By David C. Valente
In the recent case, Pfannenstiehl v. Pfannenstiehl, the Massachusetts Appeals Court found that a beneficiary’s interest in an irrevocable trust, created by the beneficiary’s father, should be included in the marital estate, and therefore be subject to equitable division in the beneficiary’s divorce proceedings. In a decision that surprised estate planning and family law attorneys alike, the court ordered the husband to pay approximately 50% of the value of his interest in the trust to his spouse, in addition to her attorneys’ fees.
The parties, Curt and Diane, were married in 2000 and had two children, each of whom had special needs. Diane had given up her position in the United States Army Reserve to care for the children, and the family’s income was approximately $350,000 annually, about half of which came from distributions from the trust at issue. The trust was originally established by Curt’s father for the benefit of Curt, Curt’s siblings, and the descendants of each. The trust itself held ownership interests in the family’s business, and there was a history of substantial distributions from the trust to Curt and his siblings. Perhaps not surprisingly, the distributions to Curt ceased shortly before Curt filed for divorce.
Exposure Due to Ascertainable Standard
One of the most concerning conclusions made by the trial court and upheld by the appellate court (collectively the “Court”) was the finding that Curt’s interest in the trust was subject to division in his divorce because the trust had an “ascertainable” standard. Another distressing conclusion involved valuation. The trust was held and managed as a single share for the benefit of Curt, his siblings and their respective descendants. In other words, there was not a separate share set aside for Curt’s exclusive benefit. The trustee was empowered to make equal or unequal distributions among the beneficiaries, of whom there were eleven at the time of the Court’s decision, though that class could expand through birth or adoption. Despite these facts, the Court concluded that Curt had a one-eleventh beneficial interest in the trust and ordered him to pay roughly 50% of the value of that interest to Diane, even though Curt had no means by which to compel a distribution from the trust. In other words, though the trustee had discretion to distribute to Curt much less than one-eleventh of the total trust’s total value, and although the trust prohibited an assignment of his interest to creditors, the Court considered him to have access to a pro-rata share and decided that his ex-spouse was entitled to 50% of that amount.
The trust instrument directed the trustee to make distributions of principal and income “to provide for the comfortable support, health, maintenance, welfare and education” of the beneficiaries. It also contained a spendthrift clause, the purpose of which was to prohibit the assignment of a beneficiary’s interest to a creditor, including a beneficiary’s ex-spouse. The Court found that Curt’s interest was presently enforceable, and that he and Diane had relied on distributions from the trust to sustain their lifestyle. The appeals court affirmed the trial court’s decision that Curt’s interest in the trust constituted marital property, finding that the trust’s ascertainable standard gave Curt a “present enforceable right to distributions from the 2004 trust.” This was so, despite language conferring discretion upon the trustee that enabled it to make distributions [and impliedly, no distributions] in any given year to any one or more of Curt and any other beneficiary. Purportedly relying on “settled trust law,” the Court found that the distributions were “woven into the fabric of the marriage,” and rejected Curt’s argument that the inclusion of a spendthrift clause precluded his interest from being included in the marital estate.
One purpose of an ascertainable standard (e.g. “for the health, education, maintenance and support…”) is tax-driven: so that the trustee of a trust is not considered the owner for income or estate tax purposes. However, such a standard also constrains the trustee, so that trustee does not have free reign to approve or deny requests whimsically. This standard also has the effect of imposing a duty on the trustee to inquire about a beneficiary’s need for requested distributions.
Is Asset Protection for Children at Risk?
The Court’s decision is unsettling for advisors and clients alike, as it brings into question the level of asset protection that will be afforded to a child (or other beneficiary) who divorces at a time when he or she has an interest in a trust, particularly one for whom distributions have been used to sustain his or her lifestyle. Numerous modern trusts include an ascertainable standard. What to do? On the one hand, some practitioners advocate that clients adopt a wait-and-see approach, as Curt has sought further appellate review from the Massachusetts Supreme Judicial Court. On the other hand, clients with trusts including “ascertainable standard” language as described in this article, particularly where a child is a beneficiary and is also named as a trustee (which was not the case in Pfannenstiehl), may wish to consider strategies intended to mitigate the effects of Pfannenstiehl.
Mitigation Strategies to Consider
One such strategy for new trusts as well as those that can be amended includes conferring full discretion upon a trustee who is “disinterested” as defined by the Internal Revenue Code, meaning a person or entity not too closely related (e.g., a parent, sibling, employee, etc.) to a beneficiary. Conferring “full discretion” means that the trustee will not be restricted to making distributions pursuant to a prescribed ascertainable standard; instead, the trustee will have complete discretion over whether to make, or not make, a distribution to one or more beneficiaries. With the benefit of enhanced asset protection comes the risk that a trustee may be overly liberal or overly conservative with respect to distributions, although there are other ways to implement “checks and balances” upon such a trustee. A beneficiary could serve as a co-trustee (along with a disinterested trustee), but without having distribution authority.
Another option is to grant a non-general “power of appointment” to a trusted third party in the terms of the trust. If unfortunate circumstances arise, such as a divorce or other creditor issues, the third party could “appoint” or direct some or all of the trust property to certain individuals (known as “permissible appointees”) or to a completely separate trust or other entity for their benefit. Another tool is a provision allowing the trustee to change the governing law of the trust to a jurisdiction more favorable to beneficiaries from an asset-protection standpoint. For instance, the laws of Nevada provide that, after the elapse of a waiting period of two years, a spouse, former spouse, or child may not reach assets in a properly drafted irrevocable discretionary or spendthrift trust, and the trustee may make payments to or for the benefit of the intended beneficiary of the trust. Other asset protection strategies for a beneficiary (as opposed to the settlor of a trust) include a pre-nuptial or post-marital agreement, either of which establishes the rights of spouses in the event of divorce, death, or both. Whether to wait and see if Pfannenstiehl will be reversed, or to plan around it, is a personal, collaborative decision, based on numerous tax and non-tax factors that clients should discuss with their attorney.
David C. Valente
Don J.J. Cordell
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