Trust Drafting Tips: How to Make Trusts Harder to Reach in Divorce

Trust Clauses: Less Protective Approaches and How to Improve Them

Trustee

Traditional trusts may name the beneficiary as trustee. To permit this without causing inclusion in the beneficiary's estate, the beneficiary/trustee's rights to make distributions must be limited to an ascertainable standard. (The negative implications of this standard to divorce protection are discussed below.) If the beneficiary is the sole trustee, the powers granted in the trust agreement might expose the trust assets to being reached in a later divorce. Individual trustees too often fail to adhere to trust formalities. If the beneficiary is the sole trustee and those failures exist, the risk of a later attack succeeding could be exacerbated.

The preferable approach would be for the beneficiary not to serve as trustee. The optimal approach would be to name an institutional trustee so that the professionalism, policies and procedures of a professional trustee are present.

Traditional trusts more often relied on family members to serve as trustees. Modern trust drafting more likely would utilize an institutional trustee, and if the home-state law is not optimal, an institution in a jurisdiction that provides better law. In planning for the risks of a beneficiary's future divorce, the difference between the beneficiary as a sole trustee in a home state that has less than optimal trust laws, and a trust using an institutional trustee in a trust-friendly jurisdiction, are dramatic. This difference may be one of the most impactful drafting decisions when planning a trust for divorce protection.

Independent Trustee

When naming a trustee, the preferable approach is to, at minimum, name an independent trustee, i.e., not the beneficiary or someone the beneficiary can control (e.g., an employee of a company owned by the beneficiary), and to vest distribution decision-making in that independent trustee.

Distributions

In broad terms, a trust can be characterized, based on the distribution standards included in the governing instrument, as a “support trust” or a “discretionary” trust. A support trust is one that provides that the trustee pay to the beneficiary as much of the trust income as is necessary for the beneficiary's health, education, maintenance and support. In contrast, a discretionary trust leaves it to the trustee's discretion to determine what, if anything, to distribute. Many trusts are combinations of these.

Traditional trust drafting more often would incorporate a standard for distributions, such as pay income (even when not required, such as to qualify for an estate tax marital deduction), or to provide for the beneficiary's health, education, maintenance and support (HEMS). Modern trust drafting tends to more often favor giving an independent trustee the discretion as to what distributions to make.

A purely discretionary distribution standard is more protective against a future ex-spouse than any other type of standard. A court generally should not be able to force a trustee to exercise a completely discretionary distribution right. As the trust distribution standard moves toward a blend of support/discretion, or a pure HEMS — or even more so, toward a mandatory distribution standard, e.g., “pay out all income annually” — the risk of a court enforcing a distribution in a divorce case worsens. A trust incorporating a HEMS standard is not fully protective of matrimonial claims in that the trustee may be required to make support distributions. However, a HEMS trust is protective of the trust because the beneficiary is only entitled to distributions that are required for her health, education, maintenance and support. Unfortunately, the law on this is quite complex, and varies significantly depending on the state law involved.

The Restatement (Second) of Trusts provides that a purely discretionary trust will be honored as giving the trustee unfettered discretion to distribute or not distribute, regardless of the support needs of the beneficiary. In a jurisdiction whose laws follows this Restatement, a discretionary trust should not be accessible in divorce. The Restatement (Third) of Trusts, however, holds that a discretionary trust can be enforced as a support trust (based on the notion that the trustee must act in the best interests of the beneficiary). So, in jurisdictions that follow the newer Restatement, even a discretionary trust may not be as protective as desired. The answer for clients in those jurisdictions is to apply the law of another jurisdiction, and preferably structure the trust to have situs in a better jurisdiction.

Support Trust

The right to distribute principal and/or income pursuant to a HEMS standard is also referred to as in accordance with an “ascertainable standard,” the tax equivalent to a standard of living. If the spouse/beneficiary is named trustee and the right to distribute to herself was limited to an ascertainable standard, the principal of the trust should avoid inclusion in her estate for tax purposes. If a power may be exercised only in accordance with an ascertainable standard relating to health, education, support, or maintenance, it is not treated as a general power of appointment for tax purposes. If it is not treated as a general power, it will not create exposure to the estate tax. IRC Sec. 2041(b)(1)(A).

This tax paradigm, however, could undermine a significant portion of the protection the trust might have otherwise afforded in a matrimonial action. If the spouse/trustee can make distributions to herself, how might the court consider this power in the context of a matrimonial action? An ascertainable standard might be challenged, depending on state law, to assert that HEMS should include payment of child support, and perhaps even alimony. The meaning of “support” under the tax law is not limited to the bare necessities of life. It includes other reasonable living expenses, but it does not necessarily extend to all expenditures that might be considered customary in the descendant's position in life. There is more to the analysis then merely identifying the nature of the distribution standard. If the trust provides that the trustee “shall pay,” rather than the discretionary “may pay,” the trust may be more susceptible to reach.

Pay-All-Income Standard

A traditional trust often gave the spouse/beneficiary a mandatory income right. For example, the trust might mandate that income must be distributed quarterly. This income right might expose the actual income, or an estimated income stream, to the reach of an ex-spouse. Certainly, a mandatory income stream might be viewed as a resource in determining maintenance or child support.

Sprinkling Provision

Ideally, the trust (excluding marital trusts that are required for tax purposes to distribute all income to the spousal beneficiary) should give the trustee the power to “sprinkle” trust income and corpus among a class of beneficiaries, not merely the spouse. Including multiple beneficiaries, each of whom has the right to receive distributions in the discretion of a trustee, makes the rights of any one beneficiary indeterminate. This should enhance the protection the trust affords in a later matrimonial action.

Use of Property

Traditional trusts rarely, if ever, addressed holding personal-use assets. Modern trust drafting, in contrast, generally provides for and encourages the trust holding personal-use assets. While the most common personal-use asset is a residence, this could also include a vacation home, artwork or even jewelry. If the spouse is a beneficiary of such a trust, he can use the assets held by the trust, but he does not own them. While a court might consider the “use” to be an available resource in its analysis, the court should not be able to distribute property held in an irrevocable trust. So, if a client/beneficiary wishes to buy a house (or other assets), the traditional approach of the trustee distributing cash to the beneficiary to purchase a house should not be followed. Instead, the trust itself should purchase the house and permit the beneficiary to live in it. This would keep the economic value involved in the protective envelope of the trust.

Practitioners should be aware of a common twist on this planning. If the trust was created in a jurisdiction with more protective trust laws than the client's home state, the trust should not own real property in the home state; to do so would taint the trust as subject to the jurisdiction of home-state courts, which might negate the sought-after benefits of creating the trust in a better jurisdiction. In these instances, the house (or other tangible property) can be held in a single-member limited liability company formed by the trustee and owned by the trust.

No Distributions for Spouse of Beneficiary

The trust instrument could expressly state that it is the settlor's intent not to allow distributions to a beneficiary's spouse, and further limit distributions to a married beneficiary to solely the immediate and direct personal needs of that descendant/beneficiary (even pursuant to a HEMS standard). While this type of provision might make it clear that a broader reading of a HEMS distribution standard is not intended to include the spouse, it may also unduly limit distributions while the beneficiary is happily married. For example, most irrevocable trusts are created for general asset protection benefits, not only for divorce protection benefits. If the child/beneficiary is being sued, actual distributions to the spouse, if permitted, would enable the spouse to receive trust benefits without the child/beneficiary's claimant reaching the assets. As with all distribution decisions, the pros and cons of any restriction should be weighed.

Crummey Power

Many irrevocable trusts include an annual demand, or “Crummey” power, to assure that gifts to the trust qualify for the annual gift tax exclusion. The trust beneficiary is given, for example, 60 days, to demand the distribution of a portion of the gifts made to the trust. This gives the beneficiary the immediate right to the money given, so that the donor can realize a favorable gift tax result. This is done to preserve the donor/grantor's lifetime gift exemption (but for the withdrawal right the donor would use up a portion of his/her lifetime gift exemption on each gift made to the trust). Crummey v. Comm'r, 397 F2d 82 (9th Cir. 1968). Crummey powers may provide another mechanism of attack for a matrimonial practitioner. A Crummey power permits the beneficiary to demand a distribution of the amount given in a particular year to the trust, typically the annual gift exclusion ($14,000 in 2017).

During any period when an ex-spouse has the power to withdraw, that amount may be exposed. New trusts might consider whether to even include such powers. With the transfer tax exemption now at $5,490,000 (2017), most estates are not subject to an estate tax. If a Crummey power is not included, then gifts to the trust will require an annual gift tax return. So clients safely below the estate tax threshold should weigh the better protection of excluding Crummey powers and avoiding the annual ritual of issuing written Crummey notices, versus the costs of filing a gift tax return.

End of Trust

Trusts were traditionally structured to end with distributions of trust principal at specified ages — for example, principal may have been directed to be distributed to the beneficiary in approximately one-third increments as follows: one-third at age 25, one-half at age 30 and the balance at age 35. Once distributed, any protection the trust afforded terminates as to the portion of the trust distributed. Modern trust drafting tends to favor very long-term or perpetual trusts. This coordinates with the holding of personal use assets above. If the trust, for example, can hold a house and other assets, there is less need to distribute significant trust assets outright to the beneficiary at any age.

Practitioners should advise clients to evaluate with estate-planning counsel decanting existing trusts into new trusts that retain assets long-term. While the new trust may be limited by the rule against perpetuities of the old trust, incremental protection may be achieved. This should preferably be done well in advance of a divorce, to lessen the challenges that it was “pre-divorce planning.” New trusts should be structured to last as long as state law permits.

Powers of Appointment

Traditional trust drafting incorporated powers of appointment — the right of a named person and power holder to designate where trust assets would be distributed — generally to avoid an unintended imposition of the generation skipping transfer (GST) tax. Modern trust drafting uses powers of appointment for this purpose, but also to infuse additional flexibility into the trust instrument, to garner a step-up (increase) in income tax basis on the death of a beneficiary by causing inclusion of assets in that person's estate, etc. Practitioners should be cautious that the increased use and flexibility of powers of appointment does not undermine the intended protections of the trust plan. For example, if a power of appointment is too broad, it may be construed as a general power of appointment, causing inclusion in the power holder's estate. This could create an opportunity that opposing counsel in a matrimonial action could seek to exploit.

5 and 5 Power

Traditional trusts have sometimes given a beneficiary the right to demand a withdrawal each year of the greater of 5% of the trust principal, or $5,000. While the $5,000 has become economically insignificant, the 5% of principal may not be. If a power is granted up to but not exceeding these amounts, the trust assets, other than those subject to the power, will not be included in the power holder's estate. This power, however, might be another opportunity for opposing matrimonial counsel to exploit. The argument may be proffered that the ex-spouse can demand up to 5% of the principal of an irrevocable trust, so that amount each year should be deemed available to reach in the matrimonial action (assuming the trust assets are otherwise reachable). If not reachable, this amount, it may be argued, is an available resource to the ex-spouse/beneficiary.

We will conclude our discussion of ways to protect trust assets in divorce in next month's issue. Topics will include trust protectors, the power to change the trust situs, life insurance tax reimbursement, charitable remainder unitrusts, Qualified Personal Residence Trusts (QPRTs), gifts versus loans, spousal lifetime access trusts (SLATs), the reciprocal trust doctrine, domestic asset protection trusts and inter-vivos QTIP trusts.

*****
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of The Matrimonial Strategist'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.

Trusts have traditionally been used to protect wealth from divorce. However, what many estate planners refer to as “traditional” trust drafting (which continues to be used by many practitioners) is not nearly as effective at protecting wealth from the potential risks of divorce as approaches advocated by what some loosely refer to as “modern trust drafting.”

Much of this article compares and contrasts what might be viewed as a traditional approach to drafting clauses in an irrevocable trust, to what the modern approach to trust drafting would advocate. While the reasons that the modern approach will likely prove superior to the traditional approach might be obvious, the point is explained not only so that it is clear to matrimonial practitioners, but so that hopefully it will encourage estate planning attorneys to focus their drafting efforts on providing greater protection from future matrimonial actions of beneficiaries.

There are also a number of ancillary drafting considerations that might have an important impact on the security of trust assets from later matrimonial challenges, and these are explained as well. This article does not, however, get bogged down on nuances of state law, but rather focuses more on general planning ideas that should have applicability in a wide range of client matters. Individual practitioners will have to address how the application of those constructs may be impacted by their home state laws. While some of these concepts were addressed in “Trusts and Divorce” in the January and February 2010 issues of TheMatrimonial Strategist (see http://bit.ly/2nJzekb and http://bit.ly/2p107Q, respectively), this article expands on those concepts and addresses many new drafting and planning ideas that were not covered there. Trust drafting has also evolved rather substantially since that time.

Trust Clauses: Less Protective Approaches and How to Improve Them

Trustee

Traditional trusts may name the beneficiary as trustee. To permit this without causing inclusion in the beneficiary's estate, the beneficiary/trustee's rights to make distributions must be limited to an ascertainable standard. (The negative implications of this standard to divorce protection are discussed below.) If the beneficiary is the sole trustee, the powers granted in the trust agreement might expose the trust assets to being reached in a later divorce. Individual trustees too often fail to adhere to trust formalities. If the beneficiary is the sole trustee and those failures exist, the risk of a later attack succeeding could be exacerbated.

The preferable approach would be for the beneficiary not to serve as trustee. The optimal approach would be to name an institutional trustee so that the professionalism, policies and procedures of a professional trustee are present.

Traditional trusts more often relied on family members to serve as trustees. Modern trust drafting more likely would utilize an institutional trustee, and if the home-state law is not optimal, an institution in a jurisdiction that provides better law. In planning for the risks of a beneficiary's future divorce, the difference between the beneficiary as a sole trustee in a home state that has less than optimal trust laws, and a trust using an institutional trustee in a trust-friendly jurisdiction, are dramatic. This difference may be one of the most impactful drafting decisions when planning a trust for divorce protection.

Independent Trustee

When naming a trustee, the preferable approach is to, at minimum, name an independent trustee, i.e., not the beneficiary or someone the beneficiary can control (e.g., an employee of a company owned by the beneficiary), and to vest distribution decision-making in that independent trustee.

Distributions

In broad terms, a trust can be characterized, based on the distribution standards included in the governing instrument, as a “support trust” or a “discretionary” trust. A support trust is one that provides that the trustee pay to the beneficiary as much of the trust income as is necessary for the beneficiary's health, education, maintenance and support. In contrast, a discretionary trust leaves it to the trustee's discretion to determine what, if anything, to distribute. Many trusts are combinations of these.

Traditional trust drafting more often would incorporate a standard for distributions, such as pay income (even when not required, such as to qualify for an estate tax marital deduction), or to provide for the beneficiary's health, education, maintenance and support (HEMS). Modern trust drafting tends to more often favor giving an independent trustee the discretion as to what distributions to make.

A purely discretionary distribution standard is more protective against a future ex-spouse than any other type of standard. A court generally should not be able to force a trustee to exercise a completely discretionary distribution right. As the trust distribution standard moves toward a blend of support/discretion, or a pure HEMS — or even more so, toward a mandatory distribution standard, e.g., “pay out all income annually” — the risk of a court enforcing a distribution in a divorce case worsens. A trust incorporating a HEMS standard is not fully protective of matrimonial claims in that the trustee may be required to make support distributions. However, a HEMS trust is protective of the trust because the beneficiary is only entitled to distributions that are required for her health, education, maintenance and support. Unfortunately, the law on this is quite complex, and varies significantly depending on the state law involved.

The Restatement (Second) of Trusts provides that a purely discretionary trust will be honored as giving the trustee unfettered discretion to distribute or not distribute, regardless of the support needs of the beneficiary. In a jurisdiction whose laws follows this Restatement, a discretionary trust should not be accessible in divorce. The Restatement (Third) of Trusts, however, holds that a discretionary trust can be enforced as a support trust (based on the notion that the trustee must act in the best interests of the beneficiary). So, in jurisdictions that follow the newer Restatement, even a discretionary trust may not be as protective as desired. The answer for clients in those jurisdictions is to apply the law of another jurisdiction, and preferably structure the trust to have situs in a better jurisdiction.

Support Trust

The right to distribute principal and/or income pursuant to a HEMS standard is also referred to as in accordance with an “ascertainable standard,” the tax equivalent to a standard of living. If the spouse/beneficiary is named trustee and the right to distribute to herself was limited to an ascertainable standard, the principal of the trust should avoid inclusion in her estate for tax purposes. If a power may be exercised only in accordance with an ascertainable standard relating to health, education, support, or maintenance, it is not treated as a general power of appointment for tax purposes. If it is not treated as a general power, it will not create exposure to the estate tax. IRC Sec. 2041(b)(1)(A).

This tax paradigm, however, could undermine a significant portion of the protection the trust might have otherwise afforded in a matrimonial action. If the spouse/trustee can make distributions to herself, how might the court consider this power in the context of a matrimonial action? An ascertainable standard might be challenged, depending on state law, to assert that HEMS should include payment of child support, and perhaps even alimony. The meaning of “support” under the tax law is not limited to the bare necessities of life. It includes other reasonable living expenses, but it does not necessarily extend to all expenditures that might be considered customary in the descendant's position in life. There is more to the analysis then merely identifying the nature of the distribution standard. If the trust provides that the trustee “shall pay,” rather than the discretionary “may pay,” the trust may be more susceptible to reach.

Pay-All-Income Standard

A traditional trust often gave the spouse/beneficiary a mandatory income right. For example, the trust might mandate that income must be distributed quarterly. This income right might expose the actual income, or an estimated income stream, to the reach of an ex-spouse. Certainly, a mandatory income stream might be viewed as a resource in determining maintenance or child support.

Sprinkling Provision

Ideally, the trust (excluding marital trusts that are required for tax purposes to distribute all income to the spousal beneficiary) should give the trustee the power to “sprinkle” trust income and corpus among a class of beneficiaries, not merely the spouse. Including multiple beneficiaries, each of whom has the right to receive distributions in the discretion of a trustee, makes the rights of any one beneficiary indeterminate. This should enhance the protection the trust affords in a later matrimonial action.

Use of Property

Traditional trusts rarely, if ever, addressed holding personal-use assets. Modern trust drafting, in contrast, generally provides for and encourages the trust holding personal-use assets. While the most common personal-use asset is a residence, this could also include a vacation home, artwork or even jewelry. If the spouse is a beneficiary of such a trust, he can use the assets held by the trust, but he does not own them. While a court might consider the “use” to be an available resource in its analysis, the court should not be able to distribute property held in an irrevocable trust. So, if a client/beneficiary wishes to buy a house (or other assets), the traditional approach of the trustee distributing cash to the beneficiary to purchase a house should not be followed. Instead, the trust itself should purchase the house and permit the beneficiary to live in it. This would keep the economic value involved in the protective envelope of the trust.

Practitioners should be aware of a common twist on this planning. If the trust was created in a jurisdiction with more protective trust laws than the client's home state, the trust should not own real property in the home state; to do so would taint the trust as subject to the jurisdiction of home-state courts, which might negate the sought-after benefits of creating the trust in a better jurisdiction. In these instances, the house (or other tangible property) can be held in a single-member limited liability company formed by the trustee and owned by the trust.

No Distributions for Spouse of Beneficiary

The trust instrument could expressly state that it is the settlor's intent not to allow distributions to a beneficiary's spouse, and further limit distributions to a married beneficiary to solely the immediate and direct personal needs of that descendant/beneficiary (even pursuant to a HEMS standard). While this type of provision might make it clear that a broader reading of a HEMS distribution standard is not intended to include the spouse, it may also unduly limit distributions while the beneficiary is happily married. For example, most irrevocable trusts are created for general asset protection benefits, not only for divorce protection benefits. If the child/beneficiary is being sued, actual distributions to the spouse, if permitted, would enable the spouse to receive trust benefits without the child/beneficiary's claimant reaching the assets. As with all distribution decisions, the pros and cons of any restriction should be weighed.

Crummey Power

Many irrevocable trusts include an annual demand, or “Crummey” power, to assure that gifts to the trust qualify for the annual gift tax exclusion. The trust beneficiary is given, for example, 60 days, to demand the distribution of a portion of the gifts made to the trust. This gives the beneficiary the immediate right to the money given, so that the donor can realize a favorable gift tax result. This is done to preserve the donor/grantor's lifetime gift exemption (but for the withdrawal right the donor would use up a portion of his/her lifetime gift exemption on each gift made to the trust). Crummey v. Comm'r , 397 F2d 82 (9th Cir. 1968). Crummey powers may provide another mechanism of attack for a matrimonial practitioner. A Crummey power permits the beneficiary to demand a distribution of the amount given in a particular year to the trust, typically the annual gift exclusion ($14,000 in 2017).

During any period when an ex-spouse has the power to withdraw, that amount may be exposed. New trusts might consider whether to even include such powers. With the transfer tax exemption now at $5,490,000 (2017), most estates are not subject to an estate tax. If a Crummey power is not included, then gifts to the trust will require an annual gift tax return. So clients safely below the estate tax threshold should weigh the better protection of excluding Crummey powers and avoiding the annual ritual of issuing written Crummey notices, versus the costs of filing a gift tax return.

End of Trust

Trusts were traditionally structured to end with distributions of trust principal at specified ages — for example, principal may have been directed to be distributed to the beneficiary in approximately one-third increments as follows: one-third at age 25, one-half at age 30 and the balance at age 35. Once distributed, any protection the trust afforded terminates as to the portion of the trust distributed. Modern trust drafting tends to favor very long-term or perpetual trusts. This coordinates with the holding of personal use assets above. If the trust, for example, can hold a house and other assets, there is less need to distribute significant trust assets outright to the beneficiary at any age.

Practitioners should advise clients to evaluate with estate-planning counsel decanting existing trusts into new trusts that retain assets long-term. While the new trust may be limited by the rule against perpetuities of the old trust, incremental protection may be achieved. This should preferably be done well in advance of a divorce, to lessen the challenges that it was “pre-divorce planning.” New trusts should be structured to last as long as state law permits.

Powers of Appointment

Traditional trust drafting incorporated powers of appointment — the right of a named person and power holder to designate where trust assets would be distributed — generally to avoid an unintended imposition of the generation skipping transfer (GST) tax. Modern trust drafting uses powers of appointment for this purpose, but also to infuse additional flexibility into the trust instrument, to garner a step-up (increase) in income tax basis on the death of a beneficiary by causing inclusion of assets in that person's estate, etc. Practitioners should be cautious that the increased use and flexibility of powers of appointment does not undermine the intended protections of the trust plan. For example, if a power of appointment is too broad, it may be construed as a general power of appointment, causing inclusion in the power holder's estate. This could create an opportunity that opposing counsel in a matrimonial action could seek to exploit.

5 and 5 Power

Traditional trusts have sometimes given a beneficiary the right to demand a withdrawal each year of the greater of 5% of the trust principal, or $5,000. While the $5,000 has become economically insignificant, the 5% of principal may not be. If a power is granted up to but not exceeding these amounts, the trust assets, other than those subject to the power, will not be included in the power holder's estate. This power, however, might be another opportunity for opposing matrimonial counsel to exploit. The argument may be proffered that the ex-spouse can demand up to 5% of the principal of an irrevocable trust, so that amount each year should be deemed available to reach in the matrimonial action (assuming the trust assets are otherwise reachable). If not reachable, this amount, it may be argued, is an available resource to the ex-spouse/beneficiary.

We will conclude our discussion of ways to protect trust assets in divorce in next month's issue. Topics will include trust protectors, the power to change the trust situs, life insurance tax reimbursement, charitable remainder unitrusts, Qualified Personal Residence Trusts (QPRTs), gifts versus loans, spousal lifetime access trusts (SLATs), the reciprocal trust doctrine, domestic asset protection trusts and inter-vivos QTIP trusts.

*****
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of The Matrimonial Strategist'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.