Previously published in Philadelphia Bar Association Probate and Trust Law Section Newsletter, June 2017
What parent wants their hard-earned money getting distributed to a former daughter/son-in-law or a creditor of their child? In our estate planning practice, we have yet to meet such a parent. Thus, we often recommend our clients (parents or grandparents) establish and fund a trust for the benefit of their children (or future generations). One of the many benefits of establishing an irrevocable trust (in Pennsylvania or New Jersey) is that if properly managed the assets held in the trust are protected from creditors – Inclusive of a divorcing spouse. Our family law colleagues have begun to erode this protection such that in some jurisdictions, an irrevocable trust with a spendthrift clause may become subject to equitable distribution or included in the calculation for alimony. This article examines several recent divorce court cases in which one of the divorcing parties was the beneficiary of an irrevocable trust. It concludes with some insight and recommendations for drafting and administering an irrevocable trust so that the trust assets do not become the property of the non-beneficiary former spouse.
Prior to examining these cases, it is important to lay the framework and explain the key principles of an irrevocable trust. A trust is traditionally established through a legal document (inter vivos (during life) or testamentary (created at death under a Will)) that empowers a trustee to manage and oversee assets for the benefit of an individual. For example, a settlor may create a trust during his/her lifetime that gives legal ownership of one’s house or another asset (e.g. brokerage account) to a trustee. The trustee has the legal responsibility to manage and oversee the trust asset for the benefit of the trust beneficiaries (e.g. settlor’s children). The terms of the trust establish how and when the trustee may grant the economic interests of the trust assets to the trust beneficiaries (e.g. use of the house or access to the income earned on the investments). Such economic interest may be discretionary (completely up to the trustee to determine) or mandatory (trustee must distribute).
This economic interest is often limited and protected by the inclusion of a spendthrift clause. A spendthrift clause restricts a beneficiary’s ability to transfer rights to future payments of income or principal to a third party. In effect, the clause prevents “spendthrift” beneficiaries from squandering an inheritance before they receive it and also protects a beneficiary’s inheritance from creditors, in some/most jurisdictions inclusive of a divorcing spouse. The trust is a separate legal entity from the trust beneficiaries and is a separate taxpayer.
It is for this reason that trust assets were traditionally protected during the division of property or calculation of alimony in a divorce proceeding. With this framework in mind, we now turn to the examination of the case law in a few jurisdictions, to review the attempted erosion of spendthrift provision protection.
In Pfannenstiehl v. Pfannenstiehl, 88 Mass. App. Ct. 121 (2015), the lower court awarded the non-beneficiary wife sixty percent (60%) of the present value of the husband’s interest in a discretionary spendthrift trust. The trust in question was settled by the husband’s father after his son’s marriage. A sibling and the attorney were the trustees. There were more than eleven (11) current beneficiaries under a distribution scheme which allowed for distribution of “income and principal as the trustee, in its sole discretion, may deem advisable …, whether in equal or unequal shares, to provide for the comfortable support, health, maintenance, welfare and education” of the beneficiaries. Trustees distributed irregularly, unequally and in some years made no distributions. Notably, the trust instrument included a spendthrift clause. The lower court opined that the husband had a one-eleventh (1/11) interest in the trust and therefore, awarded the wife a portion of such interest.
On appeal, the decision was reversed. The court held that the interest was too speculative because it was nothing more than an expectancy and thus not assignable. For a trust to be included in the consideration of available assets or sources of income, the trust instrument must be examined to determine if the interest is fixed and enforceable or remote and speculative. Interest in a discretionary trust is traditionally considered too remote for inclusion.
The court distinguished the trust in Pfannenstiehl from the trust involved in Comins v. Comins, 33 Mass. App. Ct. 28 (1992), which was determined to be a fixed interest and available for consideration of calculation of alimony. The Comins trust had one beneficiary, who received all of the income and held a power of appointment over the trust upon her death. In contrast, the Pfannenstiehl trust had over eleven (11) beneficiaries, was to continue for future generations and therefore, the trustees were required to consider the long-term needs of the trust. Further, the distributions were made unequally between beneficiaries and in some years some beneficiaries did not receive a distribution. The court opined that the inclusion of the spendthrift clause was only mildly influential and did not bar inclusion under other circumstances. The court did; however, hold that on remand the lower court might consider the expectancy as part of the opportunity of each spouse to acquire future assets and income.
Duckett v. Enomoto, No. CV-14,01771-PHX-NVW, 2016 WL 1554979 (D. Ariz. 2016), is not a divorce case, however, it still provides useful insight in relation to trust provisions and creditor protection. In Duchett, the court held that the Internal Revenue Service could attach a lien to a beneficiary’s interest in a discretionary trust. The court opined that such attachment was dependent on (a) state law; (b) the rights of the beneficiary; and (c) the obligations of the trustee. If the trustee had complete discretion over distributions, then the lien could not attach. Conversely, if the trust instrument required mandatory distributions, then the lien could attach. However, the court noted that between these two extremes were hybrid discretionary trusts which required further review. The Enomoto Trust was held to be a hybrid discretionary trust.
The trust instrument stated that “the Trustee shall pay to Dennis Masaki Enomoto so much or all of the net income and principal of the trust as in the sole discretion of the Trustee as may be required for support in the beneficiary’s accustomed manner of living, for medical, dental, hospital, and nursing expenses, or for reasonable expenses of education, including study at college and graduate levels.” (emphasis added). The Court acknowledged that the trustee was obligated to distribute under an ascertainable standard, but only in his or her “sole discretion.” Nonetheless, the Court held the lien attached because of the term “shall.” “Shall” is a mandatory direction which requires payment and thus, the discretion is limited to the amount to be paid. The Court also took into consideration that Dennis was the sole beneficiary.
In IMO Daniel Kloiber Dynasty Trust u/a/d December 20, 2002, 2014 WL 3924309, the non-beneficiary spouse was apparently successful in receiving a portion of a Delaware Dynasty Trust. The factual background of the matter was that the beneficiary spouse’s father established the Trust for the benefit of his son (the husband), his son’s spouse (who was required to be married to and cohabitating with son) and the son’s descendants. During the divorce proceedings, the wife argued that the Trust was includable in their property settlement based on Garretson v. Garretson, 306 A.2d 737 (1973). Under Garretson, a Delaware Support Trust (providing for distributions for health, education, maintenance and support) was determined to be susceptible to division between divorcing spouses, since a spouse is not a creditor and therefore is not bound by the spendthrift provisions. In Kloiber it appears the wife prevailed in securing an interest in the Dynasty Trust because in an Order to Sever the Trust, dated August 16, 2016, there is an agreement to sever the Dynasty Trust and fund a separate trust for the benefit of the wife.
Pennsylvania has a long history of enforcing spendthrift provisions and protecting trust beneficiaries. The impact of divorce on trusts is examined in the following cases:
In Erny Trust, 202 A.2d 30 (Pa 1964), the settlor executed an irrevocable trust that was to pay one-half of the net income to his wife, and one-half to their foster daughter upon his death. The settlor and wife then divorced, and the settlor remarried soon after. When the settlor died, the question arose as to whether the one-half share of the trust income went to the settlor’s first wife, the wife at the time the trust was created, or to the second wife, the wife at the time of his death. The lower court held that the trust referred to the settlor’s time-of-death wife and not his time-of-deed wife, and awarded the one-half share of the trust income to the settlor’s second wife.
The Supreme Court of Pennsylvania reversed the decision of the trial court and held that the trust was to be construed to refer to the first wife. The court looked to the settlor’s intentions from the language of the trust, and stated that the word “wife” did not indicate whether the settlor meant a specific wife. Thus, the circumstances under which the word “wife” was used needed to be considered. At the time the trust agreement was executed, the settlor was happily married to his first wife, who was his only wife and the only person the settlor could have been thinking of when using the word “wife” in executing the trust. The court stated that it could not attribute to the settlor a “prescience of future events when he might acquire another and different wife.” Thus, the court held that the first wife had the right to the one-half share income from the trust.
A similar result was found in the recent case of In re Irrevocable Trust Agreement of Klein, PICS Case No. 16-0355 (C.P. Monroe, Jan 7, 2016), in which the settlor and his wife purchased a $2.5 million dollar life insurance policy and created an irrevocable trust and split-dollar agreement regarding the life insurance policy. The irrevocable trust was designed to benefit the wife and the children, and the beneficiary of the policy was the irrevocable trust. The wife was required to pay all the premiums of the policy and the settlor was the original donor.
When the settlor and his wife divorced, the question arose whether the wife should remain as a beneficiary and co-trustee of the irrevocable trust. The court found that the irrevocable trust set forth the parties’ intentions at the time of execution and referred to the wife as the donor’s spouse. Further, the court stated that there was no language in the irrevocable trust addressing divorce or a requirement that the parties’ remain married. Like the court in Erny, the court looked to the settlor’s intentions from the language of the trust at the time of execution. The court stated that absent any language indicating that the terms of the trust only applied if the parties’ remained married, the plain meaning of the trust showed that the parties intended the trust to benefit the wife. Further, the wife continued to pay the premiums for the policy after the divorce. Thus, the court held that the wife remained a beneficiary and co-trustee following the divorce, as the parties intended to continue the policy for the benefit of the wife and the children.
The seminal case in New Jersey involving an irrevocable trust and divorce is Tannen v. Tannen, 416 N.J. Super. 248, 3 A.3d 1229 (2010). The court held that an interest in a purely discretionary trust was not deemed an asset attributable to the beneficiary in a divorce proceeding.
During their marriage, the wife’s parents established an irrevocable trust for the benefit of the their daughter, the wife. The wife and her parents all served as the trustees. The trust assets included the family’s home, commercial property and liquid assets. The trustees regularly paid the real estate taxes and contributed to the housekeeper’s salary and other capital improvements for the real property. Trust assets were also used to pay for the private schooling of the children.
The trust instrument provided that distributions were to be made for “the beneficiary’s health, support, maintenance, education and general welfare,” and were to be made in the sole discretion of the trustees “in the beneficiary’s best interests, after taking into account the other financial resources available to the beneficiary[.]” The trust further provided that “the beneficiary shall not be permitted, under any circumstances, to compel distributions of income and/or principal prior to the time of final distribution” and the trust instrument included a spendthrift clause.
During the divorce proceedings, the trial court ruled that the wife had a fiduciary duty to seek income from the trust and imputed a monthly distribution of $4,000 attributed to the wife for the calculation of alimony. The Appellate Division reversed holding that the trust assets were not attributable to the wife. Although one consideration was whether there was income available to either party through investment of any assets held by that party. It was opined that such income does not have to actually be available, so long as the party has the ability to access the income . . . it is inconsequential if the income is actually received. Here, based on the specific language of the trust, the income was determined not to be available or attributable to the wife.
Interestingly, the Appellate Division recited the fact the wife had contributed her residence to the Trust and that she could alienate her interest in the Trust with the consent of the trustees. However, the court ignored these facts in reaching its decision, because such contribution makes the trust at least partially self-settled, and thus, under New Jersey law, not protected from creditors.
These cases provide important insight into how we draft and administer trusts in a manner that maximizes the protections afforded. Of course, this must be balanced with the specific needs and desires of our clients, accordingly, sometime maximum protection must give way to other planning goals. Drafting insights include:
- Use the word “may” as opposed to “shall.”
- Include a detailed and specific spendthrift clause.
- Establish a purely discretionary trust.
- Include a disinterested trustee responsible for making distributions.
- Include multiple beneficiaries.
Trust administration insights include:
- Do not fund the trust with personal assets, but instead, all the assets should be attributable to a third-party donor.
- If the trust is purely discretionary do not create a systematic distribution scheme. Instead, have the distributions ebb and flow with the needs of the beneficiary.
- Refrain from distributions during a divorce or bankruptcy.
Barbara E. Little devotes her practice to all aspects of estate planning, estate and trust administration, estate and fiduciary litigation, business succession planning, nonprofits and family foundations. She practices out of Obermayer’s Philadelphia, PA and Cherry Hill, NJ offices. She can be reached at 215.665.3257 or 856-857-1402 or Barbara.Little@obermayer.com.
Janene B. Reilly is an attorney in Obermayer’s Philadelphia office, focusing her practice in the areas of estate planning and estate and trust administration. She can be reached at 215-665-3062 or Janene.Reilly@obermayer.com