Prenuptial and Postnuptial Agreements in Estate Planning

How can the assets of mom and dad be subject to a child’s divorce?  Easily, depending upon in what state you live and/or in what state you own property.

In California, we are a community property state, which means that property acquired during marriage belongs to the spouse’s equally, regardless of title, and would be subject to equal distribution between the spouses on divorce.  A prenuptial or postnuptial agreement can negate the community property presumption, and identify certain property as the separate property of one spouse or the other.

However, what many people do not realize is that often it is not enough that they have entered into a prenuptial or postnuptial agreement with their own spouse.  It may well be very important for adult children to have these agreements with their spouses, not only to identify marital and separate property in the event of that child’s divorce, but to ensure that the parent’s estate isn’t taken into consideration in the child’s divorce settlement.  That’s right.  A court may look to an expectancy that the child has of an inheritance or gift from his/her parents to determine the value and nature of the divorcing child’s divorce settlement.

In California, a community property state, inheritances generally will be the separate property of the inheritor.  However, what if the adult child does not live in California?  Instead, what if the divorcing child lives in a state which does not make the distinction between marital and separate property?  What if the divorcing child lives in a state which includes anything a spouse owns as subject to distribution upon divorce?  Well, the unpleasant answer to this is that “everything a spouse owns” may well include that child’s share of a trust or that child’s receipt of gifts from the parents.  What may come as even more of an unpleasant surprise, the trust share or receipt of gifts isn’t necessarily limited to distributions which have already occurred.  Instead, a court may take into account the value of the expectancy of future gifts from the parents and include that in the divorce settlement.

As an example, let’s say that parents Bill and Betty set up a trust whereby their children Sally and Sam each receive income from the trust annually, and at Bill and Betty’s deaths, the children will each receive ½  of the principal.  In addition, Bill and Betty have been making annual gifts to Sally and Sam of $20,000.  Sally lives in Massachusetts and is divorcing her husband.  In this example, it is likely that the court will conclude that Sally will continue to receive the annual $20,000 gift from her parents as well as the income she will continue to receive from the trust, and include that  as property subject to distribution in the divorce.  Moreover, it is possible that Sally’s future inheritance of the ½ of the principal from the trust may also be subject to Sally’s divorce now, depending upon how speculative her expectancy is.  Indeed, that is what the court ruled in  D.L. vs. G.L. (AC 01-P-1253) 61 Mass. App. Ct. 488 (2004).

What this means from an estate planning perspective, where families often engage in gifting programs or in establishing trusts to benefit children or other family members, is that these practices may make sense for estate planning, but they must be practiced in combination with sensible prenuptial or postnuptial agreements to ensure that those intended to benefit from these estate plans will ultimately be the beneficiaries.

Dianne Harmata is a business and estate planning attorney, with offices in Mission Valley and North County.  She can be reached via email at dianne@harmata.com or by telephone at 619-233-4711 or 760-724-6880.  Follow her blog at SanDiegoTrustLaw.com.

IRA Rollover Pitfalls to Avoid

IRA Rollover Pitfalls

For individuals with multiple IRAs, the Tax Court ruling in Bobrow v. Comm’r, T.C. Memo. 2014-21, should give pause, as it completely turns on its head the conventional wisdom under which financial advisors have been operating for years.  The tax court ruled that IRA rollovers are limited to one per taxpayer, not one per IRA, for each 12-month period.

Rollovers can generally occur between traditional IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, 403(b) plans, and others.  As summarized by the court in Bobrow, “IRC Section 408(d)(3)(A) allows a payee or distributee of an IRA distribution to exclude from gross income any amount paid or distributed from an IRA if the entire amount is subsequently paid into a qualifying IRA, individual retirement annuity, or retirement plan not later than the 60th day after the day on which the payee or distributee receives the distribution.”  In other words, the owner of an IRA can receive distribution from the IRA, but within 60 days thereof, contribute it to another qualifying IRA, without income tax consequence, as a rollover.  This ability, however, is not without restrictions.

IRS Publication 590 tells us that “if you make a tax-free rollover of any part of a distribution from a traditional IRA, you cannot, within a 1-year period, make a tax-free rollover of any later distribution from that same IRA.” (emphasis added).  The same IRS Publication 590 provides in an example that two rollovers within 12 months are permissible as long as they were not involving the same IRAs.

However, unfortunately for the taxpayers in Bobrow v. Comm’r, T.C. Memo. 2014-21, though IRS Publication 590 stated that more than one nontaxable rollover within 12 months could be permissible, Internal Revenue Code Section 408(d)(3)(B) provides that a taxpayer may make only one nontaxable rollover contribution within each one-year period, not per IRA, but per taxpayer.  The IRS’s own Publication 590 explaining this rule is wrong and should not be relied upon.

Unfortunately for the Bobrows, this was a misunderstanding that cost them more than $60,000 in tax and penalties.

Why is a Living Trust Important?

A revocable living trust is a document a person (Trustor) creates to manage assets during that person’s lifetime, and to administer the disposition of those assets after the Trustor’s death.

Living Trusts are so named as they take effect during the Trustor’s lifetime, rather than a document, such as a will, which is only effective upon a person’s death. This results in one of the first advantages of a living trust over a will. During the Trustor’s lifetime, and while the Trustor has mental capacity, the Trustor can serve as the person responsible for managing the Trust assets. This person is called the Trustee. However, unlike a will, should the Trustor become incapacitated and unable to manage his/her own affairs, the Successor Trustee (the individual named to serve as an alternate to the original Trustor) can step in and manage the Trust Estate for the Trustor.

Without a Living Trust, an individual might not have anyone in place to manage his/her affairs for him/her upon incapacity. This could result in the family’s having to petition the court for conservatorship, which could be a lengthy and expensive proposition.

A second major advantage of a Living Trust is the ability to administer an estate in a timely and generally cost-efficient manner after the death of a Trustor. Unlike a will, there is often no need to petition the court after the death of a Trustor. Instead, the Trustee can gather the estate assets and ensure that the Trustor’s wishes are accommodated typically without need for court intervention. The administration of a Will, on the other hand, will generally require an Executor (the person named in the Will to administer the estate) to petition the court, and proceed through the probate process whereby the court oversees the administration of the estate. The probate process is often lengthy and can be quite expensive.

A third advantage of a Living Trust is privacy. As the administration of a Living Trust can avoid the probate process, the nature of the decedent’s property and the identity of the decedent’s beneficiaries can remain private. This is in contrast to the probate of a will, a court process which becomes a public record, and enables others to learn of the details of the decedent’s property as well as the identities of those will inherit that property.

While a Living Trust may not be for everybody, it is also not solely the domain of the wealthy. In fact, in California, estates valued above $150,000 will be subject the probate process unless a Living Trust is properly utilized.

Dianne Harmata is an attorney with Harmata & Associates, a law firm which practices estate and business planning. Dianne Harmata can be reached at 619-233-4711 or via email at Dianne@Harmata.com