September 2014 - Premarital Agreements and Estate Planning: Twin Strategies for Protecting Children and Businesses From the Risks of Divorce

by Kathleen O. Peterson and Paula Clarkson

Premarital Agreements and Estate Planning: Twin Strategies for Protecting Children and Businesses From the Risks of Divorce

Multi-generational businesses and closely held corporations are the lifeblood of the Orange County economy. Those who have ownership interests in these entities, particularly founders, become concerned about what will happen if their partners or co-owners end up in marriages that end in divorce. The most obvious tool to give some measure of protection is a pre-nuptial agreement. However, when the co-owner is a family member, particularly a child or grandchild, professionals advising these families should consider the alternative or additional use of trust planning to accomplish some of the same goals.

What Is a Pre-Marital Agreement?

Pre-marital agreements are commonly entered into between prospective spouses to confirm the separate property nature of a business or other asset before a couple marries, and to define who will own what as the marriage goes on or ends. Cal. Fam. Code § 1610(a) (West 2014). The agreements can also seek to define or set spousal support limits in the event of a break-up of the marriage. In theory, this creates certainty and predictability for both parties, hopefully leading to a more streamlined, less contentious divorce should the marriage fail. However, the enforceability of pre-marital agreements is often the most hotly contested issues in divorce cases.

Why Are Pre-Marital Agreements Set Aside?

There are three primary reasons why pre-marital agreements are not enforced. First, the technical rules for drafting and entering into a pre-marital agreement must be carefully followed. In California, the rules for the formation and enforcement of such agreements have changed through the years. Since 1986, California follows the Uniform Premarital Agreement Act (Cal. Fam. Code § 1600 et seq.). To be enforceable, a pre-marital agreement must be in writing, although there does not need to be consideration as is usually required in contract formation. Cal. Fam. Code § 1611. The agreement must also: (1) be entered voluntarily, and (2) not be unconscionable when entered. Cal. Fam. Code § 1615. The statute is drafted in a peculiar way, and rather than stating what must be present in order for the agreement to be valid, it states the situations in which an agreement would not be enforced. “Voluntary” is defined as:

  1. The party against whom enforcement is sought was represented by independent legal counsel, or waived such counsel in a separate writing;
  2. The party against whom enforcement is sought had not less than seven days between the time the agreement was first presented and he or she was advised to seek independent counsel and the time the agreement is signed;
  3. If unrepresented by counsel, the party was fully informed of the “terms and basic effect of the agreement” as well as the “rights and obligations” he or she is giving up and was proficient in the language in which the explanation of the parties’ rights was conducted and the agreement written. Cal. Fam. Code § 1615(c). “Unconscionable” is defined as:
  1. That party was not provided a fair, reasonable, and full disclosure of the property or financial obligations of the other party.
  2. That party did not voluntarily and expressly waive, in writing, any right to disclosure of the property or financial obligations of the other party beyond the disclosure provided.
  3. That party did not have, or reasonably could not have had, an adequate knowledge of the property or financial obligations of the other party. Cal. Fam. Code § 1615(a)(2).

From these code provisions it is easy to see that such agreements are fraught with after-the-fact challenges and many of the grounds for challenge rest with the disclosure and other interactions that take place between the parties to the agreement, as opposed to the drafting that is done by lawyers. Also, parties seeking to obtain pre-marital agreements often do not leave enough time before a wedding for the agreement to be properly prepared and for the requisite disclosures to be made. In the flurry of wedding preparations, the pre-marital agreement can keep sliding down the “to do” list and is often turned to after invitations have already been sent, which is problematic.

The second reason why these agreements are set aside is that the parties to such agreements sometimes can be over-reaching in seeking to set future spousal support amounts that are unreasonable or even unconscionable at the time they are to be enforced. The courts may enforce a waiver of post-dissolution spousal support if executed by knowledgeable, informed people who had the benefit of independent counsel. In re Marriage of Pendleton & Fireman, 24 Cal. 4th 39, 53-54 (2000); Marriage of Melissa, 212 Cal. App. 4th 598, 610 (2012). However, even a properly negotiated and executed pre-marital agreement that contains a post-dissolution waiver of spousal support may not be enforced if the agreement is found to be “unconscionable” at the time of enforcement. Cal. Fam. Code Section 1612(c). (Note that before 1986 waivers of post-dissolution support were void as against public policy.)

Third, even the best-drafted and most carefully negotiated agreement can be undone if the parties co-mingle separate property and community property or otherwise do not follow the spirit of the agreement.

An alternative or additional method to avoid the unpredictability of pre-marital agreements is the use of irrevocable trusts for the transfer of business assets both during life and at death.

What Is a Trust?
A trust is a legal agreement created by one party (the Trustor) wherein another party (the Trustee) holds property for the benefit of a third party (the Beneficiary). For example, a father creates a trust for the benefit of his daughter and the trust is managed by the daughter’s aunt. Trusts may be revocable or irrevocable. To provide protection in the event of divorce one may use either a revocable or irrevocable trust.

Revocable Trusts
A revocable trust is usually created by a person (Trustor) for his or her own benefit (Beneficiary). The benefits of a revocable trust include clear transition of property management if the Trustor becomes incapacitated and allows the Trustor to specify how the assets are to be distributed upon his or her death. Because the revocable trust assets are owned by the trust creator (the Trustor) and the Trustor can revoke the trust, the trust assets are subject to all of the claims of the Trustor (Probate Code § 18200) including potential division during the dissolution of a marriage.

One of the benefits of creating a revocable trust either during or after marriage is so that the spouse’s premarital assets or assets inherited during the marriage are kept separate from the marital assets. Separate property trusts can be created to hold property that is defined as separate under a pre-marital agreement, assets that are separate property by operation of law (gifts and/or inheritances), or hold the person’s community property assets. Creating a revocable trust is often a good solution because there is clear tracing of where the assets came from and what they were used to purchase during the marriage. Problems can unwittingly occur though if a business is held in the separate property trust and one of the spouses works in the business during the marriage. Upon dissolution of the marriage, a portion of the business growth could end up being attributable to the marital efforts and may become a marital asset without a properly drafted and enforced pre-marital agreement even if the asset is held in a separate property revocable trust. Therefore, it is always good practice to consult with both a family law and estate-planning attorney prior to making any decisions and defining assets as separate and/or community property.

Use of Irrevocable Trusts to Transfer Assets
Business owners often transfer their business interests to their children during life or at death. Although gifts and inheritances are deemed the separate property of the recipient, inadvertent commingling of those separate property assets could result in the assets being recharacterized as community property in the event of a divorce. If assets are transferred outright to a child, often the child comingles those assets with the marital assets resulting in a portion of the business being lost to the family upon the child’s divorce.

The use of a trust to transfer family business assets can identify a clear beneficiary of the business asset and can also provide significant asset protection for the child upon divorce if the business assets are transferred to an irrevocable trust for the benefit of the child at the business owner’s death. The irrevocable trust becomes the owner of the asset, not the child, and thus not subject to marital property division when the child divorces. Also, because the ex-spouse is not a beneficiary of the trust, he or she is not entitled to information about the trust or its assets. This prevents your child’s ex-spouse from owning an interest in your family business.

In order for the irrevocable trust to provide the asset protection and hold legal title separate from the child, restrictions are usually put on the distribution of income and/or principal from the trust to the child. In some instances, a third party is named as Trustee and that Trustee has complete discretion over distribution of income and principal from the trust. In other instances, the child is Trustee but has limitation on distribution of income or principal for the child’s health, education, maintenance, and support needs.

Unlike a pre-marital agreement that specifies ownership between the husband and wife and division of assets upon the dissolution of the marriage, the irrevocable trust specifies the ownership of the asset in the trust, not the child, and specifies the beneficiary of the trust (your child not your in-law). Therefore, if the child divorces, the trust still continues for the benefit of the child and is not part of the marital asset division, thus keeping the business in the family line.

When Can an Irrevocable Trust Be Invaded Upon Divorce?
If the irrevocable trust provides that the child has a right to compel the trustee to pay income, principal, or both from the trust for the benefit of the child, the family court may order the trustee of the irrevocable trust to pay an equitable and reasonable amount of that distribution to satisfy the child’s spousal or child support obligations. Cal. Prob. Code §§ 15305(a), (b). Furthermore, even if the child does not have the right under the trust to compel the trustee to pay income or principal, if the court determines it is equitable and reasonable under the circumstances, the court may order the payment of child and spousal support out of the distributions the trustee makes to the child. Cal. Prob. Code §§ 15305(a), (c). Although potentially requiring some of the assets to be available for spousal and child support obligations, an irrevocable trust is the best solution to protect the family business assets from being distributed to the ex-spouse of a child at divorce.

However, the recent court of appeal decision in In re Marriage of Williamson, 226 Cal. App. 4th 1303 (2014), demonstrates how carefully the courts look at situations in which parents of divorcing parties make cash or trust transfers to their children, only to have those transfers substantially decrease or disappear once divorce proceedings are initiated. That case involved the amount of spousal and child support, concluding that “advancements on inheritance” cannot be considered income that is subject to support. Id. at 1313-15.

The court of appeal noted the trial court’s conclusion that the party’s parents could not be forced to continue to make cash gifts and that “generous relatives do not have a duty to support a family member’s minor children.” Id. at 1315.

While there are shortcomings and advantages to both pre-marital agreements and trusts, practitioners should consider both strategies in advising clients with multi-generational businesses and significant wealth to come up with the proper mix of protections to reach the objectives of the client. As in many legal situations, planning and early consideration can prevent surprise and unforeseen results years down the road.

Paula Clarkson is a certified specialist in Estate Planning, Trust & Probate Law and partner at the law firm of Merhab Robinson, Jackson & Clarkson in Orange County. She can be reached at paula@mrjclaw.com. Kathleen O. Peterson practices family law and business litigation in Irvine, California. She can be reached at kathleen@kopetersonlaw.com