Many of our estate planning clients prioritize ensuring that their child’s inheritance is not exposed to a child’s divorce.
Many of our family law clients are concerned about whether an inheritance (past or future) will have an impact on their rights in their divorce case.
Inherited wealth is the intersection of estate planning and family law.
Can Inherited Wealth Classify as Marital Property?
Under the normal operation of law in Maryland and Washington, D.C., property acquired by inheritance or gift from a third party, even if acquired during the marriage, does not qualify as “marital property”.
However, assets received by inheritance or gift that are titled jointly, or commingled with marital property, can quickly and easily lose their protected status as “non-marital property”.
For example, if Spouse 1 inherits an account from a relative, and deposits all or some of the funds from that account into an account held jointly with Spouse 2, there is a high risk the character of those funds has changed from “non-marital” to “marital” by virtue of Spouse 1’s choice to title them jointly.
However, title does not necessarily control. Imagine Spouse 1 deposits those same inherited funds into an account held in his/her sole name, but in which other funds are on deposit, such as income earned from employment during the marriage. These inherited funds have now been commingled with marital funds, and there is also a high risk that the character of those funds has changed from “non-marital” to “marital”, particularly if there are frequent deposits and withdrawals from that account, (after which it becomes impossible to isolate what portion of the account is comprised of marital funds vs. non-marital funds).
Finally, imagine Spouse 1 chooses to invest inherited funds into jointly-titled real estate as a contribution towards payment of debt or improvements. Even if it is possible to isolate the amount of Spouse 1’s contribution, Spouse 1 may not have a good chance of recovering those assets in the event of divorce.
How Can I Protect My Child’s Inheritance from Becoming Marital Property?
You may love your child’s spouse and never imagine an instance wherein your child’s inheritance will be used for any purpose other than the benefit of their family, but our job is to plan for the unexpected, and we’re not just talking about divorce.
Imagine the scenario wherein your child has inherited significant wealth after your passing, and then your child predeceases his/her spouse. Your child’s former spouse then remarries. If your child’s inheritance had become marital property before his/her death, that wealth may now be enriching a family tree that you never encountered during your lifetime. This is why we counsel even intact families regarding the consequences of allowing inherited wealth to become marital property.
Here are three ways a child’s inheritance can avoid becoming marital property:
1. Holding a child’s inheritance in trust.
In making an outright distribution to a child of his/her inheritance, the child has unfettered control and access to their inheritance. This leaves open the possibility for a child to intentionally or unintentionally comingle the inheritance with marital assets, meaning the inheritance becomes marital property.
Alternatively, a parent can establish a trust to hold a child’s inheritance. The trust could be managed by the child himself/herself as “trustee.” But the better approach to ensure that the property is not commingled is to have a trusted third party serve as “trustee.” The child will have access to their inheritance in trust for whatever their needs might be. However, the child will not have control of the trust, and the inheritance would effectively be firewalled from marital assets.
While the advantage of this approach is taking control and risk out of a child’s hand, the potential disadvantages to this approach are several. Perhaps the biggest downside is the administrative cost of the trust. After the parents’ deaths, once the trust is funded, it will be a separate taxpaying entity and will be required to file a separate tax return on an annual basis. The trust’s tax return will issue an IRS Form K-1 to the child which may complicate his/her own personal tax return. And finally, trust distributions may still have an impact on alimony and spousal support claims (see below).
2. The “Letter of Instructions”
How closely can your child follow directions? Are they likely to be badgered or guilted by a spouse if they keep their inheritance in an account titled in their sole name with no further money added to the account?
If your child is a rule-follower and if you feel like your child’s retention of separate inherited assets will not cause conflict, then the “letter of instructions” approach may be for you.
You can provide a detailed letter of instructions to your child explaining to them that you love them and you love their spouse. However, out of an abundance of caution, you expect that whatever they inherit will be held by your child in a separate account in their sole name. And they are never to add any additional assets to the account such as wages or other money earned in any way during the marriage.
If your child follows these directions, they will retain full control over their inheritance outside of a trust. Moreover, the inheritance will almost certainly remain classified as non-marital.
If your child does not follow these directions, however, any commingling of inherited wealth with marital funds would even more likely result in a finding by a Court that the nature of the property was deliberately changed to marital because your child was aware of that risk before making that choice.
3. A Pre-Nuptial or Post-Nuptial Agreement
Finally, couples are free to enter into an agreement to classify inherited wealth as marital or non-marital property. If this agreement is entered into before marriage, it is a pre-nuptial agreement. If the agreement is entered into during marriage, it is a post-nuptial agreement.
Remember, however, that there must be some consideration in a post-nuptial agreement, meaning both sides have to receive the benefit of the bargain. Moreover, both parties should be represented by separate counsel and there will need to be full and clear disclosure about all of the parties’ respective assets for such an agreement to avoid challenge.
A thoughtfully-drafted pre-nuptial or post-nuptial agreement can establish a shared understanding and contractual obligation to treat inherited wealth as non-marital.
Even if Inherited Wealth Remains Non-Marital, Can It Still Affect Alimony and Child Support Determinations?
Yes.
Even if a spouse is successful in maintaining the “non-marital” classification of his/her inherited wealth, those assets are still considered when the Court determines alimony, and child support, and may even be considered if held in trust.
Particularly, any income generated by non-marital assets is relevant to this determination. In both Maryland and Washington, D.C., relevant factors for determining whether alimony (or “spousal support”) should even be awarded include (a) the standard of living the couple maintained during the marriage, and (b) the ability of either spouse to pay support to the other, among others.
There is no way to contract around the impact of non-marital property on the calculation of child support. Even the use of a trust to shield a child’s inheritance from becoming marital property would not provide protection to the extent income is thrown off of the trust.
The only method to protect against an award of alimony that takes non-marital wealth into consideration would be a valid pre-nuptial or post-nuptial agreement.
Jeremy Rachlin, Esq. chairs the firm’s Estate & Trust Practice Group. Meg Rosan, Esq. chairs the firm’s Family Law and Mediation Practice Groups. Jeremy & Meg frequently work together on prenuptial and postnuptial agreements, including agreements designed to protect generational wealth. Jeremy can be reached at (301) 656-1177 x305 or jrachlin@bulmandunie.com. Meg can be reached at (301) 656-1177 x317 or mrosan@bulmandunie.com.
