Protecting the Kids From a Divorce Disaster
Jun 17, 2024![Couple to left fighting with parents to right looking concerned](https://kajabi-storefronts-production.kajabi-cdn.com/kajabi-storefronts-production/file-uploads/blogs/2147498322/images/ad016d5-61fd-1e02-1afe-4cf75df47d7_Protect_the_Kids_From_Divorce_1_.jpg)
This one's going to be in two parts and it's about protecting the kids from a potential divorce disaster. The first part is putting together your own estate plan and what you can do to protect an inheritance that's going down to the kids so that it doesn't end up being claimed in a divorce. And as an aside, these techniques will also work to protect the inheritance against other bad things like lawsuits, bankruptcy, and creditors against the children. Part two is going to be how you can guide your adult children, and what they can do to protect themselves from a divorce, and there are some really good potential solutions on that end, too.
Starting out with part one and the plan for your assets, we're talking about an estate plan that includes a revocable living trust and the ancillary documents that go along with it. Revocable living trusts are a great way of doing estate planning where you're keeping control of your assets during life, but it's set up so that if you end up becoming incapacitated or pass on, none of the assets in the trust have to go through the probate court process. I suppose you could try to do this with a Last Will and Testament, but it will end up going through the probate court process with all of its downsides.
The simple truth is if you're going to take these types of steps to help your kids to avoid losing the inheritance you are leaving them to a bad divorce, you might as well make sure that you're getting them as much as possible while avoiding the big four downsides of probate. What are those downsides? For this, we’ll simply take out a portion from my book Estate Planning Basics:
- “Probate generally eats up between four and ten percent (4-10%) of the gross estate before any debts are subtracted. It is also fairly typical for a law firm to charge a flat 5% to handle everything as the executor. While this does put a ceiling on the amounts a law firm will end up charging, it is a pretty high ceiling. Five percent of even a $500,000 estate would be $25,000 in fees. Most good revocable living trust packages run less than $9,500 with more of them in the $5,000-$7,000 range. There are also cheaper packages but beware of what you are getting.
- There are also typically delays of between 6 months and a year and a half, and often longer if the estate is governed by a Last Will and Testament that is contested. Most times, the family members are waiting on receiving most probate assets for the duration of the process.
- Probate leaves plans more open to being contested. Since probate is such an elaborate bureaucracy with certain tasks that have to be completed in a set order, all it takes for someone to throw a wrench in the works is for them to file an action stating that they think something is wrong. And now the process can come to a grinding halt until their problem is taken care of. More often than we would like to think, people are paid off to go away.
- Privacy is out the door when it comes to a probate estate. Because probate is a court process, the filings are typically open to the public. It is not uncommon for probate to require a listing of all of the deceased person’s accounts, date of death values of all assets, and a listing of the names, addresses and ages of the beneficiaries. And anyone can copy down this information.”
It’s also that last one that can be a big detriment when it comes to relationships and your children. While the marketing people will go through and get their information in order to fill out their marketing lists and start marketing to the beneficiaries that they know are going to be receiving some kind of inheritance, your child’s information is also in the probate file and could be targeted by some “Romeo or Juliet” who's really just trying to get to them for their money. If they see there's a whole bunch of money going to them, that's just going to make them a potential target. With a revocable living trust holding the bulk of your assets outside of probate, already they are not seen publicly receiving a large inheritance.
The second big point is after death that the revocable living trust is the conduit to get the estate to the kids the right way, but you're keeping control during life. So when you're setting up a revocable living trust, you're the Trustor, Trustee, and first level Beneficiary. If anything happens and you becoming incapacitated, the successor trustees steps in to manage things for you, and you're not giving up control and oversight of your assets to a court. It's all happening privately by the people that you choose.
When you do pass on, the inheritance is not going directly to the kids. The best way to protect your assets from getting claimed in a divorce against your child is that they don't have actual control over them, and instead we're setting up Asset Management Trusts for the kids. These protective trusts are going to keep the inheritance from being potentially claimed in a divorce because your child doesn’t own any of the inheritance.
This is usually when I hear attorneys who live more in the legal world than the legal world stand up like they are in court and scream “Objection! Inheritances are not marital assets to be divided!” While legally true, this doesn’t track with reality. What typically happens is your child gets the inheritance, and then their spouse persuades them to buy the “dream house” and have the deed titled in both of their names, or simply transfer the money into their existing jointly held stock accounts. All of those assets are “co-mingled,” and end up being lost. If you want to be realistic about protecting the legacy you are leaving your child, then we need a solid plan and not one based on legal theories that don’t track with the real world.
So how does the Asset Management Trust work to protect the inheritance for your child? When the inheritance goes from the revocable living trust into the Asset Management Trust, that trust is now irrevocable and it can't be changed. Your child is the beneficiary, but they are not the trustee. Someone else is the trustee. And while the Trustee has the obligation to take care of the beneficiary, they are not obligated to actually give them money on demand. In other words, any distributions are “discretionary” in the control of the Trustee. The trustee can give them money or not. One thing the Trustee should never do is distribute a large sum to the beneficiary to buy a house. If the Asset Management Trust has enough money to actually buy the house, the trust should buys and own the house, and the Trustee can allow your child to live in the house. And if they are married, then the spouse can also live in the house as long as the Trustee lets them. What if the marriage breaks up? The spouse is probably going to want half the house, but unlike with a house purchased with the inheritance but deeded into the child and their spouse’s name, the house is not on the table for divorce. In fact, the Trustee can then begin the eviction process on the spouse consistent with state and local laws. If the house is purchased inside the confines of that Asset Management Trust, then the spouse can’t get half the house. It was never in your child's actual name, and certainly not in the spouse’s name.
So what does the trustee do with the other invested assets? The trustee can give them money to assist with bills, extra money for vacations, and even pay for the grandkids’ education. But any time there is a big purchase, that should happen with the Asset Management Trust buying the asset and titling it in the name of the trust. It's all in the discretion of the trustee. So you have to be clear with the trustees that you're picking how you want things done. In addition, because of longevity issues, you probably also want a trust a company at the bottom of the trustee list just in case things get really nasty. This way the trust company can really lock things down, it's not some friend or family member being put in the middle of some big huge uproar, and the company is going to protect your child because the company is a legal fiduciary.
As a bonus, this also gives your child the excuse to deny taking money out their spouse may want to spend frivolously. “Sorry, honey, but the Trustee said no.”
So where does the money in the trust go after your child passes on? This is where we can direct the funds to specifically go to your child’s children and not their spouse. The funds can remain in the trust until the grandchildren reach a suitable age, and then gets distributed outright to them. If there are no grandchildren, then it would pay into the other children’s Asset Management Trusts with the same protections and inheritance provisions.
One item to make sure you are reviewing with your attorney or estate planner is that this setup does require a discussion around Generation Skipping Taxes. You don’t know what the Generation Skipping Tax is? Don’t worry about. Most attorneys don’t know either, but make sure that your attorney does.
Another component in your estate plan to protect your children from a divorce disaster depends on inheriting tax-deferred (and tax-free) accounts that 1) can minimize income taxes and 2) protect the inheritance from divorce, creditors, lawsuits, and bankruptcy. Now we are discussing IRA Trusts. These specialized trusts have all of the “magic language” that the federal government says needs to be inside a Trust for it to be treated as a “person” for inherited income tax purposes. Unfortunately, a bit of tax background is needed for this:
When someone receives an inheritance as the beneficiary of a retirement account that beneficiary has a few options:
- They can take the money out, pay all the taxes, and it’s done. However, that can be a huge amount of taxes because it's a hundred percent income taxable, and it all goes on the beneficiary’s 1040 tax return in one year
- The beneficiary can also set up an inherited IRA, move the money into the inherited IRA, and now they have ten years to take that money out in their discretion as long as it is all withdrawn (and taxed) by the end of the tenth year. However, this is not in any way protected.
- Can't we just have it go to that revocable living trust so it filters down to the asset management trust? Yes, but now it is a five-year even distribution and taxation schedule. There is no discretion to take more out in one year and less than the next and it's half the time. So it's a much shorter period of time which means it's more likely to push you up into these those other tax brackets
- The final option is using IRA Trusts. Now the inheritance coming from the retirement account gets the 10-year optional distribution schedule, and the Trustee can protect the inheritance the same way as the Asset Management Trust.
As part of the inheritance planning to protect the kids from a divorce disaster, we also set up an IRA trust for each child. So now the IRA trust gets treated as an individual for taxation purposes, but the trustee is the person who is in charge. The retirement account funds go into the IRA trust and into an inherited IRA that the trustee sets up. The trustee pulls the money out of that inherited IRA account over ten years, it gets taxed as it comes out, and the funds not used to pay taxes are reinvested inside the IRA Trust. Once the ten years is up and the IRA Trust has done what it needed to do, then the remaining funds get transferred over to the corresponding child’s Asset Management Trust.
Over those ten years, the IRA trusts provide the same exact type of protection against divorce, lawsuits, creditors and all of the other bad things the asset management trust protects against. And that's the way you're going to end up protecting your kids from these potential divorces without sacrificing a better inherited income tax situation.
This setup can solve some really big concerns if you see your child’s spouse, or a probable spouse coming into the picture, and you really just don't have a good feeling about it. At the very least you can protect what you're leaving down to them through this type of estate planning setup. But what about the assets and resources your child is building on their own?
Now we're talking about a whole other strategy from a different perspective, but there are still a lot of protective steps that can shield your child from the effects of a bad divorce if they are willing to be proactive. And we’re not just talking about a Premarital Agreement , although that is part of it. This is a whole legal and personal strategy.
The biggest element is something that's not really widely known, but it is becoming more and more popular, and that is a domestic asset protection trust. It's not available in all states, but that doesn’t mean your child can’t take advantage of a particular state’s rules if their trust meets the requirements to bring the trust under that state’s laws. The state I cite most often is Wyoming. Under Wyoming law, you can have a domestic asset protection trust with the following characteristics:
- The trust must be irrevocable:
- It must expressly state Wyoming law governs the validity, construction, and administration of the trust;
- The settlor (the trustor and grantor) must have personal liability insurance equal to lesser of $1,000,000 or the value of the trust assets; and
- Provide for discretionary distributions of trust income and/or principal to the settlor in the sole discretion of the Trustee.
[Paraphrased from my book The Divorce Firewall Strategy, soon to be rebranded as the Ultimate Premarital Agreement Strategy.]
As the settlor/grantor/trustor, your child cannot be the trustee. It has to be someone trusted who is not subordinate to them, like and employee, and the trustee must be able to use their own independent judgment. So if your child can’t be the trustee of their own trust, what can they actually do with this trust? They can be the Investment Advisor for the trust, which comes with a lot of power and authority. The Investment Advisor can:
- Determine the makeup of the assets inside the trust and manage those investments;
- Be the Manager of any limited liability companies or the President/CEO of any corporations owned by the trust;
If you really think about it, the only thing the Investment Advisor can’t do is distribute money to themselves (or other beneficiaries). Only the Trustee can do that. But under Wyoming law, this does mean that the assets inside the trust are protected against lawsuits, including divorce, against your child.
So now your child can put their own disposable income into the trust for investment over time while keeping it fully protected. And if your child is really going somewhere and they're building their own business, then it can be formed inside the Domestic Asset Protection Trust. Let’s use the usual John, Jane, and Jim Doe example.
John and Jane Doe are concerned about their son Jim Doe. While they are very pleased with Jim’s direction in life and how well he is succeeding, Jim is not necessarily as smart when it comes to romantic relationships. Therefore, John and Jane Doe help their son Jim set up a Domestic Asset Protection Trust with Cousin Jeremy Doe as Jim’s trustee. Jim Doe is the Investment Advisor, and they hired a company in Wyoming to be the Administrative Trustee to hold a few assets within the state and make sure tax returns for the trust are handled properly. As the Investment Advisor, Jim Doe does the following:
- Jim funds the trust with everything he has to invest, except several thousand dollars in his own bank account for his living expenses;
- Cousin Jeremy sets up a Wyoming Limited Liability Company with Jim Doe as the LLC’s Manager, and Jeremy puts sufficient assets into the LLC to get the business started;
- Jeremy hired Jim as the main employee of the LLC, and executes an employment contract with Jim on behalf of the LLC;
- Jim builds his business with the authority to run and contract on behalf of the business as the LLC’s Manager;
- Jim keeps putting all of his disposable income into the trust to be invested in a diversified portfolio;
- Once Jim has enough money in the Domestic Asset Protection Trust to buy a house, Jeremy buys the house as an asset of the trust and allows Jim to live there
Once Jim does meet a potential spouse or partner, the only assets Jim has available for even a potential divorce would be the several thousand dollars in his own name for living expenses. Everything else is in the trust. However, Jim can enjoy living in the house owned by the trust, and Jim still gets to run his business through the LLC in the trust.
But this is only the first part of the strategy, and the rest is just as important.
If your child really wants to be protected against the potential for divorce, other than not getting married, there also needs to be a Premarital Agreement in addition, and in conjunction with, the Domestic Asset Protection Trust. But there are also several steps to take in the relationship first. A Premarital Agreement is not something to be discussed after the marriage proposal has been made and the venue booked. It needs to be well known by both parties that a Premarital Agreement is going to be required very early in the relationship. Here is the best way for your child to approach the Premarital Agreement :
- When a romantic relationship is going beyond the casual dating phase when they may be “talking to” several people and it is going to become exclusive, at this point your child should make it clear that they are only getting into an exclusive relationship if it could potentially lead to marriage, but that any marriage would need a Premarital Agreement. If they are not comfortable with a Premarital Agreement in a marriage, then they can part ways now before it gets to serious. And you child needs to actually walk away if this happens.
- Before moving in together, there should be a Co-Habitation Agreement signed and in place, and with each of them having their own attorneys. (Yes, this is actually a critical piece so no one gets to say they “didn’t know what they were signing.”) It will also state that each of them gets to do whatever they want with their excess money. This agreement is very similar to a Premarital Agreement because it outlines the financial responsibilities towards the common household, including how much each person is contributing to the joint operating account, who is handling specific chores, and that non-emergency expenses for the household over a certain dollar amount need to be discussed first. It should also be explicitly It is at this time that it should be revealed in the cohabitation agreement that your child has a Domestic Asset Protection Trust, that the trust and its contents are not the other person’s business, and they are allowed to put their excess income into the trust. All of this sets the stage for the Premarital Agreement if the relationship proceeds to the marriage phase.
- Once marriage is being considered, the discussion of the Premarital Agreement should happen even before the proposal. Your child and their spouse-to-be can come up with whatever grand proposal they want after the Premarital Agreement is discussed and signed. The Premarital Agreement would contain all of the same primary terms as the Co-Habitation Agreement, but it would additionally discuss items such as raising children in more detail, what kind of alimony there would be (if any) in a divorce, and what kind of work schedule there would be if children did come into the picture. Once again, the Domestic Asset Protection Trust should be listed as a separate asset that will at all times remain off the table in the event of a divorce.
- Even after marriage, the Premarital Agreement should be updated as circumstances change, and certainly no less than every three to five years. For example, even if a Premarital Agreement was updated 16 months prior, if a child was born and the couple decides one of them will stay home or only work part time, then that needs to be updated in the Premarital Agreement. No, this can’t just wait. No, this isn’t something that needs to be just dropped. No, we can’t just let this go. These updates need to be done. (Check out my previous blog Why Prenups Blow Up: Seven Ways Premarital Agreements Fail.)
This strategy does require discipline, but it’s the same level of discipline that people need when funding their revocable living trust and changing their assets over time. However, it is more “difficult” because people don’t think of romantic relationships as needing discipline, but they do. I could go into a whole series of things people say when trying to denigrate Premarital Agreements and how to respond, but that is probably best left for some YouTube shorts and Reels. But for the practical and legal aspects of protecting your adult children from a bad divorce, this is a series of protective legal and practical items worth considering.
For more information on the inheritance aspect of this strategy, check out the course In-Law Planning at http://www.InLawPlanning.com, and for the protective planning by your adult child, check out The Divorce Firewall Strategy at http://www.DivorceFirewallBook.com.
Stay connected with news and updates!
Join our mailing list to receive the latest news and updates from our team.
Don't worry, your information will not be shared.
We hate SPAM. We will never sell your information, for any reason.