Dodging Estate Taxes may Backfire in your Children’s Divorces

Families rushing to give away assets before the $5.12 million gift- tax exemption reverts to $1 million at year end need to carefully consider the impact on their children in their divorces. Be careful; Dodging Estate Taxes may  Backfire in your Children’s Divorces.

In Colorado any gifts and inheritances are excluded from equitable division in divorce cases provided these assets are kept separate. However, any appreciation on the gifts or inheritances are equitably divided upon divorce.

In order to save estate taxes, efforts are generally made to reduce the value of the gifts made for gift tax purposes. Gift tax returns are often created using substantially discounted values. When the children get divorced, these values are often looked at for the purposes of establishing the initial value of the gift and calculating the appreciation to be shared with the divorcing spouse. The result can lead to unintended consequences. Instead of paying the Internal Revenue Service, parents often find that their children are paying substantial amounts in their divorces, due to the appreciation in the gifts made. You cannot have it both ways and what you save in estate taxes can often be made up in divorce settlements.

The other problem that parents may experience when gifting a fractional interest in a family limited partnerships to children, is that all the assets needs to be valued at the time of the divorce. By gifting away assets to children, parents are inviting a complete valuation and investigation of the family limited partnership assets. I have seen many examples of children receiving 1or 2% of a partnership that owns numerous interests in commercial or apartment buildings. The cost of valuing those interests in a divorce and then discounting for minority and marketability discounts can be enormous.

Popular vehicles for estate planning include the following

Grantor Retained Annuity Trusts (GRATS) and Qualified Personal Residence Trusts (QPERTS)

A GRAT is an estate planning tool intended to minimize estate and gift taxes when assets are transferred from one generation to another. An irrevocable trust is formed for a specific period of time. If applicable, the grantor pays a gift tax when the trust is established. Assets are transferred into the trust and then an annuity is paid out every year to the grantor. When the trust expires, the beneficiary receives the assets tax free.

Qualified personal residence trusts (QPERTS) have similar tax savings. If you transfer your home through a so-called QPERT (qualified personal residence trust), you reserve the right to maintain use of the property for a specified number of years. The property is then valued at a discount because heirs don’t get immediate use. However if the Grantor dies during the period in which the Grantor has reserved the right to use the property, the QPERT is dissolved and the residence is then taxable as part of the Grantor’s estate.

There is no clear case law as to what date is used to determine when a beneficiary spouse’s interest in a GRAT or QPERT becomes property and therefore subject to equitable division in a divorce. Some courts have held that the interest in these types of trusts becomes property at the time of the transfer into the trust, while others have held that an interest becomes property when the trust is terminated. The date the beneficiary spouse’s interest in a GRAT becomes property is vital in figuring out to what extent it is marital property subject to equitable distribution and to what extent it is separate property. The difference in opinion on this matter creates a huge discrepancy for outcomes of beneficiary spouse’s interest in GRATS and QPERTS in dissolution proceedings.

The GRAT or QPERT it is often valued for gift tax purposes at a very low value based on IRS guidelines, resulting in a lot of appreciation at the termination of the trust that may be valued and allocated to a divorcing spouse. This appreciation may be somewhat artificial because it is calculated using very low initial values. It therefore becomes in the interest of the non-beneficiary spouse to argue that the GRAT or QPERT becomes property at the date of creation, at the artificially reduced IRS value, and that all of the associated appreciation is marital in nature. The beneficiary spouse obviously wants to argue the opposite position.

When is an Interest in a Trust Considered Marital Property?

Would it make a difference if you set up a trust with your children as beneficiaries? It depends if it is revocable or not. Your revocable trusts are not property interests in your children’s divorces. If the trust is irrevocable then you need to look at whether the beneficiary has a mandatory/vested/remainder interest in the trust, or whether his or her right to receive benefits is purely discretionary or tied to somebody else’s property. Discretionary trusts where the beneficiary has a mere expectancy are generally not considered property in a divorce, but may be an economic circumstance. The Colorado Supreme Court has found that when a trustee has uncontrolled discretion to distribute income, that does not give the beneficiary an enforceable contractual right to receive distributions and therefore does not give the beneficiary spouse a property interest. In re Marriage of Jones, 812 P.2d 1152 (Colo. 1991).

Every trust document must be read carefully and analyzed for the key components in determining whether or not a trust is property in any divorce.

Regular Gifts From A Reliable Source May Be Considered Income For Child Support And Maintenance Purposes

If gifts are regularly received from a dependable source, they may properly be used to determine the amount of a child support obligation. Parents should be aware that regular gifts can be counted as income for child support purposes in a divorce action.

Get Good Legal Advice Before You Give Away The Family Fortune

Be sure to ask your estate planning attorney how your proposed gift might impact your children’s divorces. If in doubt, ask a divorce attorney.

by Suzanne Griffiths