributions “at such times and in such amounts as the trustee determines” allows the trustee to make distributions with consideration of the current relevant circumstances. This can provide greater protection under most states. It is not clear that the Berlinger court would have necessarily pushed so far if the husband not taken some of the steps he had.

Trust-'Friendly' Jurisdictions

Include a provision in the trust agreement allowing the trustee or trust protector to change jurisdictions. This will facilitate changing jurisdictions well in advance of any problems arising. The better approach, however, is to have the situs of the trust in a trust “friendly” jurisdiction from inception. The most common are Alaska, Delaware, Nevada and South Dakota. Specifically for matrimonial protection, Nevada appears to have the best statutory provisions with no exception creditors whatsoever, even for alimony and child support. See, http://bit.ly/1maVITL.

Perpetual Term

Modern trust drafting favors very long term or even perpetual trusts. Too often, older trusts, and even newer trusts prepared by many practitioners, have mandatory payouts when a beneficiary attains a certain age. That can emasculate any protection the trust might afford.

Division of Trust

Trusts should include broad and liberal powers to divide the trust into separate entities. While these powers have traditionally been included when generation-skipping transfer tax planning was undertaken, they can have important uses in maximizing divorce protection for a trust. For example, a trust may not name the client as a beneficiary, but rather give a trust protector or a person acting in a non-fiduciary capacity the right to name or add the client as a beneficiary. If the trust is divided and the power to add the client as a beneficiary is only made over a small portion of the trust, the larger portion of the trust may remain safer from a future attack.

Trust Protector Flexibility

The trust should include the designation of a trust protector who is a fiduciary granted the power to change trustees, governing law, situs and other important factors affecting the trust. This can provide an incredible level of flexibility to respond to a future matrimonial challenge.

Power to Add or Change Beneficiaries

The trust could give an independent party, such as the beneficiary's close friend, the power to add and remove beneficiaries, including the ability to remove that beneficiary and add that beneficiary's spouse. As illustrated above, the client could be added or removed as a beneficiary. If the client remarries, adding the new spouse as a beneficiary might facilitate a means of providing indirect economic benefit to the client without naming the client as a beneficiary. This strategy should provide a greater safeguard against a challenge by a former spouse. The person holding this power might expressly be designated to act in a non-fiduciary capacity so that no court could impute a responsibility to add the client as a beneficiary or to act with regardam to a fiduciary obligation to the client.

Improving Old Irrevocable Trusts: Decanting

Many existing trusts were designed in less than optimally protective manners. What can be done? While the presumption has historically been that if a trust is irrevocable, it cannot be changed, decanting can improve even old trusts that do not incorporate the flexibility of modern trust drafting discussed above. Decanting is the process of merging, or poring over, an old trust into a new and improved trust. This technique has grown significantly in popularity and use in recent years and may provide a vital method for practitioners to guide clients to improve trusts before a matrimonial challenge. This might raise the issue of pre-divorce planning, an issue with which practitioners are familiar. Therefore, the brief discussion below will focus only on the decanting. Trust decanting may provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:

1. Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
2. Under state statute. A growing number of states permit decanting pursuant to state statute. Alaska has a very robust statute and if the old trust is not presently located in Alaska, it may be feasible to move the situs of the old trust to that state and then take advantage of the Alaska decanting statute.
3. Under state common law. For example, New Jersey common law has provided a basis to merge an old trust into a new trust.

Decanting may enable a trustee to:

• Extend the term of an existing trust, although generation-skipping transfer tax issues must be addressed. If a client is a beneficiary of a trust that is set to distribute all principal at age 40, and the client is 37, decanting the trust into one that is perpetual may insulate trust asset from a future claim that may have had a greater chance of success if the assets were owned directly.
• Change trustee provisions to incorporate some of the more modern clauses discussed above.
• Change governing law and situs to a state that is more favorable to achieving trust objectives, such as Nevada, which does not provide for exception creditors.

Types of Trust and Trust Transactions

There are hosts of ways trusts can be structured to take advantage of modern trust planning and provide matrimonial protection in a range of circumstances. Some of these are noted below with specific explanation as to how matrimonial practitioners can apply the following techniques.

BDIT

A parent creates a trust for a beneficiary, e.g., a child, and funds the trust with a one-time gift of $5,000. The terms of this trust, called a “Beneficiary Defective Irrevocable Trust” (BDIT) instrument, grants to the child a $5,000/5% power to withdraw. When the power lapses, the trust is treated as if the child withdrew $5,000 and contributed the cash to the trust, and that transforms the child as the grantor and deemed owner of the trust for income tax purposes. IRC Sec. 678. Then the child sells a highly appreciated asset to the trust. This can be a useful tool when, for example, a child has married but already owns an interest in a family business outright. If the parent sets up a BDIT, the child could sell its interest in the family business to the BDIT for a note. While this may not diminish the marital estate, since the note is equal to the value of the business that would be included in the estate, it may provide an important protection for a family business.

Two Generations CRUT

Approximately five million baby boomers a year are retiring. A substantially greater proportion of them are in second and later marriages than their parents' generation. For many, retirement assets comprise a significant portion of their net worth. How can these boomers provide on death for their spouse and children from a prior marriage? One answer may be to use a Charitable Remainder Unitrust (CRUT) as beneficiary for IRA assets. If the surviving spouse is named as beneficiary, he or she would be required to withdraw the IRA account over a proxy for life expectancy, using the number of years specified in IRS tables. This would leave little for the surviving spouse in later years, and perhaps nothing for the children from the prior marriage, barring premature death of the second spouse. If instead a CRUT is named as beneficiary, the IRA could be distributed on the client's death to the charitable trust with no income tax due. PLRs 199901023 and 9820021. The surviving spouse could receive 5% per year of the value of the account for as long as he or she lives. On the surviving spouse's death, the children from the prior marriage could receive 5% per year until they die, at which time the balance would go to charity. This technique can provide tax advantage, a more assured cash flow, and avoid issues of a second spouse cutting out the children.

New Trust Problems

Late Funding of Bypass Trust

For many years, bypass trusts have been a standard part of estate planning. If assets were not put into this trust on the death of the first spouse, a valuable estate tax exemption would have been lost. Now, with portability, the surviving spouse can preserve the deceased spouse exemption without a bypass trust. No doubt what will occur is many clients will simply not fund bypass trusts provided for in wills. This will prove devastating over time for children of prior marriages seeking to receive the inheritance intended for them. Practitioners should know, when they identify such situations, that there may be a position to argue for the retroactive funding of the bypass trust and thus protect those intended heirs.

Courts have recognized the existence of a bypass trust funded long after the death of the first spouse. Est. of Richard v. Comm'r, 103 TCM 1924 (2012). It may be feasible, depending on the facts and state law, to argue that a “constructive” trust, or perhaps a “resulting” trust be imposed over the assets improperly transferred to the surviving spouse instead of the bypass trust. Stansbury v. United States, 543 F. Supp. 154, 50 AFTR 2d 82-6134 (N.D. Ill. 1982), aff'd 735 F.2d 1367 (7th Cir. 1984). Another approach some commentators have suggested is to argue that the deceased spouse died owing a “debt” to the bypass trust, measured by the amount that would now be held by the trust if the funding amount had not been wrongfully withheld.

General Power Trap

There is another growing trust landmine of which matrimonial practitioners should be aware. In simple terms, when a taxpayer dies, any assets owned by that taxpayer get a step-up in income tax basis. This means unrealized capital gains are eliminated. If the taxpayer had paid $10 for an asset worth $100,000, the new tax basis on death becomes $100,000. To help clients capture as much basis step-up elixir as possible, tax practitioners have begun to use general powers of appointment. If a taxpayer did not own an asset on death, but had the power to appoint that asset to his or her estate, creditors or the creditors of his or her estate, that power alone will suffice to pull the assets into that taxpayer's estate and generate the sought after basis step-up.

With the assured growth in these powers, matrimonial practitioners will need to be alert to who may hold a power to redirect assets, whether such powers are themselves reachable in a matrimonial action as a marital asset, and whether prenuptial agreements should address the exercise or non-exercise of these powers. Perhaps all prenuptial agreements should acknowledge that the spouse not holding a power of appointment has no claims or rights, or ability to mandate an exercise of a power held by the other spouse.

Conclusion

The continued evolution of trust planning and drafting, and the ramifications of the dramatic recent changes in the tax law, are reverberating through every area of matrimonial planning creating new planning opportunities, and potentially worrisome traps.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD , is an attorney in private practice in Paramus, NJ, and New York City. A member of the Board of Editors of our sister newsletter, The Matrimonial Strategist, Mr. Shenkman concentrates on estate and closely held business planning, tax planning, and estate administration, and is the author of more than 40 books and 800 articles.

Planning for trusts has evolved substantially over the years. “Modern” trusts are more comprehensive, flexible and protective than those that were more typically completed only a few short years ago. Understanding the characteristics of modern trust drafting is critical to achieving better protection for clients. But this planning can extend well beyond just planning new trusts. Even existing irrevocable trusts that might have been created in a less optimal manner may be improved. And it may be feasible to bring back into a protective trust structure gifts and bequests that were made out of trust. The IRS and the Obama administration have taken a less-than-favorable view of some of the planning techniques. Practitioners need to be aware of these risks so that they can encourage clients to act quickly when advisable.

Are Trust Assets Reachable?

Whether a trust is reachable in a divorce proceeding will depend on a number of trust characteristics. If a trust is deemed a “support” trust, which directs the trustee to make distributions to support the beneficiary, it may be reachable. A common support standard is Health Education Maintenance and Support, referred to by the acronym “HEMS.” Support trusts may have to rely on a spendthrift provision for any protection from claimants. In contrast, a “discretionary” trust gives the trustee the power to determine if, when, and how much to distribute from the trust. A pure support trust might be easier to reach in a matrimonial action. A pure discretionary trust may be more difficult to reach, because the trustee does not have to exercise the discretion given. While these generalities provide useful constructs, reality is much more complex because many trusts are actually a blend of the two principals, and all of this is compounded by the differences in state law.

In 2011, a New Jersey case held that the trust could not be counted for purposes of determining alimony. It was not 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). See, Shenkman, Martin M. et al., “Recent NJ Case Upholds Protection of Trust,” The Matrimonial Strategist , Feb. 2012. In a recent Florida case, the court permitted the former spouse of a beneficiary to access distributions as they were made from a discretionary trust. Berlinger v. Casselberry, Case No. 2D12-6470 (Fla. 2d DCA Nov. 27, 2013).

Although the trust in the Tannen case was not pierced, the costs incurred were likely substantial, and it is not fully clear that the conclusion was correct; the trust in Berlinger was pierced. Why accept this level of risk? With modern trust drafting and planning options, the risks to which the beneficiaries in Tannen, Berlinger and scores of other cases were subjected may be avoided.

Modern Trust Provisions

When planning a trust, or correcting a problematic existing trust (see below), consider counseling clients to incorporate each of the following provisions or mechanisms to provide a greater level of protection from a future matrimonial action.

Independent Trustee

It has become more common to name institutional trustees for a host of reasons. Having an institutional trustee imbues a trust with independence, which can be helpful. Also, institutional trustees have processes and procedures that greatly enhance the likelihood that trust formalities will be followed. This can be vital to the trust's being respected in a challenge. This is something few individual trustees tend to do. When an institutional trustee is vested with distribution decisions, the distribution will likely be the result of a documented formal process of consideration by a distribution committee.

Discretionary Distribution Standard

Whenever possible, and even in light of the Berlinger case above, discretionary distribution standards should always be favored. Permitting an independent trustee, ideally an institutional trustee, to make distributions “at such times and in such amounts as the trustee determines” allows the trustee to make distributions with consideration of the current relevant circumstances. This can provide greater protection under most states. It is not clear that the Berlinger court would have necessarily pushed so far if the husband not taken some of the steps he had.

Trust-'Friendly' Jurisdictions

Include a provision in the trust agreement allowing the trustee or trust protector to change jurisdictions. This will facilitate changing jurisdictions well in advance of any problems arising. The better approach, however, is to have the situs of the trust in a trust “friendly” jurisdiction from inception. The most common are Alaska, Delaware, Nevada and South Dakota. Specifically for matrimonial protection, Nevada appears to have the best statutory provisions with no exception creditors whatsoever, even for alimony and child support. See, http://bit.ly/1maVITL.

Perpetual Term

Modern trust drafting favors very long term or even perpetual trusts. Too often, older trusts, and even newer trusts prepared by many practitioners, have mandatory payouts when a beneficiary attains a certain age. That can emasculate any protection the trust might afford.

Division of Trust

Trusts should include broad and liberal powers to divide the trust into separate entities. While these powers have traditionally been included when generation-skipping transfer tax planning was undertaken, they can have important uses in maximizing divorce protection for a trust. For example, a trust may not name the client as a beneficiary, but rather give a trust protector or a person acting in a non-fiduciary capacity the right to name or add the client as a beneficiary. If the trust is divided and the power to add the client as a beneficiary is only made over a small portion of the trust, the larger portion of the trust may remain safer from a future attack.

Trust Protector Flexibility

The trust should include the designation of a trust protector who is a fiduciary granted the power to change trustees, governing law, situs and other important factors affecting the trust. This can provide an incredible level of flexibility to respond to a future matrimonial challenge.

Power to Add or Change Beneficiaries

The trust could give an independent party, such as the beneficiary's close friend, the power to add and remove beneficiaries, including the ability to remove that beneficiary and add that beneficiary's spouse. As illustrated above, the client could be added or removed as a beneficiary. If the client remarries, adding the new spouse as a beneficiary might facilitate a means of providing indirect economic benefit to the client without naming the client as a beneficiary. This strategy should provide a greater safeguard against a challenge by a former spouse. The person holding this power might expressly be designated to act in a non-fiduciary capacity so that no court could impute a responsibility to add the client as a beneficiary or to act with regardam to a fiduciary obligation to the client.

Improving Old Irrevocable Trusts: Decanting

Many existing trusts were designed in less than optimally protective manners. What can be done? While the presumption has historically been that if a trust is irrevocable, it cannot be changed, decanting can improve even old trusts that do not incorporate the flexibility of modern trust drafting discussed above. Decanting is the process of merging, or poring over, an old trust into a new and improved trust. This technique has grown significantly in popularity and use in recent years and may provide a vital method for practitioners to guide clients to improve trusts before a matrimonial challenge. This might raise the issue of pre-divorce planning, an issue with which practitioners are familiar. Therefore, the brief discussion below will focus only on the decanting. Trust decanting may provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:

1. Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
2. Under state statute. A growing number of states permit decanting pursuant to state statute. Alaska has a very robust statute and if the old trust is not presently located in Alaska, it may be feasible to move the situs of the old trust to that state and then take advantage of the Alaska decanting statute.
3. Under state common law. For example, New Jersey common law has provided a basis to merge an old trust into a new trust.

Decanting may enable a trustee to:

• Extend the term of an existing trust, although generation-skipping transfer tax issues must be addressed. If a client is a beneficiary of a trust that is set to distribute all principal at age 40, and the client is 37, decanting the trust into one that is perpetual may insulate trust asset from a future claim that may have had a greater chance of success if the assets were owned directly.
• Change trustee provisions to incorporate some of the more modern clauses discussed above.
• Change governing law and situs to a state that is more favorable to achieving trust objectives, such as Nevada, which does not provide for exception creditors.

Types of Trust and Trust Transactions

There are hosts of ways trusts can be structured to take advantage of modern trust planning and provide matrimonial protection in a range of circumstances. Some of these are noted below with specific explanation as to how matrimonial practitioners can apply the following techniques.

BDIT

A parent creates a trust for a beneficiary, e.g., a child, and funds the trust with a one-time gift of $5,000. The terms of this trust, called a “Beneficiary Defective Irrevocable Trust” (BDIT) instrument, grants to the child a $5,000/5% power to withdraw. When the power lapses, the trust is treated as if the child withdrew $5,000 and contributed the cash to the trust, and that transforms the child as the grantor and deemed owner of the trust for income tax purposes. IRC Sec. 678. Then the child sells a highly appreciated asset to the trust. This can be a useful tool when, for example, a child has married but already owns an interest in a family business outright. If the parent sets up a BDIT, the child could sell its interest in the family business to the BDIT for a note. While this may not diminish the marital estate, since the note is equal to the value of the business that would be included in the estate, it may provide an important protection for a family business.

Two Generations CRUT

Approximately five million baby boomers a year are retiring. A substantially greater proportion of them are in second and later marriages than their parents' generation. For many, retirement assets comprise a significant portion of their net worth. How can these boomers provide on death for their spouse and children from a prior marriage? One answer may be to use a Charitable Remainder Unitrust (CRUT) as beneficiary for IRA assets. If the surviving spouse is named as beneficiary, he or she would be required to withdraw the IRA account over a proxy for life expectancy, using the number of years specified in IRS tables. This would leave little for the surviving spouse in later years, and perhaps nothing for the children from the prior marriage, barring premature death of the second spouse. If instead a CRUT is named as beneficiary, the IRA could be distributed on the client's death to the charitable trust with no income tax due. PLRs 199901023 and 9820021. The surviving spouse could receive 5% per year of the value of the account for as long as he or she lives. On the surviving spouse's death, the children from the prior marriage could receive 5% per year until they die, at which time the balance would go to charity. This technique can provide tax advantage, a more assured cash flow, and avoid issues of a second spouse cutting out the children.

New Trust Problems

Late Funding of Bypass Trust

For many years, bypass trusts have been a standard part of estate planning. If assets were not put into this trust on the death of the first spouse, a valuable estate tax exemption would have been lost. Now, with portability, the surviving spouse can preserve the deceased spouse exemption without a bypass trust. No doubt what will occur is many clients will simply not fund bypass trusts provided for in wills. This will prove devastating over time for children of prior marriages seeking to receive the inheritance intended for them. Practitioners should know, when they identify such situations, that there may be a position to argue for the retroactive funding of the bypass trust and thus protect those intended heirs.

Courts have recognized the existence of a bypass trust funded long after the death of the first spouse. Est. of Richard v. Comm ' r , 103 TCM 1924 (2012). It may be feasible, depending on the facts and state law, to argue that a “constructive” trust, or perhaps a “resulting” trust be imposed over the assets improperly transferred to the surviving spouse instead of the bypass trust. Stansbury v. United States , 543 F. Supp. 154, 50 AFTR 2d 82-6134 (N.D. Ill. 1982), aff'd 735 F.2d 1367 (7th Cir. 1984). Another approach some commentators have suggested is to argue that the deceased spouse died owing a “debt” to the bypass trust, measured by the amount that would now be held by the trust if the funding amount had not been wrongfully withheld.

General Power Trap

There is another growing trust landmine of which matrimonial practitioners should be aware. In simple terms, when a taxpayer dies, any assets owned by that taxpayer get a step-up in income tax basis. This means unrealized capital gains are eliminated. If the taxpayer had paid $10 for an asset worth $100,000, the new tax basis on death becomes $100,000. To help clients capture as much basis step-up elixir as possible, tax practitioners have begun to use general powers of appointment. If a taxpayer did not own an asset on death, but had the power to appoint that asset to his or her estate, creditors or the creditors of his or her estate, that power alone will suffice to pull the assets into that taxpayer's estate and generate the sought after basis step-up.

With the assured growth in these powers, matrimonial practitioners will need to be alert to who may hold a power to redirect assets, whether such powers are themselves reachable in a matrimonial action as a marital asset, and whether prenuptial agreements should address the exercise or non-exercise of these powers. Perhaps all prenuptial agreements should acknowledge that the spouse not holding a power of appointment has no claims or rights, or ability to mandate an exercise of a power held by the other spouse.

Conclusion

The continued evolution of trust planning and drafting, and the ramifications of the dramatic recent changes in the tax law, are reverberating through every area of matrimonial planning creating new planning opportunities, and potentially worrisome traps.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD , is an attorney in private practice in Paramus, NJ, and New York City. A member of the Board of Editors of our sister newsletter, The Matrimonial Strategist, Mr. Shenkman concentrates on estate and closely held business planning, tax planning, and estate administration, and is the author of more than 40 books and 800 articles.