<b><i>Pfannenstiehl</i></b> Reminds Practitioners to Plan Trusts Carefully

The case addressed whether or not to include in the marital estate the husband's interest in a multi-million-dollar trust established by the husband's father many years before the divorce. The principal of the 2004 trust was comprised of interests in the family's corporations that owned and operated for-profit colleges. The trustees were the husband's brother and the family lawyer, whom the court felt was operating in concert with family wishes, not impartially.

Spendthrift Provision and Trust Distributions

The husband cited a spendthrift provision in the subject trust, and argued that the 2004 trust value and income from the trust were both isolated and not includible in the marital estate.

The court was not persuaded by the husband's spendthrift isolation theory because the trust had made regular monthly distributions to the husband in 2009-2010. There was also an outright distribution of $300,000 in 2008. The regular monthly distributions only ended on the eve of the husband's divorce filing. In contrast to the final payment for the husband, the 2004 trust payments continued to the husband's brother and sister, who were also beneficiaries. The court was also influenced by the fact that the family lifestyle was interconnected to the 2004 trust distributions. Specifically, there was a cutoff of the monthly payments to the husband of $20,000 to $65,000 in August 2010, one month before the commencement of divorce proceedings in September, 2010. This cutoff, of course, stands in stark contrast to the continuing pattern of distributions to the husband's two other siblings, and undermines the husband's theory of exclusion of the 2004 trust.

All of these factors made the court view the husband's assertion of the trust's spendthrift protection as suspect. The court found that the income stream was not too remote or speculative, nor purely discretionary to consider as available. The overall pattern also suggested an implied control and understanding as to distributions by the family, including the husband. The court viewed these facts as constituting a distribution pursuant to an ascertainable standard, not a discretionary trust, and therefore includible in the marital estate.

The Pfannenstiehl court thus viewed the trust as a “support” trust. Had the trust been viewed as a discretionary trust ' one that grants the trustee the discretion to determine if, when and how much to distribute from the trust to the beneficiary ' a different result would have come into play.

Non-Arm's-Length Payments from Closely Held Business

The husband was employed as an assistant bookstore manager for a private university owned by his family, and earned about $170,000 per year. The judge found that a “normal incumbent” in this assistant bookstore manager position would earn roughly $50,000 to $60,000 per year. The judge also found that this handsome and inflated salary flowed from the husband's “familial relations.” It is quite common in closely held family businesses for salaries and perquisites to be established based on personal objectives rather than market forces. Until an income tax audit or divorce forces clients to reconsider the reasonableness of such structures, or to better document the basis for the compensation, they are often ignored. The court's perspective on the inflated compensation in Pfannestiehl was that this fact further demonstrated the family control over all financial matters, including the trust. This all points out how important these matters are to consider and how the excessive compensation can have a broader effect on outcome.

Division of a Sprinkle Trust

A common trust-planning strategy is to name multiple beneficiaries of a trust, rather than have a trust for one single beneficiary. If the trustee holds a discretionary distribution power, the argument is that there is no way to assign a particular portion of the trust to any beneficiary. For example, if a single trust is created for siblings and descendants and distributions are solely discretionary, how can any portion of the trust be considered available to any particular beneficiary?

In addition to the regular annual distributions noted above, the court observed that upon termination of the 2004 trust, the husband would receive a share equal to that of his siblings. The husband therefore has a vested beneficial interest subject to inclusion in the marital estate.

In Pfannestiehl , the judge found that the total value of the 2004 trust was $24,920,217. The judge, noting that there were 11 beneficiaries, calculated the husband's one-eleventh interest in the trust at $2,265,474.31. The wife was allocated a portion of the 2004 trust worth $1,133,047.79. Likely, the regularity of all distributions to all beneficiaries out of the trust, and the egregious facts in the case, especially the husband's conduct, motivated the court's decision.

Lessons to Consider

The settlor, trustees and family made a host of mistakes in Pfannenstieh :

1. The trustees should not have ceased regular distributions on the eve of filing for divorce. The change emphasized the implied agreement that had to have existed between the trustees, the husband/beneficiary's brother and the family lawyer, and the husband/beneficiary. It is preferable that trusts not make regular distributions. It might be possible to accomplish the beneficiary's financial goals by making less frequent distributions of varying amounts to break the implication of a regular periodic distribution. When cash flow is needed, loans can be mixed into the equation to further break up the regularity of distributions.

Another approach to reducing the risk of ongoing distributions is to have the trust buy and hold personal use assets. So, for example, instead of making distributions to, in part, support payments of a monthly mortgage, the trust could purchase the house (or other personal-use assets). There are a number of ways to minimize the creation of regular distributions. All of these however require more proactive professional involvement in trust administration. If the trust has a support standard, recommend that the trust be modified into a discretionary trust.

2. The fact that a trust has been in existence for a number of years before the divorce may not suffice to exclude that trust from the marital estate. Clients need to understand that risks may exist and be encouraged to take actions to address other risk points of even old trusts.

3. Traditionally, irrevocable trusts have been viewed as immutable. However, in recent years the concept of decanting ' merging an existing trust into a new trust with new administrative provisions ' has taken hold. More than 20 states have enacted legislation permitting decanting. In fact, even a trust formed in a jurisdiction without a decanting provision can utilize a statute in another state to decant. Rather than accepting irrevocable trust terms as they exist, practitioners should explore the possibility of decanting the trust into a more favorable trust structure. If the Pfannenstiehl trust had been decanted into a discretionary trust (and been operated in that manner) the result may have been different.

When planning a trust, decanting consideration should be given to whether the process can be undertaken without involvement of the beneficiary who is concerned about divorce. In many instances the trustee or a trust protector may be able to effectuate the decanting. Keeping the beneficiary/client out of the process may deflect to some degree a later challenge that the decanting was pre-divorce planning.

4. Having a class of beneficiaries to which distributions can be made is preferable to having just one beneficiary. It should be more difficult for a court to attribute trust assets or income to one of many different beneficiaries. Although there were 11 beneficiaries in Pfannenstiehl , the court nonetheless held that 1/11th of the trust was attributable to the husband/beneficiary. Likely, the negative facts discussed above were a motivator for the court's action. While having multiple beneficiaries was not determinative in Pfannenstiehl , that should not dissuade practitioners from encouraging clients still using that approach.

5. Use of a true independent trustee, such as a corporate trustee, is recommended. The court in Pfannenstiehl viewed the brother and family lawyer as simply carrying out family wishes as to distributions, or the cessation of distributions, on the eve of divorce. Using an independent institutional trustee can obviate those issues. Also, using an institutional trustee should provide for more experienced and professional trust administration that might have avoided some of the issues in Pfannenstiehl .

6. Form the trust from inception in a trust-friendly jurisdiction, e.g. , Alaska, Nevada or South Dakota. If the trust is in a jurisdiction whose law may be less favorable, e.g. , Massachusetts, evaluate whether a change of situs could be completed. This may not require a decanting and, depending on the terms of the trust, it may be feasible for a trust protector to effectuate this change.

Conclusion

Pfannenstiehl should serve as a warning against relying on a discretionary trust in Massachusetts. But more important, it should serve as a caution to all practitioners to proactively review trusts before a matrimonial action occurs. When consulting with clients at the time of a prenuptial agreement, or before the divorce is filed, steps may be feasible to strengthen a trust.

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.