April 17, 2014

Elective share statutes - hidden dangers for blended families - part 3: solutions

by jdporter

We hope this mini-series on the knotty estate planning issues presenting in the (fictional) later lives of the Drapers convinced you that blended families often face much greater risks to relationships, harmony, and the orderly flow of wealth than they might first realize.

Elective share statutes are one of the main unrealized dangers.

In part 1 we saw that like many other states, Kentucky statutes give a surviving spouse the right to elect against the will and receive one-third of the real property owned by their deceased spouse who dies testate, and one-half of the personal property (including financial assets) in the probate estate of their deceased spouse.

In part 2 we saw that this elective share right creates challenging financial planning issues for a surviving spouse that involve tradeoffs between the surviving spouse's anticipated life expectancy, desired lifestyle, present personal wealth in his or her own name, and inheritance objectives for his or her own beneficiaries.

In this part 3, it's time to discuss solutions Don could have used while he was living to avoid the mess that Megan's electing against the will is likely to create for Sally, Bobby, and Eugene.

One of Don's best approaches would have been for him and Megan to have gotten a prenup before they married. The common image of prenups is that they're not very romantic, because planning who will get what upon divorce isn't a completely romantic element of most people's wedding plans. That's a fair criticism, but it's also ignores other really important issues prenups can address.

A type of prenup we refer to in short-hand as a "limited scope" prenup doesn't have to address the "divorce" issues of equitable division of marital property or spousal maintenance. Instead, a couple could waive testamentary rights they would otherwise have in the estate of a deceased spouse, including a preference in serving as executor and, importantly, the right to elect against the other spouse's will.

We know that Don's a pretty impetuous guy, and deliberate planning (including a prenup) before he married Megan wasn't really part of his general approach to the world.

After all, this is the guy who personally bought a full-page ad in the New York Times and wrote a "Manifesto" denouncing his biggest client, Lucky Strike, in a brilliant move to get ahead of the fact they were about to fire his agency anyway, and didn't tell his partners anything about the ad before it got published.
Why Im Quitting Tobacco

So, it's not fair to expect that Don got a prenup, and it's a safe bet Megan wouldn't have wanted one.

Another solution for Don and Megan would have been a limited scope postnup agreement. As with the limited scope prenup agreement, the postnup would not have to address divorce issues, but each spouse could waive their testamentary rights in the estate of the other, including the right to elect against the will of the other.

Prenup agreements and postnup agreements both require that each spouse be represented by separate counsel. Like any contract, they are most enforceable when supported by adequate consideration.

This means an interesting estate planning tool combining estate tax and elective share planning with potential asset protection benefits would have been an "inter vivos QTIP" trust.

Future posts will discuss the details of how inter vivos QTIP trusts work, but the short form is that they're a trust one spouse sets up and funds to hold property for the lifetime benefit of the other spouse.

An inter vivos QTIP trust is a way to move property out of the funding spouse's taxable estate, control how that property will be used for the surviving spouse, and who will receive the property when the surviving spouse is no longer living.

Suppose that Don and Megan had entered into a limited scope postnuptial agreement and in connection with that agreement, Don had funded an inter vivos QTIP trust for Megan. Don's probate estate against which Megan could take an elective share would have been reduced, and a pool of assets would have been set aside for Megan's lifetime use.

If Don so chose, a corporate trustee could have administered the trust when Don was no longer living, reducing risks that Megan would deplete the trust unfairly or too aggressively.

The trust could have provided that when Megan was no longer living, its assets would be divided and administered however Don decided was best for the benefit of his three children.

If Don thought Megan was going to get suspicious and wouldn't go along with a limited scope postnup (possibly supplemented by an inter vivos QTIP trust), he could have put some of his financial and real estate assets into a limited partnership or limited liability company (for instance, "SCDP Investments, LLC", and then given or sold a majority voting interest in that company to his children, retaining only the nonvoting interests for himself.

While he was living, as long as he was on good terms with his children, it's reasonably likely the distribution policy of SCDP Investments, LLC would have been favorable to Don, helping support his lifestyle. (After all, if the children became uncooperative, Don could reduce their inheritance of other assets under his estate plan....)

When Don died, the distribution policy of SCDP Investments, LLC would have been controlled by the children. If Don wanted to make sure the children couldn't unfairly harm Megan's lifestyle, he could have had a preferred class of membership interests created in the LLC's operating agreement that entitled the holder of that class of units (for instance, Megan, as his widow) to a fixed distribution amount per year.

If Megan elected against Don's will, she'd receive the nonvoting interests Don owned in the LLC, not the voting interests he'd already given or sold to his children. She'd take Don's property (the LLC units), but she would have no guaranteed cash flows or access to liquidity associated with that property.

If Don had implemented the LLC approach to side-stepping risks from the elective share statute, it might open an opportunity up for some very interesting negotiations between Megan and Don's children after he dies.

This case study shows that while "freeze-in" to a family business or investment holding company is often bad (as we've written about before), if freeze-in is intentionally done to control cash flows from a family's assets that are received by certain beneficiaries, it can be a powerful tool.

It's time to take a rest from the Drapers for at least a while, but they're so much fun and such a great vehicle for estate planning case studies, that we're confident that sooner or later, they'll be back!

Image above © AMC TV. Fair use rationale: critical discussion of the Mad Men television series. For detailed rationale, see here.