This is part 8 in my series, Estate Planning – What You Need to Know.
Part 8 – You Can Give Your Children Divorce and Asset Protection.
Of the thousands of clients I’ve worked with, most know how they want to distribute their assets when they die:
For married couples, it’s usually to the surviving spouse and then in equal shares to their children.
For a divorced client or widow, it’s usually in equal shares to his or her children.
Is that enough planning? Does that protect your children?
Determining who gets what is only half the task of good estate planning. Equally, if not more important, is determining how your loved ones will receive their inheritance.
Divorcing Spouses and Plaintiffs
If your child receives his or her share of your estate outright, it will be subject to claims of divorcing spouses, creditors and plaintiff’s attorneys.
If your child is married and receives an inheritance, nine times out of ten, he or she will place the inherited assets (say a check) in a joint account with his or her spouse.
California is a community property state which means all property acquired during marriage is considered owned one-half by each spouse subject to a few exceptions. One of these exceptions is an inheritance.
Inherited property is separate property. However, the separate property is transmuted to community property when your son or daughter transfers it to an account owned jointly with the spouse.
No problem as long as the marriage is solid.
But if the marriage ends, the spouse will claim half of the inherited property as his or her share.
Most parents would not choose to leave half of their child’s inheritance to a divorcing spouse.
If your child receives the inheritance while single and subsequently gets engaged, does he or she write a prenuptial agreement to maintain the inherited property as separate property?
Without a prenuptial agreement, your son or daughter will have to keep the property in a separate account and field questions from his or her fiancé and then spouse about why it’s not in a joint account. (Question: “Why do you keep your inheritance in a separate account?” Answer: “Don’t worry honey, it’s just in case we get divorced.” I wouldn’t wish that conversation on anyone.)
In my experience, the only couples that sign prenuptial agreements are those that are on their third or forth marriage.
Another matter to consider is lawsuits. When your son or daughter receives an inheritance outright, the property is in his or her name. If he or she is ever sued, the inheritance is subject to the claims of the plaintiff. It’s fair game in a lawsuit.
Solution – Lifetime Inheritance Trusts
Instead of distributing your estate to your children outright, you should consider leaving their share to them in a lifetime protection trust.
Lifetime inheritance trusts are created with special provisions in your revocable living trust.
Your revocable living trust will include instructions for your trustee to create separate trusts (we call them “lifetime protection trusts”) for each of your children when you pass away.
The trustee will then allocate the inheritance to those separate trusts for each child, rather than outright to each child.
If your child is old enough, she can be the trustee of her own trust. The trust, rather than the child, will own the property.
The significance of this is truly amazing.
Divorcing Spouse. Let’s say your son has a rocky marriage. You were savvy enough to include lifetime protection trust provisions in your living trust. When you pass away, your son receives his inheritance in trust, not outright. So his divorcing wife will have a real tough time getting her claws on it.
The trust can also be drafted to distribute the trust property in separate trusts for your grandchildren upon the death of your child in a way that will avoid further estate taxes. This protects the original inheritance from more estate taxes and from a divorcing spouse, and it provides a legacy for the grandchildren.
To Prenup or Not to Prenup. If your daughter is engaged and receives her inheritance in trust, there will be less need for a prenuptial agreement with her fiancé. The inheritance is already set aside and significantly protected in the trust. Your daughter may not even have to address the issue.
Keep the Attorneys Away. The lifetime protection trust will also serve as a deterrent to plaintiff’s attorneys.
Your child does not really own the trust property – the trust does. If your son is sued, be it a professional business claim or a vehicle accident or you name it, the trust property will be significantly protected.
Your son has a right to receive trust distributions at the discretion of the trustee, but during a lawsuit, the trustee will make no distributions, so there will be nothing for the plaintiff to attach.
The trust substantially removes the inheritance from your son’s attachable assets.
Unless the estate is very small with no life insurance, I usually recommend my clients include provisions to create lifetime protection trusts for their children in their revocable living trust.
Bottom line. If you’re going to do your estate planning, why not take the extra step to protect the inheritance?