Use of Trusts in Planning for Possible Divorce of Trust Beneficiary- MASSACHUSETTS CASE: PFANNENSTIEHL

 


business-transactionBACKGROUND

One common discussion point clients ask about is “What can I do to protect my child’s inheritance (or gift) due to a child’s bad marriage?” In that discussion, clients can consider placing assets in a trust because the assets maintained in the trust should receive more protection. The assets held in trust will be less susceptible to claims in divorce than if the child receives an outright distribution. While the maintenance of property in trust for the benefit of a minor beneficiary is probably the most common use of trusts, another useful part of many estate plans involves the desire of family members to protect the family “estate” for the benefit of their descendents.

Generally, the receipt of an inheritance would be free from “equitable distribution” in the event of a divorce by a recipient to an inheritance or gift. However, the income produced on the inheritance, as well as any growth on the inherited assets, would typically be susceptible to equitable distribution if that beneficiary were to be involved in a divorce proceeding.

The Massachusetts case, Pfannenstiehl v Pfannenstiehl, 475 Mass. 105 (2016), brought national attention to this issue. Fortunately, the appeals court reversed a trial decision that would have eviscerated trust planning as a means of protection (at least for Massachusetts residents). In New Jersey, Tannen v. Tannen, 416 N.J. Super. 248, 3 A.3d 1229 (App. Div. 2010), aff’d, 208 N.J. 409, 31 A.3d 621 (2011) addressed many of the issues raised by Pfannenstiehl concerning divorce of a trust beneficiary. Our Court found that the issues presented matters of first impression in New Jersey and our Appellate Court decision was affirmed, without opinion, on appeal by the New Jersey Supreme Court.

In a nutshell, the issue raised is the degree of discretion afforded a trustee to make, or to withhold, distributions to a beneficiary. If the family court can force distributions to be made, either to the beneficiary or, worse yet, to the ex-spouse of the beneficiary, then the benefits of trust planning can be negated. This is also a topical issue in New Jersey by virtue of the newly enacted Uniform Trust Code (P.L. 2015, ch. 276) NJSA § 3B:31-1 et seq. as noted below.

OLD NEW JERSEY LAW

 

TANNEN- FACTS

Mark and Wendy Tannen were married in 1988 and by the time of their divorce proceedings, they had two children, ages 17 and 14. In year 2000, Wendy’s parents, Leonard and Gloria Phillips had established a trust for Wendy’s benefit that provided substantial benefits to her and her family in the form of income and use of a residence. During the divorce proceedings, Mark asserted that the trust assets and trust income were resources used to enable them to maintain their standard of living. Generally, upon termination of a marriage, parties will divide, through “equitable distribution”, the “marital estate” which includes assets acquired during marriage. In addition, alimony and child support can be awarded to provide for the standard of living “as the circumstances of the parties and the nature of the case shall render fit, reasonable and just…” N.J.S.A. § 2A:34-23. (While the New Jersey alimony laws were reformed in 2014, P.L. 2014 ch. 42, the reformation is not relevant to the issue addressed below.)

TANNEN TRIAL COURT DECISION

At the trial court, Mark’s attorneys were successful in forcing the trustee of the trust to become a party to the divorce proceeding. Under the terms of the trust agreement, the trustees (who included Wendy and her parents), were to use the trust corpus in a wholly discretionary manner. The trust provided for payments to be made, in the trustee’s sole discretion, for the beneficiary’s “best interests” and included the following direction:

“Notwithstanding any other provision in this trust agreement to the contrary, it is the express intention of the Grantors in creating this trust that the beneficiary shall not be permitted, under any circumstances, to compel distributions of income and/or principal prior to the time of final distribution”. 416 N.J. Super. at 256.

Further, the trust included the standard “spendthrift” provision, which prevented the “alienation” of the beneficiary’s interest. This means that the beneficiary could not sell or borrow against her share of the trust. Nevertheless, the lower court felt that the trust should be obligated to pay $4,000 per month to Wendy and further ordered that the Trustee continue making other payments on the marital home held by the trust for housekeeper expenses. In the event that the Trust did not comply with the court’s directive, “their refusal would be deemed…an abuse of discretion”. 416 N.J. Super. at 259.

In the trial court’s opinion, the court reasoned that Wendy’s “reluctance or failure to pursue income from the [Trust] constituted unreasonable action on her part and a breach of fairness in her fiduciary duty”. 416 N.J. Super. at 258. The trial court found that Trust income was to be considered in determination of fair alimony to be paid by Mark to Wendy. The trial court felt that it “had the authority to compel a distribution of income to [defendant]” stating that “where a Trustee acts outside the bounds of reasonable judgment, the court will interfere with the administration of a Trust”. 416 N.J. Super. at 258–59. For the legal rationale upon which the court based this opinion, it relied on the Restatement (Third) of Trusts, Section 50, Comment (d)2 which implied that a trust beneficiary “would certainly be unjustly enriched if she were to receive alimony, have a limited child support obligation and ultimately receive the entire Trust income anyway.” 416 N.J. Super. at 259.

TANNEN APPELLATE DECISION

The Appellate Court reversed the trial court’s determination, both that the divorce court had jurisdiction over the trust, as well as the fact that the trust could be commanded to make distributions to Wendy and/or Mark. 416 N.J. Super at 273. In fact, the Appellate Division found that the trust resources could be looked at for Wendy’s support and maintenance, but could not be considered in this context. In the Appellate Court opinion, the Court provided a thorough and well-reasoned analysis of the law.

The Appellate Division decision focused on the statutory analysis contained in N.J.S.A. § 2A:34-23(b)(11) where in granting an alimony award, the judge must consider “the income available to either party through investment of any assets held by that party”. A question to be considered was whether or not the Trust assets should be considered “held by Wendy” based on the rationale of earlier courts. Case law had included a focus on the right to access funds and not to actual receipt of funds. Citing Judge, now Justice, Long, the court addressed income generated by an inheritance and the provision “so long as the spouse has the ability to tap the income source…whether he or she actually obtains the cash at hand is inconsequential”. 416 N.J. Super at 263 (citing Aaronson v. Aaronson, 245 N.J. Super. 354, 364–65 (App. Div. 1991)).

The court analysis utilizes two bodies of law produced in the academic arena, the Restatement (Second) of Trusts and a more recent version, Restatement (Third) of Trusts. Under the Second Restatement of trust law, the commissioners differentiated between discretionary trusts and support trusts. According to the Appellate Division decision, a discretionary trust provided a trust beneficiary with no right to force distributions, whereas a support trust enabled a beneficiary to bring a claim against the trust to demand that distributions for his or her “support” be provided. By contrast, the Third Restatement of the law of trusts reviewed the terms of a discretionary trust finding that all trusts are “discretionary”, but support trusts are trusts that maintain a standard in which the trustees are obligated to follow. However, the Court found that there was little support in the New Jersey case law for adopting the Third Restatement holding in this regard. 416 N.J. Super at 272.

The Appeals Court relied on Weidenmeyer v. Johnson, 106 N.J. Super. 161, 165 (App. Div.) aff’d 55 N.J. 81 (1969) for the proposition that the trustee’s discretion should control, particularly when granted broad discretionary powers. Moreover, the Appellate Court took issue with the lower court’s imposition of a “fiduciary duty” upon divorcing spouses. The court found “[c]ertainly no reported decision in this State has ever categorized each party’s obligation to the other in a divorce proceeding as a ‘fiduciary duty’; the essence of which is to ‘act primarily for another’s benefit.’” 416 N.J. Super at 263 (citing Black’s Law Dictionary 563 (5th Edition 1979)).

In considering the circumstances, the appeals court found that the Trustees were to use the trust assets for the defendant’s “health support, maintenance, education and general welfare”, and such a standard entitled Wendy to these benefits only taking into account her other available resources. This limit upon the Trustee’s discretionary authority relates to the right of spousal support. 426 N.J. Super at 271. In effect, the Court found that the Third Restatement rule should not be followed in the matter at hand. Moreover, because of the limitations imposed upon the trustees in compliance with this standard provided, the court concluded that the trust should not be considered an asset “held” by the beneficiary pursuant to the aforementioned rule contained in N.J.S.A. § 2A:34-23(b)(11). Indeed, the court relied on the fact that the settlor to the trust, Wendy’s father, testified that his intention in creating the trust was that she would not be able to compel trust distributions. He also testified that it was not his intent in settling any of the trusts that Mark be relieved of his obligations to support Wendy or the children. 416 N.J. Super. at 265. As noted above, the appeals court decision was affirmed without opinion by the New Jersey Supreme Court.

NEW MASSACHUSETTS CASE

 

PFANNENSTIEHL- FACTS

Curt and Diane Pfannenstiehl were married in 2000 and had two children. They lived a middle class lifestyle in Massachusetts based upon Curt’s earnings from a bookkeeping job that he held at his father’s company. His earnings were around $170,000 and his total income was around $190,000. After a 10-year marriage, Curt and Diane were in the process of a divorce.

What makes the Pfannenstiehl matter interesting is that Curt was also a beneficiary of an irrevocable trust that was established by his father in 2004, a few years after Curt and Diane had married. The distributions from the trust could be made among a class of beneficiaries that included Curt’s father’s “issue.” Issue had included not only Curt and his siblings, but also all of the grandchildren. Thus, there were 11 beneficiaries to the trust. The trust provided that the trustees were to make distributions and “shall pay to, or apply for the benefit of, a class composed of any one or more 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.” 475 Mass. at 108.

According to the trial court decision, the value of this trust was about $25,000,000. At trial, the court considered the trust to be a part of Curt’s “marital share” and awarded Diane sixty percent (60%) of Curt’s interest in the trust itself. Because his interest represented one of 11 beneficiaries, the trial Judge valued Curt’s interest in the trust at about $2,200,000 (a pro-rata 1/11th of the total value) and ordered payments of $1,168,000 to Diane in $50,000 monthly installments over a 2-year term including a three percent (3%) interest rate. This decision was made notwithstanding the fact that the trustees had no obligation to pay funds to Curt in order to satisfy his obligations.

Under Massachusetts law, the family court is permitted to make equitable division of the “marital estate.” The trial decision was widely discussed in the estate planning community because, in the words of at least one commentator, it abrogated centuries of law concerning spendthrift trusts.

PFAFFENSTIEHL APPEAL

On appeal, the court found that, while a trial judge has considerable discretion in determining how to divide marital assets equitably, it questioned whether an interest in a trust is sufficiently similar to a property interest to be included in a marital estate and subject to equitable division under Massachusetts law. The appeals court reversed the trial court decision and remanded for further proceedings consistent with its decision. In considering Curt’s interest in the trust, the trial court found that the trust gave the trustees the ability to make distributions in their “sole discretion as they may deem advisable from time to time.” Thus, like many trusts, Curt had no ability to force distributions from the trust because the trust is a “discretionary” trust. He had no more than “an eligibility for distributions.” 475 Mass. at 112.

Diane argued that the “ascertainable standard” for distributions gave Curt a present enforceable interest to compel distributions when he needed them. However, the court noted that the trial court mandate for distributions to be made to Curt so that he could make payments to Diane, could not actually be carried out because Curt did not have an ability to compel distributions due to the termination of the marriage. Thus, the court found that the ascertainable standard did not render Curt’s future acquisition of assets under the trust as sufficiently certain to include it in the marital estate under Massachusetts law. It is interesting to note that in Massachusetts, the Uniform Trust Code was adopted in 2012 and even though the circumstances involved in this case occurred prior to that, the court referenced the UTC provisions for the definition of “ascertainable standard.” 475 Mass. at 113. (New Jersey contains a similar definition of ascertainable standard in our UTC).

NEW NEW JERSEY STATUTE

 

UTC ENACTED JULY 17, 2016

The recent adoption of the New Jersey Uniform Trust Code has raised a question about the degree to which the UTC provisions may affect the Tannen decision of the New Jersey Supreme Court. It was not the expectation of the UTC drafting committee that the provisions would modify the Tannen result. In fact, it was the expectation that the provisions in the newly adopted UTC would ratify existing law. Specifically, under the Uniform Trust Code, §503 would grant a spouse or former spouse a right to compel distributions as an “exception creditor.” The provisions of UTC §503 were not adopted in New Jersey. Indeed, none of the provisions enabling “exception creditors” to force distribution from a trust containing a spendthrift provision were enacted.

Two other provisions in the UTC do effect the obligations of a trustee to make distributions either for creditors (N.J.S.A. § 3B:31-38) or for beneficiaries (N.J.S.A. § 3B:31-68). It is interesting to note that in the Massachusetts Uniform Trust Code, neither UTC §503 nor UTC §504 (the corollary to N.J.S.A. § 3B:31-38) were enacted. However, both New Jersey and Massachusetts have a version of UTC §814. See N.J.S.A. 3B:31-68; Mass. G.L. c. 203E Section 814.

The relevant new provisions are recited below:

EFFECT OF SPENDTHRIFT “EXCEPTION CREDITORS”

N.J.S.A. § 3B:31-38. Creditor of beneficiary prohibited from compelling distribution subject to trustee’s discretion
Discretionary Trusts; Effect of Standard.
a. Whether or not a trust contains a spendthrift provision, a creditor of a beneficiary may not compel a distribution that is subject to the trustee’s discretion, even if:
(1) The discretion is expressed in the form of a standard of distribution; or
(2) The trustee has abused the discretion.
b. This section does not limit the right of a beneficiary to maintain a judicial proceeding against a trustee for an abuse of discretion or failure to comply with a standard for distribution.
c. With respect to the powers set forth in section 1 of P.L.1996, c. 41 (C.3B:11-4.1), the provisions of this section shall apply even though the beneficiary is the sole trustee or a co-trustee of the trust.

EFFECT OF A DISCRETIONARY STANDARD

N.J.S.A. § 3B:31-68. Exercise of discretionary power
Discretionary Powers.
Notwithstanding the breadth of discretion granted to a trustee in the terms of the trust, including the use of such terms as “absolute,” “sole,” or “uncontrolled,” the trustee shall exercise a discretionary power in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries.

COMMENT AND CONCLUSION

The Tannen case is a significant case for estate planning. Since the Appeals Court decision was affirmed, it has the force of a New Jersey Supreme Court decision. It upholds the long-standing position that by conveying assets into a trust, a transferor of property (parent, grandparent) can protect the assets through the terms of the trust in a manner greater than if the assets had been left outright and free of trust. Clients often want to ensure that their hard earned wealth is maintained for decedents and not “in-laws”, who can quickly become “out-laws” in the divorce setting. Had the trial court decision been upheld, our clients may have needed to seek to establish trusts outside the state of New Jersey in order to protect the assets from unwanted claims. Moreover, to the extent that the trial court forced the trustees into the divorce proceeding as parties, trusts could be subjected to unnecessary and unwarranted litigation.

The Massachusetts decision in Pfannensteihl shined a bright light on the issue of using trusts to protect an inheritance and, fortunately, the appeals court seems to have come to the “correct” decision from an estate planning perspective. However, there may be a split of opinion between the matrimonial lawyers and estate planning lawyers regarding the propriety and the effect of this decision and the use of trusts to protect a child’s inheritance. In the view of many estate planning lawyers, the paramount objective should be the donor’s original intent in creating the trust in the manner in which the trustor chose. By contrast, matrimonial lawyers may view the principle question as whether the parties are able to maintain their standard of living both before and after divorce. In the opinion of this author, the new UTC provision reinforced the use of trusts as a planning technique; however, as with all new statutes, it may be years before a court will interpret the new statute in light of the old cases.

Those spouses who have married into families with considerable wealth should be warned that their rights in trusts established by their parents-in-law and grandparents-in-law do not represent the resource upon which they can rely after a divorce. Fortunately, no distinction was made to force the use of “disinterested trustees” in order to protect the family assets.

Nevertheless, while a trust will receive protection in New Jersey, marital laws may differ from State to State. Thus, if a trust is established and maintained in New Jersey, the New Jersey protection should be offered. When the married couple resides in other jurisdictions, the question of “choice of law” may be invoked if the law of the residence of the divorcing spouse is more favorable to one of the litigants.