Judge Promotes Ex-Spouse to Primary Beneficiary of Trust

Imagine that you set up a trust for your son and give an independent trustee the discretion to make distributions to your son for his health, education, maintenance and support.  Next, imagine that your son gets divorced, loses his job, and is unable to pay his alimony.  Can your son’s ex-wife access the trust to satisfy the unpaid alimony.  In Tennessee and some other states, the answer is a resounding “No.”  These states zealously protect a person’s right to determine the beneficiaries of the person’s largesse.  Other states have determined that the public policy of making sure that alimony is paid is a higher priority.

Florida is one of the states that places more importance on satisfying alimony claims.  In the recent case of Berlinger v. Casselberry, the Court prohibited the trustee from making distributions to the primary beneficiary of the trust unless and until the beneficiary was current on his alimony obligations.  The Judge’s Order effectively meant that the alimony had to be paid first, and thus, the beneficiary’s ex-wife became the primary beneficiary of the trust.  The reason that the ex-wife sought the Court’s help is because her ex-husband was not working and was receiving no income that she could attach to satisfy her alimony.  Her ex-husband’s trust was directly paying all of his living expenses.  This technique of paying a beneficiary’s expenses out of the trust is specifically authorized by a recent Tennessee statute, but it was not allowed in the Florida case.

The Berlinger case highlights the significance of choosing the state law that will govern the trusts that you establish.  Tennessee passed substantial changes to its trust laws in 2013 to strengthen the rights of a grantor to choose who will benefit from the trust.  If you believe you can do a better job of picking your beneficiaries than a judge, you should make Tennessee law the governing law for your trusts.

Same-Sex Spouses Are Married for U.S. Tax Laws

On Thursday, August 29, 2013, the IRS issued Revenue Ruling 2013-17 regarding the tax treatment of same-sex spouses. Effective immediately, same-sex spouses will be treated the same as a heterosexual married couple for federal tax purposes. The District of Columbia and 13 states now allow same-sex spouses to become legally married. Prior to the issuance of the Revenue Ruling, the IRS did not recognize a same sex marriage for purposes of federal tax laws. The change in policy does not apply to civil unions or registered domestic partnerships.

There are numerous tax ramifications to this change. One consequence is that same-sex couples are now required to file a joint income tax return, even if they live in a state that does not recognize same-sex marriages. For 2012, they have an option to file as two single persons or as a married couple. However, if they want to file as two single persons, they must file or amend their 2012 income tax returns on or before September 16, 2013. If they file their 2012 income tax returns after September 16, 2013, they are required to file as a married couple. Due to the so called "marriage penalty," it is hard to predict whether it is better to file together or separately. In general, if there is a wide disparity between the amounts of income earned by the spouses, it will be better to file a joint return. If the spouses earn approximately the same amount of income, it will probably be better to file as two single persons.

In addition to the very quick decision that must be made with respect to 2012 income tax returns, a decision also needs to be made about filing claims for refund. If it would result in a tax refund, the spouses can amend their tax returns for 2011 and 2010, and perhaps 2009 (depending upon when their 2009 tax returns were filed), to file their returns as married filing joint. They do not have to amend their returns if it would cause additional taxes to be paid.

A gift or bequest to your spouse now qualifies for the federal gift or estate tax marital deduction. If taxes have been paid on a gift or bequest to a same-sex spouse within the last 3 years, or if gift tax exemption has been used, you should consider filing a refund claim. If your Will makes a bequest to a trust for your spouse, you should consider modifying the trust to qualify for the estate tax marital deduction. If you are not married, have an estate of more than $5.25 million, and plan to make a bequest to a same-sex partner, you should consider getting married in one of the states that allows same-sex marriages.

Correlation between Divorce and Disinheritance

This week, I worked with three different clients whose families had some involvement with one or more disinherited children. Two of my clients treat their children disproportionately, or totally disinherit a child. The third client has been emotionally and financially disinherited by one of her parents. I ruminated on the family circumstances that led to the disparate treatment of the children. In all three families, the disinherited child's natural parents went through a bitter divorce. In all three families, the parent who is disinheriting a child had remarried. One parent who is disinheriting a child was disappointed in the child, primarily because the child "favored" the child's other parent.

When I reflected on other clients of mine who are either disinheriting a child or have been disinherited, or whose sibling has been disinherited, I noticed a pattern. In a significant percentage of these families, there was a divorce of the child's natural parents. As we all know, divorce is not only difficult for the spouses, but is also difficult for the children. A lot of divorcing couples use their children to exact emotional or financial retribution. Predictably, a child who is cast into the middle of a nasty divorce is more likely to experience emotional problems. When the attention of one of their parents is diverted by a new spouse, it is not surprising that the child may become closer to their parent who does not remarry.

If you have gone through a divorce, and are considering disinheriting one of your children from a prior marriage, you should make allowances for the fact that your divorce created difficulties for your children. If your parents go through a divorce, my advice to the children is to continue to honor both of your parents and do the best you can to avoid taking sides in disputes between your parents. Your parents will take note if they perceive that you are teaming up against them.

Estate Tax Refund Ordered for Widow of Same Sex Marriage

A previous article detailed a case in which Edith Windsor had to pay $350,000 of federal estate taxes when her spouse died because Edith’s spouse was a woman rather than a man. The tax penalty was based on a 1996 federal law signed by President Clinton known as the Defense of [Heterosexual] Marriage Act (“DOMA”). The actual tax cost was significantly higher than $350,000 because New York also charged more than $200,000 of inheritance taxes that would not have applied if Edith’s spouse had been a man.

A federal judge in New York recently ordered the IRS to refund the federal estate taxes that were assessed. The judge ruled that DOMA is unconstitutional.

It appears that the constitutionality of DOMA will eventually be decided by the U.S. Supreme Court. Unless and until DOMA is thrown out, you should assume that gifts and bequests to your spouse will not qualify for a gift or estate tax marital deduction unless your spouse is a member of the opposite sex.

Contracts to Make a Will

In a recent case, Estate of Ina Ruth Brown, the Tennessee Court of Appeals upheld the validity of a contract to execute Wills. These contracts are most often used in second marriages when at least one of the spouses has children from a prior marriage.

The contract typically works as follows: Each spouse agrees to bequeath certain property to the survivor with the understanding that the survivor will bequeath the property to the children of the first spouse to die following the survivor’s death.

Following the execution of the contract, the husband and wife each execute Wills which are consistent with the contract. After the first spouse dies, the children of the surviving spouse sometimes persuade the surviving spouse to change his/her Will in a way that totally disinherits the stepchildren. That is exactly what happened in the Brown case.

After Mrs. Brown died, her son probated her Will, which left everything to him.  Mr. Brown’s children filed a Will contest.  The children should have filed a claim for breach of contract against the estate of Mrs. Brown rather than a Will contest.  Nevertheless, the Court of Appeals granted to Mr. Brown’s children the property they were entitled to receive based upon the contract.  Even though Mr. Brown’s children were ultimately successful, it took them 8 years and significant legal fees to protect their rights.

Estate planning for spouses in second marriages is challenging. Each spouse wants to benefit their spouse and benefit their children from the prior marriage. The best solution is to transfer separate assets to the spouse and children upon the first spouse’s death. When there are not enough assets to take care of the spouse and the children, various approaches are used to enable the property to benefit the surviving spouse during his/her lifetime with the property to pass to the children upon the surviving spouse’s death. All of these techniques inevitably create tension between the stepparent and the stepchildren.

I have prepared contracts to make a Will for several couples, though only after investigating other solutions and with a warning to my clients that such contracts are a challenge to enforce by the children of the first spouse to die.

Stepmom Snatches 401(k) from Her Stepchildren

In a recent case, Cajun Industries, LLC vs. Robert Kidder, et al., the decedent designated his three children as beneficiaries of his 401(k) plan after his first wife died. He remarried a few months before he died and did not realize he needed to make any changes because he still wanted his 401(k) plan to go to his children. Unfortunately, when he died, his new wife successfully claimed the entire 401(k) account due to a federal law known as ERISA. This law required Mr. Kidder to fill out a new beneficiary form after he remarried and to obtain the consent of his new wife.  Because his wife had not consented to his designation in favor of his children, ERISA required the account to be distributed to his wife.

There were two other potential solutions that would have allowed the funds in the 401(k) account to go to Mr. Kidder’s children. Prior to getting married, Mr. Kidder could have asked his wife to sign a prenuptial agreement wherein she agreed to sign a waiver of his 401(k) plan. Alternatively, before he married, Mr. Kidder could have rolled his 401(k) account to an IRA and then designated his children as beneficiaries of his IRA. The rules requiring a spousal waiver to a beneficiary designation do not apply to IRAs.

Premarital Residence Divided Equally Between Spouses in Divorce

In the Liner divorce case, the court awarded 1/2 of the equity in the husband’s premarital residence to the wife. As a general rule, assets owned by one spouse prior to the marriage are treated as separate property and are not divided in the divorce. There are some exceptions, including the division of appreciation of the property if the non-owner contributes to the appreciation. This case did not involve appreciation. Rather, the wife was awarded 1/2 of the house primarily because she made non-financial contributions to the ongoing maintenance and management of the residence.

This case demonstrates the importance of entering into a prenuptial agreement or an asset protection trust prior to marriage. Assets that you transfer into an asset protection trust prior to the marriage will belong to the trust and will not be subject to division in the event of a divorce.


 

Conservator Allowed to File for Divorce on Behalf of Ward

In the attached Carnahan decision, the Tennessee Court of Appeals appointed a disabled man’s daughter as his conservator despite his objections.  The Court also allowed the daughter to file a divorce on behalf of her father.

It is somewhat unusual for a child to be appointed as a conservator ahead of a spouse who is willing and able to serve in such role. However, in this case, the ward’s wife had signed a prenuptial agreement that waived her right to seek the appointment of a conservator for him. If there had not been a prenuptial agreement, it is likely that the wife would have been appointed as the conservator due to the priorities set forth by Tennessee law.

It is also unusual for a court to give the conservator the power to file a divorce on behalf of the ward. This is generally thought to be such a personal matter that it should not be exercised by a conservator. When the daughter’s father had legal capacity, he decided to get married. By allowing the daughter to file for divorce in her capacity as conservator, the court allowed the daughter to substitute her judgment regarding her stepmother in place of her father's decision made while he was competent. Have you ever seen a friend or family member marry someone whom you did not approve of?

There are two lessons to be learned from this case. You should address conservatorship in your prenuptial agreement and your financial and healthcare powers of attorney. If you do not want your future spouse to participate in the appointment of your conservator, then make sure that point is addressed in the prenuptial agreement.

Your financial and healthcare powers of attorney should clearly state who you want to serve as your conservator in the event that you become incapacitated. Further, your powers of attorney should state whether or not you want the agent or conservator to be able to file for a divorce on your behalf. I personally do not like the idea of an agent under a power of attorney or a conservator being able to file for divorce. When your spouse is not your agent or conservator, it will often be one of your children. Your children are likely to benefit financially if you obtain a divorce before you die. Therefore, your conservator or agent has a built-in financial conflict of interest. Even if there is not a financial conflict of interest, a lot of step-children dislike their step-parents and might file for divorce just to be mean.
 

President Terminates Enforcement of Defense of Marriage Act

I previously wrote about Edith Windsor, who was required to pay $350,000 of estate taxes because her deceased spouse was a woman rather than a man. This tax was caused by the Defense of Marriage Act (“DOMA”), which classifies same sex married couples as unmarried for purposes of federal taxation and various benefits.

President Obama has decided that certain portions of DOMA are unconstitutional and has directed the Justice Department to stop defending the law in court, including the pending appeal in the Windsor case.

There are many people who agree with the President’s assessment of the constitutionality of DOMA. Nevertheless, it is not the President’s job to determine the constitutionality of laws that have been enacted. Laws may be changed by Congress or ruled to be unconstitutional by the judicial branch of the government. It would create chaos if the President is allowed to prohibit enforcement of laws that he does not like.

If DOMA is overturned by Congress or the U.S. Supreme Court, this will be a watershed event for same sex married couples. There are numerous tax and non-tax benefits provided to couples who are treated as married by the federal government.

Estate Planning for Second Marriages

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.

Wife Receives Joint Assets Upon Divorce Due to Prenuptial Agreement

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.

Widow Receives Partial Elective Share Despite Prenuptial Agreement

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.
 

Tennessee Becomes Second State to Allow Community Property Trusts

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.
 

Ask Your Spouse to Sign Your Buy-Sell Agreement

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.
 

Pre-Marital Planning Can Protect 401(k) Plan Upon Divorce

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.

Switch ILIT Solves Estate Planning Dilemma for Wife in Second Marriage

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.
 

Marital Unitrust Reduces Friction with Stepchildren

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.  
 

Making Gifts to Your Granddaughter's Future Ex-Husband

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.
 

Estate Planning for Second Marriages

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.
 

Pre-Marital Asset Protection Trust Enhances Divorce Protection

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.