Managing Your Trusts in Divorce

If you're in the midst of a divorce settlement, it's natural to focus on dividing property and maintaining income. Too often, wealth "planning" ends with cancelling joint credit cards and closing joint checking accounts — rarely does it involve a thorough review of other important estate planning elements, like trusts.

Dissolving your marriage is likely to change how you want to distribute your assets and dispose of your estate. A vital step in any divorce is updating relevant documents to reflect your new circumstances.

A number of points should be kept in mind when revising your trusts.

• Legal considerations. State law may impose requirements and limitations on how trusts may be treated in a divorce. Provisions favoring one party could be revoked.
• Minor heirs. Trusts may need modification to protect their interests.
• Official designations. You should revise trust documents if you don't want your former spouse to continue as your trustee.

It's important to address these issues at the time of divorce, rather than risk the consequences of overlooking them.

Family Trusts: An Evolving Area of Law

Family trusts raise several issues that should be addressed in a divorce. In many states, laws governing the disposition of trusts in a divorce are changing, so it's important to get legal advice.

Gifted and Inherited Assets

Treatment of gifted and inherited assets is often a charged issue in a divorce. Many people going through divorce believe that what they've received from family members is theirs alone. They are often surprised to discover they may have to share those assets with a former spouse. If gifted or inherited assets were comingled or used to pay your living expenses during marriage, both parties may have a claim. What's more, courts in many states have broad discretion to consider those assets when determining settlement terms. You may be expected to pay spousal or child support based on the assets.

Spendthrift Provisions

Trusts commonly have spendthrift provisions — protections for beneficiaries that shield assets from creditors. Increasingly though, state laws are changing to allow former spouses and children to attach or make other claims on trust assets. Judges in some states may take advantage of loopholes to circumvent spendthrift restrictions to reach settlements they feel are "fair" to both parties. This is most often seen in cases where there appears to have been bad behavior on the part of the wealthier spouse, such as late alimony or child support payments. However, the broad discretion afforded to family courts supports this trend toward equalizing financial assets in whatever way possible.

Future Inheritances

Courts generally don't consider future or contingent inheritances as marital assets when determining divorce settlements. Nonetheless, future inheritances can affect the financial picture of the divorcing spouses. Your spouse's attorney may ask to see your parents' estate plans — even if they are still alive.

Charitable Remainder Trusts

Charitable remainder trusts provide an income tax deduction and defer capital gains taxes, which makes them useful for holding securities that have appreciated significantly. For married couples, these trusts often provide lifetime payouts until the second spouse dies. But if the couple divorces, they may face unpleasant surprises. When the person who funded the trust dies, the former spouse may have to pay federal income taxes on their interest in the trust, and the grantor's estate may owe estate taxes.

However, the IRS has issued private letter rulings that provide a remedy. While private letter rulings may not be relied upon by taxpayers other than the one who requested the ruling, they do provide an indication of how the IRS may treat a specific transaction. In the case of charitable remainder trusts, they indicate that the simplest solution in divorce may be to divide the trust in two. Each ex-spouse receives a life interest in a new trust, with the remainder going to the original charitable recipient. Gift, income and estate taxes are treated the same as in the original trust.

Trusts Created During Divorce

Trusts may be created during divorce proceedings for estate planning purposes. Although the passage of the Tax Cuts and Jobs Act in December 2017 eliminated the ability of couples whose divorces are finalized or modified after December 31, 2018 to take advantage of the favorable tax rules for alimony trusts, there is still some benefit to creating certain types of trusts during the divorce process.

For instance, a divorcing couple can set up an irrevocable trust to leave funds for heirs. Such an arrangement may make sense if you worry that your former spouse won't provide enough resources for your children.

In some situations, a grantor retained annuity trust (GRAT) may be a winning strategy. These are irrevocable trusts created for a specified period that can reduce tax liabilities when assets are transferred to heirs. It may be possible to set up a GRAT with limited gift tax consequences. An annuity is then paid annually for the life of the trust. When the trust expires, the beneficiary receives assets free of any gift or estate taxes.

Significant gifts and inheritances given to a non-citizen spouse are usually subject to a transfer tax unless a qualified domestic trust (QDOT) has been established, even if the spouse is a long-time U.S. resident. However, in a divorce, these funds could potentially be transferred tax free to the non-citizen spouse without a QDOT. This is an important advantage that can be helpful when negotiating settlement terms.

While the alimony trust will no longer be available after December 31, 2018, you may still set up a trust to hold a lump sum to support an ex-spouse. Such trusts require substantial upfront funding and require careful drafting and administration in order to avoid negative tax results. However, they may be the preferable choice if you and your spouse have broken off contact and want to avoid future interaction, as the trust assets are segregated from those of you or your ex-spouse and are managed by an independent trustee.

Don't Forget Your Trusts

Your trusts may not seem like a high priority when you are dissolving a marriage, but it's important to thoroughly review your plan with your legal and wealth management advisors during divorce proceedings. You should make sure your documents are up to date and that they reflect your wishes and your new status. If you overlook them when negotiating a property settlement, you may be vulnerable to unpleasant surprises at tax time, when trusts make distributions and when estates are settled. Addressing these issues in a timely way will prevent headaches down the road.