Challenging Estate Plans

The population is aging. Americans 85 and older are the fastest-growing demographic group. Five million Baby Boomers will be retiring every year for the next 15 years. Retirement is a major life inflection point that stimulates estate planning. The year 2012 saw a deluge of trusts being formed to take advantage of what was perceived as the last opportunity to make large gift transfers before a possible decline in the exemption from $5 million to $1 million. The result of all of this should be the need to evaluate more trusts in more divorce cases in the future.

Modern trust drafting has introduced new concepts that will affect the analysis of trusts. The powers granted to the settlor of the trust and other persons present interesting challenges and opportunities for matrimonial practitioners. Some of these issues are discussed below. Apart from the terms of the governing instrument and state law, the manner in which the trust is operated could have important bearing on its treatment in a divorce. As trusts have grown more complex, the ability of most clients to administer them in conformance with their terms has become more problematic. These growing lapses may well serve as fodder for matrimonial practitioners looking for a way to access trust income or assets.

The following is a checklist of estate-planning techniques and some of the missteps that might help matrimonial practitioners attack the technique. Intermingled with estate planning techniques are various concepts and issues that might also come into play. The discussion highlights how the dramatic changes in the estate and income tax rules have affected trusts, and hence the weak points that might more commonly exist.

Common Trusts: Operational and Drafting Challenges

Bypass (Credit Shelter) Trusts

Summary: This is one of the most common estate-planning-oriented trusts. The objective of this trust is to permit a surviving spouse to have access to the trust assets ' sometimes just the income from those assets ' and to prevent those assets from being included in the surviving spouse's estate. When the governing documents for many of these trusts were created, there was an expectation of a significant estate tax savings.

New Environment: For all but the wealthiest clients, the anticipated federal estate tax benefits have been eliminated. Further, not only may there be no estate tax benefit, but retaining assets in the bypass trust will prevent a basis step-up on the second spouse's death, costing the heirs more in capital gains taxes. This dramatic change in circumstances provides a further incentive for trustees to distribute appreciated assets out of bypass trusts, or in some instances terminate these trusts.

Relevance to Matrimonial Practitioners: Review the terms of the governing trust document. If the spouse/beneficiary remarries and then divorces, the argument may be advanced that the assets and income of the trust should not be considered. Many trust instruments limit distributions to the surviving spouse to an “ascertainable standard.” If the goal is to attack the trust, and the distributions exceed the authority of the trust, such action may provide a basis to challenge the trust itself. Because of the emphasis on securing an income tax basis step-up on the second death, some estate planners endeavor to characterize bypass trusts as grantor trusts for income tax purposes. In some instances, the bypass trusts are planned from inception eventually to qualify for that tax treatment. If the bypass trust is a grantor trust, the income is reported on the income tax return of the spouse/beneficiary. If, however, the source of the tax payments on the income is joint funds from the later marriage, that commingling may provide a basis to attack the bypass trust.

Another approach to reach the trust assets might be to evaluate distributions from the trust. If the trust mandates that income be distributed to the spouse/beneficiary, and it has in fact regularly been so distributed, perhaps it may be argued that the distribution is a cash flow that should be factored into the resources available to that spouse/beneficiary. If the trust has a discretionary distribution standard but income was distributed regularly, it might be argued that there was an implied agreement between the spouse and the trustee to make regular distributions, even if not required.

Qualified Terminable Interest Property Trusts (QTIP)

Summary: Bequests to spouses are often made in trust for personal reasons more than ' or in addition to ' tax reasons to protect the assets for the benefit of that spouse and to assure that the assets pass to the intended children (from that marriage or a prior marriage). For many years, the most commonly used trust that qualified for the estate tax marital deduction has been the QTIP trust. While there can be considerable variability in the terms of the trust, the hallmark of a QTIP is that the surviving spouse must receive income distributions at least annually.

New Environment: With the decline in the relevance of estate taxes, more wealthy clients will simply opt for outright bequests, regardless of the consequences of such an approach. For future matrimonial actions, practitioners may find more assets in the spouse's own name, ripe for commingling issues, than may have been the case in the past. A technique that has received significant attention in the estate planning literature will present an interesting challenge ' and in some instances planning opportunity ' for matrimonial practitioners facing QTIP trusts. This technique is a disclaimer of the income interest in a QTIP trust. This might be done so that the entire value of the QTIP is treated as a gift by the disclaiming spouse to remove the value of the trust from his or her estate and utilize a deceased spouse's unused exemption before remarriage. If this is done, the spouse/beneficiary will no longer have any right to income but may be able to receive principal distributions in the discretion of another trustee.

Relevance to Matrimonial Practitioners:

1. The disclaimer of the QTIP income interest might also be a proactive pre-marriage step. Example: Wife is married to Husband One, who dies and leaves a substantial QTIP trust for Wife. Wife plans to marry Husband Two. She also has a significant exemption from Husband One that she can use. If Wife marries Husband Two and he dies, Wife will lose the portable exemption (the deceased spouse unused exemption, “DSUE,” of Husband One). Before marriage, she disclaims the QTIP income interest to use the DSUE and safeguard it.

2. The disclaimer of an income interest in a QTIP might be a proactive pre-divorce planning step. Example: Wife is married to Husband One, who dies and leaves her a large QTIP. Wife marries Husband Two, but the marriage is not the bliss she had hoped for, and unfortunately she did not obtain a prenuptial agreement. Before filing for divorce from Husband Two, Wife could disclaim the income interest in the QTIP formed by Husband One, cutting off the regular income stream/cash flow that the trust had heretofore provided her. Wife may be willing to do this because she can remain (depending on the terms of the trust) a discretionary principal beneficiary. But a discretionary principal distribution will be impossible to quantify in that later matrimonial action. While the assets of the QTIP may be excluded from the second marital estate in all events, the conversion of a steady mandatory annual flow of income into a discretionary distribution with no certainty, may have an impact on the evaluation of the economics of the respective spouse in the later divorce.

3. Another issue affects QTIPs. In a number of states that have decoupled these trusts, QTIPS may not, for complex technical reasons, qualify for the state estate tax marital deduction. This could have a costly and unanticipated state estate tax cost on the death of the first spouse. As a result, many estate planners include language in wills that transform these QTIP trusts to general powers of appointment trusts that the surviving spouse can appoint to anyone. Even if the technical issues that give rise to these trusts are resolved, the language creating this power may remain in many wills for years to come. Consider the impact of this language in a later matrimonial action. The spouse/beneficiary may be able to appoint the trust assets in his or her discretion.

Qualified Personal Residence Trust (QPRT):

Summary: QPRTs have been used to leverage the shift out of a client's estate of a valuable marital residence at a discounted rate.

New Environment: When many QPRTs were created, the client's estate was assumed to be subject to federal estate tax (and perhaps state estate tax as well). Now, however, many QPRTs will provide no federal estate tax savings. Worse, the appreciating home will be excluded from the client's estate and will not qualify for an income tax basis step- up on death.

Relevance to Matrimonial Practitioners:

1. Clients might choose to have the QPRT sell the home before the QPRT term ends and thereby qualify for the home sale exclusion. If this is done, the QPRT instrument will often provide for a mandatory annuity payment to the client/settlor for the duration of the trust. Thus, if the home is sold, the spouse who had a right to live in the home will, instead of that right, receive a monthly cash distribution out of those sale proceeds from the trust for the remainder of the QPRT term. If the home was a marital asset, likely this annuity would be as well. The receipt of a regular monthly cash stream for a fixed number of years may be an easy asset to divide as contrasted to the home prior to sale.

2. If the QPRT will cause tax harm instead of benefit, as many will, many trustees/clients will endeavor to unravel the QPRT to get the home back into their estate for basis step- up purposes. This might be done by simply terminating the trust. In other instances, it may be done by the settlor living in the home after the QPRT term ends without paying rent. If this is done, it may provide an avenue of attack for a matrimonial practitioner seeking to pierce the trust. After all, if the client remained in the home, ignoring the terms of the trust by not paying rent, why should the trust be respected to insulate the home in a later matrimonial action?

3. Consider the potential capital gains tax savings in the calculus of how to structure and negotiate a settlement. Perhaps the family can be convinced to unwind the QPRT as part of the matrimonial action, with the capital gains tax savings contributing to the settlement numbers.

4. Many clients simply do not administer the QPRTs properly and, in order to save modest costs of meeting with their estate planner, never address the formalities required at the end of the QPRT term. What should happen is that the house should be deeded from the QPRT to the heirs (typically children) and then if the client/settlor wishes to remain in the house he or she should rent it back pursuant to an arm's length lease and pay rent. In many cases nothing is done. If the deed remains in the name of a terminated trust and if the settlor resides in the house without paying rent, it could be argued that a transfer never really occurred. Consequently, the home the settlor believed was out of the matrimonial equation might be brought back in.

Spousal Lifetime Access Trust (SLAT):

Summary: Ultra-high net-worth clients may be comfortable making gifts of their estate tax exemption ($5,340,000 in 2014) to a trust for heirs without retaining any rights to access those funds. However, for a moderate-wealth client (the definition of wealth is obviously subjective and will depend on spending patterns and so forth, but most important for planning, it is defined relative to the new high-exemption amount), it will often be inadvisable to fund an irrevocable trust the client cannot access. The solution for many married couples is to fund non-reciprocal SLATs. Example: Husband sets up a trust for Wife and descendants, and gifts $5 million to it. Wife sets up a trust for Husband and descendants, and gifts $4 million to it. In this way, so long as the spouses are both alive and married, the husband can receive distributions from Wife's trust, and the wife can receive distributions from Husband's trust. To avoid the IRS dismantling the plan, the two trusts should be drafted to have substantive differences between them so that they are not mirror or reciprocal.

New Environment: Many SLATs were created in 2012 and for moderate-wealth clients, SLATs for many estate planners are becoming the favored planning technique. While traditional/simple life insurance trusts may have fit this category, the more modern SLAT is a more robust and complex trust containing powers to characterize it as a grantor trust, decanting powers, a trust protector, etc. Many of these trusts hold not merely term life insurance but permanent life insurance, investment assets, and business interests as well.

Relevance to Matrimonial Practitioners:

1. One of the key concerns of many clients structuring SLATs, especially younger clients, is the risk of premature death of the other spouse. Example: If Wife One dies prematurely, the husband will no longer be able to indirectly access the assets in the trust he created for the wife through distributions to her. How the clients may have addressed this risk could have important implications if instead of a premature death, the couple divorces. One approach to addressing premature death is to purchase life insurance on each spouse in the respective trusts. In this way, if Wife predeceased Husband, the life insurance on her life held in the trust she created for her husband could replace the assets/cash flow to which her husband will lose indirect access in her trust. If access is lost due to divorce, the insurance proceeds will not have been received.

2. Another approach is to provide for what is often referred to as a “floating spouse” clause so that whoever the spouse is at that time will be a beneficiary. Example: Husband creates SLAT for Wife and all descendants. The term “Wife” is defined as anyone to whom Husband is married. If Wife predeceases Husband, he will again be able to access SLAT assets indirectly through Wife Two. The implications to matrimonial practitioners are significant. The potential interest of Wife Two must be carefully delineated in a prenuptial agreement with Wife Two. Also, if Wife One divorces Husband, she will no longer be a beneficiary of the trust. It may be feasible to make distributions pursuant to the standards of the trust while she remains married, in anticipation of the economic consequences of the divorce.

Conclusion

Additional trusts and common trust provisions, and their relevance to matrimonial practitioners, will be reviewed in a future installment of this article.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD , a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration.

The population is aging. Americans 85 and older are the fastest-growing demographic group. Five million Baby Boomers will be retiring every year for the next 15 years. Retirement is a major life inflection point that stimulates estate planning. The year 2012 saw a deluge of trusts being formed to take advantage of what was perceived as the last opportunity to make large gift transfers before a possible decline in the exemption from $5 million to $1 million. The result of all of this should be the need to evaluate more trusts in more divorce cases in the future.

Modern trust drafting has introduced new concepts that will affect the analysis of trusts. The powers granted to the settlor of the trust and other persons present interesting challenges and opportunities for matrimonial practitioners. Some of these issues are discussed below. Apart from the terms of the governing instrument and state law, the manner in which the trust is operated could have important bearing on its treatment in a divorce. As trusts have grown more complex, the ability of most clients to administer them in conformance with their terms has become more problematic. These growing lapses may well serve as fodder for matrimonial practitioners looking for a way to access trust income or assets.

The following is a checklist of estate-planning techniques and some of the missteps that might help matrimonial practitioners attack the technique. Intermingled with estate planning techniques are various concepts and issues that might also come into play. The discussion highlights how the dramatic changes in the estate and income tax rules have affected trusts, and hence the weak points that might more commonly exist.

Common Trusts: Operational and Drafting Challenges

Bypass (Credit Shelter) Trusts

Summary: This is one of the most common estate-planning-oriented trusts. The objective of this trust is to permit a surviving spouse to have access to the trust assets ' sometimes just the income from those assets ' and to prevent those assets from being included in the surviving spouse's estate. When the governing documents for many of these trusts were created, there was an expectation of a significant estate tax savings.

New Environment: For all but the wealthiest clients, the anticipated federal estate tax benefits have been eliminated. Further, not only may there be no estate tax benefit, but retaining assets in the bypass trust will prevent a basis step-up on the second spouse's death, costing the heirs more in capital gains taxes. This dramatic change in circumstances provides a further incentive for trustees to distribute appreciated assets out of bypass trusts, or in some instances terminate these trusts.

Relevance to Matrimonial Practitioners: Review the terms of the governing trust document. If the spouse/beneficiary remarries and then divorces, the argument may be advanced that the assets and income of the trust should not be considered. Many trust instruments limit distributions to the surviving spouse to an “ascertainable standard.” If the goal is to attack the trust, and the distributions exceed the authority of the trust, such action may provide a basis to challenge the trust itself. Because of the emphasis on securing an income tax basis step-up on the second death, some estate planners endeavor to characterize bypass trusts as grantor trusts for income tax purposes. In some instances, the bypass trusts are planned from inception eventually to qualify for that tax treatment. If the bypass trust is a grantor trust, the income is reported on the income tax return of the spouse/beneficiary. If, however, the source of the tax payments on the income is joint funds from the later marriage, that commingling may provide a basis to attack the bypass trust.

Another approach to reach the trust assets might be to evaluate distributions from the trust. If the trust mandates that income be distributed to the spouse/beneficiary, and it has in fact regularly been so distributed, perhaps it may be argued that the distribution is a cash flow that should be factored into the resources available to that spouse/beneficiary. If the trust has a discretionary distribution standard but income was distributed regularly, it might be argued that there was an implied agreement between the spouse and the trustee to make regular distributions, even if not required.

Qualified Terminable Interest Property Trusts (QTIP)

Summary: Bequests to spouses are often made in trust for personal reasons more than ' or in addition to ' tax reasons to protect the assets for the benefit of that spouse and to assure that the assets pass to the intended children (from that marriage or a prior marriage). For many years, the most commonly used trust that qualified for the estate tax marital deduction has been the QTIP trust. While there can be considerable variability in the terms of the trust, the hallmark of a QTIP is that the surviving spouse must receive income distributions at least annually.

New Environment: With the decline in the relevance of estate taxes, more wealthy clients will simply opt for outright bequests, regardless of the consequences of such an approach. For future matrimonial actions, practitioners may find more assets in the spouse's own name, ripe for commingling issues, than may have been the case in the past. A technique that has received significant attention in the estate planning literature will present an interesting challenge ' and in some instances planning opportunity ' for matrimonial practitioners facing QTIP trusts. This technique is a disclaimer of the income interest in a QTIP trust. This might be done so that the entire value of the QTIP is treated as a gift by the disclaiming spouse to remove the value of the trust from his or her estate and utilize a deceased spouse's unused exemption before remarriage. If this is done, the spouse/beneficiary will no longer have any right to income but may be able to receive principal distributions in the discretion of another trustee.

Relevance to Matrimonial Practitioners:

1. The disclaimer of the QTIP income interest might also be a proactive pre-marriage step. Example: Wife is married to Husband One, who dies and leaves a substantial QTIP trust for Wife. Wife plans to marry Husband Two. She also has a significant exemption from Husband One that she can use. If Wife marries Husband Two and he dies, Wife will lose the portable exemption (the deceased spouse unused exemption, “DSUE,” of Husband One). Before marriage, she disclaims the QTIP income interest to use the DSUE and safeguard it.

2. The disclaimer of an income interest in a QTIP might be a proactive pre-divorce planning step. Example: Wife is married to Husband One, who dies and leaves her a large QTIP. Wife marries Husband Two, but the marriage is not the bliss she had hoped for, and unfortunately she did not obtain a prenuptial agreement. Before filing for divorce from Husband Two, Wife could disclaim the income interest in the QTIP formed by Husband One, cutting off the regular income stream/cash flow that the trust had heretofore provided her. Wife may be willing to do this because she can remain (depending on the terms of the trust) a discretionary principal beneficiary. But a discretionary principal distribution will be impossible to quantify in that later matrimonial action. While the assets of the QTIP may be excluded from the second marital estate in all events, the conversion of a steady mandatory annual flow of income into a discretionary distribution with no certainty, may have an impact on the evaluation of the economics of the respective spouse in the later divorce.

3. Another issue affects QTIPs. In a number of states that have decoupled these trusts, QTIPS may not, for complex technical reasons, qualify for the state estate tax marital deduction. This could have a costly and unanticipated state estate tax cost on the death of the first spouse. As a result, many estate planners include language in wills that transform these QTIP trusts to general powers of appointment trusts that the surviving spouse can appoint to anyone. Even if the technical issues that give rise to these trusts are resolved, the language creating this power may remain in many wills for years to come. Consider the impact of this language in a later matrimonial action. The spouse/beneficiary may be able to appoint the trust assets in his or her discretion.

Qualified Personal Residence Trust (QPRT):

Summary: QPRTs have been used to leverage the shift out of a client's estate of a valuable marital residence at a discounted rate.

New Environment: When many QPRTs were created, the client's estate was assumed to be subject to federal estate tax (and perhaps state estate tax as well). Now, however, many QPRTs will provide no federal estate tax savings. Worse, the appreciating home will be excluded from the client's estate and will not qualify for an income tax basis step- up on death.

Relevance to Matrimonial Practitioners:

1. Clients might choose to have the QPRT sell the home before the QPRT term ends and thereby qualify for the home sale exclusion. If this is done, the QPRT instrument will often provide for a mandatory annuity payment to the client/settlor for the duration of the trust. Thus, if the home is sold, the spouse who had a right to live in the home will, instead of that right, receive a monthly cash distribution out of those sale proceeds from the trust for the remainder of the QPRT term. If the home was a marital asset, likely this annuity would be as well. The receipt of a regular monthly cash stream for a fixed number of years may be an easy asset to divide as contrasted to the home prior to sale.

2. If the QPRT will cause tax harm instead of benefit, as many will, many trustees/clients will endeavor to unravel the QPRT to get the home back into their estate for basis step- up purposes. This might be done by simply terminating the trust. In other instances, it may be done by the settlor living in the home after the QPRT term ends without paying rent. If this is done, it may provide an avenue of attack for a matrimonial practitioner seeking to pierce the trust. After all, if the client remained in the home, ignoring the terms of the trust by not paying rent, why should the trust be respected to insulate the home in a later matrimonial action?

3. Consider the potential capital gains tax savings in the calculus of how to structure and negotiate a settlement. Perhaps the family can be convinced to unwind the QPRT as part of the matrimonial action, with the capital gains tax savings contributing to the settlement numbers.

4. Many clients simply do not administer the QPRTs properly and, in order to save modest costs of meeting with their estate planner, never address the formalities required at the end of the QPRT term. What should happen is that the house should be deeded from the QPRT to the heirs (typically children) and then if the client/settlor wishes to remain in the house he or she should rent it back pursuant to an arm's length lease and pay rent. In many cases nothing is done. If the deed remains in the name of a terminated trust and if the settlor resides in the house without paying rent, it could be argued that a transfer never really occurred. Consequently, the home the settlor believed was out of the matrimonial equation might be brought back in.

Spousal Lifetime Access Trust (SLAT):

Summary: Ultra-high net-worth clients may be comfortable making gifts of their estate tax exemption ($5,340,000 in 2014) to a trust for heirs without retaining any rights to access those funds. However, for a moderate-wealth client (the definition of wealth is obviously subjective and will depend on spending patterns and so forth, but most important for planning, it is defined relative to the new high-exemption amount), it will often be inadvisable to fund an irrevocable trust the client cannot access. The solution for many married couples is to fund non-reciprocal SLATs. Example: Husband sets up a trust for Wife and descendants, and gifts $5 million to it. Wife sets up a trust for Husband and descendants, and gifts $4 million to it. In this way, so long as the spouses are both alive and married, the husband can receive distributions from Wife's trust, and the wife can receive distributions from Husband's trust. To avoid the IRS dismantling the plan, the two trusts should be drafted to have substantive differences between them so that they are not mirror or reciprocal.

New Environment: Many SLATs were created in 2012 and for moderate-wealth clients, SLATs for many estate planners are becoming the favored planning technique. While traditional/simple life insurance trusts may have fit this category, the more modern SLAT is a more robust and complex trust containing powers to characterize it as a grantor trust, decanting powers, a trust protector, etc. Many of these trusts hold not merely term life insurance but permanent life insurance, investment assets, and business interests as well.

Relevance to Matrimonial Practitioners:

1. One of the key concerns of many clients structuring SLATs, especially younger clients, is the risk of premature death of the other spouse. Example: If Wife One dies prematurely, the husband will no longer be able to indirectly access the assets in the trust he created for the wife through distributions to her. How the clients may have addressed this risk could have important implications if instead of a premature death, the couple divorces. One approach to addressing premature death is to purchase life insurance on each spouse in the respective trusts. In this way, if Wife predeceased Husband, the life insurance on her life held in the trust she created for her husband could replace the assets/cash flow to which her husband will lose indirect access in her trust. If access is lost due to divorce, the insurance proceeds will not have been received.

2. Another approach is to provide for what is often referred to as a “floating spouse” clause so that whoever the spouse is at that time will be a beneficiary. Example: Husband creates SLAT for Wife and all descendants. The term “Wife” is defined as anyone to whom Husband is married. If Wife predeceases Husband, he will again be able to access SLAT assets indirectly through Wife Two. The implications to matrimonial practitioners are significant. The potential interest of Wife Two must be carefully delineated in a prenuptial agreement with Wife Two. Also, if Wife One divorces Husband, she will no longer be a beneficiary of the trust. It may be feasible to make distributions pursuant to the standards of the trust while she remains married, in anticipation of the economic consequences of the divorce.

Conclusion

Additional trusts and common trust provisions, and their relevance to matrimonial practitioners, will be reviewed in a future installment of this article.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD , a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City. He concentrates on estate and closely held business planning, tax planning, and estate administration.