I came across an interesting article regarding estate planning for second marriages. The article highlights some of the most common issues faced by male business owners who have children from a prior marriage. Women, of course, face many of the same issues.
In recent years, I have seen a tremendous increase in the use of prenuptial agreements. I attribute this to high divorce rates, as well as increased awareness of the potential benefits of prenuptial agreements.
Death and divorce are the two primary circumstances governed by prenuptial agreements. Generally, the agreement details the provisions that will be made for the surviving spouse upon the death of the first spouse. The agreement also details the division of the couples’ assets upon divorce.
A recent case decided by the Tennessee Court of Appeals demonstrates the divorce protection provided by a prenuptial agreement. Mrs. Cummins spent more than $2 million buying two separate homes which were titled jointly in the names of Mr. and Mrs. Cummins. Due to the wording of the prenuptial agreement, Mrs. Cummins was awarded both homes.
Mr. Cummins claimed that he was entitled to 50% of the appreciation of the homes. The Court awarded all of the appreciation to Mrs. Cummins since she had paid all of the property taxes, insurance, and maintenance expenses associated with the homes.
Mrs. Cummins was very fortunate to receive 100% of the homes. Even when there is a prenuptial agreement, both spouses generally share in the value of homes that are titled jointly in the names of the couple. Mrs. Cummins could have saved the aggravation and expense of this lawsuit if she had titled the homes solely in her name.
I am surprised by the number of cases involving prenuptial agreements that fail to accomplish the intended purpose. When the agreements do not work, it is generally because the parties fail to follow the proper procedures. The parties should be represented by separate counsel and must make a full disclosure of their assets to each other. Further, the agreement should be signed prior to the eve of the wedding.
In the Estate of Joseph Brightman Cooper, the proper procedures were not followed. First, there was no listing of the assets of each party. Apparently, Mr. Cooper told his bride that he owned a house with 18 to 20 acres. Mrs. Cooper testified that Mr. Cooper neglected to tell her about the cattle and farm equipment that were located on the farm. Mr. Cooper may have assumed that she knew about the cattle and equipment since she had lived in the same community, had visited his home on several occasions, and had known him for 20 years prior to the marriage. It also appears that Mrs. Cooper was not represented by an attorney.
After Mr. Cooper died, Mrs. Cooper did not like the provisions made for her in Mr. Cooper’s Will and asked the Court to award her 40% of the estate. The Court ruled that she could not receive part of the house and farm because she had known about this property when she signed the prenuptial agreement. However, since Mr. Cooper had failed to tell her about the cows and equipment located on the farm, she could receive 40% of the value of these assets as well as 40% of all other assets owned by the estate.
The Coopers’ prenuptial agreement only covered property owned by the spouses at the time of the marriage. This is very unusual. Most prenuptial agreements eliminate elective share rights with respect to all property belonging to the estate of the first spouse to die.
Mrs. Cooper received approximately $185,000 from Mr. Cooper’s estate. In addition to paying $185,000 to Mrs. Cooper, the estate paid significant legal fees. The prenuptial agreement was partially successful because it prevented Mrs. Cooper from receiving any portion of the house and 18 acres. I did not know Mr. Cooper, but presume that his intent in signing the prenuptial agreement was to prevent his wife from claiming an elective share of his estate. His intent was thwarted due to his failure to follow proper procedures.
There are three lessons to be learned from this case. First, if you want to make sure that your children receive what you want from your estate, make sure the prenuptial agreement is properly drafted and follows the proper procedures. Second, if you want to be able to receive a share of your spouse’s estate upon his or her death, do not sign a prenuptial agreement, or, alternatively, negotiate for the amount that you want to receive in the event of death and include this in the prenuptial agreement. Third, if you are a surviving spouse and signed a prenuptial agreement, all may not be lost. The Cooper case is one of several Tennessee cases that have allowed a surviving spouse to claim an elective share of the decedent’s estate despite having signed a prenuptial agreement.
The Tennessee legislature has enacted the Tennessee Community Property Trust Act of 2010. If the Governor signs the bill, the new law will allow resident and nonresident married couples to convert their property to community property by transferring the property to a new type of trust known as a Tennessee Community Property Trust. Alaska is the only other state that allows residents of common law states to voluntarily convert some of their assets to community property.
There are three types of benefits that a Tennessee Community Property Trust will provide. First, community property is a property ownership system that provides for equal ownership of property by husband and wife, including a sharing in the appreciation and income from the property. Some couples may find this equality and sharing arrangement to be a preferred form of property ownership.
Second, community property receives a significant federal income tax advantage. At the death of the first spouse to die, both spouses’ interests in the community property will be eligible to receive a basis increase (not to exceed fair market value), up to a maximum increase of $4,300,000 in 2010, and a full basis adjustment to the fair market value of the property for deaths in 2011 and later years. As a result, there will be no capital gains tax payable if the first spouse dies in 2011 or later and the property is sold for its value after the first spouse’s death. Further, the increased basis will allow for increased depreciation deductions for business and investment depreciable property. If the property had been jointly-owned by the husband and wife in a common law state such as Tennessee, only one-half of the property would receive such an adjustment in basis.
Assume that in 1983 John and Martha Brown paid $200,000 for a farm that is worth $600,000 at the time of John’s death in 2011. Federal tax law allows Martha to increase the income tax basis of John’s half of the farm to $300,000 (one-half of the fair market value of the entire farm). Martha’s basis for her half of the farm will remain at $100,000 (one-half of the original purchase price). Thus, Martha’s total basis in the farm will be $400,000. When Martha sells the farm for $600,000, she will realize a capital gain of $200,000 and pay a federal capital gains tax of $40,000. Federal tax law would allow Martha to increase the basis of the farm to $600,000 if the farm had been held in a Community Property Trust. Thus, when Martha sells the property, she will not pay any capital gains tax.
The third advantage of a Tennessee Community Property Trust is the division of assets owned by the trust for purposes of funding a credit shelter trust upon the death of the first spouse and obtaining fractional interest discounts upon the death of the surviving spouse. Funding the credit shelter trust and obtaining fractional interest discounts will reduce Federal estate tax and Tennessee inheritance tax upon the death of the surviving spouse. These same advantages can be obtained by converting ownership to tenancy-in-common; however, tenancy-in-common will not allow the favorable income tax advantage discussed above.
A Community Property Trust has the following requirements:
(1) It must declare that the trust is a Tennessee Community Property Trust and contain certain language that gives notice of the consequences of the trust;
(2) At least one trustee must be Tennessee resident or a Tennessee bank or trust company; and
(3) It must be signed by both spouses.
If the spouses divorce, the trust will terminate and the trustee must distribute one-half of the trust assets to each spouse. When property is distributed from a community property trust, it will no longer constitute community property. The equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust.
A debt incurred by only one spouse before or during marriage may be satisfied from that spouse’s one-half share of a community property trust and a debt incurred by both spouses during marriage may be satisfied from all of the trust assets. Thus, a Tennessee Community Property Trust has inferior creditor protection to tenancy by the entirety ownership, and should not be utilized by couples with potential creditor problems.
The new law will become effective July 1, 2010. I expect that Tennesseans will establish a lot of these trusts in July of 2010, similar to the wave of Tennessee Investment Services Trusts that were established in July of 2007 when the Tennessee Investment Services Trust Act became effective. It will take longer for Tennessee banks and trust companies to market the advantages of this opportunity to nonresidents. The advantages will be greater for nonresidents who live in states that impose income taxes on capital gains and rental income.
When you own a business with one or more other persons, it is advisable to enter into a written agreement with the other owners. These agreements have different names depending upon the type of entity: shareholder agreements for corporations, partnership agreements for limited partnerships and general partnerships; and operating agreements for limited liability companies. These agreements are sometimes generically referred to as “Buy-Sell Agreements”.
Buy-Sell Agreements typically restrict transfers to third parties and specify rights of the parties under certain circumstances such as death, divorce and disability. It is not uncommon for these agreements to give the company and/or the other owners an option to buy your interest in the company for a predetermined price in the event that you die, or become disabled, or transfer your stock to any other person, including your spouse upon divorce. The price is generally less than a proportionate share of the value of the entire business.
If a divorce court awards a portion of your interest in the company to your spouse, your spouse may contend that he or she is not bound by the Buy-Sell Agreement. Alternatively, your spouse may argue that your interest in the company should be valued based upon the different method than that contained in the Buy-Sell Agreement.
Customarily, spouses do not sign Buy-Sell Agreements unless they own an interest in the company. However, a recent case decided by the Tennessee Court of Appeals provides a good reason for asking your spouse to sign the Buy-Sell Agreement.
In the Inzer (pdf) case, the wife argued that her husband’s stock in his company should not be valued in accordance with a formula contained in the Buy-Sell Agreement. The Court indicated that the wife’s argument would have been meritorious if she had not signed the Buy-Sell Agreement. Because she signed the Agreement, the Court ruled that she was bound by the valuation formula.
For purposes of valuing the couples' marital estate, the stock was valued significantly below its pro rata share of the total value of the company. Because the husband was awarded the stock, this meant that the wife received a smaller share of the other assets. As a result of this case, I plan to recommend that my clients ask their spouses to sign their Buy-Sell Agreements.
A recent decision by the Tennessee Supreme Court (PDF) ruled that the entire increase in value of a 401(k) plan that occurs after marriage is a marital asset that is subject to equal division upon divorce. It does not matter whether the increase in value is attributable to appreciation of the assets that were held in the plan prior to marriage or contributions that were added to the account during the marriage. The pre-marital balance of the plan was separate property that was not subject to division.
The case confirmed that IRAs are treated differently. Appreciation of a pre-marital IRA that occurs during the marriage continues to be separate property and is not a marital asset subject to division upon divorce, unless the other spouse substantially contributed to its preservation and appreciation.
There are two lessons to be learned from this case. First, keep good records that demonstrate the account balance of the 401(k) plan on the date of your marriage. Second, if your 401(k) plan permits in-service withdrawals, you should establish an IRA, rollover your 401(k) to the IRA prior to your marriage, and exclude your spouse from making any investment decisions for your IRA.
Recently, a client told me “as is so often the case second marriages, the value of the wife’s estate that she can leave her children will vary significantly depending on whether she predeceases her husband.” My client’s observation is so accurate. I have encountered this dilemma when working with other clients, but had not understood that this problem affects numerous second marriages.
My client’s husband is very wealthy and plans to make a generous bequest to her in his Will. Furthermore, they jointly own a valuable house.
If her husband dies first, she will own the house and will receive the bequest from her husband’s Will. If she dies first, she will have neither the house nor the bequest.
She is comfortable with the amount that she will be able to leave her children if she survives her husband. However, she is concerned that the inheritance for her children will be insufficient if she predeceases her husband.
The solution that I proposed works as follows:
The couple establishes an irrevocable life insurance trust (“ILIT”) that will buy a last to die insurance policy on the lives of the husband and wife. If the wife dies first, her children will be the beneficiaries of the ILIT. If the husband dies first, his children will be the beneficiaries of the ILIT.
The parties agreed to split the premium payments during their joint lives. The will of the first to die will make a bequest to the trust that is sufficient to pay premiums during the period of survivorship.
The “Switch ILIT” solved my client’s dilemma of making sure that her children will be well provided for regardless of whether she predeceases her husband.
I discourage the use of a marital trust for a surviving spouse when the decedent’s children from a prior marriage will be the remainder beneficiaries. Such trusts have an inherent conflict of interest and should be avoided when possible.
Most marital trusts base the payments to the surviving spouse on the trust’s income. The surviving spouse wants the Trustee to purchase investments that produce a lot of income. Conversely, the stepchildren prefer the Trustee to invest in assets that will appreciate in value over time.
When a marital trust is the only practical solution, I recommend a marital unitrust, which works as follows: The surviving spouse receives the greater of the income earned by the trust or five percent (5%) of the value of the trust determined as of the beginning of each calendar year. In order to reduce volatility in the amount of the annual payments to the spouse, payments should be based on a 3 year average of the value of the trust.
The Trustee invests in a mixed portfolio of equities and fixed income investments. Principal assets will need to be liquidated each year to make the payments to the spouse because income will be significantly less than 5%.
The spouse wants growth because it will increase distributions in the future without reducing current distributions. The Trustee’s job will be much easier to accomplish because the spouse and the stepchildren will have the same goals.
Wealthy grandparents often make gifts to their grandchildren. A grandparent can give $13,000 per year to each grandchild without incurring gift tax. If gifts are made over several years, estate taxes upon the death of the grandparents can be substantially reduced.
There is a hidden trap in making gifts. The danger is that your grandchild may get divorced in the future. Some states consider all property owned by either spouse to be marital property which is subject to a 50/50 division upon divorce.
The problem is illustrated by a family that I now represent. The grandmother made gifts of stock of the family business to her granddaughter in the 80s and 90s. The grandmother died in 1997. Two years later, her granddaughter married a man the grandmother never met.
I did not know the grandmother, but have represented the grandmother’s daughter for the last several years. The daughter continued her mother’s pattern of making annual exclusion gifts to her daughter. Rather than direct gifts, the gifts were made to a Cristofani Trust (pdf) that benefits the daughter’s husband and all of her children and grandchildren.
The granddaughter recently obtained a divorce in a state that treats all property owned by either spouse as marital property. In accordance with state law, the judge awarded one-half of the granddaughter's stock in the family business to the granddaughter’s husband. The net result is that when the grandmother made gifts to her granddaughter, she was also making a gift to her granddaughter’s future ex-husband.
The stock awarded to the ex-husband was subject to a Shareholder’s Agreement, which allowed the company to purchase the stock from the ex-husband. As you might imagine, the family was upset about having to buy back the stock.
The laws of the states where the grandmother and granddaughter lived at the time of the gifts would not have included the gifts in the marital estate if the granddaughter had obtained a divorce in either one of those states. However, division of property is determined by the state in which the couple resides at the time of the divorce.
Fortunately, because the gifts by the daughter were made to a trust, these gifts were protected in the divorce. The moral of this story is to consider making gifts to a properly designed trust in order to reduce the chance that the donee will lose part of the gift if they subsequently obtain a divorce in the wrong state.
A recent case (pdf) decided by the Tennessee Court of Appeals highlights the challenges of planning for spouses involved in a second marriage, especially when both spouses have children from a prior marriage. The children of the first spouse to die generally do not fair well.
The case involved Mr. and Mrs. Reinhart, who both had 2 children from a prior marriage. When Mr. Reinhart died, his entire estate went to his widow. Before her husband's death, Mrs. Reinhart had prepared a Will which left her estate in 4 equal shares to the children if her husband predeceased her. After her husband died, Mrs. Reinhart changed her Will to leave her entire estate to her two children. The stepchildren were not successful with their attempt to overturn the change that had been made to Mrs. Reinhart's Will.
I was not involved in the case, but I would venture a guess that the Reinharts had an "understanding" that the survivor would treat all 4 children equally. I have heard this plan many times before. It is a simple and beautiful estate plan when it works. Regrettably, what happened with the Reinharts occurs frequently. It is natural for a widow or widower to spend more time with their own children than with their stepchildren. The children are often successful in persuading their parent to change the parent's Will in their favor.
Another concern is the potential remarriage of the survivor followed by a significant transfer of assets to the next spouse. If this occurs, the children of the survivor can also lose their inheritance.
Estate planners are very well aware of the dangers of planning for couples in second marriages. The problem is that there are drawbacks to all potential solutions that we can recommend.
My preferred solution is to give the children of the first spouse to die a significant portion of their inheritance at the first death. In some cases, this benefit is funded by life insurance. The survivor can then leave all or most of their estate to their own children. This solution might generate estate taxes at the first death and may not be feasible if it does not leave enough assets to take care of the survivor for their remaining lifetime.
Another solution is to put a significant amount of assets in a marital trust for the survivor. There are a variety of safeguards that can be used to ensure that the trust is not depleted during the survivor's lifetime. These safeguards are often disliked by the survivor. The trust arrangement puts the stepchildren in the position of "waiting" for the survivor to die. I have been involved with a lot of these trusts where the survivor and the stepchildren were all unhappy with the arrangement.
My least favorite solution is for the spouses to enter into a contract that requires the survivor to treat the children equally. At best, this gives the children of the first spouse to die a chance to sue their stepsiblings if they are not treated as outlined in the contract.
Married persons who have children from a previous marriage must plan carefully if they want to provide for their children and spouse without pitting them against each other.
More than 50% of marriages end in divorce. When one spouse enters the marriage with significant assets, they often leave with less than they started with.
The traditional method for protecting your assets is to enter into a prenuptial agreement before you get married. I recommend this to all of my clients who are getting married.
In lieu of or in addition to a prenuptial agreement, Tennessee residents can protect their assets by transferring them to an asset protection trust {pdf} before they get married. Even if they do not have a prenuptial agreement, their spouse will not be entitled to any of the trust assets upon divorce. Furthermore, their spouse will not be able to claim any portion of the trust assets upon death. This latter point is especially important for later-in-life marriages when one or both spouses have children from prior marriages.
I have mostly used pre-marital asset protection trusts for young adults who have received substantial gifts and/or inheritances from their parents and grandparents. As a general rule, these young adults have relied solely upon the protection afforded by the trust because they were not willing to discuss a prenuptial agreement with their future spouse.
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