Protecting Your Assets From a Future Former Spouse

By:
Daniel S. Rubin, JD, LLM
Published Date:
Jun 1, 2017

No one weds with the intention of later divorcing, but most people recognize at least a possibility that the person standing next to them at the altar might actually be their "future former spouse." Individuals of means, in particular, will want to do what they can to protect against the potentially disastrous financial consequences of divorce.

Most commonly, individuals protect themselves against such a possibility with a prenuptial agreement. In many situations, however, a prenuptial agreement may be  impractical—or even impossible—to obtain. At the very least, a prenuptial agreement may be less than desirable in light of the sensibilities of one's intended spouse—or those of his or her family. Because a prenuptial agreement is also first and foremost a contract, it must satisfy a number of specific requirements to be upheld in court against a motivated litigant—almost certainly the case in a matrimonial contest.

Many people should consider a complementary or alternative strategy. One such strategy is a self-settled spendthrift trust, also sometimes referred to as an "asset protection trust.”

A Background on Spendthrift and Discretionary Trust Protections

A "spendthrift" trust is a trust in which the beneficiary’s interest cannot be accessed by the beneficiary’s creditors, due to an expression of intent by the creator (the "settlor" or "grantor") of the trust. The underlying public policy is that the protection of the beneficiary's interest carries out the stated intent of the settlor, who was free to make any desired disposition of his or her property and who was under no obligation to provide for the satisfaction of any creditor's present or future claims against the beneficiary. Stated otherwise, the use of a spendthrift trust takes nothing from the beneficiary's creditors that they had previously.

A discretionary trust, which may or may not also contain a spendthrift clause, is a trust in which distributions to the beneficiary are left wholly within the discretion of the trustee. Discretionary trusts limit the extent of the beneficiary's interest in the trust, making it tenuous enough that it will not qualify as a property right, subject to attachment by creditors.  In effect, the beneficiary's interest will only come into existence when—and to the extent that—the trustee decides to make a distribution to the beneficiary. In other words, a creditor cannot compel the trustee to pay anything to the creditor that the beneficiary could not compel for payment to himself.

Self-Settled Spendthrift Trusts

For policy reasons, the same protections have not historically been extended to the beneficial trust interest of the settlor in so-called "self-settled" trusts, in which the person creating the trust is also a beneficiary of the trust. This has been the case regardless of a number of factors, including whether the settlor is the sole beneficiary of the trust; whether the settlor has ever even received any distributions from the trust; whether the trustee is a close friend or relative of the settlor (or a completely independent corporate fiduciary); whether the settlor funded the trust with all or nearly all of his or her assets; and, perhaps most significantly, whether or not the settlor had—or even anticipated—any creditors at the time that the trust was created.

Since 1997, however, 16 states have enacted legislation extending trust protections even to a settlor-beneficiary of the trust. Such trusts are called "self-settled spendthrift trusts" or "asset protection trusts.” In many (although not all) such states, the protection of the settlor-beneficiary's interest is expressly stated as applicable even against the claims of a future former spouse. Delaware is one such state, and its legislation—titled the "Qualified Dispositions in Trust Act," which has also served as a model for a number of other states that later enacted their own self-settled spendthrift trust legislation—is instructive of the manner in which such trusts work in premarital asset protection planning.

Trust Requirements Under the Delaware Qualified Dispositions in Trust Act

The Delaware Qualified Dispositions in Trust Act (the "Act") allows the settlor (referred to under the Act as the "transferor"), to retain a beneficial interest in a trust that he or she creates. At the same time, it protects the trust's assets from the settlor's creditors. Specifically, the Act provides that “the interest of the transferor or other beneficiary in the trust property or income therefrom may not be transferred, assigned, pledged or mortgaged, whether voluntarily or involuntarily, before the qualified trustees actually distribute the property or income therefrom to the beneficiary . . . .” In order for a self-settled Delaware trust to be protected, however, several express statutory requirements must be met.

First, the settlor must transfer property to a "qualified trustee," meaning either an individual resident of Delaware (other than the settlor) or an entity authorized by Delaware law to act as a trustee and "whose activities are subject to supervision by the Bank Commissioner of the state, the Federal Deposit Insurance Company, the Comptroller of the Currency." Notably, however, the Act does not require that all trustees be qualified trustees—only that one of the trustees be a qualified trustee, thus enabling the settlor to appoint friends or family members as one or more additional trustees. Significantly, because a majority of the trustees is commonly authorized to act on behalf of the trust, the trust can therefore be administered without the concurrence of the qualified trustee to every single trustee action. Although the settlor cannot act as a trustee, the settlor can permissibly name himself as an "advisor" to the trust with certain authorities, including an "authority under the terms of the trust instrument to remove and appoint qualified trustees or trust advisers" or “authority under the terms of the trust instrument to direct, consent to or disapprove distributions from the trust." The settlor can also serve as an "investment advisor" with the power to "direct, consent to, or disapprove a fiduciary's actual or proposed investment decisions."

In order to provide some additional nexus between the trust and Delaware, the qualified trustee must have the power to maintain or arrange for custody in Delaware of some or all of the property that is the subject of the qualified disposition, or maintain records for the trust on an exclusive or nonexclusive basis, or prepare or arrange for the preparation of fiduciary income tax returns for the trust, or otherwise materially participate in the administration of the trust.

Finally, there must of course also be a valid "trust instrument”—defined as "an instrument appointing a qualified trustee or qualified trustees for the property that is the subject of a disposition”—which contains a spendthrift clause, which states that the trust is irrevocable, and which expressly incorporates Delaware law as controlling the validity, construction and administration of the trust.

The "Exception Creditor" Question
 
Notwithstanding the general language of the Act, Delaware law—as a matter of public policy—classifies two types of creditors as being expressly exempted from the protection otherwise afforded to a qualified disposition. Such creditors are often called "exception creditors."

One such class of exception creditors concerns any person who suffers death, personal injury, or property damage on or before the date of a qualified disposition that is at any time determined to have been caused in whole or in part by the act or omission of either such transferor or by another person for whom such transferor is or was vicariously liable.

More importantly, the other such class of exception creditor includes any person to whom the transferor is indebted on account of an agreement or order of court for the payment of support or alimony (but not to any claim for forced heirship, legitime, or elective share) in favor of the transferor's spouse, former spouse, or children, or for a division or distribution of property in favor of the transferor's spouse or former spouse, to the extent of such debt. For this purpose, however, a "spouse" or "former spouse" includes "only persons to whom the transferor was married at, or before, the time the qualified disposition is made." Therefore, if a person creates a Delaware "asset protection" trust prior to marriage, his or her future former spouse will not be an "exception creditor" under Delaware law—and therefore will not be able to avoid the protections afforded by the trust on that basis.

The Fraudulent Transfer Question

Where a creditor, such as a future former spouse, is not an exception creditor, the creditor's sole recourse in an attempt to enforce his or her claim against a Delaware self-settled spendthrift trust is to argue that the funding of the trust was a fraudulent transfer, which is sometimes called a "voidable transaction.” In this regard, the Act provides that:

[N]o action of any kind, including, without limitation, an action to enforce a judgment entered by a court or other body having adjudicative authority, shall be brought at law or in equity for an attachment or other provisional remedy against property that is the subject of a qualified disposition or for avoidance of a qualified disposition . . . unless such action shall be brought pursuant to [Delaware's Uniform Fraudulent Transfer Act] and, in the case of a creditor whose claim arose after a qualified disposition, unless the qualified disposition was made with actual intent to defraud such creditor.

In this regard, consider whether it is even possible to prove actual intent to defraud in the case of a future former spouse. To do so would seemingly require the future former spouse to prove not that the settlor had a concern that the marriage might end in divorce, but rather that the settlor actually entered into the marriage for the very purpose of later divorcing.

Even if it were possible to somehow prove that the settlor married for the purpose of later divorcing, the applicable statute of limitations for making such a claim would likely present a substantial hurdle for the future former spouse. In Delaware, the applicable statute of limitations provides that where the creditor's claim arose concurrent with or subsequent to the qualified disposition (as is necessarily the case where the trust is established before marriage since nobody has marital rights before the actual marriage), the action must be brought within four years after the qualified disposition is made. Thus, even in the case of actual intent to defraud, the marriage need not ever last more than one day less than four years for the statute of limitations to serve as an absolute and total bar to recovery by a future former spouse.  Of course, where the trust is established on a date prior to the day before the wedding, the statute of limitations would bar recovery even before the fourth wedding anniversary.

Conflict of Law Issues

As noted, 16 states currently provide for self-settled spendthrift trust protections.  Obviously, this means that 34 states do not. What, then, will be the effect of such a trust when the settlor and his or her future former spouse are living in a state that does not recognize self-settled spendthrift trust protections as being valid under that state's own laws?

The Restatement (Second) of Conflict of Laws Section 273, speaks to this question and provides that:

Whether the interest of a beneficiary of [an inter-vivos] trust of movables is assignable by him and can be reached by his creditors is determined . . . by the local law of the state, if any, in which the settlor has manifested an intention that the trust is to be administered, and otherwise by the local law of the state to which the administration of the trust is most substantially related.

In fact, in some jurisdictions, a settlor's ability to designate the law of a particular jurisdiction as the governing law of his or her trust is expressly provided for by statute.  For example, Section 7-1.10 of New York's Estates, Powers and Trusts Law provides that: “Whenever a person, not domiciled in this state, creates a trust which provides that it shall be governed by the laws of this state, such provision shall be given effect in determining the validity, effect and interpretation of the disposition in such trust . . . .”

And, in interpreting a prior version of this statute, New York's highest court stated in Hutchinson v. Ross, 262 N.Y. 381 (1933), that "[t]he statute makes [a settlor's] express declaration of intention [of controlling law] conclusive . . . ." Furthermore, although the prima facie ability of a New York domiciliary settlor to create a valid trust governed by the laws of another jurisdiction is not expressly conferred by this statute, it has been so interpreted by the courts.  For example, in the matter of In re New York Trust Co., 87 N.Y.S.2d 787 at 792 (1949), the court stated that:

It is inconceivable that a state committed to [the policy of New York’s Estates, Powers and Trusts Law Section 7-1.10] would deny its own residents the corresponding right to establish trusts in other states . . . . [U]nder the law of this state, a New York resident may choose another state as the situs of a trust as freely as a non-resident may create a trust in New York.

Finally, it is worth noting that "New York law recognizes the right of individuals to arrange their affairs so as to limit their liability to creditors, including the holding of assets in corporate form[,] . . . . making irrevocable transfers of their assets, outright or in trust, as long as such transfers are not in fraud of existing creditors . . . ." In re Joseph Heller Inter Vivos Trust, 613 N.Y.S.2d 809 at 810 (N.Y. Sur. 1994).

Conclusion 

Although prenuptial agreements are recognized as generally valid under the law of all 50 states and are often a good option to protect against certain consequences of divorce, not every individual getting married can—or will want to—obtain a prenuptial agreement. Even where a prenuptial agreement is feasible, some uncertainty will always exist as to whether its terms will be enforced in the event of a divorce. A self-settled spendthrift trust created before marriage in a state that recognizes them as valid and enforceable is an alternative or complementary way to guard against the potentially devastating financial consequences of divorce.


rubin_danielDaniel S. Rubin, JD, LLM (taxation), is a partner in the Trusts and Estates and Asset Protection practice groups of the New York City law firm of Moses & Singer LLP.  Mr. Rubin has been named by Worth magazine as one of the "Top 100 Attorneys" in the nation for private clients, by Law & Politics as a "New York Super Lawyer" and as one of The Best Lawyers in America for Trusts and Estates by U.S. News-Best Lawyers. Mr. Rubin is a fellow of the American College of Trust and Estate Counsel where he is the incoming chair of the Asset Protection Committee, a faculty member and lecturer at the Heckerling Institute on Estate Planning, and an adjunct professor at the University of Miami School of Law. Mr. Rubin is also the co-author of the third edition of the Bureau of National Affairs' Tax Management Portfolio on Asset Protection Planning. He can be reached at DRubin@mosessinger.com or 212.554.7899.

 
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