From the June 2005 issue of Investment Advisor • Subscribe!

June 1, 2005

Family Tree of Life

How to use a "flexible inflexible trust" to control and protect assets

In every family, sooner or later a patriarch arises who through the use of artful and prudent planning provides not only for his immediate family, but for generations of family members to come. One planning technique that such a patriarch might choose to employ is the "flexible inflexible trust." This dynamic dynastic estate planning technique supplies both the flexibility to allow total control by a patriarch or a beneficiary, as well as the power to accomplish the goals that such a patriarch might have. Those goals might include protecting trust assets from creditors, divorce, and the taxman, regardless of the political fluctuations that may affect the estate tax on the federal or state levels.

Estate planning trusts are often considered stodgy instruments that bind beneficiaries to an unresponsive trustee or establish an age-sensitive distribution pattern. The benefits of the most powerful asset protection and tax planning tool available domestically, a non-self-settled trust, are lost in these trusts. They bind settlors--those who establish trusts--to a document that they cannot amend in order to keep attuned to changing family circumstances. The document may also be drafted without awareness of the tax benefits that trusts can provide.

To the sophisticated, these should not be a concern, however. Properly drafted, a flexible inflexible trust allows settlors to control a trust during life, and on death--or earlier, if they desire--permit their beneficiaries to control their inheritances through the generations without subjecting trust assets to estate taxes, unnecessary income taxes, creditors, or divorcing spouses.

Moreover, the integration of insurance techniques into the plan allows tax-free growth as well as leveraged use of the generation-skipping transfer tax (GSTT) exemption and guarantees that the untimely death of the patriarch will not adversely affect his family. It is quite apparent that wealth inherited in trust is far more valuable than wealth that is inherited outright.

The flexible inflexible trust is unsurpassed when it comes to building and protecting wealth by saving and shifting tax and by protecting its beneficiaries' assets from creditors or divorce. One of the best ways to save and shift tax is by using the generation-skipping transfer tax exemption, which permits setting up a dynastic trust to avoid the imposition of the transfer tax. In 2005, a $6 million estate, after deducting the $1.5 million exemption, would suffer $2,105,000 in taxation. Had that $6 million been the result of growth in a GSTT-protected trust, no estate tax would have been due. Wealth takes a lifetime to build, and without planning, only a death to dissipate.

Leveraging the GSTT via insurance is an excellent use of this tool. Using the tax-free compounding of cash-value life insurance products over a lengthy period can produce significant wealth. Different family members are in different tax brackets. The flexible inflexible trust can thus shift income from the trust's or parent's high tax bracket into the non-working senior or over-14-year-old junior generations' lower tax brackets.

By causing the grantor or beneficiary rather than the trust to be taxed, the asset-protected trust principal as well as the GSTT tax-exempt portion of that trust can be allowed to grow and expand. Settling the trust into a no- or low-tax state can be beneficial in lowering the trust's overall tax bracket.

Protecting assets from creditors, predators, and unsuccessful marriages is often the primary reason for setting up a trust. Government taxes may be high, but the "creditor tax" can be 100%. In California, for example, divorce ends more marriages than death. The flexible inflexible trust prevents a child's spouse from sharing in her inheritance. But since asset protection laws and taxation vary among the states, careful selection of where the trust is settled can enhance a trust's asset protecting capacity and lower a trust's overall tax obligation.

The Ultimate in Asset Protection

The non-self-settled trust provides the ultimate in asset protection. In most states an individual cannot self-settle a trust for his benefit that will protect his assets from his creditors. However, his parents can set up an asset-protected trust for him. The beneficiary can be allowed to use trust assets, rather than passing out cash, to purchase assets in his own name. To take fullest advantage of this feature, the trust should be drafted to allow the trustee to acquire homes, businesses and other assets, whether speculative or not, giving the trustee or beneficiary the same type of control he would have if he had received cash outside of the trust. To the extent cash needs to pass outside the trust, asset protection is achieved by transferring the cash as a loan and having the trust secure its interest.

The flexible inflexible trust allows settlors' children the opportunity to shift business opportunities into a trust, affording them asset, divorce, and tax protection. Rather than start a business exposed to creditors, or succeed in growing the business and have transfer tax concerns, the GSTT-exempt trust portion of a flexible inflexible trust that was set up for the child by his parents can establish a limited liability corporation to own the business in asset-protected and transfer-tax-free mode.

Settlors can maintain control over irrevocable trusts and change the trust's distribution patterns at will by drafting the trust in a discretionary manner, giving the trustee a letter of wishes and by appointing a protector. When settling a flexible inflexible trust, the following issues need to be considered:

A letter of wishes is a communication written to the trustees by the settlor of a discretionary trust. This letter may be amended. Its purpose is to provide guidance to the trustees in the exercise of their trust discretions. It has no legally binding force. It sets out how the settlor would like the trustees to administer the trust both during his lifetime and after his death. Family circumstances change over time. These letters provide guidance on how the settlor would like the trustees to deal with changed circumstances after his death.

A protector is a person appointed to oversee the trust. He may be the beneficiary's best friend. The protector has veto power over the trustee with respect to discretionary matters, as well as the power to remove the trustee and appoint alternate trustees. The trust protector holds the power to direct the trustee in matters relating to the trust and will do so if he believes the letter of wishes is not being followed.

The Advantages Afforded by Time

The benefits of the GSTT exemption are magnified by the length of the trust's duration. By settling the trust in a jurisdiction that has negated the Rule Against Perpetuities, which limits a trust's duration, the flexible inflexible trust can permit assets to remain beyond the reach of estate taxation devastation for countless generations.

The rule against self-settled trusts allows creditors to attach the maximum amount that a trustee might distribute to a settlor-beneficiary. A settlor's interest in property held by such a trust, spendthrift or otherwise, is reachable by his creditors. The flexible inflexible trust should be set up for a child's benefit by the parents so that the child does not have a self-settled trust.

A non-self-settled discretionary trust, in conjunction with a letter of wishes and a protector, is a flexible trust that can adjust to changed family situations and tax laws. Trust assets are protected from creditors; the beneficiary has no property right that a judge could pass to a predator.

By using the flexible inflexible trust, parents can give their children their inheritance by endowing a child as trustee, with all the rights over trust assets that she would have had if she had been given the trust's assets outright. In addition, she also gets creditor, divorce, and tax protection unobtainable with outright ownership.

Controlling Beneficiaries

Beneficiary control is accomplished by using a distribution trustee and granting powers of appointment. The beneficiary can be a trustee with broad investment and trust administration authority. Although he is a trustee, he may not act alone on decisions regarding distributions to himself, therefore necessitating a distribution trustee. This is because certain powers that can be given to an independent trustee would cause tax and creditor problems if given to a beneficiary as trustee.

The distribution trustee's authority can be limited to approving distributions to the beneficiary. The distribution trustee could be a trusted non-beneficiary friend or an attorney. The beneficiary can be given the power to replace the trustees, thereby maintaining the beneficiary controlled feature of this trust, as long as the replacement distribution trustee is not a related or subordinate party. This strategy creates a superb asset and divorce protection shield.

Powers of appointment, which provide an individual with the flexibility to rewrite trusts, can change the trust's distribution pattern. There are two types--a general power, and a limited, or special, power of appointment. The settlor may convey these powers to a beneficiary.

A special power of appointment eliminates control interference of remote beneficiaries by giving the beneficiary or trustee the power to disinherit complainers. The power to appoint is the power to remove. This power can be exercised by the beneficiary in favor of anyone except his estate, or creditors of his estate, without causing estate inclusion. Its prime importance is to permit the trust to be reformulated to best fit a family's changing needs. This power doesn't cause property to be included in the powerholder's estate for federal estate tax purposes and can be given without adverse tax consequences.

Providing Flexibility

The virtually unrestricted ability to amend the trust adds flexibility to adapt to changes in the law, family circumstances, or the attitude of the primary beneficiary at least equal to outright ownership, and, in many instances, in excess of outright ownership.

For example, the trust could acquire a home for a beneficiary's use without adverse tax consequences. Without a trust, his parents would have to acquire the home. Unlike the rent-free use of a home owned by a trust, the rent-free use of a home owned by parents could have adverse gift tax consequences. In addition, the home would be included in the parent's estate.

The flexible inflexible trust can be one of the most powerful asset protection tax planning tools available. It is an amendable, non-self-settled trust attuned to changing family circumstances. It permits settlors to control it during life and, on death, permits their beneficiaries to control their inheritance without subjecting trust assets to estate tax, unnecessary income tax, creditors, or divorcing spouses. Wealth inherited in trust is far more valuable than wealth inherited outright. The flexible inflexible trust is unsurpassed when it comes to building and protecting wealth.

Alan R. Eber, LL.M. (Taxation), is an attorney in Encino, California, specializing in estate planning and asset protection. He can be reached through his Web site at www.assetprotectionlaw.com, by e-mail at alaneber@assetprotectionlaw.com, or by telephone at 818-906-0126.

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