The vital role prenups play in protecting family wealth

Few things alarm parents more than the thought of family wealth ending up in the hands of a child’s ex-spouse. For many of our clients, this is a top concern with respect to estate planning and preserving generational family wealth.

Families often take steps to protect their wealth against these unintended beneficiaries. A prudent plan may include setting up an irrevocable trust for the benefit of a child (and other descendants) but not their spouse, and encouraging adult children to execute prenuptial agreements (“prenups”) prior to marriage.

Many parents believe creating and funding a well-drafted and properly administered irrevocable trust will adequately protect family wealth. But this may no longer be enough. We’ve seen divorce courts increasingly consider inheritances and trust distributions when identifying, valuing and distributing marital property, and when entering orders for spousal or child support.

For this reason, we regularly suggest to our clients that they use prenuptial or even postnuptial agreements as part of the family’s overall plan to preserve wealth. Here, we’ll explain why.

The case for trusts

Historically, courts have not treated assets held in an irrevocable trust as marital property in a beneficiary’s divorce. Instead, the trusts’ assets have been treated as separate property, not subject to equitable distribution. This typically has held true even if one spouse was the sole beneficiary of that trust, provided that he or she was not the trustee and the trustee was not making regular distributions during the marriage.

This is due to the fact that when a trustee has complete control over whether to distribute funds, the beneficiary's access to the trust assets is often considered uncertain. In that case, the beneficiary has no ownership right and the trust would not be considered part of the marital estate.

The evolving landscape

Some recent court rulings reflect the reality that many trustees, even those who are “independent” (meaning they are not beneficiaries), have close relations to the beneficiary. (Often, trustees are parents or siblings.)

Perhaps even more importantly, trustees have routinely made distributions that in reality have supported the lifestyle of not only the beneficiary but, indirectly, his or her spouse and minor children’s family.  In some such cases, courts have concluded that it would be unfair for the nonbeneficiary spouse to lose the indirect benefits those distributions provided.

With these realities in mind, a court might consider not only the size of a trust in the context of a divorcing beneficiary’s overall wealth and the trustee’s relationship to the beneficiary, but also the pattern and purpose of distributions. Moreover, if a trustee has loaned money to beneficiaries, a divorce court may scrutinize those loans (i.e., loan vs. gift).

Given the way the legal landscape continues to evolve,¹ we advise clients to consider six key points when creating trusts for the benefit of other family members:

1. Whether an adult child should be a trust’s sole beneficiary.
2. Whether the child should have the power to direct future distributions.
3. Whether he or she should receive trust assets outright upon attaining a certain age.
4. Whether an adult child should be a co-trustee or sole trustee of a trust of which he or she is the sole beneficiary.
5. Whether trust distributions should be completely discretionary or whether the trust should require at least annual payments of income.
6. When distributions of principal to a beneficiary should be made (e.g., upon settlor’s death).

Because divorce courts may consider trust assets and inheritance when issuing financial orders, a non-trust beneficiary spouse may receive a relatively larger percentage of marital assets than he or she would have had the trust assets not been taken into account. The non-beneficiary spouse might also receive “extra” spousal support to reflect the couple’s lifestyle over the course of a long-term marriage that was supported in part by distributions to the beneficiary spouse.

For this reason, we strongly suggest supplementing the family’s estate plan with marital agreements for all beneficiaries.

There is another, practical reason trusts can be less effective than anticipated in divorces: It may become necessary for the trustee to make distributions so that the beneficiary can meet court-ordered spousal and parental support obligations. It’s unlikely a trustee would refuse to make such distributions because, as we’ve noted, the trustee is often a parent of the beneficiary and grandparent to the beneficiary’s children.

The path to protecting assets

Family courts have broad discretion, and litigation outcomes are by definition uncertain. That’s why we suggest that clients and their adult children discuss the need for a prenup between any trust beneficiary and a prospective spouse, as opposed to relying upon an irrevocable trust, alone, to protect family assets.

We have found that adult children tend to be more receptive to the prenup conversation before their relationship becomes serious and an engagement is on the horizon, because in that context it is obvious that parents are focused exclusively on the concept of preserving family wealth and not on one specific family outsider.

While prenups are not inviolable, a well-drafted and properly executed prenup is likely to hold up as long as both parties were represented by competent, independent counsel; there was sufficient time to negotiate the terms; and both spouses made full financial disclosures (including income from all sources, assets, liabilities and any beneficial interest in trusts). Many families dislike the idea of fully disclosing all their sources of wealth. However, full disclosure is the best way to ensure that the prenup, if ever contested, would be found to be valid and enforceable.

Even without a parent’s prodding, an adult child contemplating marriage should consider having a prenup. In addition to protecting family wealth, prenups serve as a roadmap in the event of divorce or death, which is likely an unpleasant and turbulent time.

When an adult child is already married, postnuptial agreements can fulfill the same role. In either case, a marital agreement that supplements a strong estate plan can make it easier to protect family wealth in the event of a divorce.

We can help

For more information about prenuptial and postnuptial agreements, including how to discuss marital planning with members of your family, contact your J.P. Morgan team.