Many couples rightly view inherited wealth as different from their other marital assets when they get divorced and are often surprised to discover it could still be shareable with their spouse.
Although the court does differentiate between “matrimonial property”, assets the couple have built up through their joint endeavour, and “non-matrimonial property”, being wealth which has come from outside sources, such as inheritance or gifts from family, it is not automatically safe from financial claims.
It is therefore important for families considering lifetime gifts to children or leaving a considerable estate on death to put in place protective measures. Often that means a pre (or post) nup, but is that the only option?
What counts as inherited wealth in a divorce, and why does it matter?
Inherited and gifted assets take many forms in a divorce case: it could be anything from cash in a bank account to an interest in property/land, a shareholding in a family business, or a trust interest. Essentially, in order to be treated as non-matrimonial in nature, it must be easy to trace the origin of the asset. If inherited or gifted money has been mingled with other marital assets over a long period of time, they are more likely to be shared.
Non-matrimonial resources are not the product of the hard work of either spouse (which is always shared regardless of which one of them earned it, there being no discrimination between homemaking and bread-winning in law). The law recognises that it is fair for such assets to stay with their intended recipient in the event of a divorce, unless the assets are such that the needs of both parties would not be met without those assets being shared.
How does English law treat inherited wealth without a pre-nup?
The starting point is an equal division of only the matrimonial property except in cases where that would not adequately meet everyone’s needs, the court will order wider non-matrimonial assets to be shared if required to ensure needs are met. The difficulty is that many assets people expect not to be treated as matrimonial and shareable, are because what happens to a gift or inheritance after it is made really matters.
Where an interest in a family business is given to the next generation, even if that business is generational and has been in the family for years, its growth in value during the marriage, with support from the spouse being assumed even if not real, would mean an element of the value of that spouse’s shares would then be considered matrimonial and shareable.
At the point someone receives an inheritance or gift from family, usually the last thing on their mind is how that might be treated if they were to split up in the future. Very often people will put that money to use for the benefit of their family at the time, perhaps paying off a mortgage to reduce outgoings.
However, the family home will always be considered to be matrimonial property, which is shareable on divorce, regardless of who paid for it or in whose name it is owned. It can come as a big surprise to people when they take initial divorce advice to learn that by applying inherited funds to pay down a mortgage, increasing the equity in the family home, it means that they have inadvertently placed that inheritance in the sharing arena.
Similarly, if gifted or inherited money is invested in a project having been mingled with wider marital funds, after a passage of time and potentially various encashments and reinvestments, it can become difficult to distinguish which proportion of an asset came from the non-matrimonial source. This is a particular risk after a longer marriage, and very often the entire asset is shared as part of the “matrimonial pot” – having been “matrimonialised”.
The first step in sorting out finances on divorce is financial disclosure and that relates to all assets, matrimonial or not. The other information exchanged relates to each party’s assessment of what they will reasonably need in the future in terms of:
- Capital resources – for example, a future home.
- Pension provision – usually thought of in terms of retirement income.
- Income pending retirement – a budget of expenditure is prepared.
“Needs” is an elastic concept and is based on the standard of living the couple enjoyed while they were together. It also relates to needs generated by the relationship, such as the need for financial support for the main carer of children. Not all needs are relationship generated. For example, after a short childless marriage while a couple are in their younger years, it would not be reasonable to suggest that someone’s needs in retirement should be met by their former spouse when they have a whole working life ahead of them.
The extent of needs can be a significant focus of argument, with each spouse criticising and trying to minimise the other’s claimed needs. Ultimately this can be determined by a judge if they are unable to agree a settlement.
This is important because only when needs are met by the sharing of matrimonial property, will inherited wealth be ring-fenced and retained.
What is a pre-nuptial agreement (PNA) and how does it protect inherited wealth?
Pre-nuptial agreements and post-nuptial agreements (PNAs) are contracts between those getting married or those already married which regulate how their financial resources would be divided if they ever divorce in the future. They are increasingly common, particularly among the younger generations who value the autonomy they provide and the open conversations that lead to them.
Since the landmark decision in Radmacher v Granatino in 2010, couples entering into PNAs in the UK are advised to expect to be bound by them so long as they are:
- Freely entering into the agreement (so no duress/undue pressure to sign) – this means allowing enough time for the draft to be reviewed and then to be signed no closer than 28 days to the wedding in the case of a pre-nup.
- With a full understanding of the implications of signing it (something the lawyers explain: i.e. whether they are better or worse off with it than without it and why) – so there must be independent legal advice on both sides; and
- At the time of the future divorce, it is fair to hold them to its terms (i.e. the reasonable basic needs of the financially weaker spouse are still met).
There is therefore an element of crystal ball-gazing required when we advise coupes on PNAs. We try to predict different circumstances, such as the birth of children, ill-health, differing lengths of marriage at the point of separation, and advise on provision that would be considered reasonable in those eventualities.
PNAs do not have to prescribe every pound of resource to be paid to a spouse on divorce, although some do. Often couples will want to set out the principles by which they would want to divide their assets. Very often PNAs will define assets and resources which are to be considered their respective “separate property” which will always remain theirs, with other joint property to be shared. Then there is often a mechanism for ensuring that reasonable housing needs will be met if a top up to their share of joint property and their own separate property is needed to achieve that.
Separate property will usually include existing gifted/inherited wealth, but also any future gifts or inheritances. That is then agreed to apply for both spouses. Crucially, PNAs will tend to say that such assets will remain separate and not shareable regardless of:
- The asset growing in value during the course of the marriage.
- The couple living in a family home which was gifted or inherited – when without that agreement it would automatically be subject to the sharing principle.
- Income generated by the asset being used to fund the family’s lifestyle.
- Contributions from the other spouse during the marriage.
- Mingling the asset with other funds during the marriage.
- Decisions taken for tax reasons, such as reporting the income generated by an asset as joint.
It is also possible to agree that a declaration of trust which confirms each party’s contribution to a property’s value will bind them in terms of their shares in it if they divorce, whereas absent a PNA to that effect a declaration of trust holds no weight after a marriage.
Where a valid PNA is in place, instead of the court applying its usual assessment of which assets are matrimonial and shareable (the starting point being equality) and which are non-matrimonial, the court would instead start with the terms of the PNA and the provision the couple agreed would be fair. Only if that provision would not meet the spouse’s reasonable needs will the court look to depart from the PNA. They are therefore very effective when the couple have assets which exceed those defined reasonable needs.
What alternatives exist if no pre-nup was put in place?
Families often consider wider wealth protection mechanisms which can provide greater control. Commonly we see discretionary trusts put in place so that there remains a distance between the intended beneficiary and the asset and requests for provision have to be made to trustees rather than being absolute. Such structures offer tax-advantages in many cases, with capital being lent from the trust to the beneficiary.
A divorce court will consider trust interests in the event of a divorce and will look at the history of distributions to the beneficiary spouse. If there is a regular pattern of distributions and/or all requests have been made positively by trustees, the court is likely to assume the same pattern will continue in the future and can make awards accordingly, applying “judicial encouragement” to trustees to make provision to enable the order to be complied with.
Family investment companies (FICs) became popular when the tax-treatment of trusts changed in 2006 and are often used alongside trusts, which can own the shares. They enable families to own various investments, most commonly stocks and shares, and to retain dividend income tax-free within the FICs. They provide significant scope for capital growth as a result and offer the same distance between control and value from the intended long-term beneficiaries.
However, such assets are not out of reach of the divorce court. A shareholder of FICs who gets divorced will have to disclose their interest in the company and it will need to be valued. Whilst the company can be structured to enable only blood relatives to own shares, that does not prevent the court making orders which factor in that resource available.
If a trust is considered to be “nuptial” in nature (which applies where there was a nuptial element to the trust – i.e. it was settled with the marriage in mind and it makes ongoing financial provision to one or both spouses) the divorce court has wide powers to vary its terms. It can go as far as removing trustees or excluding beneficiaries and can even transfer assets out of the trust to provide for the spouse.
It is always therefore advisable to enter into a PNA which disapplies the court’s powers from such assets.
What steps can families and wealth holders take to protect intergenerational assets?
It is essential that all angles are considered carefully when families are succession and inheritance tax planning. That requires collaboration from family lawyers, private client lawyers, corporate lawyers, tax advisers and wealth managers. We are well-placed to work with you as financial professionals to ensure your clients’ wishes come to fruition.
Taking early specialist advice is crucial as many steps will take time to put into effect. It may be necessary to consider the effect of plans in different jurisdictions. Keeping clear records of assets held, values and intended aims and concerns will help the advisers work efficiently to achieve a long-term strategy for preserving the wealth in the family.
When should individuals seek legal advice?
Specialist advice should be sought in the approach to any major life decision, from getting married (or remarried), to receiving an inheritance or succession planning to future-proof a business. The legal landscape will change as well as the tax consequences and how these interact will need to be understood and considered carefully.
Early and collaborative advice is essential for families seeking to protect multi-generational wealth so that everyone has a clear understanding of the risks involved in maintaining their existing wealth for the future security of those they love.
If this is something that you would like advice on then please get in contact with our Family Law team.