I DIG IT Divorce

IDIGT (pronounced: “I dig it”) is another wonderful tax acronym for an Intentionally Defective Irrevocable Grantor Trust. Selling assets to an irrevocable trust has become the fav leisure activity of the ultra-wealthy, not only cause it makes great talk on the links, but it can provide an incredible array of tax and asset protection benefits. But rather than extol the benefits of this technique, let’s look at what happens when Jr. gets divorced and Jr.’s ex wants to Dig It too.

√Fiduciaries. Who are the fiduciaries of the trust? Some IDIGTs are structured with an institutional trustee. That’s a good thing. Others have a family member, some have both a family member and institution. But many parents insist on naming Jr. as a fiduciary of his own trust. The ex will carefully evaluate what powers Jr. has in endeavoring to share in the IDIGT nectar. If Jr. is an investment adviser making investment decisions that might not provide much of a toe hold. But what if Jr. were a trustee and had broader powers? Might that open the door? What if Jr. were given the power to distribute to himself? Would that open the proverbial barn door to the Ex?

√Distribution Standards. What distributions standards does the trust agreement provide? Having an independent institutional trustee with sole discretion to make distributions might be best. How could a court force an institution to make a distribution to Jr. to fund divorce obligations when the trust agreement itself doesn’t obligate the institutional trustee to do anything? On the other end of the rainbow many clients proceed AMA (not against medical advice, Against My lawyer’s Advice) and insist that the trust give Jr. the right to distribute to himself pursuant to an ascertainable standard (to make payments or distributions to maintain his lifestyle). Ouch! Might the Ex get her toe in that door? After all if Jr. can maintain his lifestyle from the trust, shouldn’t that lifestyle include paying for his Ex? Safer trusts continue for life or in perpetuity. But many benefactors liken that to controlling from the grave and prefer to pay out the trust to Jr. at some specified age. According to Murphy’s Law that distribution birthday is usually just prior to the Ex filing so she might end up getting some of Jr.’s trust birthday presents.

√Actual Distributions. What distributions have actually been made? Yes, odd for tax folks to actually consider reality, but what exactly has that trust been paying for? Shocking as it might seem some trusts, especially when Uncle Joe or Aunt Jane are a trustee, pay for stuff the trust instrument just never authorized. Gee, might the Ex ask for the trust check register and bank statements and demonstrate that the Trust has basically been making regular distributions to Jr. for a decade to support his ne'er-do-well habits? Might a court consider that a pattern that it will use to justify a result that is more supportive to Ex that Jr. and his family might have anticipated?

√Look Under the Hood. Well what does that IDIGT own anyhow? In many cases mom sells interests in the family business or real estate LLCs to the trust (ya know, after having an appraiser confirm the 80% discount and all that other fun stuff). What does that have to do with divorce? What does the operating agreement for the LLC provide for? Some operating agreements mandate certain minimum distributions. This might be done to qualify gifts of LLC interests for the annual gift tax exclusion. Others might contain a mandated distribution requirement pegged to the approximate state and federal income tax rate of the members to avoid phantom income. This is when a member might have to report income on her tax return but not get a cash distribution that is even sufficient to pay the tax. This type of clause is often negotiated by unrelated minority partners. If the operating agreement mandates distributions and there is a history of cash flow (e.g., rental stream) might that create a different result for the Ex’s attack? Contrast that with an operating agreement that has no requirements for distributions and has harsh restrictions on transferability. If cash flow has to end up in the trust then Jr. may loose the belt and have to rely only on his trust suspenders (yes, Brooks Brothers sells them in plaid).  If the trust has some of the cracks in its armor described above, that could be trouble for Jr.’s matrimonial negotiations.

√Really Look Under the Hood. Well what does that LLC actually do? What does the tax return and financial data for the LLC show? Does Jr. have a car, cell phone, travel and entertainment and other goodies run through the LLCs books? Might that discovery enable the Ex to torpedo the entire structure on the basis that Jr. was using and abusing it all? What about compensation? Might Jr. have taken no compensation from the family Widget LLC and instead let all profits flow through the LLC to the trust in an attempt to characterize all economic benefits as passive return on immune assets? Might the court believe that Jr. should have been paid a fair wage from the LLC for running the Widget business? Might that fair wage look like something that should be considered for alimony and child support?

√Smell Test. Tax courts love applying what is really a smell test (but of course disguised in more sophisticated garb). Might a matrimonial court apply a smell test to Jr.’s trust? If Jr. and all involved with the trust disregarded all the formalities might the Ex increase the likelihood of piercing the entire structure trust, LLCs and all? Say Jr. was named manager and operated the LLC but ignored many LLC formalities (undocumented loans, personal expenses, etc.), and this was coupled with a trust that was not operated in conformity with the governing legal documents (did not pay the note pursuant to its terms from the family business it purchased, did not issue Crummey powers if required, had a blank Schedule A, did not have appropriate documentation for the purchase of assets), and so forth. What quantum of disregard would persuade a court to dismiss the shield the structure might otherwise provide against the Ex? After all, if Jr. and the other fiduciaries disregarded many or even most formalities, why should the court respect the entities as against the Ex if Jr. himself did not respect them?