Pasternak & Fidis Reporter

April 30, 2012

Are Trust Assets Vulnerable to Claims of Creditors (Including a Divorcing Spouse)?

A question commonly raised by clients during the estate planning process is: “What can we do to ensure that the assets we give to our children will not be available to the child’s spouse at divorce?” (One answer is for the adult child to have a premarital agreement. See “Premarital Agreements and the Young Couple” in the October 2006 issue of the Pasternak & Fidis Reporter.) This question actually comprises two separate issues. The first is whether a judge can give assets received by one spouse by gift or inheritance to the other spouse as part of the equitable division of marital assets. The second is the effect of these assets on an alimony claim of either party. (There is a third question, the effect of the trust on a child support obligation, which is beyond the scope of this article.)

In general, in the three local jurisdictions, Maryland, Virginia and the District of Columbia, property acquired prior to the marriage from any source, and property acquired by gift or inheritance during the marriage, is treated as each spouse’s separate property and is not subject to equitable division at divorce. Thus, in general, a parent’s gifts to a child in trust will remain the exclusive property of the child.

Alimony stands on a different footing. A recent case from New Jersey reminds us that the law in this area is evolving. A family court judge who perceives an inequity may attempt to correct the inequity and achieve a fair result, even if that requires stretching common interpretations of the law of trusts. In the New Jersey case discussed below, this included an order by the trial court judge that imputed income and assets of a third party trust to a spouse, and directed the trustee of a discretionary trust to distribute monthly income to the beneficiary-wife.

The determination of a spouse’s obligation to pay or right to receive alimony is based on a number of factors, including: (i) each spouse’s ability to be wholly or partly self-supporting; (ii) the standard of living during the marriage; (iii) the financial needs and resources of each party; (iv) contributions to the marital relationship, monetary and non-monetary; and (v) the ability of the party from whom alimony is sought to meet his or her own needs. A judge may take into account income a spouse receives from a trust as well as other resources and income that are independently available for support. The court will look at historic means of support for the family. This can include direct sources of income (earnings, dividends, capital gains), but also indirect sources (e.g., regular and ongoing gifts and distributions from a trust). A spousal support determination can also take into account things like the use of a company car, the right to live in a home rent-free, and payment of family expenses by a third party.

In the New Jersey case of Tannen v. Tannen, Mark Tannen filed for divorce from Wendy Tannen, his wife of 18 years. Mark and Wendy had two children, ages 17 and 14. The issues at trial included Wendy’s alimony claim.

During the marriage, Wendy’s parents established an irrevocable “discretionary support” trust for her sole benefit, with Wendy and parents as co-trustees. The trustees, in their sole discretion, were permitted (but not required) to distribute any or all of the trust income and principal for Wendy’s health, support, maintenance, education and general welfare, after taking into account other resources available to Wendy. Wendy did not have the power to compel distributions from the trust. The trust also included a so-called “spendthrift” provision preventing Wendy from encumbering future trust distributions.

At the time of trial, Wendy’s trust included marketable securities in excess of $1 million, a commercial income-producing property, and the couple’s unmortgaged residence. The trust paid the annual real estate taxes on the residence and half the annual cost of a housekeeper. The trust also paid for substantial improvements to the home. In the four years before trial, the trust generated at least $124,000 per year in investment and rental income.

At trial, Mark argued that the income of the trust was “available” to Wendy for purposes of determining his alimony obligations. The trial court judge agreed, noting that alimony orders are based upon actual income, potential to generate income, and imputation of income. The trial court judge found that Wendy had a fiduciary duty to seek income from the trust and, if she did not do so, income could be imputed to her. The trial court judge also determined that the terms “support” and “maintenance” in Wendy’s trust required the trustees to distribute “such sums as are necessary to maintain” Wendy’s lifestyle. Therefore, the trial judge ordered the trustee to distribute to Wendy $4,000 per month, and to continue making payments on the marital home and for the housekeeper’s expenses. Mark was ordered to pay alimony of $4,500 per month. The trial court order was reversed on appeal. The appeals court held the trust assets were not available to Wendy and the trustee could not be required to make monthly distributions to her. The appeals court noted that, in general, a trial judge may impute income to a spouse when he or she is voluntarily unemployed, underemployed, or made investment decisions that caused assets to generate less income. Furthermore, the appeals court noted that income generated by a spouse’s inheritance or by another asset is crucial to the issue of that spouse’s need, whether or not the spouse chooses to actually receive the income. The issue here, however, was access to—i.e., the ability to reach—the income source.

In this case, the appeals court found that Wendy’s interest in the trust did not cause the trust to be an available asset from which income could be imputed to her. The court reached this decision because the trust: (i) was wholly discretionary, i.e., it gave the trustees the sole discretion to pay out income and principal; (ii) was established for the limited scope of Wendy’s health, support, maintenance, education, and general welfare; (iii) required that the trustee take into account other financial resources available to her; (iv) expressly stated the parents’ intent that Wendy not be permitted, under any circumstances, to compel distributions; and (v) provided that Wendy had no ability to assign, transfer, or encumber future distributions from the trust (the spendthrift provision). The appeals court sent the case back to the trial court to make a final determination as to Mark’s alimony obligation.

How should this affect your planning if you are in Maryland, Virginia, or the District of Columbia? Whether the assets in a trust you establish for a loved one will be available to satisfy the claims of creditors (including a divorcing spouse) will depend on the character and terms of the trust. Is it a discretionary trust, i.e., a trust that gives an independent trustee absolute discretion over distributions? Such a trust is generally protected from all creditors. Is it a support trust, i.e., a trust to provide for the beneficiary’s support? Such a trust relies on its spendthrift provisions to protect its assets from creditors; however, there are exception creditors in every state who may be able to reach the assets, generally including a divorcing spouse. Is it a hybrid trust, i.e., a discretionary support trust? In a hybrid trust, the specific terms can and will affect the extent to which creditors can reach the trust assets. To enhance protection from creditors, the beneficiary cannot control distributions from the trust. The beneficiary should not be the sole trustee of his or her trust. If the beneficiary will be a co-trustee, the beneficiary’s control should be limited to asset management and investment decisions.

It always is difficult to balance the desire to protect assets given to a loved one from his or her creditors, on the one hand, and respect for the beneficiary’s autonomy by giving him or her control over the assets, on the other hand. By (i) making gifts in trust rather than outright, (ii) naming an independent third party as trustee for the purpose of making distribution decisions, and (iii) allowing the beneficiary of the trust to serve as co-trustee for the sole purpose of making investment decisions, it often is possible to find a balance between the two. Trusts are imminently flexible. Ultimately, parents must decide: To what extent do they want to impose their judgment of what is best for their descendants, and how far into the future do they want to impose this judgment?

One final issue to note: The above discussion relates to third party trusts, i.e., a trust established for the benefit of a person other than the person creating and funding it. A person may wish to create a trust for his or her own benefit that will be protected from future creditors; however, such a trust cannot be established under Maryland, Virginia, or District of Columbia law. There are a handful of states that permit a so-called self-settled spendthrift trust, also known as a domestic asset protection trust. The states with the most protective laws are Delaware, Nevada, and Alaska. A person does not need to live in one of these states to create such a trust.

Please contact one of the lawyers in the estate planning and administration practice if you are interested in discussing creditor protection for yourself or your loved ones.