Spouses who are facing a marital break-up must exercise caution in preserving their inheritance and trusts in divorce. While advance planning may be the best protection, there are some steps that can be taken when divorce is imminent. It is important to understand the nature of trusts and inheritance, and their role in an individual’s wealth management strategy. In my book, Frumkes & Vertz on Divorce Taxation, we provide a detailed analysis of inheritance and trusts in divorce.
No one intends to forfeit their trusts and inheritance in divorce court. Perhaps that’s why, in most states, the law provides some automatic protection. For instance, in Pennsylvania, only the increase in value can be divided. The increase is measured from the time of the inheritance until the date of separation. In the case of a trust, the increase in value only includes trust growth and income that is actually available for withdrawal. In other words, the initial value of the trust or inheritance is preserved from equitable distribution, and will not be divided between spouses unless it is retitled in joint names or commingled with marital property.
To add further protection, many spouses wisely enter into prenuptial agreements that protect the increase in value of trusts and inheritance in divorce. In fact, for high net worth families, a prenuptial agreement is a common part of a wealth succession and estate plan. Divorce and taxes are two of the main obstacles when high net worth families plan to transfer wealth to future generations, so it makes sense to deal with both issues together.
There are two types of claims that might impact on inheritance and trusts in divorce:
- The income they generate (and rarely, the principal) might be exposed to spousal support obligations and alimony. In those cases, it may be necessary to determine the net after-tax value of the income, by applying the proper tax rates. The rate may depend upon whether the income will be taxed at the entity-level (as in a trust or probate estate), or as short- or long-term capital gains (if it involves investment returns), or as ordinary taxable income of the beneficiary.
- The second kind of claim that might affect trusts and inheritance in divorce is equitable distribution, generally by dividing the increase in value of a trust or inheritance. Many courts do not quantify the after-tax value of marital property unless the tax liability is imminent. Yet, when dividing a trust or inheritance in divorce, the tax characteristics may set them apart from other asset classes, like bank accounts or real estate. It might be prudent to quantify the tax liability and consider who might be responsible for paying the tax when it is divided.
Many people inherit real estate, or retirement accounts, that may have built-in tax liabilities. For inherited real estate, the beneficiary receives a stepped-up tax basis, which is the value of the property when the grantor died. When the property is sold, income tax may be assessed on any gain from the date of inheritance to the date of sale, if the beneficiary did not use the property as a residence for two of the last five years prior to sale. Inherited retirement accounts may be taxable when funds are withdrawn, and there may be a requirement to make withdrawals if the grantor was over 70-1/2 years old.
Handling inheritance and trusts in divorce properly ensures a more equitable outcome. Advance planning is the surest and most effective way to ensuring that trusts and inheritance are preserved, but even if it is too late for a prenup, there are some effective strategies available. Read more in my book, Frumkes & Vertz on Divorce Taxation.
For family law help in Western Pennsylvania, call Brian Vertz. He has represented all kinds of people with complicated child support and divorce issues. His law firm is a powerful team of lawyers dedicated to family law. In Pittsburgh and Western Pennsylvania, call me at 412-471-9000.