Not all trusts are created equal, especially when it comes to protection in a divorce.
No client wants to leave an estate to a child only to find that the money is lost later on in a divorce. The estate planning answer for a lot of parents is to leave inheritances in trust for the benefit of their child. But trusts vary widely, and because this is a message many clients miss, planners must reinforce the idea.
Most clients continue to use trusts that will provide modest protection—or perhaps none—if a child later divorces. There are far better options. To understand the alternatives, the nuances of will and trust provisions have to be addressed. Advisors need to assess the fine print of every trust to see what it will really do. Poorly crafted trusts are the weak link in most clients' wealth transfer plans.
Before starting a conversation about trusts, it helps to understand a client's mind-set. They usually make two common mistakes when they plan wealth transfers via trusts: They insist on simplicity, and they insist on control. This is a classic estate planning double fault, and their kids will not only lose the point but also the money.
Begin by explaining that simplicity should never outweigh protecting heirs. Planners can play a vital role in helping clients understand and gain comfort with the recommendations of the estate planner to achieve these protective goals. As for control, clients must understand that a properly structured trust is more about providing an heir flexibility and security, not about setting limits.
* The trust ends at some specified age, typically when a client feels the child will be mature enough to handle money. Many end at 25 or 30. Some divide up the principal and make distributions in segments, for example, at age 25, 30 and the balance at 35.
* The child is named co-trustee at some age, say 21, so that the child can be in control of his or her financial future.
* Trustees can distribute money to maintain a child's standard of living. In tax jargon, this is often referred to as a health, education, maintenance and support standard.
* Children often have the right to distribute to themselves to maintain a standard of living.
While there are no reliable statistics on trust terms, most estate planning lawyers would tell you the above approach has been the norm. That's too bad, because clients can get better results.
The typical trust will accomplish what has historically been most parents' main goal: to protect a child from imprudence until that child attains an age and maturity to be able to handle money. But this is one of many goals. The reality is that distributing money outright at any age is often a mistake. What if a divorce occurs the year after the distribution? Not knowing when a divorce might occur indicates that trusts should be made to last as long as possible.
Naming a child as trustee or co-trustee is common, but it also vests the child with power over distributions that might undermine the protection the trust would otherwise afford if the child trustee divorces. If the child can make distributions to himself or herself during a marriage, might a court be inclined to try to force a child trustee to continue making distributions after a divorce?
Distributions to maintain a child's standard of living have considerable appeal to most clients. They want a safety net for a child to assure a reasonable lifestyle, and setting up in advance what seem like reasonable distributions for this type of support might allay parents' concerns about a child's potential to spend money on extravagances.
But might a court interpret the requirement to maintain a child's standard of living as including in that standard the care of a minor child? What about child support? This could well be a hole in the trust, and trying to stem the bleeding of assets through this hole during a divorce will be a weak attempt to rectify what proper planning could have secured from the start.
A recent landmark case in New Jersey , Tannen v. Tannen, held that the wife's trust could not be touched to satisfy divorce claims. The wife's parents created the trust for her, and named themselves and the wife as co-trustees.
The court, on appeal, held that no income could be imputed to the wife from the trust for purposes of determining alimony or child support in the divorce. Even though the trust distribution included details on both support distributions to maintain a standard of living and discretionary distributions to be determined by the trustee, the court treated the trust as a discretionary trust. Based on this and other factors, the court held that the wife did not have an income interest in the trust which she could enforce, and hence which the court could attribute to her in the divorce. The New Jersey Supreme Court affirmed.
This case will likely influence similar challenges that occur in other states, so it's important for planners to be aware of the ruling. The wife was fortunate in how the court resolved the matter, and advisors should guide clients to avoid potentially close calls in their own planning.
While the Tannen trust worked, the family still had to defend it through costly litigation. It's possible to do better protecting wealth should an heir divorce.
Trusts can generally be classified based on their distribution provisions as either support or discretionary trusts. The Tannen trust included standard of living support, but also gave the trustees discretion, so it was really a mixture. Depending on the state involved, a court might find a different result with a similar trust.
The safer approach is always to have a trust designed as solely a discretionary trust, no standard of living support or any other standard for distribution. The risk is that if the trust, as in the Tannen case, has a support standard, the court might interpret that standard as including the payment of a particular matrimonial obligation or other claim.
In contrast, a pure discretionary trust, in which distributions are the sole discretion of the trustee, is harder to consider as a resource. With no mandated standard for distributions, since all distributions are discretionary, what can the court force the trustee to do? Most clients, however, are loath to give that much discretion to a trustee, so the decision becomes a weighing of better divorce protection on one hand and greater certainty over distributions on the other. Ask any lawyer—in our litigious society, the recommendation will be to favor better divorce protection.
The message for advisors to get across to clients is that divorce is a major threat to wealth transfers. For many clients, it poses a greater risk than the estate tax. Unfortunately, too many clients leave assets outright to adult heirs instead of in trusts, or opt for trusts that do not afford the protections available with better trusts. It's worth spending some extra time and effort to make sure clients understand the potential future consequences—for their children and heirs—of estate planning decisions.
Source: SourceMedia and Financial Planning (02/2012).