We often meet with clients who want to protect gifts to their adult children. In most cases, their intention is to ensure that if their child divorces in the future, the inherited assets are not divided with their former spouse. This article explains how we think about this issue.
Understanding the Problem
Wisconsin is a marital property state. Part of what that means is that all assets owned by either spouse at divorce are presumed to be marital, and the default rule in a divorce proceeding is that assets of the couple are divided equally. See Wis. Stat. sec. 767.61(2).
However, this does not necessarily mean that funds received by gift or inheritance will be divided equally in a divorce proceeding. In fact, the property division statute has a specific exception to this rule for property received by gift or inheritance. See Wis. Stat. sec. 767.61(2). Under that rule, property received by gift or inheritance remains the property of the recipient spouse and is not subject to division in the divorce proceeding.
Although this seems like a clear exception, in practice it is not. This is because over time, the source of funds becomes less and less clear. If Child A receives an inheritance, keeps it in a separate individually titled account, receives no income from it, and divorces a year later, Child A’s account is almost certainly not subject to division. However, if Child B receives an inheritance, adds it to a joint brokerage, uses some to pay down a marital mortgage, uses some to buy a jointly titled lake home, collects income in the account, then divorces 10 years later, the result will probably be different. That is because all of these actions—including adding interest to the account—are considered mixing individual and marital property in a way that makes it difficult to trace the property back to its inherited source.
This all means that parents, when giving an inheritance, cannot say with certainty what will happen if their child gets divorced. The inheritance might be divisible, or it might not. A lot depends on what the child does with it and how long they are married after they receive it.
Possible Solutions
Parents concerned about this issue have three possible solutions.
First, they can make an outright gift and tell their children that they expect them to keep it separate if possible. This is the easiest option from a plan design perspective, keeps things simple for the child, and does not create any additional tax or trust administration costs for the child. However, the parents do have to accept that some or all of the inheritance might be divisible depending on circumstances beyond their control. This is the most common choice.
Second, on the other extreme, parents can give funds to a trust for the child that is managed by a third party, such as a bank or trust company. In that case, the trust funds are fully protected from a divorcing spouse, as well as from any creditors the beneficiary has. However, the administrative costs (tax and trustee fees) are significant. If IRAs are included in the trust, the tax consequences can be very significant. The beneficiary also does not have control over the asset, and has to ask a bank (who has an incentive to keep funds in the trust) if they want to use the money. For that reason, most parents only use these types of trust funds if there is a very good reason beyond concerns about divorce, such as a beneficiary with AODA or mental health issues, or in cases with very large inheritances.
Finally, parents can use a separate share trust to hold the inheritance. This is a bit of a middle ground. With a separate share trust, the child is the trustee of their own trust, and has a legal right to withdraw funds or close the trust entirely. However, so long as the child keeps the funds in the trust, they do not belong to the child and (at least in our view) are not subject to division in the divorce proceeding. There is a necessary disclaimer here, which is that no one can guarantee what a court will do in a future situation. We can only say what we believe a court will do based on our interpretation of the law.
This creates the benefit the parent wants (divorce protection) but still allows the child autonomy to decide how to use their inheritance. It does create some additional tax costs related to the trust’s annual tax return. However, it does not create any management costs since the trustee is the child, not a paid professional.
How to Think About Separate Share Trusts
We think the best way to think about separate share trusts is as a tool for influencing behavior.
The trust provides no guarantee of any particular result. The child can choose to immediately withdraw the inherited funds, leaving the child in the same place as if they had received a direct gift. Rather, the benefit of the trust is that the child has to opt out of the trust to make the property divisible. In an outright gift, the child has to opt in to a management protocol that will keep the funds separate.
In a way, this is similar to opt-in and opt-out options in 401(k) plans. Studies have shown that if the default option is for the employee to contribute to their 401(k) plan, almost all do. However, if they have to take affirmative action to opt in, only a little over half will do it.
In this context, by creating this trust the parents have made protection the default option, and allowed the beneficiary to opt out. This makes it much more likely that the funds will stay separate compared to a situation where the default is mixing, and any level of protection requires the child to understand the situation and act to keep the inheritance separate. For parents who want to do everything they can to keep inherited funds separate while allowing their children full control over the funds, a separate share trust will be an option worth considering.
A Note on IRAs
One final consideration is worth noting. Qualified retirement funds, such as 401(k) plans, traditional IRAs, and any other pre-tax funds, do not mix well with separate share trusts. The exact reasons are beyond the scope of this article, but keeping IRA funds in a separate share trust (or, for that matter, in a trust with a professional trustee) will likely cost the beneficiary 10-15% of the account value in additional income tax. As a result, separate share trusts will generally not be a good option for parents who hold most of their wealth in qualified retirement accounts.
Questions
Have questions about separate share trusts? To discuss your situation in detail with an attorney, contact our office to schedule a consultation.