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?

Conclusion:
Not all IDIGTs were created equal, and certainly not all are operated like the
pristine trusts and LLCs of textbook case studies. Depending on the terms of
the governing instruments (trust, underlying entity, sale documents and more)
and the actuality of how the entire structure was operated, there will be a
wide range of potential divorce consequences to such structures. While the
intent of many such plans is to protect assets from a child or other heir’s future
divorce, the effectiveness of the structure will depend on the details of the
documents and operation.  The devil truly
is in the details, especially in a divorce challenge to an IDIGT.