A trust is a legal agreement between one or more settlors creating the trust, one or more trustees who are responsible for managing the trust, and one or more trust beneficiaries. When a trust is created, the settlor transfers ownership of certain assets to the trustee, who manages that property for the immediate or future benefit of the beneficiaries. The identities of the persons filling one or more of these roles can be family members, married couples, or individuals.
Trusts are appealing entities because they allow settlors to be flexible while creating the terms of the trust. How trust assets will be treated in a divorce depends largely on whether the party going through divorce is a settlor or beneficiary of a trust, and whether the assets have already been distributed out of the trust to the beneficiary.
Separate Property and Community Property
When property is divided as part of a divorce in Arizona, the court first determines whether it is separate property or community property. Separate property includes:
- Assets owned or acquired prior to the marriage;
- Assets obtained through inheritance or gift during the marriage;
- Assets that are agreed in writing by the parties to the marriage to be separate property; and
- Property purchased by one spouse using his or her sole and separate property.
Community property consists of property, income, and other assets that are obtained throughout the marriage. For example, a house purchased during the marriage is presumptively community property. The employment income earned by either spouse during the marriage is also community property.
Classifying the property is extremely important because separate property is generally not divided between the spouses in divorce, while community property will be divided “equitably” by the courts.
Were the Trust Assets Separate Property or Community Property When Put in the Trust?
Between settlor spouses, the character of assets as community or separate property does not change upon being transferred into the trust. However, settlors sometimes agree to treat all trust assets as community property for purposes of obtaining a full step-up in tax basis for the asset upon death of the first spouse. Those trust assets that are characterized as community property will be divided equitably in a divorce proceeding between the settlor spouses.
How is a Spouse’s Interest as Beneficiary of a Third-Party Trust Treated in Divorce?
If either spouse is a beneficiary of a third party’s trust, i.e. one created by his or her parents as settlors, the spouse’s interest is his or her sole and separate property, and it will be awarded exclusively to him or her in a divorce. However, the value of the trust interest or the amount of trust distributions may still be considered by the court when determining the amount of child support or spousal maintenance to be paid between the spouses. For example, if the spouse has received regular and continuing distributions from a family trust in the past, the judge may elect to characterize these distributions as income to the beneficiary spouse, and consider it when determining the amount of child support or spousal maintenance to be paid between the spouses.
How to Protect Trust Funds
If a settlor anticipates that a beneficiary will likely be going through a divorce, he or she may maintain said beneficiary’s share, in trust, for his or her benefit. Depending on the circumstances, it may be appropriate to name a third-party trustee to manage the beneficiary’s share. As long as the funds remain in the trust, they will not be subject to division in the beneficiary’s divorce. However, once the funds are distributed to the beneficiary, and, as is often the case, commingled with the community property of the beneficiary and his or her spouse, they will be treated as community property and subject to equitable division in the beneficiary’s divorce. For those beneficiaries receiving outright distributions from a parent’s trust or estate, it is recommended to segregate the inheritance in a separate bank account where it will maintain its sole and separate character.
Contact Our Offices Today
Divorce is difficult enough, and with the existence of a complicated agreement such as a trust, it may be even more complicated. If you are experiencing a divorce and need an experienced attorney on your side to fight for what is yours, contact one of our experienced divorce attorneys.
If you are concerned about a beneficiary’s interest being divided in divorce, please contact one of our experienced estate planning attorneys to discuss how a trust can protect the beneficiary’s interest.