A legal trust refers to an arrangement by which an individual (i.e., the grantor, trustor, or settlor) creates a trust. Another individual, the “trustee,” holds legal title to the trust property for yet another individual, called the “beneficiary.” In some circumstances, the grantor and trustee will be the same individual. For example, a parent could be both the grantor and trustee of a trust which contains a piece of real property for a child beneficiary. Certain trusts even permit the grantor to be both the trustee and the beneficiary.
A revocable living trust refers to a trust that an individual creates during their lifetime, as opposed to one created upon their death pursuant to the terms of their will. Any beneficiaries named in this living trust will receive the trust property upon the grantor’s death. A revocable living trust is quite flexible: the owner can change the terms at any time, remove beneficiaries, designate new ones, and more.
By contrast to revocable living trusts, irrevocable trusts cannot be revoked or modified once they have been signed. The main benefits of irrevocable trusts are that they can minimize the grantor’s estate tax liability and offer asset protection from lawsuits and creditors.
Generally, a trust involves two interests: (1) ownership of the trust corpus and (2) ownership of trust income. If a spouse is a trustee of a trust, then they hold legal (but not equitable) title to the trust property and the trust property is neither their separate nor their community property.
When is a Trust Considered “Community Property”?
Property owned by either spouse during or on dissolution of marriage is presumed to be community property. Tex. Fam Code Ann. § 3.003(a). The degree of proof necessary to establish that property is separate property is clear and convincing evidence. Id. at (b). However, if a spouse or a third-party establishes an irrevocable trust for one spouse before marriage, the trust assets are that spouse’s separate property and not part of the marital estate because they were earned before marriage.
That being so, if one spouse establishes a trust after marriage, then the assets’ character depends on whether they were earned or received by gift or inheritance. If the assets were earned, they are community property, even if they are in an irrevocable trust. On the other hand, if the spouse receives assets during the marriage by gift or inheritance and puts them in an irrevocable trust, the trust corpus (property making up the trust) is separate property.
The income from a separate property trust can be community property if (1) it is distributed from an irrevocable trust; or (2) if the trust is revocable. Put another way, when you have a separate property trust, the trust income may be community or separate property, depending on whether the trust is revocable (then the income is community property) or irrevocable (then the income is separate property unless it is distributed, then it is community property).
Irrevocable Trusts and the Present Possessory Interest
Undistributed income on a trust corpus that accrues during marriage is community property only if that income should have been distributed under the trust agreement. In re Marriage of Long, 542 S.W.2d 712, 718 (Tex. App. – Texarkana 1976, no writ). In Long, “the undistributed income was in the hands of the trustees but the beneficiary had a present possessory interest in the funds.” Id. Under these facts. the court concluded that “the income on the trust corpus should have been labelled community property.” Id.
Thus, if a spouse is granted a present possessory right to any portion of the trust, then the income can be divided as community property.
A discretionary trust is an irrevocable trust that is set up for the benefit of one or more beneficiaries, but the trustee maintains discretion regarding when and what funds are distributed. The discretionary trust’s beneficiaries have no rights to the trust funds and the funds are not regarded as part of their estate.
If a trust is discretionary, then the undistributed income constitutes separate property. In Re Marriage of Burns, 573 S.W.2d 555, 557 (Tex. App – Texarkana 1978, writ dism’d). Specifically, “undistributed income in a trust estate is not community property where the beneficiary does not have a claim to such income other than an expectancy interest in the corpus.” Id.
In Burns, neither spouse actually or constructively acquired the undistributed trust and estate income during the marriage. Id. Therefore, the income “though earned during the marriage, remained a part of the respective trust or estate and was not subject to division by the court.” Id at 557-558. Ultimately, “such income was not community property.” Id. at 558.
Legal trusts can be an intricate and nuanced area of the law and, in some high-asset marriages, trusts are used to shelter separate property. While trusts can be a legitimate mechanism by which to shelter such property, it is not unheard of for one spouse to employ fraudulent tactics vis-à-vis legal trusts to hide property from another spouse.
When trusts are a part of either the separate or community estate of divorcing spouses, it is critical for those spouses to both retain counsel who understand the intricacies of legal trusts and how they should be characterized during divorce proceedings. Because of the many layers involved in this analysis, a cursory understanding of trust law is almost never sufficient.