Challenging Estate Plans

New Environment: There have been a number of cases unfavorable to the viability of DAPTs. These cases have all been “bad fact bad law cases.” Nonetheless, the result of these cases has been that some practitioners creating DAPTs have used alternative approaches to lessen the risk of the challenges. One approach is to defer the point in time at which the settlor can become a beneficiary. In other instances the settlor is not listed as a beneficiary but instead a person is given the authority to add the settlor as a beneficiary.

Relevance to Matrimonial Practitioners: If your client's ex-spouse created a DAPT prior to the marriage, it will likely be far more difficult to reach those assets than if they had merely been protected by a prenuptial agreement. Some possible avenues of attack might include:

• The existence of the DAPT was not disclosed in a prenuptial agreement, assuming it should have been.
• If the ex-spouse is a current beneficiary of the DAPT (either because he or she was named as a beneficiary from inception or the time period prior to which the settlor could become a beneficiary has lapsed), it may be possible to argue that the resources of the DAPT be considered as a resource of the ex-spouse. Many of these trusts are created with institutional trustees who are given discretionary distribution powers. In that case, it might be quite difficult to argue that the ex-spouse has any access to the trust. Many DAPTs have trust protectors. Often the trust protector is given powers that might include the right to remove and replace the trustee. If the client has not been careful and has named a person who is subservient to the settlor, such as an employee, it may be argued that the settlor/ex-spouse has control over the trustee who can make distributions.

An open issue for all DAPTs is whether the home state can exert jurisdiction over the trust. In many ' if not most ' cases, many of the fiduciaries and other persons given powers over the trust all reside in the home state where the couple resided. If the connections to that state are sufficient, it may be possible to attack the trust on that basis. Perhaps the most likely means to reach assets in such a trust is to carefully evaluate the details of the operation of the trust, hoping to identify sufficiently significant issues that can be used to attack the DAPT. For example, if the trust made regular periodic distributions to the settlor, it may be possible to argue that there was an implied agreement between the settlor/ex-spouse and the trustee that would justify an attack on the trust.

Irrevocable Life Insurance Trusts (ILITs)

Summary: Insurance trusts have always been a mainstay of estate and financial planning for clients. The key concept of an insurance trust is that by having a trust, rather than the client or spouse, own life insurance, the insurance would be removed from either spouse's taxable estate. From a financial perspective, having large insurance proceeds held in trust can protect it from predators or a new spouse.

New Environment: There are a number of seemingly contradictory trends affecting life insurance trusts. The permanent high estate tax exemptions make it less important for most wealthy clients to bother using an insurance trust to avoid estate tax. So there will likely be a decline in the use of such trusts, even though all the other benefits remain important. Because of the higher income tax rates for those trusts that do exist there is a greater incentive to use permanent, rather than term, life insurance in light of the tax deferral available for assets inside an insurance policy. Another development that is important is that it has become more common to have life insurance held in trusts holding other significant assets, such as business interests. This is done so that the income earned on the other trust assets can be used to pay insurance premiums.

Relevance to Matrimonial Practitioners: Some insurance trusts have clauses that provide that, in the event of a divorce, the named spouse is no longer a beneficiary. If this was not done, then the client may remain a beneficiary of the trust, even following the divorce. Because of the significant recent changes in tax laws, many clients who have life insurance trusts have investigated terminating the trust. If the trust remains in existence, it may be feasible to identify the documentation or plans discussing how the trust was to be terminated. That might provide a road map and corroboration that the trust can be terminated and the assets thereby reachable.

Beneficiary Defective Irrevocable Trusts (BDITs)

Summary: A BDIT is a trust that is created by a third party, such as the ex-spouse's mother. This third party creates a trust and makes a gift of $5,000 to the trust. The ex-spouse/beneficiary is given an annual demand (Crummey) right to withdraw gifts to the trust. The result is that for income tax purposes the trust is characterized as a grantor trust as to the ex-spouse/beneficiary. This is vital because the ex-spouse could then sell assets to the trust without triggering capital gains. This might be used by the ex-spouse during the course of the marriage to sell assets to the BDIT, thereby removing those assets from the marital estate.

New Environment: Because of the higher income tax rates, the ability to secure an increase in income tax basis on the death of a taxpayer by having assets included in the client's estate has become a major ' if not primary ' planning objective. One result of this new planning environment is for clients to preserve their lifetime gift and estate tax exemption. This can be done by selling assets to a trust, such as BDIT, rather than gifting assets. Matrimonial practitioners may see an increase in BDIT transactions for pure estate and income tax planning reasons. It may be difficult to discern whether the tax motives were paramount or instead the ex-spouse/beneficiary was primarily intending to use the BDIT as a tool to safeguard marital assets.

Relevance to Matrimonial Practitioners: Such sales are done for a note. Matrimonial practitioners should investigate the appraisal to confirm whether or not the assets were sold at fair value. If not, a transfer at less than fair value might be considered a dissipation of marital assets. The note used in the loan component of the transaction often has an interest rate set at the minimum required interest rate necessary to comply with federal tax rules (namely to avoid the imputation of interest). It is not clear that such a rate is necessarily a fair market value interest rate. This might present an opportunity to argue that the sale for a note that was at less than a fair interest rate was a dissipation of marital assets. As with all such transactions, the details of the implementation and later operation of the trust and plan should be reviewed carefully to identify mistakes that might prove to be an Achilles heel of the plan.

Common Trusts Clauses and Doctrines: Potential Challenge Points

Trustee

Summary: Selection of trustees is a sensitive personal issue for many clients and often a matter for which the clients opt for their own comfort to ignore the advice of counsel. The selection of trustees may have an important impact on how a trust is evaluated in a matrimonial action.

New Environment: With less concern about estate tax inclusion for the majority of even wealthy clients, the hesitancy to name a spouse as trustee or co-trustee because of tax issues may wane. The result may be that the surviving spouse is more commonly named as a trustee and beneficiary. This may have important implications to future matrimonial actions of that spouse.

Relevance to Matrimonial Practitioners: What if the spouse is the sole trustee of the bypass trust? Many clients insist that their estate planner name the spouse as a co-trustee or sole trustee, even if they are advised that such an approach may provide less asset protection. When a spouse is a trustee, he or she should be limited to making distributions that conform to maintaining his or her other standard of living (an “ascertainable standard” in tax lexicon). Might the combination of the spouse/beneficiary being a trustee and the distribution standard provide a stronger argument to endeavor to reach the trust or the distributions? As the estate tax benefits of these trusts have waned, for many it is likely that the attention given to proper administration, which in many cases was not particularly stellar in the past, has decreased significantly. Again, administration of the trust in contradiction of the terms of the governing document may provide just the weakness matrimonial counsel needs.

Conclusion

The new and evolving estate and income tax planning environment will have a significant impact on the use and continuation of existing trusts, and the nature and frequency of creating new trusts – and on future matrimonial actions.

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.

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 to characterize the trust as grantor trust status 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 conformity 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. Part One of this two-part series which appeared in last month's issue, discussed bypass trusts, QTIP trusts, spousal lifetime access trusts (SLATs) and qualified personal residence trusts (QPRTs). This final installment reviews additional trusts with a focus as to how matrimonial practitioners may attack assets held in such trusts.

Domestic Asset Protection Trusts (DAPTs)

Summary: A domestic asset protection trust is a self-settled trust that the client can create and for which the client is also a beneficiary. DAPTs are used in a number of circumstances. A client might fund a DAPT prior to marriage in order to remove those assets from his or her control before the marriage occurs. For clients facing a state or federal estate tax, transferring assets to a DAPT may be used to remove future appreciation from their estate and thereby minimize or avoid estate tax.

New Environment: There have been a number of cases unfavorable to the viability of DAPTs. These cases have all been “bad fact bad law cases.” Nonetheless, the result of these cases has been that some practitioners creating DAPTs have used alternative approaches to lessen the risk of the challenges. One approach is to defer the point in time at which the settlor can become a beneficiary. In other instances the settlor is not listed as a beneficiary but instead a person is given the authority to add the settlor as a beneficiary.

Relevance to Matrimonial Practitioners: If your client's ex-spouse created a DAPT prior to the marriage, it will likely be far more difficult to reach those assets than if they had merely been protected by a prenuptial agreement. Some possible avenues of attack might include:

• The existence of the DAPT was not disclosed in a prenuptial agreement, assuming it should have been.
• If the ex-spouse is a current beneficiary of the DAPT (either because he or she was named as a beneficiary from inception or the time period prior to which the settlor could become a beneficiary has lapsed), it may be possible to argue that the resources of the DAPT be considered as a resource of the ex-spouse. Many of these trusts are created with institutional trustees who are given discretionary distribution powers. In that case, it might be quite difficult to argue that the ex-spouse has any access to the trust. Many DAPTs have trust protectors. Often the trust protector is given powers that might include the right to remove and replace the trustee. If the client has not been careful and has named a person who is subservient to the settlor, such as an employee, it may be argued that the settlor/ex-spouse has control over the trustee who can make distributions.

An open issue for all DAPTs is whether the home state can exert jurisdiction over the trust. In many ' if not most ' cases, many of the fiduciaries and other persons given powers over the trust all reside in the home state where the couple resided. If the connections to that state are sufficient, it may be possible to attack the trust on that basis. Perhaps the most likely means to reach assets in such a trust is to carefully evaluate the details of the operation of the trust, hoping to identify sufficiently significant issues that can be used to attack the DAPT. For example, if the trust made regular periodic distributions to the settlor, it may be possible to argue that there was an implied agreement between the settlor/ex-spouse and the trustee that would justify an attack on the trust.

Irrevocable Life Insurance Trusts (ILITs)

Summary: Insurance trusts have always been a mainstay of estate and financial planning for clients. The key concept of an insurance trust is that by having a trust, rather than the client or spouse, own life insurance, the insurance would be removed from either spouse's taxable estate. From a financial perspective, having large insurance proceeds held in trust can protect it from predators or a new spouse.

New Environment: There are a number of seemingly contradictory trends affecting life insurance trusts. The permanent high estate tax exemptions make it less important for most wealthy clients to bother using an insurance trust to avoid estate tax. So there will likely be a decline in the use of such trusts, even though all the other benefits remain important. Because of the higher income tax rates for those trusts that do exist there is a greater incentive to use permanent, rather than term, life insurance in light of the tax deferral available for assets inside an insurance policy. Another development that is important is that it has become more common to have life insurance held in trusts holding other significant assets, such as business interests. This is done so that the income earned on the other trust assets can be used to pay insurance premiums.

Relevance to Matrimonial Practitioners: Some insurance trusts have clauses that provide that, in the event of a divorce, the named spouse is no longer a beneficiary. If this was not done, then the client may remain a beneficiary of the trust, even following the divorce. Because of the significant recent changes in tax laws, many clients who have life insurance trusts have investigated terminating the trust. If the trust remains in existence, it may be feasible to identify the documentation or plans discussing how the trust was to be terminated. That might provide a road map and corroboration that the trust can be terminated and the assets thereby reachable.

Beneficiary Defective Irrevocable Trusts (BDITs)

Summary: A BDIT is a trust that is created by a third party, such as the ex-spouse's mother. This third party creates a trust and makes a gift of $5,000 to the trust. The ex-spouse/beneficiary is given an annual demand (Crummey) right to withdraw gifts to the trust. The result is that for income tax purposes the trust is characterized as a grantor trust as to the ex-spouse/beneficiary. This is vital because the ex-spouse could then sell assets to the trust without triggering capital gains. This might be used by the ex-spouse during the course of the marriage to sell assets to the BDIT, thereby removing those assets from the marital estate.

New Environment: Because of the higher income tax rates, the ability to secure an increase in income tax basis on the death of a taxpayer by having assets included in the client's estate has become a major ' if not primary ' planning objective. One result of this new planning environment is for clients to preserve their lifetime gift and estate tax exemption. This can be done by selling assets to a trust, such as BDIT, rather than gifting assets. Matrimonial practitioners may see an increase in BDIT transactions for pure estate and income tax planning reasons. It may be difficult to discern whether the tax motives were paramount or instead the ex-spouse/beneficiary was primarily intending to use the BDIT as a tool to safeguard marital assets.

Relevance to Matrimonial Practitioners: Such sales are done for a note. Matrimonial practitioners should investigate the appraisal to confirm whether or not the assets were sold at fair value. If not, a transfer at less than fair value might be considered a dissipation of marital assets. The note used in the loan component of the transaction often has an interest rate set at the minimum required interest rate necessary to comply with federal tax rules (namely to avoid the imputation of interest). It is not clear that such a rate is necessarily a fair market value interest rate. This might present an opportunity to argue that the sale for a note that was at less than a fair interest rate was a dissipation of marital assets. As with all such transactions, the details of the implementation and later operation of the trust and plan should be reviewed carefully to identify mistakes that might prove to be an Achilles heel of the plan.

Common Trusts Clauses and Doctrines: Potential Challenge Points

Trustee

Summary: Selection of trustees is a sensitive personal issue for many clients and often a matter for which the clients opt for their own comfort to ignore the advice of counsel. The selection of trustees may have an important impact on how a trust is evaluated in a matrimonial action.

New Environment: With less concern about estate tax inclusion for the majority of even wealthy clients, the hesitancy to name a spouse as trustee or co-trustee because of tax issues may wane. The result may be that the surviving spouse is more commonly named as a trustee and beneficiary. This may have important implications to future matrimonial actions of that spouse.

Relevance to Matrimonial Practitioners: What if the spouse is the sole trustee of the bypass trust? Many clients insist that their estate planner name the spouse as a co-trustee or sole trustee, even if they are advised that such an approach may provide less asset protection. When a spouse is a trustee, he or she should be limited to making distributions that conform to maintaining his or her other standard of living (an “ascertainable standard” in tax lexicon). Might the combination of the spouse/beneficiary being a trustee and the distribution standard provide a stronger argument to endeavor to reach the trust or the distributions? As the estate tax benefits of these trusts have waned, for many it is likely that the attention given to proper administration, which in many cases was not particularly stellar in the past, has decreased significantly. Again, administration of the trust in contradiction of the terms of the governing document may provide just the weakness matrimonial counsel needs.

Conclusion

The new and evolving estate and income tax planning environment will have a significant impact on the use and continuation of existing trusts, and the nature and frequency of creating new trusts – and on future matrimonial actions.

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.