CASE STUDY: “Outlaw” Protection

INTRO: In the last decade or so, there seems to have been a heightened awareness of and interest in “asset protection”. One aspect of asset/creditor protection that arises in the estate planning process involves the desire by parents to protect their children from post-inheritance divorces.

During the estate planning process for clients with children, the topic of in-laws – current and/or future spouses of the children – arises.

Clients occasionally make a specific bequest in their Living Trust or Will for their daughter-in-law or son-in-law. However, this is relatively rare as a result of a high divorce rate, uncertainty about the future and a strong natural inclination to provide only for descendants or “blood relatives”.

A related, but more complex issue involves how assets might be protected so that if a child divorces after inheriting, that child’s spouse is not able to take any portion of the child’s inheritance. Varying degrees of concern by clients may stem from simple caution, a fragile relationship between one’s child and his or her spouse or a doubt about the possible motives of an in-law. It is in this context that I sometimes facetiously refer to the in-laws as “outlaws”!

Let’s take an example. John and Jane Doe have a daughter, Betty. Betty has been married to Bill for 8 years and they have two young children. John and Jane are working with their estate planning attorney to establish a Living Trust. They want Betty to inherit all of their assets.

Jane and John ask their attorney: “How do we make sure that part (e.g. half) of Betty’s inheritance does not go to Bill if Betty and Bill later get divorced?” It’s an important question, but not a quick, easy one to answer.

It is first helpful to explore the basic California rules of community and separate property. It’s not necessarily intuitive, but lifetime gifts made to and inheritance received by a married person constitute separate property. So, if a married person (here, Betty) receives an inheritance from her parents and then she and Bill divorce, Bill has no claim over the assets Betty inherited. So, why worry about Betty, right? Unfortunately, we can’t jump to that conclusion.

Betty, like many married people, believes in the strength and longevity of her marriage. After Betty inherits from her parents, Bill says to Betty: “we love each other; what’s yours is mine and mine is yours; and it’s forever, right?” Betty answers “yes, of course, Bill”.

Following a brief discussion, all of the inherited assets are placed in the name of both Betty and Bill. Or more likely, no discussion takes place and Betty (without obtaining legal advice) proceeds to title the inherited assets jointly with Bill, mixing them up with community property funds.

Suppose that a number of years goes by, during which various sources of income is deposited into and expenses are paid out of these accounts for many purposes. Then, the passage of time and volume of financial transactions is such that it is extraordinarily difficult to trace which assets are separate and which are community. Bill and Betty then get divorced and Bill ends up with a substantial portion of Betty’s inheritance.

What terms might John and Jane include in their Living Trust to protect against this scenario? The most common alternatives are: 1) Betty inherits outright but John and Jane have a delicate conversation with her to advise her to keep inherited assets separate from Bill; or 2) upon their death, a protective “spendthrift trust” (type of irrevocable trust) is to be established for Betty from which she has lifetime rights to access the inherited funds based on certain stated income and principal distribution standards. In my practice, I add another alternative into the mix: 3) Betty inherits outright but the trust states expressly that it is John and Jane’s strong desire that Betty keep the inherited assets as her separate property.

Option 1 is fine for many. Option 2 has strong “outlaw” protection (and protection against other creditors of Betty); however, it’s a bit more costly and inconvenient to administer. Many clients like Option 3, using a clause I’ve developed that gives their children, like Betty, a tool. The clause does not handcuff Betty, but enables her to explain to Bill that she needs to keep inherited assets separate to honor her parents’ wishes – rather than out of any distrust of or doubts about Bill or their marriage.

Pros and cons of such alternatives should be discussed with an estate planning attorney so that your Living Trust can be drafted or revised in accordance with your applicable wishes.

This article is intended to provide information of a general nature, and should not be relied upon as legal, tax, financial and/or business advice. Readers should obtain and rely upon specific advice only from their own qualified professional advisors. This communication is not intended or written to be used, for the purpose of: i) avoiding penalties under the Internal Revenue Code; or ii) promoting, marketing, or recommending to another party any matters addressed herein.

Mr. Silverman is an attorney with R. Silverman Law Group, 1855 Olympic Blvd., Suite 125, Walnut Creek, CA 94596; (925) 705-4474; rsilverman@rsilvermanlaw.com.

ESTATE LEGAL SERVICES: Need to find an estate planning attorney in Walnut Creek CA? Contact Robert Silverman at 925-705-4474 for legal advice on Revocable Living Trust, Wills, Durable Power of Attorney, Advance Health Care Directive, Special Needs Trusts, and Irrevocable Trusts & Advanced Estate Planning, including Irrevocable Life Insurance Trust (ILIT), Qualified Personal Residence Trust (QPRT), Defective Grantor Trust (IDGT), Grantor Retained Annuity Trust (GRAT), “Crummey Trust”, and various types of Charitable Trusts.