My name is Dan Couvrette, and I’m the publisher of Family Lawyer Magazine. My guests today are Sharon Klein and Elena Karabatos, and we’re going to be talking about attacking and defending trust assets in divorce in this video.
Sharon is the President of Family Wealth, Eastern U.S. Region and National Head of the Divorce Advisory Practice at Wilmington Trust. She is responsible for overseeing the delivery of all Wealth Management services by teams of professionals. Beginning her career as a trusts and estate attorney, Sharon is a Fellow of the American College of Trust and Estate Counsel and a nationally recognized speaker and author.
Elena Karabatos is the Managing Partner of Schlissel Ostrow Karabatos, PLLC, a boutique matrimonial law firm in New York. She is a past-president of the New York Chapter of the American Academy of Matrimonial Lawyers. Elena’s practice is exclusively dedicated to matrimonial law and she is a frequent lecturer in the field.
Sharon, tell us a little bit about your practice.
Sharon Klein: Hi, Dan – thanks very much. Wilmington Trust offers the full spectrum of wealth management services in the divorce arena. That can run the gamut from running comprehensive financial projections using sophisticated proprietary analytics to help give attorneys leverage at the negotiating table, to investing settlement proceeds after the divorce is final, to acting as the neutral and impartial trustee, to advising on insurance needs, to reviewing business valuations, to reviewing estate planning documents, which typically need to be updated after a divorce, to providing custom financing and comprehensive family office services. It’s really the whole range of services that we offer to assist people who’ve been impacted by divorce.
Elena, do you want to tell us a little bit about yourself and your practice?
Elena Karabatos: Yes, Dan – thank you. Our firm does exclusively matrimonial work in New York law, and in New York State we are recognized for doing the most complex financial litigations to mediations and collaborative divorce. Basically, we do all types of matrimonial matters. Our practice is dedicated to many complex financial matters. We do see a lot of high-net-worth clients and as such, we deal with trusts all the time.
Elena, what do you see as some of the big issues with matrimonial lawyers when they’re faced with dealing with a trust?
Elena Karabatos: The first question – whether I’m representing the beneficiary of the trust or whether I’m representing the spouse of the beneficiary – the real questions is: is that trust protected, or can I access it if I need to? Or, if I’m representing the beneficiary spouse, can I make sure it can’t be accessed unless I want it to be? Those are the initial questions that clients often come to me with.
Sharon, what should matrimonial lawyers look for when dealing with trusts?
Sharon Klein: Dan, I’m reminded of the old adage when all else fails, read the instructions, because the first thing a matrimonial attorney should do, hopefully in collaboration with a trust and estates attorney, is to look at the trust instrument. Because while much will depend on state law in terms of whether a trust interest is accessible in divorce, the starting point is always going to be to determine the nature of the trust interest. The bottom line is that the less likely a beneficiary is to receive a distribution and the less control a beneficiary has over trust assets, the less likely that the trust assets are going to be accessible in divorce.
I have six key questions I think advisors should ask as they review trust documents in order to answer the question: Is this trust interest accessible in divorce?
Question #1: Who created the trust? Courts are less likely to consider a trust created by a third party, which is, for example, a parent or a grandparent, reachable in divorce, because that is more likely to have been done as legitimate estate planning, as opposed to, for example, a trust created by a spouse, which might be seen as trying to shelter assets in anticipation of divorce.
Question #2: Who are the beneficiaries? If a trust includes a class of beneficiaries, particularly if it’s a broad class with people in multiple generations, particularly if it’s a so-called open class of beneficiaries, which means more beneficiaries can be born into the class, so the total number of beneficiaries is undeterminable, it will be less likely that the trust beneficiary will receive a distribution as opposed to the trust beneficiary being the only beneficiary of the trust.
Question #3: On what basis can trustees make distributions? If a trustee is given broad authority to make distributions in its sole discretion, the timing and the amount of distributions will be uncertain. Yes, making it less likely that a beneficiary will receive a distribution than, for example, if a trustee is required to pay income, or required to pay principal to a trust beneficiary pursuant to a so-called ascertainable standard, for example, HEMS, which is health, education, maintenance, and support. Because if a trustee is required to pay income to a beneficiary, or required to pay principal to a beneficiary pursuant to a standard, it’s likely that the beneficiary could compel a distribution to that extent, making it more likely that to that extent, those trust assets will be reachable in divorce.
Question #4: Is there a spendthrift provision? A spendthrift provision is commonly inserted in trust instruments as a form of creditor protection. Basically, it prevents a beneficiary from assigning her interest in the trust and provides that a beneficiary’s interest is not subject to that person’s debts or liabilities. In essence, what happens is that a creditor has to wait until a distribution is made to that beneficiary to assert a claim against those assets. So, if you’re representing someone who’s a beneficiary of a trust, and you find a spendthrift clause, that’s a very helpful fact to have on your side. It’s not foolproof, sometimes alimony and child support have been awarded despite a spendthrift clause, and sometimes the assets in a trust have been considered as part of the marital balance sheet, but it’s a very helpful fact to have.
Question #5: Does a beneficiary have control powers? The cases show that the greater the control a beneficiary is able to exert over trust assets, the more likely that the court will consider the beneficiary’s interest in a divorce proceeding. Control features that trust and estates attorneys commonly insert in documents include the ability for the beneficiary to be a trustee, even giving the beneficiary the ability to pay principal to herself pursuant to an ascertainable standard, like HEMS because that will prevent adverse estate tax consequences, or giving the beneficiary the ability to remove and replace trustees or giving the beneficiary a so-called power of appointment, which enables the beneficiary to redirect the distribution of trust assets. The more control, the more likely that the trust will be included in the marital balance sheet.
Question #6: Who is the trustee? If you have an independent trustee acting, particularly a corporate trustee, that usually removes even the appearance of impropriety and can circumvent suspicion that might attach if a friend or family member is acting as a trustee, that they’re acting only in the interests of the trust beneficiary.
So, these are the six questions that I would ask at the outset, while reading the trust document.
Great, thank you. Elena, beyond reading the trust document, what else should a matrimonial lawyer consider?
Elena Karabatos: Well, first of all, I want to say thank you, Sharon, those are great questions. Now, I, as the matrimonial attorney looking at those questions, really, my job is to paint the picture to the court. You must remember a matrimonial court, a family law court is a court of equity. What the judge is trying to create is a fair result. That judge may not know much about trust and estates, but the judge certainly knows about fairness. So, I, as the matrimonial attorney have to argue and paint the picture as to why this trust should be accessed or why it can’t be. If I’m representing the spouse of the beneficiary, I may argue about and look at, was it treated like an ATM? Did the spouse receive regular distributions? Did the family prepare and count on a significant distribution? Was it intended to be left to the children? These are all important questions.
Quite frankly, I need to know the answers to these questions, whether or not I represent the beneficiary spouse or whether I represent the spouse of the beneficiary. But the point is, the history of the distributions is a critical factor in determining how we can argue and use it in the context of the matrimonial action. Certainly, if I’m representing the beneficiary spouse, I’m going to argue that you are stuck with the terms of the trust agreement and that it was a gift intended for the beneficiary spouse only. Anything else is not really relevant at this time.
Bottom line is, I reach out to my trust and estates attorney, people like Sharon Klein. That’s what I’m actually going to do because at the end of the day, as I’m creating this picture, I have to know how far afield I can go with my arguments. But the truth is, really the takeaway, that it’s our job in the matrimonial case to really explain to the judge how this trust was used, and how much or not it was relied upon during the party’s marriage.
Elena, I’m in absolute agreement with you. If it’s anything to do with trusts, I’d be reaching out to Sharon Klein as well. I’ve interviewed Sharon a number of times, while I’ve struggled with just asking the questions, she blurts out the answers without any notes. It’s all coming directly from her experience. So, you’re absolutely right, call Sharon Klein.
Sharon Klein: Thank you.
Elena Karabatos: Right, that is important. That is very important to call Sharon. Because remember, Sharon, we matrimonial attorneys, we’re just going to argue what feels right, what feels important to get across to the judge, and you’re going to tell us the limitations of our arguments.
Sharon Klein: Well, I think together, we would work very well, because I think you need both sides of that equation to be successful.
So, Sharon if a couple is getting divorced and they have created a trust during the marriage, what issues or potential pitfalls should they pay close attention to?
Sharon Klein: That’s a great question, Dan, because we’ve been talking about third party trusts. So now if we pivot and talk about trusts created by the spouses during the marriage, there are three issues that come to my mind immediately. The first is what’s the definition of spouse in the document because some documents make it clear that a divorced spouse is going to cease to be a beneficiary. Some documents accomplish that by using the notion of a floating spouse, which means the spouse is a beneficiary if the spouse is married to the creator at the time a distribution is made. So, that is a self-adjusting definition and can adjust and readjust and readjust again, with every marriage, divorce, and remarriage.
That definition certainly works, although there are some estate practitioners who tell me that doesn’t necessarily engender the warmest of feelings if you have the happy couple sitting opposite you and the wife, for example, knows that not only is she out in the event of a divorce but her successor wife is going to step into her shoes as beneficiary. Other practitioners tell me it’s more palatable to define spouse by the current spouse, provided that the spouse is married to and living with the creator on the date of a distribution. But if a document doesn’t have guidance about the definition of a spouse, the court will look for the creator’s intent by examining the trust provisions. So, that’s the first issue, how is spouse defined.
The second issue that arises when parties to a marriage have created the trust is a tax issue. That’s because of the recent repeal of the section of the Internal Revenue Code. We know that people create trusts to get those assets out of their estate for estate tax purposes. You can transfer assets to a trust, those assets – since you don’t own them – won’t be taxable in your estate when you die and yet, you can continue to own the trust for income tax purposes. That means you’re liable for the income taxes attributable to the trust. Why would anyone want to do that, transfer assets to a trust, get them out of their estate, so they don’t own them, yet be on the hook for the income tax liability? Because that is ideal estate planning. To the extent that the grantor or creator of the trust is paying income taxes, a so-called “grantor trust,” the trust beneficiaries are relieved of that obligation and the trust can, in essence, grow tax-free. Really, paying the trust’s taxes is a gift by the creator of the trust to the beneficiaries, but the IRS doesn’t consider it a gift. So, as I say, it’s ideal estate planning.
In addition, in the marital trust context, grantor trust status is triggered automatically in certain circumstances. If a party to a marriage creates a trust, and the spouse could be an income beneficiary, that is automatically a grantor trust. Under the so-called spousal unity rule, the person who created the trust is treated as holding any interest held by that individual’s spouse at the time the interest is created. That means if a party to a marriage creates the trust, it’s automatically a grantor trust by virtue of their marriage, and it will remain a grantor trust even after the parties get divorced because the triggering time to determine grantor trust status is the time the trust is created. That means if parties, while they’re happily married, create a trust and one spouse could be the beneficiary, that trust will remain a grantor trust after divorce. The person who created the trust will remain liable to pay the taxes attributable to the distributions made to his beloved ex-spouse forever, a kind of nasty tax result if you ask that person.
Until recently, Section 682 of the Internal Revenue Code saved the day by providing that, after a divorce, the income is picked up by the recipient of the income and isn’t taxed to the creator of the trust. The problem is that Section 682 of the Internal Revenue Code has been repealed for divorces beginning in 2019. So, beginning in 2019, you don’t have the protection of Section 682, and note that the triggering date is tied to divorce beginning in 2019. The date of the trust is irrelevant. If you get divorced, beginning in 2019, you have to examine every trust created during the course of the marriage, whether it’s five years ago, 10 years ago, 20 years ago, it doesn’t matter, to see if you have this surprising tax result.
Let me tell you, this is a big deal. It’s a big deal because it affects the staples of estate planning. The most common estate planning techniques entered into by spouses to a marriage are oftentimes grantor trusts and this is where collaboration between family lawyers and estate lawyers and investment advisors is key because the tax impact can potentially be blunted. But if a family lawyer was to say to her client, let’s finish with a divorce, and then I’ll send you to your planning attorney to update your planning, it’s going to be too late. This needs to be dealt with before the divorce is final. There are things that you could do, as I say to blunt the tax impact. For example, maybe you insert a reimbursement provision in the settlement agreement, making the creator whole for the ongoing tax liability. Perhaps you could terminate the trust and pay it out to the soon to be ex-spouse and equalize from the other assets. The point is this is an issue that needs to be addressed before the divorce is final.
The third issue that comes to mind immediately when you’re talking about trusts created by parties to a marriage is: If those parties transfer marital assets to the trust, do those assets lose their character as marital assets, and are they off-limits in divorce? There have been a number of cases that say even if one or the other spouse creates a trust and transfers marital assets to that trust, if neither spouse is a trustee, if neither spouse is a beneficiary, if neither spouse has control over the trust assets, then those assets are not considered available on the divorce balance sheet.
Then you get a case like the Yerushalmi case, which recently came out of New York, in which the court struck down apparently legitimate estate planning. As I read this case, it was shocking to me, because the technique that was utilized, the QPRT technique or the Qualified Personal Residence Trust, is a legitimate and frequently used planning technique. It involves parties transferring their interest in a residence to a trust. They reserve the right to live there for a certain term and at the end of the term, the residence passes to other beneficiaries. But in this case, the court held that since the residence was purchased by the parties during the marriage using marital funds, it was presumed to be marital property. According to the court, the fact that the title had been transferred to the QPRT and I’m quoting the court, “allegedly for estate planning purposes” while the parties continued to reside there, was under the circumstances insufficient to rebut the presumption. Now, apparently there was a backstory in this case, which would have made it inequitable for the trust to be considered off-limits in divorce and part of the trust corpus.
So, to Elena’s point, family law attorneys are going to try and weave a story. They’re going to try and poke holes in planning and show vulnerabilities. In other cases, for example, this has been accomplished to show that while trust assets themselves may be off-limits in a divorce, the value of the trust assets can factor into the balance sheet, and the other spouse can be compensated with other assets. The moral is that while legitimate estate planning should and thankfully is oftentimes respected, that won’t stop a family lawyer like Elena from at least trying to poke holes in the planning, trying to show vulnerabilities, and trying to convince a court of equity that the trust assets should be considered in a divorce.
Elena, if a trust is created during a marriage, is the property off-limits for asset division during a divorce?
Elena Karabatos: I’ll give you the answer that I give to my clients. It depends. Really, what I’m going to look at is the backstory. When you’re looking at this trust that was created during the marriage, the backstory is relevant. Was it properly done? When was it done? What was the purpose? Was there a legitimate purpose for setting up this trust? Was it done for estate planning or was it done two minutes before one spouse was about to divorce the other? Timing is extremely relevant here, purpose is relevant. How much of the marital estate went into the trust is also relevant. Imagine the spouse who didn’t participate in this finds out that all the assets are now in a trust. Does that feel fair? Another issue that matrimonial attorneys are looking at in terms of this is, and this is the key, did the spouse who’s not the creator of this trust, participate in the planning of this trust?
All of these factors put together tell a story. One of the points about the court of equity is our job as matrimonial lawyers is to tell the story and say to the court, okay, here’s the real story. Whether or not the trust is ultimately determined to be off-limits by the court, we’re asking the court, depending upon who we represent. If we represent the spouse of the beneficiary, we may say, even if you can’t access the trust, some other considerations should be made for this spouse who is now not going to get these assets. So, to answer your question, there is no straight answer. But again, it’s delving into the history, understanding it, and learning it. Quite frankly, it goes back to the collaboration with the trust and estate lawyers and the financial planners. Whether or not I represent the spouse who wants to protect the trust, who probably created the trust or the other spouse, I really want to find out as much information about the trust, its validity, what assets went in, how it was done, and all the facts that Sharon told us about so that I can argue the best that I can for my client.
Sharon, let’s say you review the trust, and you see that it doesn’t protect your client as it should. What, if anything can you do to fix the issue?
Sharon Klein: With a technique called decanting, you could potentially change the terms of even an irrevocable trust and in fact, with decanting, you might say that there’s no such thing anymore as an irrevocable trust. What decanting is, it’s the ability of a trustee to transfer trust assets into a new trust with different terms. The rationale behind decanting is that a broader power should include a lesser power, and if the trustee has the ability to pay assets outright to a beneficiary, that broad power should include something less, which is instead of paying the assets outright to the beneficiary, putting them in trust for the beneficiary.
To give you an example of how decanting was used in the divorce context, there was a recent case coming out of Connecticut, the Ferri v. Powell-Ferri case, in which a very large trust, a $100 million trust, was put out of reach of a soon to be divorcing spouse.
What happened in that case, was the husband’s father created a trust for the benefit of the husband and the husband had the right to withdraw trust principal at certain ages. Being worried that the future ex-spouse would reach the trust assets, the trustees of the trust decanted the trust into a new trust with different terms. Under the old trust, as I mentioned the husband had the right to withdraw assets at certain ages. In fact, at the time the divorce action was filed, he had the right to withdraw 75% of that $100 million trust and by the time the divorce action matured, he had the right to withdraw 100% of those assets.
In the new trust, the trustees extinguished the right of the husband to take assets at any age and made all principal distributions discretionary with the trustee. The question was, was this decanting successful in putting the assets out of reach of the divorcing spouse? The answer was yes, the court found that it was a valid decanting although they did consider the assets for alimony purposes. But putting all those assets out of reach of the divorcing spouse was a tremendous result in that case.
In that case, although the divorce was filed in Connecticut, the trust instrument was governed under Massachusetts law. About half the states in the country have a statute which enables trustees to decant. Under Massachusetts where there was no statute, the decanting was done pursuant to common law. But the point I want to draw to your attention is that you don’t necessarily have to rely on a state statute or the common law. Oftentimes, and I see a lot of documents cross my desk, oftentimes decanting provisions are put right in the trust instrument itself. So, take a look at the trust instrument and see if the trustees have the power potentially to change the terms of the trust, potentially putting them out of reach of a soon to be divorcing spouse.
Elena, do issues ever come up with the trustees?
Elena Karabatos: Oh, yes! The famous independent trustee. What I’d like to say about that is clear and you’ve heard me now, with every question that I’ve answered, talk about a presentation to a court of equity. I really want to look at the trustee and determine how independent in my eyes does that trustee seem? Is my client’s spouse’s trustee his fishing buddy best friend who made distributions from the trust all along, until lo and behold, that spouse decided to divorce my client. These are the kinds of things I look at, because really one of the arguments that we’re trying to make, particularly if we’re representing the spouse of the beneficiary is, quite frankly, that the trustee is just an alter ego of the beneficiary.
The beneficiary, all he has to do is call up the trustee and say, I’d like a distribution, and the distribution is made? Certainly, the issue here comes up and we do look at it. The more it’s removed, the harder it is to argue that. But of course, these are the arguments we make. We also see it with family members because often it’s not a friend who’s a trustee, it could be a family member. I will consult with someone like Sharon to tell me how good or not good is my argument about the trustee being independent. That’s why collaboration becomes so important. But these are the arguments and the points I’m going to look at with respect to the trustee.
Sharon, if you have an issue with the trustee, is there any way to address that issue?
Sharon Klein: Yes, Dan, as I mentioned towards the outset if you have a truly independent trustee, like a corporate trustee, that can eliminate suspicion, because the reality is that a friend or a family member may be tempted to succumb to a sense of loyalty, pressure, or a sense of obligation and make distributions. Even if they aren’t actually succumbing to the pressure, it could look like they are, and it just looks more suspicious to have a friend or a family member acting as trustee, particularly if you have circumstances like distributions stopping when a divorce action is filed. You can typically, as I say, alleviate that suspicion if you have a truly independent corporate trustee acting.
Elena, do you have any final tips for family lawyers who are dealing with trusts during a divorce?
Elena Karabatos: Yes, I’m going to say call someone like Sharon Klein. The tips are, our job is to really understand the intent of the trust, and really try to make an argument based on who we represent and what we know about the history of the trust. But we do need to consult with the trust and estate attorneys, and the financial planners, so that we really make a good argument based on real facts.
Sharon, I’m going to ask you this question, but you’ve got to keep it short because I know you could give them 100 tips. Are there any final tips you could give family lawyers? Just hit the highlights, please.
Sharon Klein: Well, Dan, I’m going to try and keep it short because there’s one final technique that occurs to me that really represents the confluence of techniques that can epitomize collaboration among investment advisors and family lawyers and estate planners and that is an asset protection trust. That could present formidable obstacles for creditors and of course, the quintessential creditor in this context is the future ex-spouse. Asset protection trusts provide an additional layer of protection against creditors. In most jurisdictions, you can’t create a trust for your own benefit and have that trust protected from creditors. In some jurisdictions, like Delaware, you can create a trust, remain a beneficiary of the trust, and have the assets protected from creditors. The reason to do the asset protection trust is, as I say, to create obstacles for creditors.
If you create an asset protection trust, you force someone to go to the jurisdiction in which you create the trust to start an action, which is why it’s very common for people to look outside their jurisdiction, even if their jurisdiction does have asset protection laws, because you force a creditor to start an action in another jurisdiction. Delaware remains one of the most popular jurisdictions because it’s had asset protection legislation on its books for over two decades. In Delaware, for example, there is a very short four-year statute of limitations. You have to prove by clear and convincing evidence that the transfer was fraudulent with respect to that particular creditor and there’s a very limited number of people in a so-called exception class of creditors, which includes a spouse, or a former spouse, or a child who has a claim from a court order or a settlement agreement. However, while they can potentially attack an asset protection trust, the exception class of creditors doesn’t include a spouse the creator marries after you create the trust. So, you create the trust and then get married, that spouse is not included in the exception class of creditors under Delaware law. That makes it a terrific technique to consider in conjunction with a prenuptial agreement. Because you could create the asset protection trust potentially years before a marriage, or under Delaware law right before marriage, and then you do a prenuptial agreement in which you disclose the asset protection trust to make it clear that it’s separate property and walled off in divorce. That’s a technique, as I say, that goes hand in hand with professionals across disciplines working together and I think that’s a very powerful technique to consider.
I want to thank my two guests today, Sharon Klein and Elena Karabatos. Their contact information is probably on the screen right in front of you. I invite you to also go to familylawyermagazine.com and listen to other podcasts and watch other videos, as well as read hundreds and hundreds of articles there, if not thousands. Thank you again for your time; it was a pleasure having you in this seminar.
Elena Karabatos: Thank you, Dan.
Sharon Klein: Thank you. It was a pleasure to be here.
Sharon is President of Family Wealth, Eastern U.S. Region and National Head of the Divorce Advisory Practice at Wilmington Trust. She is responsible for overseeing the delivery of all Wealth Management services by teams of professionals. Beginning her career as a trusts & estates attorney, Sharon is a Fellow of the American College of Trust and Estate Counsel and a nationally recognized speaker and author. www.wilmingtontrust.com/divorce
Elena Karabatos is the Managing Partner of Schlissel Ostrow Karabatos, PLLC, a boutique matrimonial law firm in New York. She is a Past-President of the New York Chapter of the American Academy of Matrimonial Lawyers and a Fellow of the American College of Family Trial Lawyers. Elena’s practice is exclusively dedicated to matrimonial law and she is a frequent lecturer in the field. www.soklaw.com
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