When Trusts Can't Be Trusted – Tracing Assets in Matrimonial Litigation
Trusts may be used to provide a means to transfer wealth or the benefits of wealth, without actually conveying title to a particular beneficiary. In a divorce action, the existence of trusts during the marriage creates an array of issues for equitable distribution purposes.
Put simply, spouses often attempt to use trusts to hide assets. Where one spouse is unaware that a trust has been created, a forensic accountant may uncover these hidden marital assets.
To begin with, let us take a look at a true-life tale of how this deceit can arise, and how it can impact the outcome of divorce proceedings.
The Story of Clarissa
Clarissa was a wealthy financial advisor and the youngest of three children. When her father died, Clarissa stepped up to help Mom, who was an amateur with money. After evaluating her mother’s financial situation, Clarissa was concerned that Mom couldn’t make it on her fixed income. Mom understood some of the problem and decided to sell the house and move into an apartment. Clarissa wanted to make sure her mother would never have to worry about having a roof over her head, and she decided to buy the condominium for her mother. At the same time, Clarissa was concerned that if she gave her mother the condo as a gift, it might result in awkwardness between them. Besides, should something happen to Mom, the condo would be part of her estate, and Clarissa’s siblings would get a piece of it, which Clarissa wanted to avoid.
Clarissa hit upon a solution: she transferred $350,000 into a trust for her mother and used the money in the trust to buy the condo. The trust owned the property, and Mom paid rent to the trust each month. Thus, in the event her mother’s health declined and she needed to move to a nursing home, or should she pass away, the condo was not Mom’s asset nor was it part of her estate. No one else in the family was told of this arrangement.
Everything was not so perfect with Clarissa’s marriage, however. Clarissa and her husband were having marital difficulties, and soon after her father’s death, Clarissa filed for divorce. In the divorce proceedings, the parties propounded standard interrogatories, which included questions about whether either spouse was the creator or beneficiary of any trust. Clarissa realized that she was the only one who knew that Mom’s condo was actually owned by the trust she funded. In a rare moment of dishonesty, Clarissa answered, “No.”
With just one word, $350,000 disappeared from the marital estate, and absent the expertise of a forensic accountant, her husband would never know the difference.
Trusts: Simple and Complex
The story of Clarissa demonstrates how easily an undisclosed trust can be used by one spouse attempting to hide assets from another. Before exploring the means of uncovering such hidden assets, it is important to understand what types of trusts exist, how they operate and how each kind of trust presents its own unique obstacle when it comes to uncovering hidden assets.
Trusts are considered separate taxable entities. While the specific terms, and therefore the legal implications of a trust can vary widely, for purposes of identifying assets in equitable distribution there are two broad categories of trusts: simple and complex.
Simple trusts must, in accordance with the terms of the governing documents, distribute all income to the beneficiaries. The earnings are allocated among the beneficiaries in accordance with the terms of the trust. Each beneficiary’s allocable share of the income is reported to the Internal Revenue Service (IRS) and to the beneficiary for inclusion in his/her individual tax return on a form K-1.
For example, as part of a comprehensive estate plan, P decides to establish a trust for the benefit of three children A, B and C, with $1 million in long-term corporate bonds paying 7% interest. The bonds mature in 15 years at which point, the trust terminates and the trust assets will be divided among the beneficiaries. The ABC Trust has $1,000 in annual operating expenses (tax return preparation fees and bank charges). If the ABC Trust is a simple trust, the trust’s net income ($69,000) is distributed to the beneficiaries who each report $23,000 of income on their individual tax returns.
Complex trusts, on the other hand, can either retain earnings or distribute them as directed in the trust instrument or at the discretion of the trustee, depending on the language of the trust instrument. The trust itself pays the taxes on undistributed earnings. Distributions of trust income to a beneficiary result in a deduction at the entity level and the issuance of a K-1 so that the earnings are taxed. If the ABC Trust is a complex trust, the distributions are not necessarily related to the income. For example, P could have directed in the trustee to distribute $10,000 to each beneficiary annually and retain and invest the balance. In that case, the trust would get a deduction of $30,000 for distributions resulting in taxable income for the trust of $39,000 and taxable income to each beneficiary of $10,000.
As we saw with condo Clarissa purchased for her mother, the creation of a trust for the benefit of a child or an infirmed parent can be a vehicle for temporarily removing assets from the marital estate while effectively retaining control over those assets. But these trusts can also constitute an obstacle in the search for the truth when it comes to equitable distribution in divorce proceedings. This is why the assistance of a forensic accountant is essential to ensuring full and fair disclosure in matrimonial litigation.
Tracing Assets in Divorce Proceedings
Generally, trusts created by a married grantor consist, to varying degrees, of marital assets. However, even if the assets used to fund the trust are non-marital, the existence of the trust is relevant to equitable distribution, as courts consider the available non-marital assets in deciding how to apportion marital assets. To the extent a party has appeared to reduce his or her available assets by transferring non-marital assets into a trust, it can lead the court to award a disproportionate share of the marital estate to that party.
Typically, matrimonial interrogatories and document requests seek information concerning any trusts to which the opposing party is a grantor or a beneficiary. Assuming the opposing party makes full disclosure in response to the discovery requests, the issue becomes one of valuation, rather than discovery. To the extent discovery may be incomplete or unreliable, there are ways to locate assets held in trusts.
The technique for identifying the creation of undisclosed trusts, as well as undisclosed gifts, is asset tracing. To do this, we go back in time, preferably to a point where the parties were getting along, and identify all of the marital assets and, assuming they are significant, all non-marital assets. We then obtain all tax returns and all bank, brokerage and retirement fund statements. As an initial review, we reconcile the income sources shown on the tax returns to the account statements produced to assure that we have documentation for all sources of income (and presumably all of the significant assets).
The substance of asset tracing involves accounting for the movement of funds in and out of accounts. While it can be a tedious and, depending on the extent of the wealth involved, time consuming process, the focus is on asset transfers rather than on individual transactions.
For example, DT sold a business three years before splitting up with S. DT divided $4 million of the proceeds between several investment advisors in different brokerage firms and kept $1 million in an unmanaged account in which DT day trades stocks based on tips gleaned from various web sites. Among eight different brokerage accounts, there were easily two thousand transactions per year. The individual stock and bond trades, however, were irrelevant to the asset tracing process. We only needed to account for deposits and withdrawals to the brokerage accounts themselves, data that is separately reported on the brokerage statements. The month-to-month gains and losses from trading and market fluctuations do not affect this analysis.
Somewhat more problematic is the trust in which the opposing party is a beneficiary. When the trust is a simple trust, it is usually easy to identify because the trust income is distributed to the beneficiary who reports it on his or her tax return. Complex trusts, on the other hand, are more difficult to identify. To the extent the trust has ever made a distribution to the beneficiary, it would have appeared as an income source on the beneficiary’s tax return. If, on the other hand, the trust is accumulating assets without making distributions to the beneficiary, it will be difficult to locate. In situations where a spouse has parents with substantial wealth, it can be helpful to seek copies of the parents’ federal gift tax returns (IRS Form 709) and, if applicable, federal and state estate/inheritance tax returns. These tax returns will show the name of the recipient and the date, description and value of the transfer. As a practical matter, it is often difficult to obtain these documents absent some compelling indication that there are undisclosed asset transfers.
Trusts present a unique opportunity to manipulate equitable distribution either by removing assets from the marital estate through deception or by understating the non-marital assets available to one spouse. Relying on financial statements produced in discovery is insufficient to ensure an equitable division of a couple’s estate – a forensic examination of these documents should be performed in order to determine what information has not been reported by the other spouse. Thorough investigation and analysis can limit the inappropriate use of trusts and make the financial data … well … trustworthy.