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When is an Inheritance a Part of Property to be Divided in the Divorce?

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When is an Inheritance a Part of Property to be Divided in the Divorce?

A recent New Jersey divorce case has important implications for estate planners.  It holds that an inherited asset is not subject to equitable distribution in divorce.  Rosen v. Rosen, 2019, N.J. Super. Unpub. LEXIS 1509 App. Div. (July 3, 2019)


               

Sometimes clients will ask their estate planner, if I pass away and my child receives an inheritance from me, and if that child later gets divorced, will their spouse receive a share of their inheritance?   The short answer, like many legal problems is, it depends.  In the event that the child commingles the inheritance with other marital assets, or if the inheritance is invested and it grows in value, then there may be a claim that it would become “marital property” subject to “equitable distribution” in the division of the marital estate.  If segregated and can be traced to the inheritance, more protection is afforded.

As a result of this possibility, many estate planners recommend that a concerned parent should leave assets in a trust for the benefit of a child rather than making an outright gift or bequest.  The use of a trust would prevent the child from commingling the inheritance with other marital assets thereby preserving the inheritance and preventing it from being a part of the marital pot.  Moreover, the use of a trust may not restrict the child’s ability to receive significant benefit from the extra resources. In the landmark precedent, Tannen v. Tannen, 208 N.J. 409, 31 A.3d 621, affirming, 416 N.J. Super. 248, 3 A.3d 1229 (2011.), the New Jersey Supreme Court reaffirmed the principal that a gift or an inheritance in trust, not commingled with marital assets, is protected in a later divorce from equitable distribution by achieving exempt status.  A recent New Jersey decision addressed the protected status of an inheritance without using a trust.

This case deals with Allison and Jay who were married in 1986 and divorced in 2017.   Jay and his two brothers had received an inheritance from their father (somehow through a trust distribution) which was converted into an LLC owned equally between the three brothers. They named the LLC “Leonard Rosen LLC” after their father.   During the marriage, Jay received periodic income distributions from the LLC and those distributions were used as a part of the marital resources.

In the family court divorce proceeding, the matrimonial Court first ordered that Allison receive 55% of all distributions from the LLC, but subsequently the trial judge amended its Order to provide that Allison receive 55% of all distributions that Jay received from the LLC (i.e., 55% of Jay’s one third interest in the LLC).  As a practical matter, as an LLC owner or member, Jay would be required to pay income taxes on his third of the income earned by the LLC. This tax consequence occurs irrespective of the amount distributions, if any, made by the LLC.  Thus, not only could Jay be in a difficult position of paying income tax on earnings not distributed, most of the distributions that were made could have been forced to be paid to Allison.

On appeal, Jay contended that the family court was wrong. He argued that the interest in the LLC and future earnings were not subject to equitable distribution in the divorce.  The Appellate Court reversed the family law judge and found that the relevant statute, N.J.S.A. 2A:34-23(h) provides that property acquired “by either party by way of….devise, or intestate succession” is not subject to equitable distribution.  Recall that in a divorce proceeding, a Court can set child support obligations and alimony obligations, but it would also divide the marital estate between the parties pursuant to equitable distribution principles.

The court also recited that “the income generated from an exempt asset is also not subject to equitable distribution. ‘[T]he income or other usufruct derived from [exempt] property, as well as any asset for which the original property may be exchanged or into which it, or the proceeds of its sale, may be traceable shall similarly be considered the separate property of the particular spouse.’ Painter v. Painter, 65 N.J. 196, 214, 320 A.2d 484 (1974).”  However, Jay was not asserting that previously received income should receive any protection, merely the future earnings.  While income generated from an inheritance may be considered in an alimony award, the Court in this matter was not considering spousal support.

As a result, the Court in Rosen found that the LLC interest and distributions therefrom are an asset exempt from equitable distribution in the context of their divorce.  Allison had never received an ownership interest in the LLC and, therefore, distributions were immune from equitable distribution.   From a planning perspective, it is better to leave an inheritance in trust if this type of marital “asset protection” is desired.  While some clients choose to forego the complications associated with creation of a trust, this case underscores an alternate means of maintaining some protection.

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