All In The Family: Disentangling The Parties… Constructive trusts as a remedy in divorce
Published in Chicago Lawyer Magazine, September 2023
By Daniel Stefani
The Illinois Marriage and Dissolution of Marriage Act, and the case law resulting from it, reflects a strong public policy rationale for disentangling litigants financially in divorce upon a judgment for dissolution. There are certain instances when such disentanglement cannot be achieved and divorced parties must remain financial partners into the future.
The typical situation is where one spouse owns a business interest and the business’s operating instrument prohibits a transfer to a spouse or former spouse. In situations where the court can’t transfer the ownership, the only true remedy for the beneficiary spouse is to “ride along” with the owning spouse. The best way to achieve this is to impose a constructive trust on the asset and have the owning spouse hold the non-owning spouse’s percentage interest as trustee.
With a constructive trust, the apportionment is typically predetermined and there are additional legal obligations on the part of the trustee spouse who holds the asset for the benefit of the beneficiary spouse. The goal of constructive trusts is to give the beneficiary spouse as much legal right to their percentage interest in the asset as possible without taking any legal title to the asset. In such a situation, the trustee spouse pays 100% of any income tax on such interest because in the eyes of the IRS, the beneficiary spouse has no ownership interest.
The Illinois Supreme Court mentioned such a remedy back in the case of In re Marriage of Hewitt in 1979. This year, In re Marriage of Landgren took the analysis one step further by finding that a constructive trust is actually an express trust if its terms are set forth in a marital settlement agreement (MSA) instead of being imposed by courts as a remedy to avoid unjust enrichment — as is typical in other civil litigation. As a result of the aforementioned, divorce practitioners should consider setting forth the terms of any constructive trust in the MSA.
Once the MSA identifies the asset subject to a constructive trust, it should also state that the asset cannot be divided between the parties due to whatever reason. It then should set forth that the owning spouse shall hold for the beneficiary spouse a certain percentage as a constructive trustee for the benefit of the nonowning spouse, with full fiduciary obligations which should be more specifically defined in the MSA. Typically, the agreement should provide constructive trust provisions and a statement of declaration of trust with the following additional caveats and obligations:
(a) The trustee spouse should notify the beneficiary of any event that would affect in any way the beneficiary spouse’s interest to change in any manner.
(b) The trustee spouse should be obligated to notify the beneficiary of his or her receipt of any income or assets regarding the interest and distribute the beneficiary spouse’s share. Typically, any distributions would be net of any tax liability which would be solely borne by the trustee spouse.
(c) The trustee spouse should be obligated to provide copies of any documents, emails and other communications to and/or from the entity running the business interest.
(d) The trustee spouse should be obligated if the asset is ever sold to transfer the beneficiary spouse’s percentage interest into his or her own name.
(e) In the event of the trustee spouse’s death, the beneficiary spouse shall be made successor trustee for the trust to the extent possible. The trustee spouse should be obligated to provide appropriate estate planning documents reflecting same.
(f) In the event of the beneficiary spouse’s death, the trustee spouse should continue to hold the interest for the benefit of the decedent and dispose of the asset in the future pursuant to the decedent’s estate plan.
(g) The trustee spouse should receive no compensation for his or her role. There should be a termination provision that the constructive trust will end when the beneficiary receives the full interest held in trust. There should also be a provision that the trustee spouse notifies the beneficiary of any change in residence or email for notification and communication purposes.
(h) The trustee spouse must take direction from the beneficiary as to his or her percentage interest.
(i) Finally, there should be a provision that the divorce court retain jurisdiction to adjudicate any and all disputes between the parties as to the effectuation and enforcement of the terms of the constructive trust, and that the beneficiary spouse shall receive legal fees for enforcement.
Leaving things to chance just invites future litigation and as such, practitioners should consider creating and setting forth the terms of any constructive trust ahead of time with specificity in an MSA, so that each spouse’s rights and responsibilities are clear.
Dan Stefani is a principal at Katz & Stefani. The firm’s practice is limited to family law matters. His work on behalf of mainly high net-worth clients, as well as spouses of high net-worth individuals, involves valuations of closely held corporations, partnerships and other entities, detailed analysis of complex financial transactions, child custody and support issues as well as paternity and domestic violence.