When planning their estates, most parents want to ensure that their child’s inheritance is protected from claims by a divorcing spouse. The same is true for many individuals who have accumulated (or expect to accumulate) significant wealth through their own efforts or from family. With the divorce rate at approximately 50 percent, this is a wise concern. The New Jersey Supreme Court and Appellate Division decisions in Tannen v. Tannen serve as a strong reminder why individuals must keep asset protection in mind when doing their estate planning and not just focus on tax minimization. Without proper planning, a divorce can have devastating financial consequences. Premarital and postmarital estate planning, such as trusts, family limited partnerships and prenuptial agreements, can be essential to avoiding such consequences. This article addresses estate planning vehicles that can help protect assets in the event of a divorce.

Discretionary Trusts

The lessons to be learned from Tannen are many, including that, under current New Jersey law, an appropriately drafted and administered irrevocable discretionary trust can provide the following protections: (a) assets held by the trust will not be considered as belonging to the beneficiary; (b) for purposes of calculating alimony, trust income (if not distributed) will not be imputed to the beneficiary; and (c) a court cannot compel a trustee to make distributions to the beneficiary. Perhaps most importantly, Tannen reinforced that the terms of a trust really do matter. In determining that the trust income was not available for purposes of determining alimony, the Appellate Division looked carefully at the trust language and determined that the beneficiary did not have "the ability to tap the income source" and compel distributions from the trust.

An irrevocable discretionary trust, when properly drafted, can serve as an invaluable estate-planning tool to protect assets from the claims of a divorcing spouse. To minimize the likelihood of a successful attack, it is important that the trust: (a) be established by someone other than the intended beneficiary; (b) name an independent trustee; (c) give the trustee full discretionary powers to make income and principal distributions "as necessary and reasonable" rather than for the beneficiary’s "health, education, maintenance and support"; (d) limit the rights and access of the beneficiary; (e) prohibit the beneficiary from compelling distributions; (f) include a spendthrift clause (prohibiting the voluntary or involuntary transfer of the beneficiary’s interest); (g) require the trustee to take into account other financial resources available to the beneficiary before making distributions; and (h) state that the trust may not be considered a financial resource available to the beneficiary in the event of divorce. Once the trust is funded, it is essential that the trustee properly maintain the trust’s books and records, avoid patterns of distributions, make distributions that follow the mandate of the trust, avoid making distributions for nonlegitimate trust expenses and resist abdicating any fiduciary responsibilities to the beneficiary.

Dynasty Trusts

High net-worth individuals often wish to leave a legacy, providing not only for their children but for their grandchildren and future generations. This can be accomplished with a "dynasty trust," an irrevocable trust designed to allow a grantor to pass wealth from generation to generation without the burden of multiple transfer taxes, including estate and gift taxes as well as the generation-skipping transfer tax. In addition, any appreciation on the assets can accrue outside of the grantor’s estate. The unique feature of a dynasty trust is its term, because it lasts as long as the grantor has descendants. Not all states allow trusts to exist in perpetuity; New Jersey does.

A properly drafted dynasty trust offers the same protections as a discretionary trust. To provide protection from claims in a divorce, it too must include a spendthrift clause, define the process for making distributions, provide the trustee with full discretion regarding distributions and limit the beneficiary’s rights to access the trust.

QPRTs

A Qualified Personal Residence Trust (QPRT) is a type of irrevocable trust to which the grantor transfers a personal residence at a discounted value for gift tax purposes. Whether the residence is primary or seasonal, the grantor reserves the right to occupy the residence for a fixed period of time which is chosen by the donor. At the end of the term, the trust terminates and the property will pass to remainder beneficiaries, commonly the donor’s children. The donor does not pay rent during the trust term, although he or she remains responsible for the carrying costs. If the donor wishes to continue living in the residence after the QPRT has ended, he or she will be required to rent the property at fair market value from the remainder beneficiaries, who will then own the residence. The beneficiary’s remainder interest, alone, is valued for gift tax purposes, not the grantor’s retained interest to live in the residence. The discounted value can result in significant potential tax savings. However, if the grantor dies during the term of the trust, the property in the trust reverts to the decedent’s estate, leading to the tax liability the trust was established to avoid. It is a gamble that may greatly reduce the overall transfer taxes (both estate and gift tax) associated with the property.

A QPRT can also be an effective means to insulate a family home or vacation property from claims in a divorce. Once again, timing (and transparency) is everything. Complete protection can be afforded only if the divorce occurs after the trust has terminated and the asset is out of the marital estate. However, all is not lost should a divorce occur during the term of the trust. Although there is a value associated with the donor’s right to live in the residence (from which the maintenance costs imposed on the grantor must be deducted) and also with the potential reversionary interest, both of which may constitute marital property, those values decrease during the term of the trust. Thus, over time (during the term of the QPRT and prior to any divorce proceedings), increasing portions of the value of the residence become nonmarital, immune from claims of a divorcing spouse, allowing the asset to pass to one’s children.

FLPs

A family limited partnership (FLP) is a limited partnership established to hold a family business or other investments. Individuals can reduce their taxable estates by placing assets in a FLP and then gifting ownership interests to other family members. (The same objectives may also be accomplished through a family-owned limited liability company.) The fractional interests are gifted at discounted values due to their lack of marketability or liquidity and minority interest. For parents, it is an effective way to lower transfer taxes while ensuring that the business or assets remain in the family. Limited partnerships consist of both general and limited partners; in a FLP, these positions are held by family members. The general partner retains control over day-to-day business activities of the entity, making investment and management decisions and determining when distributions should be made to limited partners.

Through proper drafting, a FLP can prohibit voluntary transfers and severely limit involuntary transfers as a result of divorce or insolvency of a partner. Such events may trigger a "buy back," ensuring that the asset remains "in the family." Although assets acquired by gift are not subject to equitable distribution in divorce (so long as they are not commingled with marital assets), receiving the gift through an interest in a FLP adds an extra layer of protection (including avoiding commingling). As with QPRTs, if a FLP was formed by one of the divorcing spouses, with gifts of FLP interests to the couple’s children (and full transparency), the gifted interests are removed from the marital estate, thereby allowing more assets to pass to the children.

Prenuptial/Postnuptial Agreements

One of the most effective predivorce planning tools is a well-drafted prenuptial agreement, entered into before a couple is married (preferably well before). It is a contract by which the parties can override the financial rights and obligations that would otherwise apply upon marriage under state and/or federal law and determine in advance what will happen in the event of divorce or death. The contents of such agreements can vary greatly but commonly address the division and devise of property and spousal support. They are often used by individuals with significant personal assets, heirs anticipating significant gifts or inheritances (often at their parents’ urging) and those entering into a second marriage who want to leave assets to children from their first marriage.

A postnuptial agreement is similar, but is signed during a marriage rather than before. Such an agreement might be considered if there has been a significant change in the financial circumstances of one spouse, perhaps because of a promotion, career change, inheritance or sale of a business. It may be used to protect assets earned solely by one party’s efforts, while addressing the financial security of the other party. Although similar to prenuptial agreements, courts tend to scrutinize such agreements more carefully, holding them to a higher standard of fairness.

A prenuptial or postnuptial agreement may be utilized as the sole means of protecting assets or may be used in combination with the other vehicles discussed for an added measure of precaution.

Conclusion

Any of the foregoing solutions can help to achieve one’s estate planning goals and ensure that assets pass according to one’s wishes regardless of his or her (or a child’s) marital situation. Further, they can provide peace of mind, knowing that, whatever the future may hold, one’s child, family members or other heirs will be provided for in the way that one desires. •