Introduction
So you’re married. You received a gift from Aunt Jane while she was alive. Your dad bequeathed you a generous sum of money on his passing. Those gifted and inherited assets in many instances will be considered “separate property,” not marital property. That might mean that they might not be subject to division if you divorce. But perhaps you want to backstop that hoped for result to make the protection more likely to stick if your marriage doesn’t work out. You can accomplish that, but you have to take action.
How to Maintain Separate Property
There are two key factors for you to consider.
(1) You want to avoid commingling marital property with that separate property. If you deposit your spouse’s paycheck by accident into the account with your inheritance you have now mixed (commingled) the funds. Perhaps with one such infraction a forensic accountant can dissect the account and demonstrate that but for that amount (and perhaps estimated earnings on it) the account might still be respected as your separate property. But how many such infractions, even innocent or insignificant ones, might occur before a Court concludes that golly, it’s too mixed up so it just loses it’s status as separate property? But long before that point your ex-spouse’s attorney may jump up and down that the account has been subject to commingling so that you have to negotiate some division of it.
(2) Another factor perhaps the threshold one, is can you corroborate that the particular account or asset is in fact separate property? You might prove this by identifying the wire or other transfer information for securities inherited, a deed for real estate gifted to you from a parent or other benefactor, and so forth. One aspect of this is pretty certain, the longer you wait to identify and safeguard the documentation involved, the more difficult it will be to find what you need.
The solution is to address the goal of protecting separate property now. Take steps to avoid commingling. Even better clearly differentiate the account or asset. Document the source of the wealth involved as being a gift or inheritance. And maintain that property as separate. With a 50% divorce rate shouldn’t you safeguard gift and inherited property? An unusual application of the commonly used revocable trust (sometimes called a “living trust,” or “loving trust”) can help. While these are typically used only to avoid probate (and whether that is worthwhile and how to address it is another story!)
The Revocable Inheritance Trust
You could collect corroborating documentation and just be careful not to commingle funds. But there is perhaps a simple and relatively inexpensive step that you might opt to take. Create a revocable trust (one tailored a bit to this specialized use as discussed below) to own these separate property assets. A “revocable” trust is one you can change at any time so that it is not protected from creditors or outside of your estate. But if you create such a trust and transfer all separate immune property to the trust, that might help preserve the sperate nature of the assets by serving as a separate independent accounting entity that is less likely to be commingled, and which makes the proof of retaining the separate property nature of the assets easier. How so? The trust that will own the property is a separate legal entity. You can monitor the assets transferred into the trust to assure it is only separate property assets. You can document the source of those assets. The trust can be operated independently of your personal assets.
Do You Need a More High Octane Option?
If asset protection or estate taxes are a meaningful concern a revocable trust is not the best approach for you. But frankly, some folks are not that concerned about those issues and are quite fine with a much simpler and less costly option. But that decision has to be your call and you should review with your advisers whether you really need a Ford F-350 (a self-settled domestic asset protection trust or some variant) or can make do with a Ford F-150 (the revocable trust). Keep in mind we lawyers love the highest octane option possible as it just has more pizzazz and is more exciting to work on. So you might have to rein us in. Don’t be upset if your attorney tries to explain better options. You want to hear the options so you can make an informed choice. High octane will likely be more costly, more complicated and more restrictive. That is not necessarily bad. But just like Goldilocks you want to pick the porridge that is the right temperature for you.
Which Lawyer Can I Talk To?
If you and your spouse have an estate plan in place, the law firm that did that great work for you might view creating a separate revocable trust for your inherited assets as a conflict of interest with their representing your spouse. But since separate property is not marital property and the planning suggested is not changing the character of separate property, the law firm might be OK assisting. You might ask if they feel they can represent you, and if not you might have to get a different attorney for this matter. Well, then again you might want to be careful asking your attorney about this. If your attorney is representing you and your spouse they could be prohibited from keeping secret any information either spouse gives them. Might that mean that your current attorney has to call up your spouse and ask you about the question involved? Perhaps. But before you “pass” consider that your spouse will likely know about the gift or inheritance you received, and even if they didn’t, if you file a joint income tax return (see discussion below) they might have to see that these assets exist.
If you really want to handle this the best way possible it is probably advisable to consult with a matrimonial or family attorney as well as an estate planner. Matrimonial counsel may well have some great insights to nuances. And keep in mind matrimonial rules differ pretty significantly by state so get the right advice. Hey, that means you get to pay both an estate planning attorney and a matrimonial attorney! Could it be more fun?
The following discussions will explore various aspects of how such a trust might be crafted and administered so that you can review these ideas with your advisers if this approach might be helpful to your planning.
But I already Have a Revocable Trust
Yes you may and that is probably a prudent planning step. But if you have a revocable trust it is probably intended to handle marital and other assets. If your existing revocable trust is not funded, meaning you have not transferred assets to it yet, it might be designed to work with a will that pours assets into it, including marital assets. By the way, it may be a mistake not having funded your revocable trust and that could hinder its use as a powerful tool in the event of disability, etc., but that is another story! So you would want to have a separate revocable trust just to hold separate or non-marital property. The good news is that your attorney may be able to take the existing revocable trust and tailor it to use as a new and separate trust for protecting separate assets. The bad news is, if your attorney feels that they cannot do this work for you because they also represent your spouse, you’ll need to get a new lawyer which will likely mean a completely new document.
Precatory Language
You might discuss with your attorney including descriptive language in the beginning of your trust stating the purpose and intent for the trust. That way, if there is any future challenge to the trust your intent will be clear.
You might add language in the trust expanding the standard provisions to make a clear statement of your intent. The purpose is to further clarify and support your goals. There is no assurance that a court, especially a matrimonial court, will respect these statements. But it seems prudent to make your intent in this regards clear. For example, you might state something like:
“The purpose of this trust is to hold separate property assets to maintain the characterization of those assets as separate property assets. No assets shall be given, or transferred in any manner, to the Trustee, and no Trustee shall have the authority to accept any assets into this Trust Agreement that is not inherited or gifted assets to the Grantor from a person (but expressly excluding the Grantor’s Spouse) and that is documented and confirmed as constituting separate non-marital property.”
Since the purpose of the trust is to assure that the assets do not become marital property you might go further and provide that your spouse is not a beneficiary. You may also not want your spouse to serve as a trustee so that the spouse cannot argue in the future that their efforts enhanced the value of the property and that therefore they should have rights to the trust property. On the other hand, you may be happily married, although desirous of protecting your gifted or inherited property. So, in that case you might not feel comfortable adding the language below. But in all cases discuss this with your attorney.
“The Grantor is married to [Spouse-Name] and any reference to the Grantor’s Spouse shall be to [Spouse-Name]. It is expressly intended that Grantor’s Spouse receive no benefits of any nature under this Trust Agreement and that under no circumstances shall Grantor’s Spouse serve as a Trustee, Trust protector or powerholder (directly, indirectly or as a guardian appointed for any of Grantor’s children).”
No Gifts
Many revocable trusts permit the trustee to make gifts. In some situations that may just be a smart move to provide tax planning flexibility and a mechanism to help people you care about, like an elderly aunt or adult child. But this application of a revocable trust is a bit special so you may want the opposite approach.
You might intentionally not include a provision permitting the trustee to make gifts. Although most trusts permit this, it may be preferable that no distributions are made from the trust, especially if you believe divorce may be a near term risk. If gifts are made a court might feel the assets are more accessible to you in divorce (they are fully accessible because you can revoke the trust) but a history of no distribution may provide better optics. If the trust has a history of making gifts or distributions to say children, the court might view the separate property as a more available resource for child support or other uses. While the above statements seem a bit illogical and inconsistent optics do matter.
Trustees
Consider who you name as trustee. Perhaps you might even consider naming a close friend or family member as trustee instead of yourself. You can always change that but if the account is to be insulated that may be easier to maintain if you don’t manage the assets and you don’t have the authority to transact on behalf of the trust. While that may not be necessary it’s worth a discussion with your attorney. You also don’t want your ex-brother-in-law to be named in the document! So, consider carefully who you name as successor trustees as well.
Trust Protector
A “trust protector” is a relatively new role that has grown in use in recent years. A trust protector is a person who is often given certain specified powers, e.g. to change the situs (location) and governing law of the trust. So if there is a benefit to moving the trust to a different jurisdiction that person can do so. The trust protector may also be given the power to change trustees. So if the divorce clouds are starting to accumulate on the horizon, if you amend and restate the trust to effectuate changes that might be helpful in the event of the divorce, a court might view those actions negatively as “pre-divorce planning.” However, if the trust protector replaces you as a trustee with a trust company in a different state (perhaps a state selected for laws that are determined to be most favorable), and moves the situs and governing law to a different state, which might help insulate the trust more. Even if there is no legal impediment to reaching trust assets since you still have the authority to change the trust at will, it might be harder for your soon-to-be ex to get to it.
But there is another specific potential application or benefit from using a trust protector, in a somewhat specialize manner (changing trustees, situs and governing law is a common application). What about giving someone the right to correct or clarify the language in your revocable trust document to assure assets are separate and to take other steps that might protect or enhance your plan?
Another consideration is whether the trust protector should (or must) act with a fiduciary capacity or whether that can or should be avoided. State law might mandate whether the trust protector is a fiduciary or not. A fiduciary is a position of trust and creates certain constraints and responsibilities on the trust protector if they are serving in a fiduciary capacity. You might want to specify that your trust protector can act in a non-fiduciary capacity in this particular revocable trust so that there are no limitations or standards applicable to how your named trust protector can take action to protect your objective of preserving the nature of the trust assets as non-marital property, etc.
Powers of Appointment
Powers of appointment are rights granted to a named person (sometimes called the “powerholder”) in a legal document (often a trust). So, for example, a trust might give a person the power to appoint who gets the trust assets. This power can be specified to apply while you are alive or only after your death. A power of appointment given can be broad (often anyone but the powerholder’s estate, creditors or creditors of the powerholder’s estate) or limited, e.g. to your descendants. A broader power give more flexibility to address future uncertainties, but it also may undermine your dispositive intent. Since the goal of this trust is to protect non-marital assets, particular care should be given to review the standard (boilerplate) provisions creating any powers of appointment.
For example, if your trust gives a child a power of appointment to appoint to any person other than: the child, the child’s creditors, child’s estate or creditors of the child’s estate, that power gives the child the power to appoint to anyone including your ex-spouse. You might want to narrow those powers. If the child is soured by a future divorce, and the whole point of this plan and trust is to insulate assets from divorce, the child might just appoint trust assets to your ex, and that would kinda undermine it all!
Final Takers
Wills and trusts have a final takers provision that governs who gets the goodies if everyone named above is gone. Be sure that this cannot include your spouse. If your final takers defaults to “heirs at law” that might include the spouse you are trying to protect assets from if you die before a divorce is finalized. This is a classic issue of standard boilerplate undermining your intent. Talk to your attorney about modifying the usual lingo to assure your spouse is not included if that is what you want. But that decision should not be taken lightly. If you are happily married and just seeking to protect the nature of these particular assets as non-marital “just in case” you might well want your spouse to inherit if you have not divorced. So, as with all the suggestions in this article, think through the implications under various possible scenarios.
So, be sure that the persons listed as final takers is agreeable to you. You might opt to name charities or other family members if you wish.
Tax Identification Number
You should probably obtain a Tax Identification Number for the trust and not use your Social Security number. Just keep in mind most of your advisers will tell you that you can use your Social Security Number on a revocable trust. They are technically correct, but consider the special purpose of this trust. It is intended to separate these assets from your other or marital assets. Using a separate trust Tax Identification Number doesn’t change the legal nature of the assets, but it sure sends a message that these assets are separate. It may also help remind you not to commingle assets, etc. That number should then be used on all trust accounts for the gifted or inherited assets you are seeking to protect. Bear in mind you may have to file a “grantor trust” income tax return for the trust. It is a quite simple return that informs the IRS that the trusts exists. Talk to your CPA about this (and the topic below).
Tax Filings
If your spouse knows about the gift or inherited assets, there may be no concern about how you file your tax returns to report the income (although let’s assume you want to report it properly so you don’t have the IRS knocking at your door).
The issue is that your revocable trust (whether the standard plain vanilla type or the tweaked version described in this article) is treated for income tax purposes as a “grantor trust.” That means all of the income and deductions will flow through to your personal return. So unless you file your personal income tax return “Married Filing Separate” your spouse will see the income of your separate property revocable trust on your join income tax return Form 1040. So this stuff won’t remain secret. Do you care? If you don’t then no problem you can do the plan and your spouse will know about the separate property assets.
If you want to keep the existence of the separate property, and the special separate property revocable trust that holds those assets, hidden from your spouse, you will have to file all future years’ income tax returns using the Married Filing Separate status. But if that is not what you have done until now, doing so will alert your wife that there is an issue. Also, keep in mind that in the event of divorce all of this may be discoverable.
Another alternative, but now you are getting more complex and costly, would be to set up a non-grantor or “complex” trust that files its own income tax return and pays its own income tax, but that would complicate planning and may increase income tax costs.
No-Contest Clause
Some wills and trusts include a provision that provides is someone challenges the document they are disinherited. These provisions are often referred to as “no-contest” clauses. It can be iffy whether they will be respected and even if and when respected it doesn’t assure that a legal battle many not ensue, especially if your spouse can make a colorable claim (e.g. the assets were not separate property). In some states these just don’t work. Also, your spouse may have rights to marital assets (or if you live in a community property state, community property) so proving to a court that the assets you have kept separate are in fact gifted or inherited separate property may not be avoidable. That is precisely why the segregation of assets and corroboration now is recommended. Nonetheless, you might discuss the pros/cons of including a “no-contest” provision in your special revocable trust to reinforce the idea that you intend your spouse not to have any rights. This provision will not change your spouse’s state law rights, if any, to assets.
These “no-contest” provisions are often challenged and do not hold up. Further, since your spouse has no bequest in the separate property trust (you may in fact expressly disinherit your spouse as to these assets) there may then be no “teeth” to the provision. The rationale for including it then is merely to emphasize your desire to not have her as a beneficiary and reinforce that point.
Trust Assets; Schedule A and B
Trust assets must be carefully limited to assets that can be proven to be separate immune or non-marital. You should not transfer any marital assets including existing life insurance, retirement accounts, etc., as that may be marital property. Also, if your separate property revocable trust purchases new life insurance bear in mind that this trust will not remove those proceeds from your estate.
Schedule A is that common boilerplate page at the end of most trusts that lists the initial assets of the trust. Too often this might say $10 or something like that which is then ignored by most people (that is for another story on adhering to trust formalities if you want the trust to work). Schedule A should really list everything going into the trust. So if you have provable separate property, e.g. an inheritance from rich uncle Joe of $500,000, then list that. If the $500,000 is in an index fund specify that. Also be careful of that boilerplate, standard, $10 or so many trusts list on schedule A. You don’t want that. You only want separate property assets. Do not fund (give to) the separate property trust a check for $100 to open a trust account. Unless you can prove that you have separate property $100 you are already starting off on the wrong foot. So be sure the lawyer understands and agrees with this somewhat different application and approach. You want to be consistent.
Rarely will you see Schedule B, but what might that be about? Attach the corroboration proving that the property on Schedule A was received by you solely as gifted or inherited property. Have your matrimonial or estate planning attorney confirm what applicable state law says about how separate property is defined. If it is not pristine you may not want to transfer it into this trust. That might be a copy of uncle Joe’s estate check to you, perhaps a copy of his will, maybe the bank account documents showing the deposit of the check from Uncle Joe’s estate, etc. You should also consider attaching all bank statements from the day of the initial deposit until the date of transfer in the revocable inheritance trust to prove that no marital property was ever deposited, etc. Why would you do that? Because the whole point of the revocable inheritance trust is to provide an extra measure of protection for inherited or gifted assets to keep them characterized as separate non-marital property in case of a later divorce. Attaching the documentary proof of that fact will help your argument. Also, the more years that pass from the date of your receiving a gift or inheritance the greater the risk you won’t be able to identify the proof you should have. So do it now. If all of this is attached to the actual signed trust and it is scanned so that your lawyer, trustee and trust protector all have copies, the odds of the right documentation showing up if needed is much greater.
Conclusion
Lots of people receive valuable gifts or inheritances. A significant percentages of marriages end I divorce. Many people just don’t want the cost, inflexibility, and complexity (if you think this article was complex, talk to your estate planning attorney about creating a hybrid domestic asset protection trust!) of an irrevocable trust. For these folks using a revocable inheritance trust may be a worthwhile option to discuss with your planning team.