Divorce Protection in Estate Planning: A Summarization

There have been several posts recently about protecting children or other loved ones from divorce. Many clients hope to create a financial safety net for their loved ones that won’t be lost if those loved ones find themselves in a messy divorce or even bankruptcy. This financial safety net could be in the form of an inheritance after death or a gift during life.

Because there have been so many posts on the topic, a few readers have requested that I synthesize all of the prior information into one location for easier reading. I liked the idea, so that will be the goal of this post.

One common goal many parents have when planning their estates is protecting their children’s inheritances from a child’s divorcing spouse. With the divorce rate at 50%, this is a wise concern.

The most common way to protect the assets you desire to leave your children from divorcing spouses, bankruptcy, or any other debt is through use of a discretionary trust within your will. You must set up the trust while you’re still alive. However, while you’re alive it is as if the trust doesn’t even exist. This is because the trust doesn’t actually start to hold any assets or even operate until after you have passed away. You may change or eliminate the trust any time before you die as well. 

The major parties involved in the trust after your death are the trustee and the beneficiaries. The trustee manages the trust, and the beneficiaries are your loved ones that you wish to provide for. The trustee can be a relative, a friend, a trusted attorney or other professional, or a trust company or bank. Alternatively, your child or other loved one can be trustee of his or own trust should you so desire. You also have the option of letting your beneficiary choose his own trustee after your death should you feel he is sufficiently responsible.

The operation of a discretionary trust can be broken down pretty simply. Think of the assets that are put into the trust after your death as being held in a box where (for the most part) no one can get to them. While stuff is in the box, creditors (and divorcing spouses) of a beneficiary shouldn’t be able to touch it.

The trustee cannot remove the assets from the box for his own personal purposes (unless he is also the beneficiary). As soon as the trustee opens the lid on the box and starts taking stuff out, that stuff must go directly to the beneficiaries.

This is a pretty good setup. You can leave your children their inheritances in trust and when they need money for legitimate purposes, it’s there. When a spouse files for divorce on the other hand, the box stays shut and the assets stay out of reach.

The divorce protection from discretionary trusts was recently specifically validated by the New Jersey Supreme Court in Tannen v. Tannen, making them an even more attractive option.

Outside of the will and trust context, many families are using LLCs to either operate a family business, to hold family investments, to save on estate taxes, or to protect assets. LLCs also provide opportunities for divorce protection.

Many clients have hesitation in gifting ownership interests in the family LLC to adult children, despite the fact that such gifts can be a great tool for reducing taxes and protecting assets. There are many valid reasons for this hesitation. The good news is that we can usually address all of these concerns through a properly drafted operating agreement for the LLC. One concern that comes up often is a divorcing spouse of a family member getting ahold of that family member’s LLC interest.

The key to dealing with this is a properly drafted operating agreement and a knowledge of the law. The way I like to protect ownership interests from divorce is through use of a buyout provision. Such a provision states that if one member of an LLC gets divorced and the divorcing spouse is to be awarded any interest in the LLC, the other members of the LLC have an option to purchase the that interest at a predetermined price. In Estate of Cohen v. Booth Computers, 421 N.J.Super. 134 (2011), it was held that said buyout price does not need to be market value. The strategy, then, is to include a divorce buyout clause with a predetermined price that is far less than fair value. This makes an LLC ownership interest very unattractive to a divorcing spouse.

If you have any questions, feel free to contact me.

TAX ADVICE DISCLAIMER: Any tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
NOT LEGAL ADVICE. Everything posted here is for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of me or another qualified attorney. Nothing posted on Twitter or on any website shall be construed in any way as legal advice.
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