Protecting an Inheritance in the Event of Divorce
Planning for generational transfer of wealth can be an emotional and difficult task. Clients often want to provide for children, and perhaps grandchildren and more remote descendants, for their lifetimes. Many clients would like for the inheritance to be kept in the family line and out of the hands of their descendants’ creditors. Some clients specifically seek out a planning structure that minimizes the risk that inherited funds will pass to a descendant’s ex-spouse upon divorce.[1]
Protecting the inheritance upon a descendant’s divorce may require that the client sacrifice the straightforward transfers he or she envisioned and instead implement a plan consistent with his or her desired level of protection. This article discusses how common planning strategies will impact, or be impacted by, the divorce of a descendant from the perspective of a client seeking to minimize a descendant’s spouse’s access to inherited funds.[2]
• Property Division on Divorce — In the absence of an effective marital agreement, upon divorce: 1) each spouse keeps his or her nonmarital assets;[3] and 2) a couple’s marital assets[4] are subject to equitable distribution.[5] The wealthier spouse may also have to pay alimony to the less wealthy spouse calculated based on the wealthier spouse’s income.[6] The division of marital assets and the determination of alimony in each case might be affected by the inheritance structure that has been put in place.[7]
• Inheritance by Outright Gift — Some clients prefer to leave their inheritance outright to descendants, either completely outright at death or by providing for mandatory distributions at set intervals. However, in many circumstances, an outright inheritance can negatively affect the descendant’s financial position in divorce when compared to other inheritance options. From the perspective of a client seeking to minimize a descendant’s spouse’s access to inherited funds, each benefit to a descendant’s divorcing spouse can be seen as a risk to the planning goal. Some of these risks are described below. Each client’s goals must be determined with specificity as many will not wish to avoid every possible risk. Some clients’ expressed desire to keep the inheritance within the family will be modified based on their opinions about the available planning options.
Transmutation Risk
As a general rule, assets acquired by a descendant by gift or bequest are nonmarital assets that are not subject to equitable distribution.[8] However, the doctrine of transmutation provides that, under certain circumstances, a nonmarital asset may change its character and become a marital asset.[9] Inherited assets that are intentionally or inadvertently converted to marital assets will be subject to equitable distribution upon divorce (the transmutation risk).
One way to convert a nonmarital asset to a marital asset is by interspousal gift of the nonmarital asset. Interspousal gifts during the marriage are considered marital assets.[10] An interspousal gift is established by showing donative intent, delivery or possession of the gift, and surrender of dominion and control of the gift.[11] Title to the property is not a factor in determining whether an interspousal gift has occurred[12] since Florida is not a title theory state.
It is important to note that a nonmarital asset may be converted into a marital asset despite the original owner’s fixed intention to keep the asset separate. In Hooker v. Hooker, 220 So. 3d 397 (Fla. 2017), the Florida Supreme Court upheld a trial court’s finding that a husband made interspousal gifts of two real properties, thus, causing the properties to be treated as marital assets for purposes of equitable distribution (even though title remained solely in the name of the husband and in spite of a valid premarital agreement providing that each party would retain his or her premarital assets and appreciation upon divorce).[13] If married couples do not manage their affairs so scrupulously as to entirely avoid the transmutation risk, assets inherited outright might easily pass to a descendant’s spouse upon divorce.
Even if the inherited asset itself remains a nonmarital asset, and, thus, not subject to equitable distribution, marital assets subject to division include the increase in value or appreciation of nonmarital assets 1) due to the efforts of either party during the marriage; or 2) from the contribution to or expenditure thereon of marital funds or other forms of marital assets.[14] In other words, an inherited asset might not escape division upon divorce if either spouse is found to have increased the value by personal efforts or by expenditure of marital funds. The amount divided in such a case is not technically a transmutation because the original value of the asset and all passive appreciation is still nonmarital, but a client whose descendants might face division of the appreciation on inherited property might nevertheless prefer that the result had been avoided by different planning.
Offset Risk
A nonmarital asset that escapes characterization as a marital asset and, thus, is not itself subject to equitable distribution may nevertheless be taken into account to reduce a descendant’s share of the marital assets upon divorce (the offset risk). This result can come about due to the judge’s discretion to divide the marital assets unequally, even granting 100% to the less wealthy spouse, based on the “economic circumstances of the parties” and “any other factors necessary to do equity and justice between the parties.”[15] In other words, a court has discretion to award more than 50% of the marital assets to the less wealthy spouse when the court takes into consideration the value of each spouse’s nonmarital assets.[16] A descendant who received an inheritance outright might then receive less total value upon divorce, due to the inheritance offsetting and so reducing the marital asset share, than one whose inheritance had been protected against this consideration.[17]
Alimony Risk
In addition to the impact of the outright inheritance on property division, the inheritance may also affect the amount of alimony. An award of alimony takes into account the income and assets, both marital and nonmarital, of each spouse,[18] but the wealthier spouse’s ability to pay is based mostly on that spouse’s income. As a result, the earnings on the property inherited outright may be taken into account when determining the alimony payable to the less wealthy spouse (the alimony risk). As with the offset risk, such a decision could reduce funds available to the descendant.
Privacy Risk
An additional factor that will be of importance to some families is the potential loss of financial privacy inherent in a divorce proceeding. Privacy may be particularly important with respect to interests in a family-run company in which the financial records might include the employment, salary, and related details of various friends and family members. While a number of cases reflect the court’s willingness to protect private financial details, a divorcing spouse may be able to obtain details if he or she proves them to be relevant.[19]
• Marital Agreements — In recognition of the risks referenced above, some clients insist that their descendants execute prenuptial[20] or postnuptial agreements protecting inherited funds. Such agreements are “in harmony with the public policy”[21] and can protect inherited assets from the risks discussed above. However, requiring descendants to enter into marital agreements may be a less than ideal option for a number of reasons, as descendants can 1) refuse to enter into an agreement; 2) terminate or otherwise avoid the protective terms of an agreement during the marriage; or 3) enter into a flawed agreement that fails to provide the intended protection (the marital agreement risks). In any of these situations the protections of a marital agreement are lost in whole or in part. In addition, some clients may not wish to micromanage their descendants’ actions by inserting legal considerations and oversight into a marriage, especially as applied to descendants who are already married and may be offended by such a requirement.
• Irrevocable Discretionary Spendthrift Trusts — In light of the pitfalls of outright gifts or reliance on marital agreements, it is common for a descendant’s inheritance to be held in an irrevocable discretionary trust with spendthrift provisions. As long as the assets are kept in the trust they should not be treated as marital assets and, therefore, not subject to equitable distribution. As such, the trust assets should not be subject to the transmutation risk.[22] However, a spouse’s beneficial interest in a trust could, in theory, be considered in determining whether to impose an unequal division of marital assets (the offset risk). A spouse’s distributions from an irrevocable trust, to the extent regularly withdrawn and used to support the marital lifestyle, will likely be considered in determining alimony (the alimony risk)[23] to the extent such distributions are considered “income” within the meaning of F.S. §61.046(8).[24]
A judge is permitted to take the trust assets into account to make an unequal distribution of marital assets;[25] and the judge may take any distribution entitlement or history of distributions into account to determine alimony. As with outright gifts, attribution of the trust principal or distributions to the descendant effectively opens up the inheritance to being used to support arguments as to why the spouse should benefit from alimony or a greater than 50% share of the marital assets. Distributions from the trust (funds that some clients may consider to be part of the inheritance they were trying to protect) may be garnished to pay alimony obligations.[26]
A trust may also fail to provide financial privacy, at least to the extent that a divorcing spouse proves the trust records are relevant and the beneficiary spouse has a legal right to access those records. In the Texas case, In re Topletz, 05-19-00327-CV, 2019 WL 4302254 (Tex. App. Sept. 11, 2019), a party was jailed for civil contempt upon refusing to comply with an order to produce documents from a family-run trust of which he was a beneficiary, based on the holding that the beneficiary’s right to access the records amounted to constructive possession of those records. A judge who is otherwise persuaded that trust records are relevant to the divorce proceeding may be further persuaded to force the beneficiary spouse to obtain and turn over such records.[27]
Accordingly, it is apparent that in spite of the protections offered by an irrevocable trust there remain aspects of the offset risk, the alimony risk, and the privacy risk (the trust risks). These risks may be enhanced if the beneficiary/spouse is also the sole trustee or otherwise appears to be in actual control of management of the trust assets or of distributions. The risks may be either enhanced or reduced if the trust situs and governing law is moved to another jurisdiction.
The Trust/Marital Agreement Combination
A client who seeks more protection of inherited assets than can be provided by either marital agreements or irrevocable trusts may choose to use both in combination. The combination may be accomplished by conditioning trust distributions on the existence of an effective marital agreement in place at the time of the distribution. Such a combination strategy may avoid the referenced risks because the irrevocable trust trustee can monitor to avoid the marital agreement risks and the trust and marital agreement combined can protect against the transmutation risk, offset risk, alimony risk, and privacy risk.
The trust/marital agreement combination can effectively insulate the inherited assets from affecting the outcome of divorce proceedings. However, the trustee must keep up with its oversight. After confirming, presumably through retention of an expert, that the marital agreement is in place and effective, the trustee must confirm that the marital agreement continues to be in place and effective periodically, whether or not distributions are made. In unusual circumstances, the marital agreement may be terminated or amended by the beneficiary/descendant prior to divorce. Even if the trustee learns of the termination or amendment, the trustee as nonparty to the agreement would lack the power to reinstate the intended protections.
The Trust/Waiver Combination
As an alternative to the trust/marital agreement combination, a trust provision could require, as a condition to receiving trust distributions, that each spouse of a beneficiary deliver to the trustee a waiver of rights. The spouse of the beneficiary would waive any rights he or she might otherwise claim on divorce with respect to the trust assets, specifically including all of the risks discussed above.[28] This waiver should, if properly drafted and executed, avoid both the marital agreement risks and the trust risks without the necessity of 1) invasive continuing oversight of the marital agreement, or 2) concern about the possible termination of the marital agreement. Such a waiver should be less expensive to implement and less burdensome on the spouses than a marital agreement requirement.[29] For example, unlike a marital agreement, the spouses do not have to concern themselves with disclosure of assets to each other or the fairness of the result. Conceptually, the waiver allows minimal interference with the descendant’s marriage. As long as a spouse chooses not to sign a waiver, then trust funds will not be available to the descendant, consistent with the expressed intent of the client.
Structuring to Avoid Risk
A client who has implemented the trust/marital agreement combination or the trust/waiver combination has gone a long way toward protecting an inheritance on divorce. Some steps that may provide additional insulation against an inheritance affecting a divorce are:
1) When drafting trust documents, avoid including any trust provisions for the beneficiary that could be construed as enforceable rights to 1) withdraw assets, 2) demand distributions, including distributions for health, education, maintenance and support, or 3) appoint assets to creditors, either during life or upon death. If the individual is already a beneficiary of a trust having such provisions, it may be possible to decant or modify the trust to remove such enforceable rights.[30]
2) When drafting trust documents, avoid naming the beneficiary as sole trustee such that the beneficiary might be accused of increasing the value of trust assets by the trustee’s investment decisions, delaying distributions, or foregoing trustee fees prior to a divorce. If the beneficiary is already serving as sole trustee, consider removing the beneficiary or having him or her resign from this position.
3) When drafting trust documents, avoid naming the beneficiary as a co-trustee to avoid imputation of trustee fees for alimony calculations. If the beneficiary is already serving as co-trustee, consider removing the beneficiary or having him or her resign from this position.
4) In the case of a beneficiary with a shaky marriage, the trustee can limit or stop distributions to the beneficiary well in advance of any divorce to reduce the risk the trust distributions will be taken into account for alimony purposes.
5) Consider creating the trust in, or moving the trust situs to, a jurisdiction (domestic or foreign) that provides additional protections in connection with the effect such trust may have on a divorce.[31]
Conclusion
Protecting an inheritance from impacting a descendant’s divorce is not necessarily a simple task. Each client should consider the various ways gifted assets are taken into consideration or otherwise affect a divorce proceeding and should work with his or her advisors to craft an appropriate plan in each circumstance.
[1] This article does not discuss transfer of assets to a descendant’s spouse upon the descendant’s death. A comprehensive plan will consider this related issue.
[2] While this article considers only Florida law, the planner should keep in mind the likelihood that one or more of the descendants will divorce in, and be subject to the laws and courts of, another state or foreign jurisdiction. It is advisable to plan conservatively.
[3] Nonmarital assets include 1) assets acquired before marriage; 2) assets acquired by noninterspousal gift, bequest, devise, or descent; 3) all income from nonmarital assets unless the couple treated, used, or relied on the income as a marital asset; 4) assets excluded by a valid marital agreement; and 5) assets acquired in exchange for nonmarital assets. Fla. Stat. §61.075(6)(b).
[4] Marital assets include 1) assets acquired during the marriage by the spouses either individually or jointly; 2) enhancement in value and appreciation of nonmarital assets from the efforts of either spouse during the marriage or by expenditure of marital funds or assets; 3) the paydown of principal on a note and mortgage secured by nonmarital real property and a portion of the passive appreciation of such property, if the note and mortgage secured by the property are paid down from marital funds during the marriage. The portion of passive appreciation in the property characterized as marital and subject to equitable distribution is determined by multiplying a coverture fraction by the passive appreciation in the property during the marriage; 4) interspousal gifts during the marriage; and 5) all vested and nonvested benefits, rights, and funds accrued during the marriage in retirement, pension, profit-sharing, annuity, deferred compensation, and insurance plans. Fla. Stat. §61.075(6)(a).
[5] Equitable distribution is presumed to divide the marital assets equally, unless there is a justification for unequal distribution based on all relevant factors (“[T]he court shall set apart to each spouse that spouse’s nonmarital assets and liabilities, and in distributing the marital assets and liabilities between the parties, the court must begin with the premise that the distribution should be equal unless there is a justification for an unequal distribution based on all relevant factors….”). Fla. Stat. §61.075(1).
[6] Fla. Stat. §61.08 provides a list of factors for the court to consider in determining the type and amount of alimony. Factors include the financial resources of each party, all sources of income to either party, and any other factor necessary to do equity and justice between the parties.
[7] Other consequences of divorce, such as child support, are not covered in this article.
[8] See Fla. Stat. §61.075(6)(b)2 (defining “nonmarital assets” to include, in pertinent part, “assets acquired separately by either party by non-interspousal gift, bequest, devise, or descent, and assets acquired in exchange for such assets”).
[9] Note there is also the concept of reverse transmutation, by which a marital asset becomes a nonmarital asset. See Carr v. Carr, 152 P.3d 450 (Alaska 2007).
[10] Fla. Stat. §61.075(6)(a)1.d (providing that the term “marital assets” includes interspousal gifts during the marriage); see also Hooker v. Hooker, 220 So. 3d 397, 403 (Fla. 2017) (citing Maddox v. Maddox, 750 So. 2d 693, 694 (Fla. 1st DCA 2000)).
[11] Hooker, 220 So. 3d at 403 (citing Hooker v. Hooker, 174 So. 3d 507, 511 (Fla. 4th DCA 2015), quoting Vigo v. Vigo, 15 So. 3d 619, 622 (Fla. 3d DCA 2009); Mills v. Mills, 854 So. 2d 230, 233 (Fla. 3d DCA 2003), which stated “a gift is made when a donor, intending to make a gift, delivers the gift to the donee and relinquishes all possession and control of the gift”).
[12] Hooker, 220 So. 3d at 402-03 (Fla. 2017) (citing Gardner v. Gardner, 452 So. 2d 981, 983 (Fla. 5th DCA 1984)).
[13] Id. at 403, 406-07. Factors favoring transmutation included that the parties lived and raised a family in these properties; the wife participated in maintenance, upkeep, and improvements, and had the ability to incur expenses for the properties on behalf of the husband; and the wife had unfettered access to the properties. Id.
[14] Fla. Stat. §61.075(6)(a)1.b.
[15] Fla. Stat. §61.075(1).
[16] See id.
[17] While it seems unlikely that a judge would, all else being equal, divide marital assets differently in a situation in which one spouse has nonmarital inherited assets as compared with a situation with no such assets, the possibility may not be ruled out because it is within the judge’s discretion to do so.
[18] Fla. Stat. §61.08.
[19] In Pyszka, Kessler, Massey, Weldon, Catri, Holton & Douberley, P.A. v. Mullin, 602 So. 2d 955 (Fla. 3d DCA 1991), a wife in a dissolution of marriage action requested the production of records relative to the husband’s financial interest at the law firm where he was employed as an attorney. The firm filed a motion for protective order and the trial court denied the motion. Id. The Third District determined that disclosing the partners’ financial situations violates their privacy rights. Id. When conducting a balancing test, the court reasoned that limiting the scope of discovery to protect the right of privacy of a person required the consideration of various competing interests. Id. at 956. In Pyszka, production of discovery that was probative of the husband’s financial interest in the firm served competing interests by limiting the scope of discovery to the relevant issue as opposed to the production of documents that are not germane to the husband’s interest in the firm. Id. In another dissolution of marriage proceeding, Palmer v. Servis, 393 So. 2d 653 (Fla. 5th DCA 1981), the wife sought production of records in order to discover the husband’s interest in a business. With a two-tiered approach to discovery, the wife should, first, tailor her discovery request to acquire documents that will establish the husband’s interest and, then, once the interest of the spouse is established, direct the second tier request to financial issues that are germane to the dissolution of marriage proceeding. Id. at 655.
[20] See Fla. Stat. §61.079.
[21] Del Vecchio v. Del Vecchio, 143 So. 2d 17 (1962). See also Weintraub v. Weintraub, 417 So. 2d 629, 630 (Fla. 1982) (“[T]he [c]ourt noted that while contracts which were intended to encourage or facilitate divorce were illegal as contrary to public policy, an antenuptial agreement negotiated in good faith could encourage marital tranquility.”).
[22] See Nelson v. Nelson, 206 So. 3d 818 (Fla. 2d DCA 2016) (holding that a house transferred to an irrevocable trust ceased to be a marital asset upon transfer; and that upon transfer it became an asset of the trust, an entity distinct from the wife or the husband; and further holding that transferring the house to the trust placed the home beyond the court’s reach for purposes of equitable distribution) (citing Juliano v. Juliano, 991 So. 2d 394, 396 (Fla. 4th DCA 2008) (treating a trust as a distinct entity from the husband); In re Chamberlin, 918 A.2d 1, 17 (N.H. 2007) (holding that assets used to fund an irrevocable trust were not marital assets because they ceased belonging to either spouse)). Keep in mind, however, that a trust may be moved, intentionally or unintentionally, to a jurisdiction that can be either more protective or less protective than Florida. Note that a court in Massachusetts ignored trust protections to reach a beneficiary’s interest in a discretionary spendthrift trust, but this decision was overturned on appeal. Pfannensteihl v. Pfannensteihl, 37 N.E.3d 15, 20 (Mass. App. Ct. 2015), vacated and remanded, 475 Mass. 105, 55 N.E.3d 933 (2016). The trust assets ultimately escaped division because the spouse’s interest was speculative since he was one of 11 beneficiaries of a pot trust.
[23] See Bacher v. Bacher, 520 So. 2d 299 (Fla. 3d DCA 1988).
[24] The term “income” means any form of payment regardless of source, including (but not limited to) trusts. See Fla. Stat. §61.046(8). In determining an alimony award, the court shall consider all relevant factors, including the statutory factors; the statutory factors include financial resources of each party, including nonmarital and marital assets and all sources of income (including trusts, per the definition of “income”). See Fla. Stat. §61.08(2).
[25] In Levitan v. Rosen, 124 N.E.3d 148, 151-52 (Mass. App. Ct. 2019), rev. den., 482 Mass. 1105, 127 N.E.3d 266 (2019), a Massachusetts appeals court, applying Florida law, determined that wife’s beneficial interest in a trust (including but not limited to a 5% withdrawal right) was subject to equitable division. However, due to the trust’s spendthrift clause, the trust could only be allocated to the wife (allowing other offsetting distributions to the husband). Unlike the facts in Pfannenstiehl, the wife was sole beneficiary for her primary benefit and so was not too uncertain to be allocated.
[26] Berlinger v. Casselberry, 133 So. 3d 961 (Fla. 2d DCA 2013).
[27] Arguably, a trustee observant of the duty of loyalty should refuse to turn over such information if it appears that the information is being requested for the benefit of a third party and not for the beneficiary, but that may be cold comfort to a beneficiary attempting to comply with a court order.
[28] See Gideon Rothschild, Scott L. Rubin & Bruce M. Stone, 51st Annual Heckerling Institute on Estate Planning, Special Session III-A, Protecting the Estate from In-Laws and Other Predators (sample language prepared by Bruce M. Stone). Note that the waiver concept is untested by Florida courts.
[29] Consideration for the agreement is provided by the nonbeneficiary spouse’s likely participation in the funds accruing to the beneficiary spouse once the waiver allows the undiminished beneficial entitlements to be available.
[30] For example, many trust instruments allow annual “Crummey” withdrawal rights with respect to trust contributions to be cancelled by the grantor at the time of the gift.
[31] See, e.g., Ferri v. Powell-Ferri, 476 Mass. 651 (2017), in which a trust was successfully decanted to remove trust assets from the reach of a divorce proceeding.
Patrick J. Lannon is a partner in the law firm of Shutts & Bowen, LLP, and practices in the area of trusts and estates.
Mary Karr is a partner in the law firm of Gunster, Yoakley & Stewart, P.A., and practices in the area of trusts and estates.
Dolly Hernandez is a partner in the law firm of Boyd Richards Parker Colonnelli, and represents high net worth individuals in complex marital and family law matters.
This column is submitted on behalf of the Family Law Section, Douglas A. Greenbaum, chair, and Bernice Bird, editor.
