When contemplating marriage, couples – and their families – may think about what will happen with assets if the marriage unravels. For those who are concerned about protecting their property in the event of divorce, it is important to weigh the different options available.
In a marriage, property may be categorized as marital property or separate property. Marital property generally refers to assets accumulated during the marriage, other than those received by one spouse via gift or bequest. This may include property that is held in the name of just one spouse, such as a separate bank account or retirement account, if it holds assets that were accumulated during the marriage. Marital property is subject to division in the event of divorce. Separate property generally includes property an individual brought into the marriage. It also includes property received by gift or inheritance, regardless of when an individual receives it. Separate property generally is not subject to division in the event of divorce. In community property states, property may be categorized as community property, which will affect the division of such assets in the event of divorce.
For example, consider a married couple, Jamie and Austin. Jamie draws a salary of $250,000 annually, and Austin is a community volunteer who has no salary. The $250,000 likely would be considered marital property because it is deemed to accumulate through the joint efforts of both spouses, regardless of which spouse actually earns the income. Assume Austin’s grandmother leaves him a bequest of $2 million. That $2 million is separate property and should not be subject to division in the event Austin and Jamie divorce.
Why, then, is any additional measure of protection needed for separate property? There are two reasons:
- First, many people commingle their separate assets with their marital assets, making it difficult to discern which is which. Assume Austin puts the $2 million into an investment account, and he and Jamie later add $1 million to that joint account. If they later make expenditures of $1 million, how is the remaining $2 million categorized? How are investment returns grouped?
- Second, property categorization is a state law issue, so results will differ by state. Some states are more progressive than others at trying to get to a result that is deemed fair to both spouses.
Pre- and Postnuptial Agreements as a Strategy
One common strategy for addressing the division of assets in the event of a divorce is a prenuptial agreement, which is a contract two parties enter into before getting married that dictates how assets will be divided in the event of divorce.
Prenups can be effective, but they have drawbacks, too. Initiating the conversation around a prenuptial agreement can be touchy. Engagements have ended over these discussions. Even if the initial conversation is successful, underlying tensions may exist. Surviving spouses have brought litigation against the estate of a predeceased spouse over prenups signed decades earlier.
In addition to the potential tension prenups may introduce into a marriage, there are other drawbacks. For example, for a prenup to be effective, each spouse must fully disclose his or her assets – a level of disclosure with which people with significant wealth may be uncomfortable.
Although used less frequently, another potential strategy is a postnuptial agreement, which is a contract between spouses that is executed after the marriage. This type of agreement can be effective but has many of the same drawbacks as a prenup.
A Different Option: The Trust
As an alternative to a prenuptial or postnuptial agreement, one might consider whether a trust can protect assets in the event of a divorce. The level of protection afforded by a trust depends on who establishes the trust and the terms of the trust. It also may be affected by how the trust is administered. Trust assets are more likely to be deemed separate assets and not subject to division in the event of divorce if the trust is funded by someone other than the beneficiary via gift or bequest or is in a jurisdiction that permits self-settled trusts, is irrevocable, and has a trustee with discretion over distributions.
In some states, such as Delaware, a person can establish a trust for himself or herself (known as a self-settled trust) with the intent to protect the trust’s assets from creditors, including a spouse. In some other states, these self-settled asset protection trusts are against public policy. In these states, the trust should be funded by a person other than the beneficiary.
To increase the likelihood that trust assets will be protected, the trust should be irrevocable. If a trust is revocable, a creditor – including a divorcing spouse – will be more likely to argue that those assets should be within the creditor’s reach. This argument relates to control. If the beneficiary can control those assets, the creditor will argue he or she should be able to reach them.
These criteria were long thought sufficient to protect trust assets in the event of divorce – and, for the most part, they have been. Then, in 2015, a court in Massachusetts issued a ruling in Pfannenstiehl v. Pfannenstiehl that threatened to expose trust assets in divorce cases. In that case, the husband was a beneficiary of a trust established by his father. The trustee made regular distributions to the husband, which were used to support the family. For that reason, the ex-wife argued that the trust assets should be subject to division, and a court ruled in her favor, awarding her more than half of her ex-husband’s share of the trust.
Certainly, the ex-wife, who had left her job to care for their two special needs children, had a sympathetic case, and the Massachusetts court who ruled in her favor likely was looking for a result that seemed fair. However, the result was inconsistent with trust law and threatened established estate planning techniques. The Massachusetts Supreme Judicial Court unanimously overturned the lower court and held that trust assets would be protected. Estate planning attorneys breathed a collective sigh of relief.
Trusts continue to be important in marriage and divorce. They help avoid the prenuptial conversation and, if structured properly, should protect your assets in a divorce.
