Trusts and Divorce

Take-Away: Trusts sometimes protect assets from being lost in the beneficiary’s divorce, other times the trust does not work so well as an asset protection device. Consider the estate planning trusts that clients create for income or transfer tax purposes, in which they retain an interest like a GRAT, CRUT, or QPRT. A divorce court’s equitable powers might unwind a well design trust that was created for sound estate planning purposes.

Background: We have covered this topic in the past, but it never hurts to have a refresher, particularly when more folks are creating trusts for their children and grandchildren using their available applicable exemption amount. When a trust beneficiary is in a divorce often the question comes up whether the divorce judge can take the trust assets into consideration in fashioning an equitable distribution of the marital estate. The answer turns both on the beneficiary’s interest in the trust and how trust distributions were used in the past.

Terms of the Trust: The divorce judge will normally look at the terms of the trust and the beneficiary’s interest and ‘rights’ in the trust’s principal and its income in making the decision whether the trust is vulnerable and thus included in the marital estate and  exposed to inclusion in the the judge’s division of the marital estate. Often a provision that a judge will focus on is whether the trust beneficiary can compel distributions of income or principal prior to the final distribution of the trust assets. The same with a withdrawal right, that might be included in the trust to cause it to be taxed as a beneficiary-grantor trust. [IRC 678.] A provision that prohibits the trust beneficiary from compelling a distribution, or a no-contest clause that is designed to deter petitions to the probate court to compel a distribution by the trustee, are sometimes  evidence of the settlor’s intent that the beneficiary have few, or no, rights to access trust income or principal.  However, more is involved than just the divorce judge looking at the language that is used by the settlor in the trust instrument and whether such terms spell out rights to, or confer entitlements on, the trust beneficiary.

Property Interest: Important in Michigan is its definition of a discretionary trust and the clear statement in the Michigan Trust Code that the beneficiary of a discretionary trust does not possess a property interest in the trust that is subject to attachment. [MCL 700.7815(1); 700.7505.] This rule was followed by the Michigan Court of Appeals in In re Antonia Gualtieri Living Trust, Michigan Court of Appeals, No. 341816 (March 19, 2019). In that case the trust instrument provided that ‘the trustee, in its sole and absolute discretion, shall apply to, or for the benefit of, the beneficiary as much of the net income and principal from the trust as the trustee deems advisable for the beneficiary’s education, health, maintenance and support.’ The Court concluded that this trust was a discretionary trust as defined in MCL 700.7103(d). Because it was a discretionary trust the trust was, by default, neither a support trust nor a spendthrift trust; these other trusts allow exception creditors access to the trust and its assets. In this case, the beneficiary’s ex-spouse was unable to compel the trustee to make a distribution that could be attached in satisfaction of the beneficiary’s child support and spousal support arrearages.

However, a court can also find that the language used in the trust instrument does not create a discretionary trust and instead a support trust which enables a creditor of the beneficiary to reach the trust assets in certain instances. See In re Darrell V. Wright Trust Agreement, Michigan Court of Appeals No. 319832 and 319834 (March 17, 2015). As such, courts seem to be guided (when they actually take time to read EPIC and the Michigan Trust Code!) with respect to the technical definitions of a discretionary, support, or spendthrift trust.

History of Trust Distributions: A divorce judge will also look at what actually happened in the trust’s administration. A divorce court will consider the history of trust distributions to identify any patterns and consider whether the marital couple actually used trust funds to support their lifestyle. If it becomes clear from a review of the history of trust distributions that the trust was regularly used to support the marriage’s lifestyle, there is a good chance those funds will be used in the divorce’s division of the marital estate. In contrast, if the distributions have been irregular, uneven, or sporadic, it less likely that the divorce judge will treat the trust, or its income, in fashioning an equitable distribution of the marital estate.

An example where the nature of trust distributions became critical to the court’s decision was the well-known New Jersey decision Tannen v. Tannen. In that case the wife’s parents created an irrevocable trust for their daughter’s sole benefit. The trustees, in their sole discretion, could make distributions for the daughter’s health, support, maintenance, education and general welfare as the trustees determined would be in her best interest, taking into account other financial resources then available to her [a ‘mix’ of discretion, broad, and ascertainable standard of distribution.] Over the years the trust had paid for some marital expenses, including real estate taxes on the marital home, home improvements, and private school for the children. The divorce judge imputed a $4,000 monthly trust income distribution to the daughter. That decision was reversed on appeal, the appellate court focusing on whether the daughter possessed a property interest in the trust. The appellate court focused on the facts that: (i) the daughter neither had control over the trust income nor the ability to access that income source; (ii) distributions were never made directly to the daughter, but made solely on her behalf or ‘for her benefit’; and (iii) the trust instrument expressly prohibited the daughter from ever compelling distributions of income or principal prior to the trust’s termination date, thus manifesting the settlors’ intent that their daughter have no control, direct or indirect, over the trust. Added to this ‘lack of control over the trust’ conclusion were the facts that there was a spendthrift provision in the trust that clearly stated that the ‘trust was not subject to the beneficiary’s debts or liabilities’ and the fact that over the 7 years that the trust had been in existence, the daughter never had any control over the trust or access to its income.

However, there are also some divorce decisions that will include (or exclude) a trust and its assets in the division of the marital estate, and decisions that found that a regular pattern of distributions of trust income will be considered when the court sets child support or a spousal support awards.

Estate Planning Trusts: But the question then arises what happens if the married couple create their own irrevocable estate planning trust and they later find themselves in a divorce? Planning strategies like charitable remainder unitrusts, spousal lifetime access trusts, grantor retained annuity trusts, or qualified personal residence trusts. The transferred marital asset is no longer owned by either spouse, yet the spouse may still benefit from their retained interest in the irrevocable trust. Once such interesting case was from New York, in Yerushalmi v. Yerushalmi. The divorce court initially found that a residence that had been transferred to a QPRT was no longer marital property and was excluded from the marital estate as part of the divorce proceedings because neither spouse owned the residence- it was owned by the QPRT not the parties. That decision was reversed on appeal. The appellate court held that since the marital residence was purchased by the spouses during their marriage using marital funds, it was presumed to be marital property. The fact that title to the residence was transferred to the QPRT was dispensed with by the court with the following: “Allegedly for estate planning purposes, while the parties continued to reside there was, under the circumstances, insufficient to rebut the presumption.” While the focus on title is critical to many estate planning techniques, the court was not impressed with the QPRT holding title to the home. More likely the court was concerned that under the other facts of the case, it would have been inequitable for the residence to be removed from the marital balance sheet, so the court exercised its equitable powers to reach what it felt was an equitable result.

Then again, in yet another New York divorce case, Villi v. Villi, the divorce court and appeals court respected a QPRT and said that the home and its value was not part of the marital estate. The Villi Court found that the transfer of the home to the QPRT was akin to making the gift of the home to the wife’s son, who was the QPRT remainder beneficiary, subject only to the condition that both parties could reside in the home during their retained fixed use term. The court concluded: “The home no longer constitutes marital property.”

Conclusion: While we ordinarily expect legitimate estate planning trusts to be respected, the equitable powers of a divorce court will at times ignore the legitimacy of the trust when it comes to dividing a marital estate. What may appear to us to be trust assets that are not part of the marital estate, may not be the case when a divorce judge starts to “balance the equities.”