Protecting Inheritance from Divorce

A concern many of my clients have is protecting the inheritance they leave their children from divorce. Today I’ll outline the issues that a good estate plan considers when achieving this goal.

First, many estate plans, whether they are will or trust based, distribute assets outright. As an example, when Mom dies, her assets are divided into thirds for her three children, Ben, Charlie and Diane. Her children can then take the stocks, bonds, mutual funds, and proceeds from the sale of home, and put them in their own names.

In most states, inheritance is considered a non-marital asset for purposes of divorce. But so much can thwart that characterization. Suppose, for example, that Ben takes his inheritance and puts it into joint account with his wife, Barbara. He’s destroyed the non-marital characterization of the inheritance. It’s now joint marital property.

Community property states generally treat assets as subject to the claims of the other spouse unless there is a well-written, enforceable nuptial agreement in place. Assume that Charlie and his wife Claire live in Wisconsin. That is a community property state. Other community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington. Inheritance they receive from you may be characterized as marital assets subject to the claims of a divorcing spouse.

What if inheritance is used to support basic needs? Let’s suppose that Diane, for example, uses the inheritance she received from Mom to support herself and her husband David. She pays the mortgage on their jointly held property. Here, Diane is converting non-marital assets into marital assets subject to division on divorce.

Is there a strategy to retain the non-marital characterization of an inheritance? In fact, there is! Rather than distributing the assets outright to your loved ones, you may have the inheritance held in continuing trusts. Here, your child can serve as his or her own trustee so he or she handles investment and distribution decisions. You may also grant your child a power of appointment over the trust share so that he or she can bequeath it to a spouse, children or grandchildren.

Continuing trusts can be drafted with great flexibility, or they can be inflexibly drafted, to constrain a beneficiary. Instead of naming your child to serve as his own trustee, for example, you can impose a third-party trustee such as a bank or trust company to make investment decisions and determine whether requests for discretionary distributions should be fulfilled. In most instances it is a good idea to require the child/beneficiary to, at a minimum, have a co-trustee serve when that child/beneficiary is undergoing a legal separation or if a divorce action is filed.

There are many factors and much thought that should go into the drafting of continuing trusts to protect them from divorce. I’ve read many such trusts that look like they came out of a form book, offering little to no protection. How much control should the beneficiary have over investments and distributions? If that beneficiary is undergoing a divorce or other creditor problem, do we want an independent trustee to step in, removing the child as his own trustee to prevent a judge from ordering that child to make a distribution from non-marital property? In what state does the child reside? Massachusetts has a process that allows a divorcing spouse to determine the expected inheritance of the other spouse. Is the trust drafted in such a way to prevent that information from discovery?

Finally, even if the continuing trust is well-drafted, there’s always the possibility that trust formalities are not adhered to, resulting in the loss of protection. This is a lot like the “piercing the corporate veil” argument. If the child/beneficiary/trustee makes willy-nilly (that’s a legal term!) distributions to himself rather than documenting what they’re for and how those distributions are compliant with the trust language, or if he comingles his own accounts with the trust accounts, or if he fails to file tax returns, then a court might hold that the trust isn’t being followed and hence it should be characterized as marital property.

As you can see, there’s much to protecting inheritance. It takes some thought and then education for the client and their beneficiaries to achieve the intended results.

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