Beneficial Interests Vulnerable in Divorce

Take-Away: A beneficiary’s interest in an irrevocable trust should be protected in the trust beneficiary’s divorce, as most beneficial interests arise as a result of a gift or inheritance, which under Michigan law are presumed to be the beneficiary’s separate property. But divorce judges possess equitable powers to reach a fair division of assets, and even separate property interests can be accessed in a divorce to meet the financial needs of a former spouse.

Background: A trust officer recently asked if the assets held in an irrevocable trust can be taken as part of the trust beneficiary’s divorce settlement. The lawyer’s predictably quick answer is ‘it depends.’ A divorce judge can invade one spouse’s separate property if either of three circumstances exist: (i) marital assets were used or consumed to preserve, protect or enhance the one spouse’s separate property asset [MCL 552.401]; or (ii) after the division of the marital estate the divorce judge concludes that the financial needs of the former spouse cannot be met with his/her share of the divided marital estate [MCL 552.23.]; or (iii) the separate property assets were commingled with marital assets, e.g. a joint investment marital account held formerly separate property, so that the separate property assets can no longer be traced and easily identified. If any of these situations apply, then the divorce judge is free to use his/her discretion to transfer an amount of the separate property that is invaded to be awarded to the former spouse. Presumably, a beneficial interest of a spouse in a trust constitutes the beneficiary’s separate property that might be subject to the exceptions described above, though admittedly it is hard to imagine trust assets being commingled with marital assets, but it has occurred on rare occasions where the trust beneficiary also served as trustee of the trust, subject to an ascertainable standard.

Beneficial Interests: As a broad generalization, Michigan’s laws tend to protect the interest of a beneficiary in an irrevocable trust when the beneficiary goes through a divorce.

Discretionary Trust: A exception to the rules which permit a divorce judge to invade a beneficiary’s interest in an irrevocable trust that can be classified as his/her separate property is if the trust is a discretionary trust. The beneficiary’s interest in a discretionary trust is not subject to enforcement of a judgment until the income or principal are actually distributed to the trust beneficiary [MCL 700.7505] and the trust beneficiary’s interest in such a trust is legally not to be treated as a property interest. [MCL 700.7815(1).] While the divorce judge might want to gain access to the trust assets in order to implement a fair division of the assets of the marriage, the Trust Code is clear that the assets while held in the discretionary trust cannot be touched by the divorce judge- which is often a bitter pill for a divorce judge to swallow.
Support Trust: If the beneficial interest of the spouse is in a support trust, then the assets of the trust can be exposed in the beneficiary’s divorce action. While the divorce judge cannot directly access the assets held in a support trust, those assets become ‘fair game’ when they are distributed to the trust beneficiary. [MCL 700.7503.] More importantly, the spouse’s beneficial interest in a support trust can “be reached in satisfaction of an enforceable claim against the trust beneficiary by his/her child or former spouse who has a judgment or court order against the trust beneficiary for support or maintenance.” [MCL 700.7504(1)(a).] In short, spousal support awards and child support awards are treated as exception creditors, and even a spendthrift provision in the support trust will not prevent these claims from being enforced by a divorce judge by accessing the trust’s assets.

Spousal Support Awards: Suppose the beneficiary is a beneficiary of a discretionary trust. As just noted, a divorce judge cannot directly access the assets held in that trust as the trust beneficiary is not treated as holding a property interest in the trust, and divorce judges are only supposed to divide property and not expectancies. But the divorce judge also possesses the power to award spousal support. Is there an indirect way in which the divorce judge can access the assets held in a discretionary trust by setting a spousal support award on the assumption that the trust will continue to make distributions to the trust beneficiary? Maybe.

Lifestyle: A divorce judge possesses plenty of latitude when it comes to using a spousal support award to assist the former spouse to become financially self-sufficient after the divorce is final. While multiple factors are considered by the divorce judge, the key factors are the recipient-spouse’s financial needs, the payer-spouse’s ability to pay, and the lifestyle enjoyed by both of the spouses while they were married.
Discretionary Trusts: The problem arises when the payer-spouse has limited earned income from which to pay a spousal support obligation, yet he/she is the beneficiary of a discretionary trust. While the divorce judge cannot directly access the assets held in the discretionary trust, if trust distributions contributed to a higher lifestyle enjoyed by the trust beneficiary and his/her spouse during their marriage, the divorce judge could attempt to set a spousal support award amount based upon presumed future distributions from the discretionary trust to its trust beneficiary.
Regular and Recurring Distributions: This risk to the trust beneficiary of a spousal support obligation that is based on more than the trust beneficiary’s own earnings is exacerbated when the trust distributions to the beneficiary have been regular and recurring, or when the distributions received are an identical amount, year after year, i.e. the distributions and their amounts are predictable. In these situations, the divorce judge will often presume that there is a prearrangement between the trustee and trust beneficiary that an identical amount will automatically be distributed each year from the trust to the trust beneficiary, in effect ignoring the trustee’s obligation to use its discretion to determine the beneficiary’s actual need for a distribution, or the amount of the distribution. This ‘regular and recurring’ distribution pattern is often the result when a family member serves as the trustee, where no ‘trust committee’ is involved that ‘vetted’ the need, or determined the amount, which results in the conclusion by the divorce judge that the trustee and trust beneficiary have an implied understanding that whatever the trust beneficiary asks for he/she will receive that amount distributed from the trust, which the judge then uses to justify setting a large spousal support obligation which indirectly takes into account the assets held in the trust or the income those trust assets generate.

Recent Example: This willingness of a divorce judge to focus on a regular pattern of distributions from a discretionary trust to fashion a spousal support award based upon presumed annual trust distributions to the trust beneficiary is the fairly notorious case Ferri v. Powell-Ferri, 72 N.E. 3d 541, 545 (Mass. 2017.) which was reported early last year. You will recall that this was a case where the husband was a beneficiary of an irrevocable discretionary trust established for his benefit by his father. The husband’s brother was the trustee of the trust. The husband-beneficiary possessed the right under the trust to withdraw assets when he attained age 40. The wife filed for divorce. The brother-trustee decanted the trust assets to a new trust where his brother-beneficiary no longer possessed any right to withdraw all of the assets held in the trust, obviously an attempt to keep the trust assets (subject to the husband-beneficiary’s approaching age of withdrawal) from the divorce judge’s jurisdiction. While there was no decanting statute in Massachusetts, the court found that the trustee held a common law power to decant, hence validating the decanting of the trust’s assets to the new trust where there was no power to withdraw held by the husband-beneficiary. But the husband-beneficiary’s former wife had the last laugh after he and the trust had spent a small fortune in the Massachusetts’s courts fighting the trustee’s decanting maneuver. The trial judge, after the case was remanded, ultimately set the husband-beneficiary’s spousal support obligation to be paid to his former wife close to 100% of the former husband’s earned income. In relying upon the presumption that the husband-beneficiary would continue to receive distributions from the trust at the same level that he had received them during the marriage, the divorce judge stressed that the trustee (brother) made regular, recurring, and substantially the same amount of distributions from the trust to his beneficiary-brother each year, and had done so for most of the marriage period. The judge also observed that there never had been an occasion, at least not gleaned from the trustee’s records, that a request for a distribution by the husband-beneficiary had ever been denied by the trustee. Thus, the divorce judge, whose decision was later sustained on appeal, reasonably concluded that distributions from the trust would continue to be available from the discretionary trust from which the husband-beneficiary could pay his sizeable spousal support obligation.

The message from the Ferri divorce litigation saga is that if a discretionary trust is not administered like a discretionary trust and the pattern and amounts distributed to the beneficiary are predictable, then the divorce judge can presume that those distributions will continue [despite the trust being labeled a discretionary trust] and the divorce judge will feel free to set child support and spousal support obligations of the trust beneficiary based on those assumed distributions from the discretionary trust.

Risk Factors: The dangers that a discretionary trust will be taken into account by a divorce judge result when: (i) a family member serves as the trustee; (ii) the trustee seldom (if ever) rejects a distribution request from the trust beneficiary; (iii) the trustee acts more like an agent or custodian for the beneficiary rather than a fiduciary; (iv) the trustee tends to ignores the rights and interests of the remainder beneficiaries, i.e. the trustee does not administer the trust impartially; and (v) the amounts distributed from the discretionary trust to the beneficiary are predictable and consequently those distributions played a significant role in the lifestyle of the beneficiary’s family during the marriage.

Asset Protection Trusts: There has yet to be reported a case that deals with a Michigan asset protection trust, i.e. a Michigan Qualified Dispositions in Trust, in which the trust beneficiary going through a divorce is the beneficiary of a discretionary trust. In this situation the rights of the trust beneficiary are not established under the Michigan Trust Code, but the Michigan Qualified Dispositions in Trust Act. [MCL 700.1041 et seq.] While most folks think that a trust that is created under this statute must be a self-settled asset protection trust, that is not the case. Any irrevocable trust can be established as a Qualified Dispositions Trust so long as all of the other conditions and criteria imposed by the statute are followed. Assume that a parent’s estate planning trust directs that a continuing trust be established for the deceased parent’s child as a Qualified Dispositions Trust. In that situation, if the conditions of the Qualified Dispositions in Trust statute are followed, a divorce judge cannot take the assets held in the trust, either under the property invasion statutes [MCL 700.552.401 or MCL 552.23, as described above] nor can the divorce judge indirectly access the Qualified Dispositions Trust when setting a spousal support obligation of the trust beneficiary. The Qualified Dispositions in Trust statute clearly states:

(4) if a trust beneficiary who has an interest in a qualified disposition or in property that is subject to a qualified disposition is a party to an action for annulment of marriage, divorce, or separate maintenance, all of the following apply:

If the trust beneficiary is not the transferor of the qualified disposition, the trust beneficiary’s interest in the qualified disposition or in property that is the subject of the qualified disposition is not considered marital property, is not considered directly or indirectly, part of the beneficiary’s real or personal estate, and shall not be awarded to the trust beneficiary’s spouse in a judgment for annulment of a marriage, divorce, or separate maintenance. [MCL 700.1045 (4)(a).]

Ambiguity: Not clear, however, is if a divorce judge can, despite this statutory prohibition, still set a spousal support obligation relying on the distributions that the trust beneficiary might receive from the Qualified Dispositions Trust. The statute clearly says that the divorce judge cannot treat the beneficiary’s interest in the Qualified Dispositions Trust as a property interest that is owned by the trust beneficiary, which is consistent with conventional discretionary trust law under MCL 700.7815(1). But we know that sometimes a divorce judge will look not to the trust’s assets, but the income the trust assets generate, when the judge sets a spousal support obligation of the trust beneficiary. Thus, the ambiguity is to determine what is intended by the Legislature’s use of the terms directly or indirectly? If the Qualified Dispositions Trust cannot be considered to be marital property, does the use of the word indirectly imply that the income from the not-considered-to-be marital-property is also not to be considered, or by extension available to the trust beneficiary, for purposes of establishing a spousal support obligation? There is no mention in the statute of a Qualified Dispositions Trust’s income being disregarded or ‘not considered.’ Or, consider that another provision of the Qualified Dispositions in Trust Act states that If subdivision (a) [quoted above]… do[es] not apply, subsections (2) and (3) [dealing with creditor claims] do not limit the transferor’s spouse’s property division claims, which language suggests that only a property division, and not a spousal support obligation, is the purpose of the prohibition. Thus, a narrow interpretation of the intent of the not considered prohibition it is possible that a Qualified Dispositions in Trust’s income might continue to be considered ‘available’ to the trust beneficiary when the divorce judge sets his/her spousal support obligation.

Conclusion: Apparently we will have to await a court decision where the divorce judge, after reading the Qualified Dispositions in Trust statute and its express prohibition, nonetheless determines that income (not property) from the Qualified Dispositions Trust is still ‘fair game’ when the judge awards spousal support to the non-beneficiary-spouse.