Mary: Welcome to today's episode of Vandenack Weaver Truhlsen Legal Visionaries, a weekly podcast discussing updated legal news, as well as evolving methods of providing legal service. I'm Mary Vandenack, founder and CEO at Vandenack Weaver Truhlsen. I will be your host as we talk to experts from around the country about tax issues, trust and estates, business succession, exit planning, legal technology, law firm leadership, and wellbeing.
Mary: My guest is Sharon Klein. Sharon is Executive Vice President and head of the National Divorce Advisory Practice for Wilmington Trust. Sharon is a nationally recognized speaker and author, and has an endless list of credentials and honors. Sharon has joined me for a previous episode in which we discussed the then and now of estate and marital planning today. Sharon is going to talk about considerations for estate planning at different points in the marriage. Welcome back, Sharon.
Sharon: Thanks very much, Mary, for that kind introduction. And for inviting me to be your guest again, I'm delighted to be here to continue our discussion.
Mary: Well, let's start our discussion today talking about what should be considered in the premarital planning phase. One of the things that you spoke about at a conference recently was the concept of the hidden asset that is often overlooked in premarital negotiations. Can you explain that concept to us today?
Sharon: Certainly. And I love the mystery of the hidden asset, but I'm going to demystify it right now. And it's all about portability really. So, before 2010, the federal estate and gift tax exemption was a use it or lose it proposition. To give you a very simple example, let's assume a married couple, both died in 2009 when the exemption was $3.5 million and they each owned assets worth exactly $3.5 million. If they each used their $3.5 million exemption amount with trust planning, for example, then $0 federal estate tax would've been due on the death of the survivor of them. Assume, however that the first spouse didn't use her exemption and left everything to the survivor and the survivor died with the $7 million estate, the exemption of the first to die would've been wasted and federal estate taxes up to $1.575 million would potentially have been payable, but portability, which is a concept that was introduced in 2010 and made permanent since 2012, obviates the use it or lose it nature of the federal exemption amount.
Sharon: If one spouse doesn't use the entire exemption amount, it's now possible to port it or to transfer the unused portion called the Deceased Spouse's Unused Exemption amount or de suey to the surviving spouse. And in this marital arena, de suey, the hidden asset is really a very valuable asset to consider when drafting marital agreements. Let me give you another very simple example to illustrate, consider a prospective husband and wife, they're negotiating their premarital agreement. I'm going to make husband the wealthier spouse. In this example, let's say he has assets of $24 million and wife-to-be has assets of only $1 million and her assets are going to pass to heirs other than her husband, which would leave her $11.06 million of de suey based on the 2022 $12.06 million exemption amount. Generally, in circumstances like I've described the husband wouldn't ask for any financial consideration from the wife because of the imbalance in the assets tilted in his favor.
Sharon: However, consider that if wife predeceases husband, and her executor who may or may not be husband, and I'll get to that detail in a moment, her executor elects to use portability and her $11.06 million de suey passes to husband and assume husband also dies in 2022. Yes, I'm killing them both off this year. Her $11.06 million de suey would be available to use in husband's estate. And if you have the top 40% federal estate taxes, and let's assume he has his $12.06 exemption amount intact and her additional $11.06 million to shield estate taxes in his estate could save his heirs almost $4.5 million dollars in estate taxes. So, in this example, the wealthier spouse husband, in my example, should view the de suey as an important asset to negotiate for with the less wealthy spouse wife. In my example, who knew she even had an asset to negotiate with, she should view the de suey as an important negotiating tool and Mary, the numbers that I've given you in my example are big to show the impact when the maximum exemption amounts are in play, but there's also big savings at much lower amounts because once you have a taxable estate, there's a savings of up to 40% of any amount sheltered.
Sharon: So, on a million dollars, you could be saving $400,000 of estate taxes, which is better than a kick in the pants if you ask me. So very, very important to negotiate for that. Also, I should point out that the de suey can only be preserved on a timely filed estate tax return form 706. So that means that even if an estate is under the federal filing threshold of $12.06 million in 2022, the estate must still incur the costs of filing a return. Although the standards for filing the 706 have been relaxed if it's only for portability reasons and who could file the return, well, the return can only be filed by the executor who may or may not be the surviving spouse. And yes, it may be difficult to stretch your imagination, to envision an acrimonious situation between the children of a prior marriage and the surviving spouse, where the executor is a child of that prior marriage.
Sharon: The only reason to file is to affect portability. And they're refusing to file just to be spiteful to their beloved stepparent. Yes, I know it's difficult, but try and stretch your imagination to envision that situation. And if you can, to prevent that, have the requirement to file the return documented in the prenuptial agreement to prevent a hostile executor spitefully refusing to file. You may in a situation like this, if you don't have specific authority in a prenup, be able to bring a petition to a court to request that they grant temporary executor powers to someone else solely for the purpose of filing a return. And there's also been at least one documented case where the court has required a recalcitrant executor in this exact type of situation to file a return and elect portability that by the way, was the Vose case[i] coming out of Oklahoma. Although there are those couple of options, it's much better to plan ahead for this important matter and negotiate the obligation to file in the prenup and also consider the costs of filing a return, because if it's a return that's being filed solely for portability reasons for the benefit of the surviving spouse, maybe it makes sense for the surviving spouse to show that the cost of filing the return. But if it's a return that needs to be filed in any event, then perhaps the estate should shoulder the cost as it usually does.
Mary: So, I'm just going to have to give you credit for really bringing this hidden asset to my attention in my own practice and going to comment that it's actually really fun to bring this up in the premarital planning context, because a lot of times nobody has thought about it. And so, you're really right to say, this is an asset that ought to be thought about in the premarital planning phase. There's another type of trust we have out there. That's called an asset protection trust. And these are also a tool that can be used in premarital planning. Can you explain how those trusts work in the premarital planning context?
Sharon: Absolutely. Asset protection trust can be very important in the premarital planning context and asset protection trust as its name indicates is a trust specifically designed for asset protection. And what it does is it prevents obstacles for creditors, including the quintessential creditor, who is the ex-spouse. It's still the case in most jurisdictions that a person can't create a trust for their own benefit and have the trust assets protected from creditors, but under the laws of some states, Delaware, for example, you can create an asset protection trust that limits the ability of that person's creditors to reach the trust assets. But the beauty is the creator of the trust can remain a trust beneficiary under Delaware law. For example, the creator can retain the right to receive current income distributions, the right to receive up to a 5% annual unitrust amount and the ability to receive income or principle in the discretion of an independent trustee.
Sharon: And while 20 jurisdictions now have enacted some form of asset protection. It's very, very common for clients to look outside their home states in setting up these trusts. Why is that? Well, a driving reason to create the asset protection trust as we've been discussing is to build obstacles that a creditor has to overcome and having to initiate an action in a different jurisdiction rather than walking down the street to the creditor's local friendly courthouse is an additional hurdle to bringing suit. And when selecting a trust jurisdiction, we find that Delaware is often the jurisdiction of choice because it has very attractive laws. And also while asset protection legislation in many states is very new, Alabama's actually the latest state to enact asset protection legislation. Delaware has the distinction of being one of the first jurisdictions in the country that enacted domestic asset protection legislation over two decades ago.
Sharon: So, what are the obstacles if you create such a trust? Well, in addition to bringing suit in Delaware, there's a very short statute of limitations. A four-year statute of limitations. The creditor has to prove by clear and convincing evidence that the creation of the trust was fraudulent with respect to that particular creditor. And in the family context, a spouse or a former spouse who was married to the creator before the trust was created, is included in a so-called exception class of creditors who may be able to pursue a claim against an asset protection trust. But a spouse who the client marries after creating the trust, in other words, create the trust then get married, the spouse, the client marries after the trust is created, is not included in that exception class of creditors. And so, this form of trust is a very popular technique for clients or their children to establish, to protect assets from the claims of future spouses.
Sharon: And I might add the asset protection trust is a tremendously powerful technique to consider in combination with a prenuptial agreement, which we discussed Mary as part of our last conversation. So, what people often do is you create the asset protection trust, then you disclose it fully in the prenuptial agreement and make it clear that it's walled off in the event of divorce. And as we also discussed last time, an asset protection trust with broad discretionary terms and a broad class of beneficiaries is typically an example of a trust that's most protective in divorce.
Mary: And I note that you cite Delaware as being a great state for the asset protection trust. And it is. And I just want to add a footnote that with those 20 states, all asset protection rules are not the same. So, each of those states has different rules or different basis for their rules and they change all the time. So even when I'm doing an asset protection trust in the same state that I did one a year ago, I'm going to check to see what changed cause the statutes changed frequently. Let's shift to what happens when separation or divorce occurs, what actions should someone going through a divorce take immediately?
Sharon: Well, let me tackle that question. First of all, from the financial perspective, because this is what I see every day and, and when an individual is faced with divorce, having a global asset summary report with cash flow projections with a risk assessment can provide really important data to successfully position attorneys at the negotiating table in today's environment. For example, when we have huge recent market volatility, that may be the ideal time to demonstrate why one spouse, for example, may be entitled to more assets to support a lifestyle. Given the havoc a market like this might play on a portfolio, particularly if a settlement is supposed to last a lifetime. I see many matrimonial attorneys projecting needs with an Excel spreadsheet, which is fine for a rough and quick look. But those types of Excel spreadsheets, a static, they may project for example, 5% growth a year, but when we get a pandemic or a Russia invasion and, and who knows what markets can do, sophisticated analytics, which goes way beyond an Excel spreadsheet, which can take into account stress testing a portfolio as well as considerations like tax impact, cost of living adjustments.
Sharon: That is so important to demonstrate why additional assets may be needed to support a lifestyle. So, we do this all the time for our clients. We actually have proprietary analytics software for situations like this because it is just really difficult to argue with hard data. And let me give you an illustration to emphasize why it's so important to be working with a financial advisor that could give you this kind of information. We recently had a matrimonial attorney come to us with a client whose divorce settlement he had just finished negotiating. The husband was very, very wealthy and he negotiated a $20 million settlement for the wife, which he was very happy with. And he had done it on the basis of Excel projections, which showed that and this woman was in her early sixties, which showed that her assets were going to grow at a rate that exceeded her spend.
Sharon: And he projected out to age 90 and his Excel spreadsheet showed that at age 90, she was actually going to have more assets, more than $20 million that she started with at age 62. Unfortunately, when we ran our analytics, which stress tested the portfolio, the different economic climates, different market environments, we found that not only was she not going to have more money at age 90, she ran out of money before age 90. And the attorney actually told us that he was so sorry. He didn't have that data when he was negotiating because the husband was actually very, very wealthy and he felt confident that he could have negotiated a bigger settlement. But the good news was that with those same sophisticated analytics, we were able to show her that if she tempered her lifestyle expectations, a little, which she would have to do, she could still live a very comfortable life, but much, much better to have that information at the negotiation stage.
Mary: I really appreciate that comment because if I think there's anything that gets underdone sometimes, and not just in the divorce context, but even when you're looking at funding a trust using both spouses’ exemptions or anything that the medical modeling gets oversimplified. And that's such an important factor in that. So, I appreciate you mentioning that financial perspective, cause I also am going to emphasize, you've mentioned it a couple times, both in our previous podcasts, as well as today, the importance of collaboration, I can be an expert in item A, B and C, but there's always going to be areas where the collaboration we've seen different perspectives. We have different tools. Like you mentioned, the tool that Wilmington Trust has with respect to doing that modeling, which is a lot better than my spreadsheet. And I can do a pretty good spreadsheet, but I love utilizing software like that. That takes more into consideration. I don't have time to build it. So, thanks.
Sharon: Yeah. It's the collaboration that's key. I agree with you there.
Mary: So, what about from a planning perspective, what changes should be made immediately and are there changes that cannot be made during the pendency of a separation or divorce? Does it make a difference whether there's a premarital agreement involved?
Sharon: Well, the short answer is that all planning typically needs to be updated as soon as possible. And while divorce is pending, you may be prohibited from changing things like titling of accounts or beneficiary designations, for example, under retirement plans, which may also be subject to special ERISA rules because typically the court will want to maintain the status quo until the divorce is final. But the important point to take away is that people in the process of getting divorced should change those aspects of their financial affairs. It's possible to change as soon as they can and be poised to change the balance as soon as they're able to do so. Why is that? Well, most people do not want their ex-spouse as their beneficiary or at least they want to give them as little as possible. And when you're thinking about documents that need to be reviewed immediately, the first arguments that come to my mind and I'm sure mind of many others are wills and revocable trusts.
Sharon: So those should be reviewed immediately. And in most jurisdictions can be changed as soon as possible subject to state rights or prior agreement. Typically, unless a spouse has waived marital rights in an agreement, you cannot disinherit a spouse. And so, to your question Mary, does it make a difference as to whether there's a premarital agreement or not? Yes. It makes a huge difference because that may determine the amount to which you're obligated to leave to your spouse. In most states, as I mentioned, it should be possible to modify a will to leave a soon to be ex-spouse the minimum amount required under state law or a marital agreement. There are some states, about half the states in the country that have so-called revocation on divorce statutes, which provide that if someone's divorced at their death and they hadn't modified their estate planning documents and they leave dispositions to their ex-spouse, those dispositions are revoked.
Sharon: But the problem with relying on state default law is first of all, only half the states have these types of laws, which means the other states do not. Second, even if you do have a revocation on divorce statute, that law is going to be inapplicable during the pendency of divorce. Those laws only kick in when the final divorce decree is entered. And third, even if you have a statute that kicks in, it doesn't always work perfectly. Some states, for example, New Jersey revoke dispositions to former spouses and to relatives of former spouses, other states like New York and California only revoke dispositions to former spouses, not to relatives of former spouses. And that made a huge difference in a case coming out of New York called the Matter of Lewis[ii] where a decedent was divorced from her husband for about a decade before she died, she left everything to him.
Sharon: And you know, when she died, New York law in some regard to the rescue because it revoked the disposition to her ex-husband. The problem was her alternate beneficiary was her ex-father-in-law, the father of her ex-husband and the court acknowledged that the father was just going to inherit everything and leave it all to his son. So, the son had managed to do an end run around the statute, but that's the way the statute in New York works. It doesn't revoke dispositions to relatives of an ex-spouse. So that was a terrible result in that case. That result could have been prevented if New York revoked dispositions to relatives of ex-spouses, but that doesn't always accord with intent either because sometimes people are very close with their stepchildren, and they wouldn't want those dispositions revoked just because they were divorcing from the parent of the stepchildren. So, I think the lesson to be learned is that the most prudent course of action is not to rely on state default law, but divorced spouses and spouses in the process of getting divorced should give immediate attention to their estate planning documents to ensure that they reflect their intent.
Mary: So, you mentioned the wills and trusts and some challenging outcomes that can happen with those. I've always thought a really awful situation would be that I had a bad case of COVID before they had the antivirals. I'm in the hospital. And my soon to be ex is my agent. In fact, under a power of attorney for healthcare. How does that work? And does it vary based on the state you live in?
Sharon: Yes, that's a nightmare. I think, most people want to avoid having an estranged spouse in that kind of important role. So it's really important to review financial powers of attorney, which allow a designated person to conduct financial transactions and the healthcare directives that you mentioned, which allow a designated person to make important healthcare decisions potentially end of life decisions to, to say to, I'm sorry to ensure, as I say that an estranged spouse is not going to be making those types of decisions and it does vary according to state law. So, in New Jersey, for example, the designation of a declaring a spouse as the healthcare representative is revoked on divorce in California and in New York, a financial power of attorney terminates when the agent’s marriage to the principal is terminated by divorce or annulment. In other states like Alabama, Connecticut, and Hawaii, an agent’s authority under a financial power of attorney terminates when an action is filed for the dissolution of the marriage.
Sharon: So, they don't actually have to be divorced. It's when the action is filed. But not all states have statutes dealing with this. And some states just have laws regarding financial powers of attorney and not healthcare powers of attorney. So again, the best practice is not to rely on state default law, but to proactively change documents, to ensure they reflect intent. And these types of documents typically do not have to wait until divorce. They should be changed as soon as possible. Let me give you a celebrity case in point, perhaps you remember Gary Coleman, who was the actor in that famous sitcom, Different Strokes. He had finalized his divorce with his ex-spouse Shannon Price in 2008. In 2010, he sustained a head injury and this is your nightmare, Mary. He sustained a head injury and he was put on life support. He had not updated his healthcare proxy and his ex-wife made critical end of life decisions for him. Is that what he would've wanted? Maybe not.
Mary: What about life insurance?
Sharon: Another key area, Mary you're hitting on all the hot ones. So, life insurance is a key area in the divorce arena because life insurance is often an important component of a settlement agreement or incorporated in a divorce decree to ensure that obligations are secured in the event, the obligor dies. And as we are going through this horrendous pandemic with its tragic death toll, I think attention more than ever has been focused on people's mortality. And the importance of ensuring that settlement obligations are appropriately secured. I should add that insurance is a peculiar type of asset. You have to be very proactive about reviewing it. It's not like an investment asset where you get an investment statement. You have a call with your investment advisor. You just get that little note once or twice a year from your insurance company, right?
Sharon: That it's time to pay the premium. And people have a tendency to put insurance policies in a draw sometimes for decades. And that could really be a ticking time bomb and lots of potential liability for the trustees. So, it's very important to have a periodic policy review to ensure that the policy is performing as expected. And if anybody has any questions about that, there are often questions about what a corporate trustee does to review policies or best practices. Please reach out to me and I'd be happy to share that with you, but important to note that the policy review is key to ensuring that the insurance is performing properly and also key to focus attention on other important details. Like what? Well, it sounds rudimentary to say, but it's critical to ensure that the premiums are paid. So, the policy doesn't lapse because if the policy lapses and there's no insurance on the death of the obligor, the spouse who was owed the insurance would presumably have a claim against the descends estate, but who knows if the estate is going to be large enough to support the claim.
Sharon: And that was the situation in the case, which came out of New Jersey, where there were no insurance proceeds payable on the death of the obligor, but the estate was less than the value of the claim. The lesson here is that it's prudent to consider providing in an agreement that the beneficiary spouse or another designated person receives duplicate premium notices or confirmations of payment, to be sure that the policy is being maintained. Another important detail to focus on is how the policy is owned. Is the insurance in an irrevocable life insurance trust or an ILIT? The main purpose of the ILIT is of course, to prevent the proceeds being subject to estate tax on the death of the insured. If the insured obligor owns the policy, the proceeds can be subject to estate tax at death. And there's an important lesson here for attorneys to pay attention to the ownership of the policy, because there have been cases where attorneys have been sued for failure to properly plan with life insurance, where the insurance has been included in the estate instead of passing tax free. And often the ability to sue the decedents attorney by a beneficiary who has been harmed is going to come down to a question of privity; privity is a matter of state law and state law varies. But I think the point is that the first line of defense probably shouldn't be relying on privity to absolve the attorney of liability. The first line of defense should be focusing on the correct ownership structure.
Mary: Thank you for that. That life insurance is another one of my nightmare areas where one time too many times you get the call that the policy that they think is in force is not in forced or that they have to put huge amounts of money in it to keep it in force. And so that's right. That's a big area to stay on top of.
Sharon: Let me just say, you know, you just reminded me of a story all is not necessarily lost if something is not perfect. A client came in to see me recently. He had been divorced a long time ago and part of his divorce settlement was the requirement for him to take out insurance to pay for the college education of his two children who had long since graduated college. So he didn't need insurance for that purpose anymore, but he still had the insurance and it had value. And it was in his name, which meant that if he died, it was going to be included in his estate. So, I spoke to him about collaborating with his trust and estates attorney to transfer the policy into a properly structured life insurance trust. Of course you would have to survive three years, but he was young and healthy, no reason to suspect that he wouldn't. So always good to check. Even if you're dealing with a client who's previously been divorced about how these insurance proceeds are held, and if there's anything that you could do to make the situation more efficient from a tax perspective.
Mary: So that's going to be a whole other podcast episode I decided after talking about that, so let's shift to drafting considerations. A common approach to trust drafting for spouses has been the use of formulas that connect to the federal estate tax exemption, which of course is actually a credit. Given changing family situations and a constantly uncertain exemption amount, what is the best approach to structuring trust shares?
Sharon: Well, Mary, I'm sure you're well aware that formula planning that's tied to the federal exemption amount can be dangerous generally in and out of the marital context because that amount can vary so significantly depending on the year that you're talking about. And in the matrimonial arena, one common plan in a second married situation is for spouses to wave rights in each other's estates in exchange for the surviving spouse receiving assets that exceed the federal exemption amount. In other words, assets up to the federal exemption amount, which could pass free of federal taxes can pass to children of a prior marriage. And then the estate tax on the balance of the asset, which passes to the surviving spouse, either outright or in trust is deferred until the death of the surviving spouse because of the marital deduction. But if that plan is effectuated with a formula disposition to the children of the federal exemption amount, then the amount they're going to receive and the amount in excess of the exemption that the surviving spouse is going to receive is going to be dependent on the federal exemption amount in the year of death.
Sharon: Maybe that's $6 million, maybe that's $12 million. The point is that the whole plan might be distorted if exemption amounts decrease, and the children get a lot less than anticipated or the other way around. So, it's generally advisable in all situations, not just the divorce context, to avoid formulate dispositions that are based on tax exemption amounts that could swing wildly. In the planning context, most practitioners now use provisions that are designed to be very flexible to adapt to changes in family situations and changing tax laws. And you also of course, need to be mindful of state estate tax consequences, because if you're giving a gift for the full federal exemption amount that can generate significant state estate taxes in those states that impose a separate estate tax with an exemption level that's lower than the federal. In general, now what I see practitioners doing is using more flexible ways to draft with disclaimer trusts for example.
Sharon: So, the first to die leaves everything to the survivor who could disclaim some portion of the exemption into a credit shelter trust or using partial QTIP elections, partial qualified terminal interest trust elections, where the first to die lose assets to the survivor in the QTIP marital trust. And the fiduciary can make a partial QTIP election using the first to dies exemption, to the extent that the QTIP election is not made. Or another popular technique is the Clayton QTIP where the first to die’s estate is eligible to pass into a QTIP marital trust, but only if the executive makes a QTIP election. Otherwise, the property typically passes into a credit shelter trust. And I mentioned that these are generally techniques to use for flexible planning outcomes. Some of these techniques though, are tricky in second marriage situations, right? Because is a second spouse really going to disclaim in favor of her beloved stepchildren, maybe not. Who is the executor who decides on the Clayton amount, another tricky issue. So, it just points to be mindful of if you're using these techniques in the marital context.
Mary: So one of the questions I ask clients is, well, how much do you want to make sure that each person gets and let's design around that regardless of what the exemption is.
Sharon: Exactly
Mary: The last topic I want to at least touch on briefly, and I know community property probably also merits its own podcast too. But community property jurisdictions do have unique roles and should at least be mentioned in the context of what we're talking about today. So, what would be most important to know about community property?
Sharon: Yeah, it's very important. Community property is the rule in a minority of states, but an important minority of states and community property jurisdictions have special rules. And among the community property states, there are nuances. So, you really need to check state specific laws. In general, assets owned prior to a marriage are classified as separate property. And then upon marriage, all assets and debts acquired during the marriage are classified as community property, which gives the spouses equal rights, equal ownership rights to the property. Even if the property is technically titled in the name of one spouse in the event of divorce, the community property is divided equally between the spouses and a big issue in community property states is generally called transmutation. Through the process of transmutation, the character of property can change from community property to separate property from separate property to community property and commingling of assets during marriage is one way in which inadvertent transmutation can occur. So, for example, spouses purchase a house using one or both spouses separate property acquired prior to the marriage, but then they use their community property to pay for the mortgage and upkeep. So, the issues could really get murky. In general, spouses can dispose of their 50% interest in the community property. And the other 50% must be distributed to the surviving spouse at death. A great advantage of community property is that both halves of the community property generally receive a step up in basis.
Mary: So, any last thoughts today, Sharon?
Sharon: Mary, you know, what I want to do is just reiterate the message that we ended on last time, which is that a client's success in the divorce arena is very much dependent on their team of professional advisors as we can see from the discussion today. And last time, this is a very complicated area. There's lots of nuanced considerations. There's lots of overlap between different professional disciplines and having a team, which is a trusts and estates attorney, a matrimonial attorney, a financial advisor, and an accountant. They could all collaborate. They could bring their different perspectives to the table to position clients for success. So, I would like to end on what I ended on last time, which is it's really all about the team. That's my message.
Mary: I think that's so important. And I really thank you for that. And thank you for being with us again today.
Sharon: Thank you so much.
Mary: Well, that's all for now.
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[i] In re Matter of the Estate of Anne S. Vose v. Lee, 2017 OK 3, 390 P.3d 238 (2017)
[ii] In re Estate of Lewis, 25 N.Y.3d 456, 34 N.E.3d 833 (2015)
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