Answers to Summer 2014
California Bar Exam Questions

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Summer 2014 Bar Question 5

Community Property and Trusts

  Question
 

Henry and Wynn married in 2000. During the first ten years of their marriage, Henry and Wynn lived in a non-community property state. Henry worked on writing a novel. Wynn worked as a history professor. Wynn kept all her earnings in a separate account.

Eventually, Henry gave up on the novel, and he and Wynn moved to California. Wynn then set up an irrevocable trust with the $100,000 she had saved from her earnings during the marriage. She named Sis as trustee and Henry as co-trustee. She directed that one-half the trust income was to be paid to her for life, and that the other one-half was to be paid to Charity, to be spent only for disaster relief, and that, at her death, all remaining assets were to go to Charity.

Wynn invested all assets in XYZ stock, which paid substantial dividends, but decreased in value by 10%. Charity spent all the income it received from the trust for administrative expenses, not disaster relief.

Later, Sis sold all the XYZ stock and invested the proceeds in a new house, in which she lived rent-free. The house increased in value by 20%.

Henry has sued Sis for breach of trust, and has sued Charity for return of the income it spent on administrative costs.

1. What is the likely result of Henry’s suit against Sis? Discuss.

2. What is the likely result of Henry’s suit against Charity? Discuss.

3. What rights, if any, does Henry have in the trust assets? Discuss. Answer according to California law.

All questions © 2014 California State Bar Exam. All rights reserved

 
Answer

Community Property and Trusts
Question 5, Summer 2014

W’s pre-California earnings—Quasi-community property
When in California, the law that applies to married couple’s property is California’s community property law.

However, when a married couple acquired assets in another state, before relocating to California, this property is treated under California’s community property law as Quasi-community property.

Quasi community property is property that would have been community property if the married couple had been living in California when it was acquired.

For example, earnings during marriage are community property. Here, W earned a salary for ten years. If the couple had been living in California when she earned the salary, it would have been community property.

W segregated her earnings in a separate account. This has no bearing on the spouse’s rights to the earnings as community property.

On the death of the asset-owning spouse or on the couple’s divorce, the QCP converts to CP. Each spouse owns half of the CP.

H has expectancy interest in Trust Asset as QCP.
Generally, quasi community property does not give rights to the non-acquiring spouse until either the asset-owning spouse dies or the marriage ends in divorce. However, where the QCP funds a trust and the asset-owning spouse receives income from the trust during her life, then the other spouse has an interest in the QCP, called an expectancy.

Under the California Probate Code, Section 102, when an asset-owning spouse transfers QCP to a third person and dies before his surviving spouse, the surviving spouse may require the third person to restore to the decedent’s estate one-half of the value of the QCP, when the following test is met:

(1) decedent died in California. Here, W died in California.
(2) no exchange of substantial value was provided to the surviving spouse. Here, H did not receive any property instead of W’s earnings.
(3) the surviving spouse did not give written consent or join in the transfer. Here, H did not give written consent or join in the conveyance of W’s earnings to the trust.
(4) the decedent retained the right to income from the property. Here, W was a life beneficiary of the trust, so she received income from the trust until her death.

Therefore, H can recover one-half of the value of W’s earnings, We do not know how much the trust assets appreciated during W’s life. For simplicity’s sake, we will assume the trust assets did not appreciate and remained $100,000. H’s QCP share then is $50,000.

W bought XYZ stock with the $100,000 and to fund an irrevocable trust.
A change in form of property does not change its character. The XYZ stock has the same character as the source of funds to purchase them. Therefore, XYZ stock is also QCP.

H’s right against Charity for restoral of funds it received without paying fair market value.  The probate code authorizes the spouse who has an expectancy interest in the QCP to recover those funds from a third party.  Any third party who receives QCP for less than fair market value is liable to the spouse to restore one-half of the fair market value of the property it received Here, the trust paid earnings from the XYZ stock to Charity for all the years the trust was an inter vivos trust.  Charity did not provide fair market value for the funds it received. Therefore, H can require Charity to restore one-half of the value of the income to Charity to decedent’s estate, since it is QCP.

H’s right to half the funds transferred to Charity is not based on Charity’s misuse of the funds, but is simply because Charity was the transferee of QCP funds that it received without providing fair market value in return.

Probate Code Construes Testamentary Trust.
In California, trusts which have a testamentary effect are subject to the probate code. Here, W’s irrevocable trust is both an inter vivos trust and a testamentary trust, since W directs the trustees to convey the remainder of trust assets at the time of her death to Charity. Therefore, the trust it is governed by the California Probate Code.

Under the probate code, a will is construed as passing only as much interest in property as the testator had the right to convey. Here, W had the right to convey only her half of the QCP. The testamentary trust will be construed so that W is bequething only her half the QCP.

Omitted spouse. An omitted spouse was married to the testator at the time the testator wrote her will, but who has been omitted from the will. The omitted spouse takes his intestate spousal share. That share is one-half  of the decedent’s community property and quasi-community property. Here, H was left out of the trust which disposed of W’s property. H is entitled to one-half of the QCP. Assuming the QCP is $100,000, H will be given $50,000 before the trust assets are distributed.

1. H v. Sis.
H is both a co-trustee and a beneficiary of the trust. His ability to sue Sis under each role will be discussed in turn.

H as co-trustee.
The trust appointed Sis and H as co-trustees. Co-trustees have duties to each carry out the decisions trustees are required to make. One trustee cannot delegate to the other these responsibilities. Each trustee has a duty to monitor the conduct of the other trustees. Failure to do so is a breach of trust.

The co-trustees are liable to reimburse the trust for any losses it suffered due to their breaches of trust.

Here, Sis sold the XYZ stock and invested the proceeds in a new house. The house increased in value by 20%. Therefore the trust did not suffer any losses due to exchange of the stock for the house.

Sis lived in the house rent-free. The trust suffered the loss of rental income. Therefore, H and Sis must reimburse the trust for the loss of income.

It may be that Sis was more at fault in living in the house rent-free than H was, and H may feel that Sis should contribute more to reimburse the trust. However, H has also breached his duty by negligently failing to supervise Sis, so his argument is weak. In any case, co-trustees have no right of action to sue each other.

Therefore, H has no rights against Sis as co-trustee.

H as beneficiary.
Deprived of appreciation of trust assets
A remainderman is entitled to receive appreciation in the value of the trust assets. He does not receive any income earned by the trust assets, because this is paid to life estate holders.

H is a beneficiary of the testamentary portion of the trust. Sis deprived the trust of income that would be distributed as income to the life estate beneficiaries, Charity and W.  Therefore, H has not suffered any loss as a remainderman from Sis’s living in the house rent-free.

Removal of trustee, breach of trust
A beneficiary can seek the removal of a trustee due to a breach of trust. Here, Sis’s living in the house is a breach of the duty of loyalty, by having her own business interest in the trust asset. This is a serious breach of trust that could warrant Sis’ removal. However, all beneficiaries must join in an action to remove a trustee. W, if she is living, and Charity would have to join H to remove Sis.

2. H v. Charity
Charity received income from the trust which it was supposed to use for disaster relief. Instead, Charity used it for administrative expenses.

H as co-trustee.
A trustee cannot sue a beneficiary to recover misspent trust income. Here, Charity was supposed to use trust income for disaster relief. Instead it used the funds for administrative expenses. Once distributed, the trustee cannot recover funds used improperly.

Therefore H cannot recover the income that Charity misspent.

H as beneficiary.
H can sue Charity for restoral of one-half of the income it received because that part of H’s QCP. This is unrelated to Charity’s misuse of the funds. It is based only on Charity’s receipt of funds that were QCP.

3. H rights in trust assets.
As above, H is entitled to one-half of the 100,000 of W’s earnings, as QCP.

 

Answers © 2014 Vivian Dempsey, The Writing Edge™ All rights reserved.

 
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