Seven Things the Trusted Advisor Needs to Know

Seven Things the Trusted Advisor Needs to Know BEFORE a Client Gets Divorced Meighan A. Harmon Schiller Du. Canto & Fleck LLP mharmon@sdflaw. com

Discussion Topics l 1. What does the Business Succession Planner for a Family Business need to know to avoid creating Marital Property? l 2. What forms of income will a divorce court impute to a client and how to avoid it? l 3. When will a Court consider the retained earnings of a Non-Marital business, Marital Property? l 4. When can and should someone contemplating divorce change beneficiary designations? l 5. When can saving for college actually turn out to be a bad idea? l 6. How does attorney disqualification work in divorce cases? l 7. What are the divorce process options and what is best for your client?

Why these are good things to know l Janet Langjahr in her Florida based divorce and family law blog, reports that money does not equate with happiness in marriage. Citing an article, The Rich and Unfaithful, in Forbes, she says that the wealthy are no happier in their marriages than the not as well-off. About half of wealthy people describe themselves as unhappy in their marriages, and just as many admit to cheating on their spouses in the last three years. Although half of the affluent were unhappy in their marriages, “just thirty percent were considering divorce”… JUST 30%!

Marital and Non Marital Property Defined l Section 503(a) of the IMDMA l (a) For purposes of this Act, “marital property” means all property acquired by either spouse subsequent to the marriage, except the following, which is known as “non-marital property”: l (1) property acquired by gift, legacy or descent; l (2) property acquired in exchange for property acquired before the marriage or in exchange for property acquired by gift, legacy or descent; l (3) property acquired by a spouse after a judgment of legal separation; l (4) property excluded by valid agreement of the parties;

l (5) any judgment or property obtained by judgment awarded to a spouse from the other spouse; l (6) property acquired before the marriage; l (7) the increase in value of property acquired by a method listed in paragraphs (1) through (6) of this subsection, irrespective of whether the increase results from a contribution of marital property, non-marital property, the personal effort of a spouse, or otherwise, subject to the right of reimbursement provided in subsection (c) of this Section; and l (8) income from property acquired by a method listed in paragraphs (1) through (7) of this subsection if the income is not attributable to the personal effort of a spouse.

#1: Business Succession Planning : l Factual Scenario Husband owns 30% of the stock in HFB at the time of the parties’ marriage. Five years into the marriage, all other outstanding shares are redeemed by HFB making the Husband the 100% shareholder. l Does the stock redemption create marital property? What if the stock redemption is funded by a loan personally guaranteed by the Husband for the next five years, the Husband takes a pay cut to make funds available within the company to repay the debt? What if the stock redeemed was the stock of Husband’s Father and the funds used to pay down the loan taken to fund the redemption would have otherwise been paying Father’s salary? What if Husband is one of three brothers and not a majority shareholder after the stock redemption? l l l

Scary Cases You Should be Aware of: l l l Smith v. Smith, 197 W. Va. 505 (West Virginia Supreme Court of Appeals, 1996). Parties were married in 1987 and separated in 1992. Wife was a homemaker during the marriage and Husband worked for closely held family insurance business, both prior to and during the marriage. At the time of the marriage, Husband owned 65 shares, or 28% of the outstanding stock in the business. A stock redemption during the marriage increased Husband’s percentage ownership from 28% to 44%. Court found that a stock redemption (assuming the transaction is at fair market value) does not increase the value of the stock held by the remaining shareholders because when a corporation redeems stock, the stock it receives is offset by a corresponding liability. The Court held that the trial court must look to how the liability incurred as a result of the redemption is then paid. If the liability is paid from corporate earning generated as a result of marital efforts, the increase in the value of the stock may then be marital.

l l l Mc. Leod v. Mc. Leod, 74 N. C. App. 144 (N. Carolina Court of Appeals, 1985). Parties were married in 1963. In 1970, Husband inherited 31. 47 shares of a trucking business, or approximately 30% of the outstanding shares. 1974, the corporation redeemed all other outstanding shares with cash generated primarily from a note signed by the corporation, but guaranteed by the Husband. Court found that “acquired”, as in “acquired during the marriage”, is a dynamic concept. Therefore, the Court must look at acquisition as an ongoing process, and not merely evaluate property as of the inception of title. If a non-marital asset increases as a result of active appreciation attributable to marital efforts, a portion of that non-marital asset becomes marital. Here, because the note which funded the stock redemption was paid with funds that were generated by Husband’s marital efforts, which could have otherwise augmented the marital estate, the portion of the appreciation of the value of the company attributable to that active appreciation is marital.

l l Moral of the story: A Premarital Agreement or Post Nuptial Agreement is always a safer way to go rather than relying solely on “acquired prior to the marriage”. Better still: When creating succession plans for Family Owned Business, consult with a Family Law Specialist in the appropriate jurisdiction.

#2 What is “income from all sources”? l l l Section 505 (a)(3) of the IMDMA provides: that support shall be calculated based upon “the total of all income from all sources. . . ” Often bares no relationship to taxable income or reported income. How do wealthy parents avoid supporting dependent in-law children post divorce?

Factual Scenario l l Husband Wife are both in their early fifties and have been married for twenty years. Neither of the parties have worked during the marriage. They have lived primarily on regular trust distributions to Husband of $300, 000 a year (the income of a trust has historically been paid to the Husband annually, additional distributions of principle are at the discretion of the Trustees and have occurred from time to time. ) The parties have three children and live in Lincoln Park. All three children attend The Latin School. The Husband’s family has been attending the school for three generations and his parents have happily paid the tuition for the children since Kindergarten. Five years ago the Trustees agreed to a distribution to the Husband of $2, 500, 000 to buy a house in Lincoln Park in which the now family resides. The house is in the Husband’s name alone and can be clearly traced to the trust. There are not other marital assets and no retirement savings. The family regularly vacations at the Husband’s parent’s homes in Florida and Mexico and travel at the expense of the Husband’s parents, often via private plane.

l l Husband has just learned that the Wife has been having an affair with the soccer coach at the Latin School. (**) In a rage, he goes to the school and punches the coach in the face in front of a terrified group of children. The school seeks and is given a restraining order prohibiting the Husband from being on school grounds. Wife also seeks and is given Exclusive Possession of the Marital Residence. The Grandparents are so angered by the actions taken by the Latin School and the Wife, they advise both the School and the Wife, they will no longer be paying the tuition. Wife files a request for child support and maintenance and indicates, accurately, that the cost of maintaining her lifestyle is $40, 000. 00 per month. (**) Any resemblance of the fact pattern to real people is purely coincidental!

l l l l What are the income sources the Court is going to “impute” to the Husband for the purposes of setting child support and maintenance? Regular Annual Trust Income? Discretionary Distributions that have been made from time to time? (Does it matter if the Husband’s Mother is the Trustee? ) The use and occupancy of the Lincoln Park Home? Latin School Tuition? Travel and use of luxury homes? Does it matter if the children continue to travel at Grandparents expense during Husband’s parenting time? Could a premarital agreement limit Husband’s (or Grandparents) exposure?

l Basic Rule of Thumb: If a parent has access or has historically had access to funds for the purposes of funding their lifestyle, those funds will be treated as income for support purposes. l There is a VERY strong propensity to require parents to find a way support their children consistent with the marital lifestyle. Judges are very suspicious of “RAIDS”. l Wealthy grandparents that support their adult children need to understand that when they take on the support of their adult child, they are also (to a great extent), taking on the support of their children’s children. They can always stop the support and the Court cannot require them to pay anything, but the power of contempt is a might sword. (Wealthy people typically do not like to visit their children in jail. ) l Paying expenses directly on behalf of grandchildren is always a better way to proceed. Keep the money out of the potential support obligors hands.

More Scary Cases You Should be Aware of: l l IRMO Rogers, 820 N. E. 2 d 386 (2004). Annual gifts from to the Father from his parents were part of the Father’s income for the purposes of calculating child support. If there was evidence that the gifts could stop in the future, the Court consider that factor in determining future modification of the support obligation (i. e. after they had actually stopped). The Court rejected the Father’s parent’s claim the funds provided to their son were loans because there was no history of repayment and no reasonable expectation the funds could ever be repaid. IRMO Sharp, 860 N. E 2 d 539 (2 d Dist. 2006). Father’s trust distributions constituted income for support purposes although the distributions were subject to change year to year and in spite of spendthrift provisions of the trust which by its terms were not subject to support obligations.

l l IRMO Mc. Grath, 2011 IL App (1 st) 102119. Father unemployed during several years of the marriage and at the time of the divorce, child support was reserved. Two year later, Father is still unemployed and Mother asked the Court to set support. The Court imputed to Father as income, the $8, 500 per month the Father was drawing from the assets awarded to him in the divorce Judgment and sets child support based upon that income. IRMO Lindman, 824 N. E. 2 d 1219 (2 d Dist. 2005). Court refused to grant Father’s petition to reduce child support during his unemployment because he was taking distributions from an IRA that the Court imputed to him as income.

#3 When are the Retained Earnings of a Non-Marital Business Marital Property? l Look back at 503(a) of the IMDMA l (a) For purposes of this Act, “marital property” means all property acquired by either spouse subsequent to the marriage, except the following, which is known as “non-marital property”: . . l (6) property acquired before the marriage; l (7) the increase in value of property acquired by a method listed in paragraphs (1) through (6) of this subsection, irrespective of whether the increase results from a contribution of marital property, non-marital property, the personal effort of a spouse, or otherwise, subject to the right of reimbursement provided in subsection (c) of this Section; and l (8) income from property acquired by a method listed in paragraphs (1) through (7) of this subsection if the income is not attributable to the personal effort of a spouse.

Factual Scenario l l Husband is the sole owner and shareholder of ABC Corporation, an Illinois S-Corp he incorporated in 1990. Husband Wife marry in 2000. At the time of the marriage, ABC has $1 Million in annual revenues and $60 K in retained earnings. Husband is reporting $400 K per year in pass-through income from ABC on his personal return and is taking $300 K in distributions from ABC to fund his lifestyle. Wife files for divorce in 2005. Nothing has changed with respect to the structure or operation of ABC since the marriage. At the time of the filing, ABC has $3 Million in annual revenues, Husband is reporting $1. 2 Million per year in pass-through income, but is still taking $300 K in distributions per year from ABC to fund his lifestyle (plus some additional distributions for the payment of taxes only). ABC now has $2, 000 in retained earnings.

l Are ABC’s retained earnings a Marital Asset? l Does it matter if Husband is a non-controlling fifty-percent shareholder? l Does it matter if ABC’s manufacturing process is severely outdated and ABC will need to invest $2 Million in equipment in the next year to stay operational? (i. e. Is there a legitimate business need for the money? ) l Would it matter if ABC were are C-Corporation instead of an S -Corporation?

Another Scary Case. . l In re the Marriage of Lundahl, 919 Ne 2 d 480 (2 d Dist. , 2009) Husband was the sole owner of AIS which Husband owned and incorporated prior to the marriage. Between the parties marriage and divorce, AIS’s retained earnings had grown significantly. Because Husband had the power to distribute or not distribute the earnings, the earnings were not retained to pay the expenses of the business or for any business purpose, and since the Husband had already paid taxes on the earnings, they were really the Husband’s income (from personal efforts) and properly classified as marital property. l This case was a HUGE change in how S-Corporations are treated in divorce cases in Illinois. If you have premarital agreement clients that fit this description, you may want to take a look at the agreement.

#4 The Do’s and Don’t of Changing Beneficiary Designations l The Dissolution Action Stay and “maintaining the status quo”. l Section 501. 1 of the IMDMA: l a) Upon service of a summons and petition or praecipe filed under the Illinois Marriage and Dissolution of Marriage Act or upon the filing of the respondent’s appearance in the proceeding, whichever first occurs, a dissolution action stay shall be in effect against both parties and their agents and employees, without bond or further notice, until a final judgment is entered, the proceeding is dismissed, or until further order of the court: l (1) restraining both parties from transferring, encumbering, concealing, destroying, spending, damaging, or in any way disposing of any property, without the consent of the other party or an order of the court, except in the usual course of business, for the necessities of life, or for reasonable costs, expenses, and attorney’s fees arising from the proceeding, as well as requiring each party to provide written notice to the other party and his or her attorney of any proposed extraordinary expenditure or transaction;

BUT. . . l l l Section 501. 1 (a) was held unconstitutional by Messenger v. Edgar, 623 N. E. 2 d 310 (1993); because it restrained both marital and non-marital property, the statute was excessively broad and did not survive the rational basis test. While unconstitutional, there are still a lot of Judges in Illinois that consider the spirit of 501. 1(a) good law as it relates to marital property. Judges want to maintain the “status quo”. Beneficiary changes, without very good cause, can be an invitation for the entry of a Temporary Restraining Order or Preliminary Injunction and could very likely leave a bad taste in the Judge’s mouth. This is a decision that should be made with the entire picture in full view. In other words, refer them to their divorce lawyer for advice.

#5 College Savings: When is it a Bad Idea? Section 513 of the IMDMA. Support for Non-minor Children and Educational Expenses. l (a) The court may award sums of money out of the property and income of either or both parties or the estate of a deceased parent, as equity may require, for the support of the child or children of the parties who have attained majority in the following instances: (2) The court may also make provision for the educational expenses of the child or children of the parties, whether of minor or majority age. . (b) In making awards under paragraph (1) or (2) of subsection (a), or pursuant to a petition or motion to decrease, modify, or terminate any such award, the court shall consider all relevant factors that appear reasonable and necessary, including: (1) The financial resources of both parents. (2) The standard of living the child would have enjoyed had the marriage not been dissolved. (3) The financial resources of the child. (4) The child’s academic performance.

Factual Scenario l Husband Wife divorced in 2002 and had three children under the age of 10 at the time of the divorce. The eldest child will not begin college until 2014. As is common, the Court “reserved” the issue of each parent’s contribution to college expenses pursuant to Section 513 of the IMDMA. Husband is a well paid professional earning around $1 Million per year and had an estate of around $3 Million. Wife chose to continue to stay home and raise their children after the divorce. She was awarded ten years of maintenance under the divorce judgment, which has ceased and she presently has little earned income. Wife has an estate of around $1 Million. l Luckily for the Wife, her Father is a very successful business owner who has recently sold his business and is about to retire. He comes to you for advice about how to best provide for his daughter and grandchildren in his estate planning and is particularly concerned that neither Husband or Wife have any college savings for their kids. l What should you consider?

College Savings Considerations l l l Any gifting to the Wife or Grandchildren could potentially let Husband off the hook for paying his fair share of college. Without any gifts, under the factual scenario, the Husband will pay the bulk of the expense. As Wife’s or Grandchildren’s assets increase, Husband’s obligation decreases. “College Accounts”, irrespective of who created them, often get used first. Consider timing and make sure the Grandfather is aware of the impact of his generosity.

#6 The Beauty Contest Gone Bad l l l More and more frequently, we are finding that conflicts arise in representing divorcing clients. A one hour consult is all it takes to conflict an entire firm. (Exceptions) Divorce firms that represent high net worth families are consolidating. Some clients are advised (unethically, in my opinion) to conflict out the “top” firms intentionally to require their spouse to use a less capable lawyer. While there are quite possibly thousands of attorneys practicing family law in the Chicagoland area, the community of lawyers capable of servicing your clientele is relatively small. Encourage clients to consult early.

#7 There are Options! l l Traditional Litigation Model l Pros: There is a timeline and a “Decider” l Cons: You don’t need me to tell you! Mediation l Pros: Can be faster, less expensive and more humane. l Cons: There is a power imbalance in many marriages. The process can be abused and can go on too long. There is no “Decider”. l Attorney facilitated mediation helps with power imbalance. l Late Stage l Resources: l l l Mediation Council of Illinois: www. mediationcouncilofillinois. org, JAMS Honorable Jane Waller

l Collaborative Law Model l Pros: Can be faster, less expensive and more humane; Can work better in more complex (financially and mental health) cases. Cons: Attorney Disqualification, can be expensive and can go on too long. There is no “Decider”. Collaborative Law Institute of Illinois: www. collablawil. org l Beware of the “One Trick Pony” l Encourage clients to get educated about the options before they get guided into a process.