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Protecting a Child (or Grandchild) in the Event of Divorce

By Stephen J. Smith
The Family Vision Experience

In a hypothetical case, imagine that a married couple has a 25-year-old son living in Wisconsin. The son has a girlfriend and is in a stable relationship with her. Marriage is not on the immediate horizon. The girlfriend has career aspirations that could require significant investment. She also has significant student loans. From the perspective of the parents of the son, there is the danger, if they suddenly died, leaving $1 million outright to the son or in a trust for a relatively short term based on achieving ages like 25 or 30, that a significant part of the inheritance might be lost, one way or the other. Dangers in order of likelihood could include:

  • the son could quit his job or studies in reliance upon receipt of the inheritance
  • the son could blow the money or see a significant part diverted to the girlfriend
  • the son, later married, could be divorced and lose half of what’s left in a divorce
  • although least likely to occur, the son could at some future time incur debtor/creditor problems and lose the money in a bankruptcy or the like

Before Marriage.
Under Wisconsin Law, the mere fact that the son is living with his girlfriend would not cause the girlfriend to have a legal interest in the son’s money, so long as he kept it titled in his own name.

Individual Property . . . To Start.
If the son were later to marry, assets which the son inherits start out as his individual property (not marital property), such that he would be entitled to receive 100% of his individual property in the event of a divorce, absent a hardship on his spouse or the children of the marriage. The problem is that under Wisconsin law, the general rule is that income from individual, inherited property is marital property. Unless the son were careful to segregate the income from the original principal (rather than letting the income compound in the same account), the son will have commingled the income (in which his wife has an interest) with the principal. Under Wisconsin Law, unless you can prove by tracing which is income and which is principal, everything is converted to marital property. Who keeps adequate records to go back and figure this out after a number of years have passed? An additional concern is that over time, the son might re-title his inherited property to include his spouse or might invest a significant portion of his inherited property in a joint asset, such as a marital home or jointly owned brokerage account. This re-titling or other evidence suggesting the son intended to make a gift of the inherited property to his wife could convert the inherited property to marital property. With respect to appreciation of inherited property, for example, the appreciation of an inherited vacation home, the appreciation is marital property to the extent the appreciation is attributable to the effort of the son or his spouse (for example, if they put in their own labor or jointly owned funds to remodel it). To the extent it is marital property, the wife could be entitled to half of it in a divorce, and the son could only dispose of his one-half of the marital property at his death (the other half belonging to his wife).

Unilateral Declaration.
One technical solution which the son could implement would be to give his wife a prospective unilateral declaration in writing stating that he has chosen to treat the income from his individual property as also being his individual property. We are only talking about how to classify the INCOME from the property; the unilateral declaration has no impact on whether a particular asset is the son’s individual property. Its sole use is to provide a way for the son to take property which for purposes of this discussion is admittedly his individual property and declare to his wife in writing that the INCOME from that particular property shall not be marital property (as it would be, ordinarily, under the statute) but rather shall be classified as his individual property, as well. In all my years of practice, I have never seen a client actually do this, and one wonders what impact that declaration would have upon the relationship of the son and his wife! While it seems none of us has seen actual cases involving the statute, the statute is nonetheless there as a theoretical option.

Marital Property Agreement.
The son and his wife, of course, could at any time under Wisconsin law sign a marital property agreement, which would classify property according to their wishes. In order for this marital property agreement to stand up in the event of a divorce, however, it would be necessary for the son and his wife to each be represented by separate legal counsel, for them to have made full and fair disclosure to each other of all their assets and liabilities, and the marital property agreement must be fair at the time it was entered into and at the time of the divorce. How likely is it that the parents can count on their son and his wife to (a) do this after their death, and, (b) for them to be able to actually reach agreement (since it takes two to tango)? Furthermore, most married couples tend to disregard the marital property agreement over time and end up converting property originally classified as individual property under the marital property agreement into marital property by actions such as purchasing a home with the inherited money and titling it as marital property or other form of joint ownership. (See “Individual Property . . . To Start,” above.)

Parents Create Trust.
The easiest and most effective way the parents can insulate an inheritance of their son from the dangers described above is to put it in trust. There are really two kinds of dangers that need to be addressed by the trust. The first one is the danger of the son blowing the money improvidently. This requires a third party trustee, almost by definition. The second danger is attack by a third party on the money, such as a divorcing spouse or a creditor. This does not necessarily require a third party trustee, but the protection is greater if you do have a third party trustee. With that as background, there are two continuums to be considered:

The first continuum is who will be the trustee:

  • the son is sole trustee
  • perhaps there is a friendly individual trustee
  • perhaps a bank is trustee but the son is Trust Protector (has the right to unilaterally replace one bank as trustee with a different bank as trustee)
  • a bank is trustee and no right of the son as Trust Protector to change banks

The second continuum is what will be the terms of the trust (as to the level of flexibility in the payouts):

  • the trustee has complete discretion to decide how much income and principal to distribute
  • the trustee has discretion as to how much income and principal to distribute, but ascertainable standards are given such as health, education, support and maintenance
  • the trust allows for distribution of income but no distribution of principal, except perhaps only a very narrow provision for genuine emergencies of a an extreme nature
  • the trust calls for a flat payment of income and no discretion to distribute principal under any circumstances
  • same as (d) except instead of distributing income, a fixed percentage of the market value of the trust is distributed each year (say anywhere from 3% to 5% per year), remainder to family (total return trust)
  • the trust pays out 5% or more as the market value each year to the son for life, remainder to charity (charitable remainder trust)

It is very important to realize that you don’t have to do just one approach. Perhaps the best approach is to diversify your approaches by layering several different approaches.

Assume the parents die suddenly and their 25-year-old son described above stands to inherit $1 million. Again, the dangers they face are:

  • the son could quit his job or studies in reliance upon receipt of the inheritance
  • the son could blow the money or see a significant part diverted to the girlfriend
  • the son, later married, could be divorced and lose half of what’s left in a divorce
  • although least likely to occur, the son could at some future time incur debtor/creditor problems and lose the money in a bankruptcy or the like

Consider a simple layering strategy:

outright gift to the son of – $100,000
“private” total return trust of – $500,000
charitable remainder trust of – $400,000
Total = $1,000,000

Here is how we arrived at the three-way split.

The outright part would be a nice initial gift, and it could easily be used, for example, to help with the purchase of a home, and yet it is not big enough to be an incentive to quit a job.
As for the portion to go into a trust, the other two parts were designed so that each was big enough to justify naming a bank as trustee of the trust. We did two trusts rather than one because each of the two trusts has certain advantages.

The total return trust can be made more flexible, allowing for discretionary distributions of principal if there are true emergencies or otherwise compelling reasons. If the trust runs for the son’s life, it also has the benefit of growing and then potentially passing tax free to the next generation.

The charitable remainder trust has its own advantages. The big advantage is that the charitable remainder trust is the ultimate safety net. The key is the presence of a third party (the charity) and the strict IRS rules on the requirements to set up a charitable remainder trust. As a result, there is no ability to invade the trust. No creditor of the son, for example, could invade the trust. There is nothing the son could do to attempt to force the trustee to make other distributions beyond the 5%. There should be a modest charitable deduction for the present value of the charity’s right to eventually receive the remainder.

Total Return Trust.
The total return trust would pay 4% of the market value each year (average of the last three years) to the son for life, such that the trust would escape estate taxes when he dies (generation-skipping trust). Principal could not be distributed from the trust except perhaps to leave a safety valve for emergencies, but it would be a narrow exception, or in some cases, the parents may decide it’s better not to have an exception. If the trust were to allow the son to withdraw principal beginning at some point (reaching a certain age, for instance) and the son died before the trust had been completely withdrawn, the trust would provide default provisions for who would inherit the property at the son’s death (for example, a sibling who survives the son). However, you would probably want to give the son a broad “power of appointment” whereby the son has the right to redirect how and when the property passes at his death. All of the same would be equally true if the trust were a generation-skipping trust which ran for the life of the son.

Optional End of Trust During Son’s Lifetime. Finally, the parents might decide not to have the trust run for life but rather just run for an extended period of time, say, 30 years, after which, say, the son could withdraw up to one-fourth of the principal every five years, beginning 30 years after the parents have died. The parents might conclude that by that time, many of the dangers will have significantly attenuated.

Charitable Remainder Trust.
The charitable remainder trust is defined largely by statute and requires by statute that the payout be at least 5% per year, I do not recommend a payout of more than 5%, because I worry about the purchasing power of the payout from the trust diminishing each year due to inflation, if the starting percentage payout is too high. Here, the payout would be for life, there would be a charitable deduction from the estate tax for the present value of the remainder interest payable to the charity (not large, in the case of a 25 year old), and the parents would designate the charity, but if they wanted to do so, they could give their son the power to change the identity of the charitable remainder man. The charitable remainder trust is the ultimate safety net from creditors, because the presence of the charity as remainder man makes it impossible for creditors to attack the principal of the trust.

Lots of Ways to Layer an Inheritance.
The example as to the split among these three pieces is simply illustrative of a three layer strategy. There is an infinite number of variations on these ideas, and there certainly is no requirement that there be a charitable remainder trust as part of the entire package, but at least this illustration allows the reader of this article to begin to imagine the possibilities.

For further exploration:
We can illustrate, by spreadsheet, the growth over time of the assets and payout from a total return trust, again based on assumptions you approve.

We have the ability to run a computer program which models a charitable remainder trust based on assumptions you approve.

© 2014 by Stephen J. Smith

creator, The Family Vision Experience