How to Protect an Inheritance in a Subsequent Divorce

Take-Away: While an inheritance, or a gift, received by an heir is generally treated as a spouse’s separate property, there is no assurance that the separate property asset will be retained by the heir after their divorce. The best way to assure that an asset is treated as a spouse’s separate property is for both spouses to agree to that classification in a prenuptial agreement. But now Michigan Courts have concluded in three Allard decisions that despite that agreed upon separate property classification in a prenuptial agreement, divorce judges can ignore that classification and award the separate property to the other spouse.

Background: I was asked last week by an attorney when, or how, an inheritance can be lost in an heir’s divorce. While the rules sound fairly straightforward, they can become complicated when applied to the underlying facts of a divorce. Some key rules in dealing with inherited or gifted assets when the recipient finds himself or herself in a divorce follows.

Presumption: Under Michigan law any assets that a spouse receives by way of gift or inheritance is presumed to be that spouse’s separate property. Following this general rule [and ignoring multiple exceptions] the trial court when making an equitable distribution of the marital estate, is supposed to restore the gifted or inherited asset to the individual (heir) who received the asset. This general rule applies if the gifted asset or inheritance was received either before the marriage or it was received during the marriage. The recipient, however, has the burden of proof to show that the source of the asset in the recipient’s name came as an inheritance or a gift. Consequently, it can be a lot of work just tracing the source of the asset to show that is came to one spouse as their gift or inheritance.
Shift in the Burden of Proof: If the inheritor can show that the asset came to him or her as a gift or inheritance, the burden of proof then shifts in the divorce to the non-propertied spouse to justify including some, or all, of the inherited asset in the marital estate to be divided by the trial judge following ‘equitable distribution principles’, aka what the trial judge views a fair division of the assets and debts.
Judicial Invasions of Separate Property: Several bases exists that can be used by the non-propertied spouse to convince the divorce judge to include their spouse’s separate property, or a portion of it, in the divisible marital estate.
Commingling: This first approach to attacking a separate property claim in the divorce is to show that the asset was gifted to the non-propertied spouse, or it was commingled with marital assets to such a degree that the separate property origin of the asset can no longer be distinguished. Example: If parents make an annual exclusion gift to their son, and the son deposits the gifted funds into a joint checking account held in the names of both spouses, the son has probably lost the ability to claim that part of the joint checking account consists of his separate property. By making the separate property joint between the spouses, the theory is that the separate property has been transmogrified into marital This is why I often counseled heirs to create a revocable grantor trust and to have the estate administrator directly transfer the inheritance directly to the heir as trustee of his/her grantor trust, to maintain the segregated nature of the inheritance. If inheritances are commingled or held jointly, there is a strong chance the entire asset will be treated as part of the divisible marital estate.
If You Use it, You May Lose it: Many divorce judges are not inclined to try to find, or to preserve, separate property. If inherited funds are used to pay debts or to purchase assets, often the divorce judge will assume that the inheritor used separate property assets first, before marital funds are depleted. Example: A son inherits $50,000 on the death of a parent. The son applies the inherited $50,000 to pay down the mortgage on his home that is owned jointly by the son and his wife, encumbered by a mortgage obligation borne by both husband and wife. $50,000 remains in the spouses’ joint investment account, i.e. the joint investment account was not used to reduce the mortgage balance. In a divorce, the judge will listen, but not very sympathetically, to the son’s claim that $50,000 of the home equity should be classified as his separate property, even when he can demonstrate that the source of the funds to reduce the mortgage balance was his inheritance. The increase in the jointly owned home equity will probably be treated as a gift by the husband to his wife, since she is a joint owner, and she could possibly become the sole owner of the home if she outlived her husband. Restated, judges are disinclined to swap out separate property that was expended and use marital assets to replace one spouse’s ‘lost’ inheritance. While it is difficult to advise an heir to not use a windfall inheritance to pay down debt, there is a risk that if the inheritance is used in marital debt reduction, the inheritance will not be restored to the heir in a future divorce.
Direct Contribution: Part, or all, of what is clearly separate property, can be included in the marital estate applying what is called the contribution Contributions can come in a variety of ways. An obvious example is that I inherit a cottage from my parents. I keep the cottage in my name alone. But the cottage roof needs to be replaced. I use my earned income (which is marital under Michigan law) to pay for the replacement cottage roof. Since I used marital funds to improve my separate property asset, the divorce judge can treat some, or arguably all, of the cottage as part of the divisible marital estate. Chances are pretty good the judge will let me retain the cottage post-divorce, but my former spouse may walk from the divorce with more than 50% of the marital assets, to compensate for me being permitted to retain my now improved separate property. Another form of contribution that shows up in dealing with separate property is ‘sweat-equity.’ Same example: I inherit a cottage and retain title in my name alone. My wife spends an entire summer landscaping the cottage and painting it, both inside and out. Through my wife’s contributions, she has added to the cottage’s value. In a divorce, the judge might try to quantify the value of my wife’s ‘sweat equity’ contribution, i.e. some form of phantom wages, or the judge might engage in a ‘before and after’ increase in cottage value analysis to quantify an award to my former spouse that increase in cottage value with a larger part of the marital estate. Or, consider the fact that each year I have to pay real property taxes on my inherited cottage; if I use my earnings to pay those property taxes, then the marital estate was to some degree depleted in order to preserve my separate property. Invading separate property on the basis of ‘contributions’ to its acquisition, preservation or enhancement in value is expressly authorized by statute. MCL 552.401.
Indirect Contribution: This approach is very problematic for wealthy families that own closely held businesses. I handled 3 large divorces in the last decade of practicing law where this indirect contribution ‘principle’ created a high risk to the family. It’s origins comes from a 1994 decision The facts were commonplace but the result was a big surprise. Mr. Hanaway worked in the family business. Over the years he was gifted stock in that closely held business by his father. Mrs. Hanaway stayed home and raised their children. In their divorce, Mrs. Hanaway successfully claimed that she had indirectly contributed to the growth in value of the closely held business [keeping in mind the stock came to her husband by gift, and the stock was always held in his name alone.] Her claim was premised on the fact that her husband spent long hours working at the family business and growing its value through his efforts, time that she enabled by their implicit mutual decision that she stay home, keep the home and raise their children. The court included all of the value of Mr. Hanaway’s closely held business stock in the divisible marital estate; while the stock was not awarded to Mrs. Hanaway, she ultimately received the ‘lion’s share’ of the actual marital estate to ‘balance’ against the family business stock that her husband retained. I always kept Hanaway in mind when I encouraged parents to gift parts of their closely business to their children as part of their estate plan to exploit valuation discounts and to remove appreciating assets from their taxable estates, especially when the donees were children who worked in the family business. On a couple of occasions I persuaded the parents to gift the stock to an irrevocable trust, in order to be in a position to argue that the facts were different from Hanaway, should their child ever be in a future divorce.
Active/Passive Appreciation: Yet another way in which separate property can be dragged into the marital estate in a divorce is to show that the increase in value of the separate property asset during the marriage came as ‘active’ appreciation. This is an exclusively judge-made rule that permits the divorce judge to treat as part of the divisible marital estate any appreciation experienced by the inherited or gifted asset. Let’s go back to my inherited cottage example. Assume the cottage is worth $100,000 when my parents die and I inherit the cottage. I find myself in a divorce 10 years later. At the time of the divorce the value of the cottage is now worth $175,000. The question then is whether the $75,000 appreciation in value of the cottage was ‘active’ or ‘passive.’ If ‘passive,’ i.e. market forces are the sole reason for the increase in value of $75,000, then the judge will exclude the cottage and all of its value from the divisible marital estate. In contrast, if part of that $75,000 increase in value can be demonstrated by the fact that I spent several summer vacations painting the cottage or putting in a new bathroom [assume using other cash that I inherited from my parents so that the marital estate was not depleted in any way] and it was through my ‘active’ efforts that the cottage value grew, a portion of that $75,000 (maybe all of it) will be included in the marital estate. What is active vs passive is where there are few rules for any guidance. I recall a heated argument with a circuit judge [he was my former law partner so I was more comfortable telling him, in his chambers, that he was ‘just flat wrong’] a few years back where my client had owned and contributed to an IRA prior to the marriage. No funds were contributed to the IRA during the marital period. When the divorce was filed the IRA had grown from about $100,000 to about $250,000. I claimed that the IRA was exclusively my client’s separate property, as all of it had been accumulated prior to the marriage, and that any growth in value of the IRA was purely ‘passive’ reflecting a growing stock market without any involvement of my client. The judge asked me if the investments had remained the same throughout the marital period. I responded that once or twice a year the client consulted his IRA custodian and they periodically ‘tweaked’ the IRA’s investments. In response to that honest answer the judge remarked, ‘since there was ‘active’ supervision of the investments held in the IRA by your client, the growth in value of the IRA during the marital period must be included in the marital estate for an equitable division. In sum, if a judge wants to find ‘active’ appreciation, he or she will find a way to find ‘active’ appreciation, often on pretty flimsy facts.
Need: This last way to invade a spouse’s separate property is called the ‘needs’ approach. After a divorce judge has set aside what is clearly separate property, and has then divided in an equitable manner the marital estate, the judge is directed by statute to take ‘one-last-look.’ If the trial judge concludes that the non-propertied spouse will not be able to maintain a semblance of their prior life-style in reliance on their share of the divided marital estate, the trial judge is free to then ‘invade’ the other spouse’s separate property to enable the former spouse to maintain their prior standard of living. MCL 552.23. There are no fixed rules as to ‘how much?’ or ‘in what manner?’ Sometimes this ‘invasion’ of separate property comes in the form of a spousal support award, paid over an extended period of time, and often tax deductible to the payor. But there have been reported decisions where a portion of one spouse’s separate property was awarded wholesale to the non-propertied spouse simply to address pressing financial needs that could not be addressed with the allotted share of the marital estate. In high asset divorces this ‘needs analysis’ is seldom encountered. An invasion of separate property is more likely to occur when the separate property of one spouse greatly exceeds the size of the divided marital estate.

Solutions:

Prenuptial Agreement: I used to think that the best way to protect separate property if parents were worried about a child’s future divorce was to have the child enter into a prenuptial agreement where the separate property that was gifted or inherited by them was clearly identified in a prenuptial agreement, and the parties to the agreement also agreed that neither would make a claim against the other’s separate property in a future divorce, or in any appreciation in that classified separate property during the marital period. With the recent Allard decisions, apparently an arm’s-length, honestly negotiated, prenuptial agreement will not protect separate property in the event of a future divorce. Apparently, however, a prenuptial agreement will still be effective if its purpose is to remove separate property assets from claims made by a surviving spouse, e.g. a surviving spouse who claims an elective share of the deceased spouse’s estate.

Discretionary Trusts: An additional way to protect an inheritance is to ‘wrap’ the inheritance in a discretionary trust. Under Michigan’s Trust Code (adopted in 2010) with a discretionary trust the beneficiary does not possess any property interest in the trust. If there is no property interest, there is nothing for the divorce judge to reach.
Asset Protection Trusts: Instead of a discretionary trust, a parent could use a continuing trust to hold a child’s inheritance on the parent’s death that elects to be treated as an ‘asset protection trust’ under Michigan’s 2017 Qualified Dispositions in Trust Act. That statute clearly directs a divorce judge to not ‘directly or indirectly’ consider a spouse’s beneficial interest in a qualified dispositions trust. It is too soon to tell if a divorce judge will actually follow that directive in a divorce. Divorce judges, like all judges, tend to not like to be told ‘you can’t do that.’
Revocable Trusts: The use of a revocable trust to ‘wrap’ around a gift or an inheritance is definitely not fool proof. But it serves a purpose of segregating the separate property assets, it prevents commingling inherited or gifted assets with marital assets, and it is not subject to spousal elective rights on the death of the heir. If the assets held in the marital trust generate income, it is best to use that income to pay the income taxes on the income that will usually be reported on a jointly filed 1040 income tax return. Using the trust’s income to pay the income taxes on its own income precludes a future argument that marital funds were dissipated to pay the income tax liability caused by one spouse’s separate property

Conclusion: If clients are concerned about their children or grandchildren losing inheritances in future divorces, probably the best advice to give them is to ‘wrap’ the inheritance in a trust for some duration. If a wholly discretionary trust is used, then the child-beneficiary, by law, does not possess any property interest in the trust, making it impossible for a divorce judge to find a property interest to attach [though I confess that nothing is impossible for a circuit judge who is hell-bent on doing what he/she thinks is fair.] Alternatively, the continuing trust that holds the child’s inheritance could be structured as a Qualified Dispositions in Trust, where by statute the child’s interest expressly cannot be taken, or even considered, by a future divorce judge. So while gifts and inheritances are presumed to be the recipient’s separate property, that classification standing alone provides little protection in a future divorce where both divorce statutes and judge-made legal theories provide ample access to that separate property.