Article on Marital Property Characterization in Trusts

James L. Musselman (Professor of Law, South Texas College of Law) recently published an article entitled, Separate But Equal: Proposal For Harmonizing the Rules for Marital Property Characterization of Beneficial Interests In and Distributions From Trusts With Those Applicable to Similar Types of Property, 5 Est. Plan. & Community Prop. L.J. 55 (Fall 2012). Provided below is the introduction:

The marital property rules currently used in Texas for characterizing beneficial interests in and distributions from trusts have not been formulated and applied consistently by the circuit courts. Thus far, the Supreme Court of Texas has not resolved this inconsistency. To make matters worse, the circuit courts currently do not use rules logically consistent with the marital property rules generally applicable to characterization of similar types of property. This article will describe the different approaches circuit courts have used and the different rules they have developed. The article will also propose the adoption of standard rules that will harmonize all of these approaches and allow the rules for characterizing beneficial interests in and distributions from trusts to exist in logical parity with the rules for characterizing similar types of property.

Under the inception of title doctrine in Texas, marital property is characterized as separate or community property. Property is characterized at the time of its acquisition and retains that character until the marriage is dissolved. Ownership interests in and distributions from organizations that constitute legal entities are subject to special rules.The marital property subject to characterization is the ownership interest in the entity. Because the entity-not the spouse-owns the property, it is not marital property subject to characterization. Thus, property owned by a corporation or partnership is not marital property of a spouse owning an interest in the entity; instead, the marital property is the ownership interest in the entity, such as the corporate stock or partnership interest. In addition, income earned by a corporation or partnership belongs to the entity and not to a spouse owning an interest in the entity until the entity distributes the income to the owner.

In some jurisdictions, a trust is a legal entity separate from the owners of the beneficial interests in the trust. If that is true under Texas law, then the rules for characterizing beneficial interests in and distributions from trusts should be consistent with the rules for characterizing ownership interests in and distributions from other separate entities, such as corporations and partnerships. However, none of the characterization rules currently used by the circuit courts are consistent with the rules applicable to other separate entities. The Supreme Court of Texas has ruled in cases not involving marital property law that trusts are not legal entities at all; rather, they constitute a fiduciary relationship between the trustee and the trust property. Accordingly, the property interest owned by a trust beneficiary is simply an equitable interest in the trust property. If that is also true under Texas marital property law, then the rules for characterizing beneficial interests in and distributions from trusts should be consistent with the rules for characterizing ownership interests in and income earned by other types of income-producing property. However, none of the characterization rules currently used by the circuit courts are consistent with those rules either.

This inconsistency exists because trusts are created for many different reasons and, as a result, take many different forms. Many trusts are structurally complex, and courts have struggled to apply marital property characterization rules to them in a consistent manner. The result is a hodgepodge of different approaches and rules applied by the various circuit courts. The problem is confusion for litigants and trial courts attempting to determine applicable rules for characterizing interests in and distributions from trusts. Therefore, a logical and consistent set of rules is necessary.

Section II of this article will describe the marital property rules not only for characterizing income-producing property and the income produced by such property, but also for characterizing the ownership interests in and distributions from separate entities other than trusts, such as corporations and partnerships. Section III will discuss the issue of whether a trust is, or should at least be treated for marital property characterization purposes as, a legal entity separate from the owners of the beneficial interests in the trust. Section IV will describe the different approaches utilized by the circuit courts, and the different rules they have developed as a result, to characterize beneficial interests in and distributions from trusts. Section V will propose standard rules that will (1) harmonize these various approaches and rules currently used and (2) allow the rules for characterizing beneficial interests in and distributions from trusts to exist in logical parity with the rules for characterizing similar types of property, regardless of whether a trust is treated as a separate legal entity or not. The source of the legal reasoning underlying these proposed rules is the United States Supreme Court, which utilized such reasoning to resolve a complex issue that arose in the first two decades after the adoption of the United States federal income tax.