This article was originally printed in the September 2017 issue of DBA Headnotes.
Many high-net-worth individuals and families have assets that are contained within a trust, or trusts. There are very sound legal reasons to create trusts, and a great number of families use them. The three primary reasons are:
1. Protection from lawsuits and creditors (especially for people in occupations more susceptible to lawsuits, like doctors, lawyers, and CEOs);
2. To create a legacy; and
3. Potential tax benefits.
However, high-net-worth clients and the lawyers representing them may find themselves asking the question: What happens in a divorce when a significant percentage, or most, of a couple’s assets are tied up in trusts?
For starters, when a trust is created—as long as it is done legally—the assets used to fund the trust are no longer part of the marital estate. In a great number of situations, that can certainly benefit a married couple. But in a divorce, can create some very complex issues, especially if the trust was created or funded in anticipation of filing for divorce.
If a trust was created and funded near the time of the divorce, that’s an obvious red flag, but even trusts created early in the marriage, with both spouses agreeing to the terms of the trust, might require more scrutiny than they might initially appear to need.
In order to fully analyze trust and know-how, the law should apply to the assets held by that trust, you must first understand the parameters of the trust. To do so, you need to gather the following necessary information: (1) who the trustee is, (2) who the beneficiaries are, and (3) how the distribution rules operate, based on the terms of that particular trust.
For example, if the trustee is a close personal friend of the husband rather than a bank, that could make a difference in how the trust operates. A trust might be set up to provide the wife in this situation with a certain amount of income, or all of the income of the trust. After the divorce, the husband and trustee might not be able to change how much income is distributed to the now-ex-wife via the trust, but they could conceivably change how much income the trust produces by investing the assets differently. Also, in this situation, the Wife would have no control over the principal or assets of the trust.
Oftentimes, even though both spouses signed off on a trust early in the marriage, one, or both, might not be aware of the pitfalls embedded in that trust. These include whether either spouse has ownership of the trust corpus, which is generally evidenced by having a “present possessory right to part of the corpus;” whether one spouse has discretionary control over distributions of trust income or the trust corpus; and whether the trust provides one spouse with authority to decide when, where, and how the trust corpus should be invested. These pitfalls typically reveal themselves once divorce happens, and parties who were once allies have now become adversaries.
There is some debate in the estate planning community around these issues. Most trusts are set up by one lawyer acting in the interest of both parties. The lawyer would normally have no idea that one party might want trust in order to control assets after an impending divorce. In my opinion, any time marital assets are to be transferred to a trust, each party should have their own lawyer. And these lawyers should advise each spouse on the effect this transfer of assets would have on them if they were to divorce.
Since it is difficult to change the terms of trust after a divorce, it is best to address any assets contained in trust during divorce negotiations. In some cases, the rules and circumstances around trust are so complex that it is better to dissolve the trust and disperse the assets to the spouses directly as part of the overall community property division. And while it is possible to convince a judge to ignore a trust under some circumstances when dividing marital assets, it is very difficult to do, so it is a risk at trial.
Sound legal advice from a family lawyer knowledgeable in trusts is essential in these cases, whether the client is a high-net-worth earner trying to protect his or her wealth through trusts, or the spouse of a high net worth earner trying to ensure a fair divorce settlement.