If you or one of your children is getting married, you may be concerned about protecting your family’s assets in the event of a divorce. This is a particularly significant issue for family business owners, who typically want to avoid sharing ownership with their ex-spouses or their children’s ex-spouses.
A prenuptial agreement can be an effective tool for overriding marital property rights and keeping assets in the family. But these agreements have some important disadvantages. For example, in the event of divorce, prenups are vulnerable to challenge on several grounds.
For many families, a more palatable alternative is an asset protection trust. Such a trust can protect assets against ex-spouses as well as other creditors, and it can be set up without the consent, or even knowledge, of the future spouse.
Why assets need protection
The laws regarding division of property in divorce are complex and vary dramatically from state to state. In general, however, spouses retain their “separate property,” which includes property they owned before marriage as well as property received by gift or inheritance during marriage.
Marital property, which is subject to division in divorce, generally includes all property acquired during marriage, regardless of how it’s titled. Depending on applicable state law, marital property may even include the appreciation in value of separate property (including the other spouse’s business) during marriage.
Also, separate property may lose that status if it’s commingled with marital property. For example, if you deposit an inheritance in your joint bank account, it will likely be deemed marital property.
In light of these risks, it may be advisable to take additional steps to protect separate property from potential loss in the event of divorce.
Of course, the emotional issues involved can make putting a prenup in place difficult. In addition, the requirements for an enforceable prenup make it vulnerable to attack in connection with a divorce. For example, a prenup may be unenforceable if one spouse can show that:
The agreement was signed under duress,
He or she didn’t have independent legal counsel,
The agreement was unconscionable when signed, or
The other spouse didn’t provide full financial disclosure.
Even if you dot all the i’s and cross all the t’s, there’s a risk that the other spouse will challenge the agreement, which can be costly and time consuming.
Benefits of an asset protection trust
A domestic asset protection trust (DAPT) can solve many of the problems associated with a prenup. It eliminates the emotional component, because there’s no need to obtain the consent of, or even inform, the future spouse. In some cases, a foreign asset protection trust (FAPT) may be appropriate. (See the sidebar “Should you go offshore?”)
A DAPT is an irrevocable, spendthrift trust established in one of the 15 or so states that authorize them. What distinguishes DAPTs from other types of trusts is that, in addition to offering gift and estate tax benefits, they provide creditor protection even if the grantor is a discretionary beneficiary.
DAPT protection varies from state to state, so it’s important to shop around. Ideally, you should look for a jurisdiction that provides grantors with the greatest degree of control over trust investments and protects trust assets from a broad range of creditors, including divorcing spouses.
To take advantage of this strategy, it’s critical to transfer assets to the DAPT well in advance of marriage. Otherwise, the transfer may be deemed fraudulent. Provided the trust holds legal title to the assets — and an independent trustee has discretionary control over distributions — it will be difficult for a divorcing spouse to reach those assets.
DAPTs have one potential disadvantage: Even though they’ve been around for years, the law surrounding them remains uncertain. Most experts believe that a properly designed DAPT will be effective when set up by a resident of the state whose law authorizes it. But it’s less clear whether these trusts will be recognized when set up by nonresidents.
An attractive alternative
Asset protection trusts provide an attractive alternative in situations where prenups are unavailable or undesirable. If you’re considering this strategy, talk to your estate planning attorney about the options available in your state, in other states or offshore.
Sidebar: Should you go offshore?
Domestic asset protection trusts (DAPTs) can protect assets from divorcing spouses and other creditors, but uncertainty over their enforceability means they’re a less-than-perfect solution. For families that desire a higher level of protection, and have the resources, a foreign asset protection trust (FAPT) may be a good option.
A FAPT is generally more expensive and less convenient than a DAPT, but it can be more effective in placing assets beyond the reach of creditors. These trusts are established in foreign jurisdictions that won’t enforce U.S. judgments and offer more favorable trust, asset protection and privacy laws.
Keep in mind that a FAPT won’t shelter income from U.S. taxes. Also, in addition to having the expense of setting up and maintaining a foreign trust, you’ll be required to comply with the IRS’s burdensome and costly rules for reporting foreign assets.