It's sad but true that a high percentage of marriages will end in divorce. And even if your clients aren't concerned about their own marriages, how many are worried about the financial fallout if their children's marriages were to end in divorce?
Everything may be rosy now, but it's not uncommon for people's perspectives (and personalities) to change during a divorce. If that happens, how do your clients go about protecting inheritances for married children? Here, I'll propose several planning options available to your clients to keep their wealth "all in the family."
The First Line of Defense
Premarital agreements. For many high-net-worth clients (e.g., those with a family business or other generational family wealth), the first step may be to encourage the child to consider a premarital agreement. This is a binding contract between prospective spouses that defines their rights in the event of a legal separation, divorce, annulment, or death. If executed correctly, it can be an effective planning tool. But it can also raise emotional concerns ("I love you and will always take care of you, but can you sign this premarital agreement?").
Consider the following tips to help with the process:
- Both parties should work with practiced attorneys who can educate them regarding their rights under the agreement and any rights they may or may not be waiving in a divorce. For example, beneficial rights to ERISA-governed retirement plans cannot be waived by a prospective spouse in a premarital agreement. The agreement can provide for the commitment to waive spousal rights once the parties are married.
- The couple may discuss the intricacies of dividing specific assets, including tax considerations.
- Younger prospective spouses might consider a more flexible approach (e.g., restructuring their rights at predetermined points in the future).
Postmarital agreements. These agreements are entered into after marriage, and their enforceability was initially in question. They have been upheld by the courts in recent years, however, particularly if they follow Uniform Premarital Agreement Act requirements or other state law governing premarital agreements. Nonetheless, postmarital agreements are in their legal infancy and are considered less reliable than premarital agreements.
A Secondary Line of Defense
Trusts can be effective for clients who wish to retain control of or protect potential inheritances. There are two broad categories: third-party spendthrift trusts and self-settled trusts (either domestic or offshore).
Third-party spendthrift trusts are established by an individual for the benefit of another (e.g., for spouses and children). Generally, the person who establishes the trust isn't one of the beneficiaries. This trust gives the trustee discretion over when and how distributions are to be made—making it extremely effective for family members with potential creditor concerns, including divorce. For clients who wish to protect gifted or inherited assets, the trust should vest the trustee with complete discretion to make (or not make) distributions to the child and his or her descendants.
To ensure the highest potential level of protection:
- The trust shouldn't contain provisions that may be construed as granting the child a right to withdraw funds from the trust or force mandatory income distributions. These provisions raise the concern that a court may assign all or a portion of such a right to a divorcing spouse.
- The trust should always include a spendthrift clause, expressing the grantor's intent that the child's interest in the trust shall not be subject to assignment (whether voluntary or involuntary) to any creditor. Some state laws provide automatic spendthrift protection for certain interests in a trust. But these statutes aren't foolproof, as some states may make spousal claim exceptions.
Self-settled trusts. Several states have laws protecting assets held in an irrevocable trust from an individual's creditors, even if the individual is grantor of the trust. These trusts can shield assets from the claims of a divorcing spouse.
- Most states have held that the trust must be established before marriage. (Nevada, however, has protected against spousal claims for trusts established after marriage.)
- Even if the trust is established before marriage, transfer to the trust must pass muster under state fraudulent conveyance laws.
- With such complexities, clients (and their attorneys, if outside the applicable state) should work with experienced counsel practicing under that state's laws.
Distribution techniques. In a divorce, whether or not the beneficiary has a right to receive the trust property often becomes a battleground. Keeping family circumstances in mind, your client should discuss the benefits and drawbacks of various distribution methods with his or her attorney. Some popular distribution techniques include:
- Outright. Funds are distributed outright and free of trust (no strings attached). This technique is often favored by clients with mature, financially astute children. This distribution standard offers little to no asset protection.
- Mandatory income/discretionary support. Mandatory income provisions require the trustee to distribute income annually (or more frequently). They also provide distributions of principal under a standard such as "health, education, maintenance, and support" or at the trustee's total discretion. The trust will not provide asset protection for mandatory distributions; if the beneficiary can demand assets, they may be available for asset division.
- Staggered. Trust assets are distributed at intervals, such as when the child reaches certain ages (e.g., 1/3 at 25, 1/3 at 30, and 1/3 at 35). These provisions are frequently used to keep the child from squandering the inheritance. On the positive side, funds are available to the beneficiary at ages when major events (e.g., marriage or purchasing a first home) will likely occur. Until those triggering ages are reached, the trustee typically makes discretionary distributions. Any mandatory distribution may be considered available and part of the marital estate.
Benefits of a corporate trustee. A corporate trustee may be more effective than a family member trustee since it removes the perception that family dynamics are part of the distribution decision. Many personal trust service companies offer advisor-directed trust services: you retain investment custody while the company serves as the administrative trustee.
Protecting the Family Business
Buy-sell agreements. The main goal of a buy-sell agreement is to ensure continuity and stability of the family business during a time of change. This may be accomplished through ownership transfer restrictions:
- By outlining how—and to whom—shares of a family business may be transferred, buy-sell agreements can prohibit such transfer to undesirable third parties (e.g., divorcing spouses).
- In some cases, the court will protect the business interest itself but will value the interest in order to allocate the remaining marital estate assets. Therefore, it's important that a method for determining the sale price of shares, as well as how the purchase will be funded, be contained within the buy-sell agreement.
A buy-sell agreement can also be used to provide for the mandatory purchase (or right of first refusal) of a shareholder's interest. This is vital when a family business has several owners—and those owners (including the divorcing owner) do not want to partner with an ex-spouse. The following agreements can be considered:
- Redemption agreement: Purchased by the business itself
- Cross-purchase agreement: Purchased by other shareholders
- Hybrid agreement: Purchased through a combination of the business and other shareholders, upon the occurrence of triggering events as described in the agreement
Finding the Balance
Individually, premarital and postmarital agreements, spendthrift trusts, self-settled trusts, and buy-sell agreements can be valuable tools for protecting inheritances for married children. But they need not be used alone. Sometimes, a combination of methods will best meet your client's needs. Further, before implementing any of these measures, clients should consider which strategy will deliver the balance of flexibility, control, and accessibility they desire.
We can't predict the future, of course. But with careful planning, you can help your clients ensure that their children's inheritances are protected according to their wishes.
What other strategies do you recommend to your clients for protecting inheritances for married children? Are there some measures that have proven more successful than others? Please share your thoughts with us below.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.