Inherited Trust Shares and Divorce – Protecting your Children

Among the most important benefits of holding assets in a living trust is ensuring that they pass to beneficiaries protected from creditors, for instance, from a child’s divorcing spouse. A testamentary gift to your child outright and in their own name can be considered part of their marital estate in the event of divorce. Giving assets to a child in a trust share often provides a good solution: your beneficiaries still have significant access, but the assets remain significantly protected from creditors. That is, when you do things right.

As with most legal vehicles, a trust is a tool and must be used correctly. Precisely what that means can sometimes be a moving target. In the unusual recent case of Pfannenstiehl v. Pfannenstiehl, (Mass. App. Ct., Nos. 13-P-906, 13-P-686 & 13-P-1385, August 27, 2015), the Massachusetts Appeals Court ruled that in certain circumstances, assets held in an inherited trust share can be considered part of a marital estate.

The case involved the heir to a substantial fortune made from running for-profit colleges. The husband, in addition to being the beneficiary of a dynasty trust, was also employed by one of the universities on terms far better than fair market. When divorce proceedings were initiated, the systematic payments from the trust to the husband were suspended. The wife sought to have the husband’s interest in the trust included as a martial asset. As they say, bad facts make bad laws.

Citing Massachusetts law providing that “in making the determination of what to include in the estate, the judge is not bound by traditional concepts of title or property,” and observing that “during the marriage, the family was able to enjoy an upper middle class lifestyle…attributable, in large measure, to the distributions to the husband from the 2004 trust,” the court ignored decades of established jurisprudence and held that the trust share could be included in the marital estate.

The language of the trust share in question stated that “. . . the Trustee shall pay to, or apply for the benefit of, the Donor’s then living issue such amounts of income and principal as the Trustee, in its sole discretion, may deem advisable from time to time, whether in equal or unequal shares, to provide for the comfortable support, health, maintenance, welfare and education of each or all members of such class . . . .” Despite decades of established jurisprudence to the contrary, three of the five justices held that such “shall” language rendered the distributions mandatory, notwithstanding that the trustee was given sole discretion.” As a result, the Court ruled that the husband’s interest in the multi-million dollar trust established by his father was part of the marital estate, of which more than half was given to his wife in the divorce.

The court made this ruling despite the presence of strong spendthrift language in the trust – language meant to protect a beneficiary’s right to distributions from potential creditors. The court ignored the provisions, writing that it was being “invoked as a subterfuge to mask the husband’s income stream and thwart the division of the martial estate in the divorce.”

What does this mean for the creators and inheritors of trusts? First, the sky is not falling. Pfannenstiehl is an isolated case that makes a limited exception to an otherwise well established and widely held rule of law. But it does give notice: the asset protection offered by a trust does not exist apart from the actions that carry it out. A trust is not just a document, it is a legal entity, and to ensure that it does what it is meant to do, you have to toe the line. If you need help determining where these lines are, contact an estate planning attorney.

Update: On April 5, 2016, the Massachusetts Supreme Court overturned the lower court’s ruling including a beneficial interest in a trust share in the marital estate for purposes of divorce. The Court ruled that an interest in a discretionary support trust is too speculative to be part of the marital estate.