The Restraint Continuum In Passing On Wealth

In September 1986, Fortune magazine published an article on how many of Americas wealthier citizens had decided not to pass their wealth to their families. In the years since, this theme has been repeated in numerous other national publications.

In many cases, the articles focused on the extreme ends of the spectrum: to provide a sizable inheritance to heirs (to their potential damage) or to provide a majority of the inheritance to charity (and substantially disinherit family).

The articles, in many cases, adopted an overly simplistic view of estate planning. Most planning is not done at the extreme ends, but somewhere in the middle. If we look at the alternatives along a continuum, with at one extreme, disinheritance, and the other, fee-simple inheritances, most planning lies in between.

Many planners believe the primary goal of estate planning is to “pass as much wealth to the next generation, as tax-free as possible.” Assets and tax savings, not the family, have become the pivotal focus. Compare the number of articles in professional publications discussing tax-saving techniques to articles that discuss the practical, non-tax issues of family inheritance. Needless to say the comparison is a bit lopsided to the tax-driven side.

However, an evolution is building in estate planning. Increasingly, clients are concerned about the impact of providing unearned wealth to family. From news articles, experiences of friends and personal experience, wealthy clients are increasingly concerned about the detrimental impact of their wealth on their families and are increasingly refusing to have taxes drive the planning process. Many clients have come to believe their families have more to fear from an unrestricted inheritance than they do from excessive estate taxes.

The evolution is the result of this changing perspective about inherited wealth. The pivotal goal of estate planning is becoming to “protect and preserve the family” not “ protect and preserve the assets.” It is not that the preservation of family funds is unimportant; it just pales in significance when compared to protecting family.

Why is this distinction important? Because when the assets serve as the focal point, maximizing wealth transfer is the key planning goal. When the family is the focal point, the planner is forced to concentrate on other issues, such as:

1) Taking account of the personality, family situation (e.g., divorce-prone marriage) and character of each inheritor.

2) Minimizing the sources of potential family conflicts.

3) Aiding the clients desire to pass on productive values to future generations.

4) Creating opportunities and incentives for family, without providing an unearned lifestyle.

5) Placing reasonable restraints on inherited wealth.

In most cases, some form of restrained wealth lies at the core of each of these issues.

This new perspective is the direct result of a number of demographic and societal changes. First, there has been an explosion of wealth in this country in the last two decades. It is estimated that somewhere between $41 trillion and $136 trillion will pass in the next 40-50 years. It is not just the wealth, but also the demographics of that wealth (and related perspectives and implications) that are driving the revolution. A study by US Trust, A Portrait of the Affluent in America Today, noted that only 10% of todays millionaires inherited their wealth.

Second, most millionaires have an abiding desire to use their wealth to help, but not support, their adult heirs.

According to the US Trust study, 83% of todays millionaires expect their children to contribute to the cost of their own education on the assumption that something given is never as valuable as something earned. Ninety-one percent of the women and 80% of the men expect their children to support themselves entirely from their own earnings. They will provide opportunities, but unrestricted lifestyle support is not generally in the cards.

Third, the estate tax confiscation of family assets has been diminishing the last several years. Although it is unlikely that the estate tax will be eliminated in 2010, it will be reduced for the vast majority of taxpayers, increasing the concerns about too much wealth passing to family.

Fourth, clients are increasingly examining estate-planning approaches that provide for asset protection to the clients and their heirs. For example, more than 40% of first marriages end in divorce and clients are increasingly reviewing how to protect their heirs from the expectation of divorce.

Finally, many clients have an abiding fear that they have failed to teach their children financial responsibility. As a consequence, they are unwilling to place sizable inheritances in the hands of a proven spendthrift.

Restraints on an inherited wealth have always been a part of estate planning. For example, Q-TIP trusts have long been used to provide current benefits to a surviving spouse, while assuring that the decedent, not the spouse, governs ultimate disposition of the trust assets. Transfers to young beneficiaries are often delayed for years after they reach adulthood, allowing them to mature before receiving the inheritance.

The restraints that can be placed on beneficiaries can be perceived in terms of a restraint continuum. On one end lies an outright, fee simple, disposition to the heirs, while at the other end lies an outright unfettered contribution to the general fund of a charity. In between these two ends lies a constraint continuum of trusts benefits, family partnerships, non-voting stock and family charitable structures.

These restraints are typically designed to accomplish a particular goal of the client. The type of restraint, therefore, is a direct result of the goal the client is attempting to accomplish. The fine-tuning of the restraint will reflect the particular concerns and values of the client in the development of the estate plan. Among the reasons the client might be considering a restraint on inherited wealth are:

  • Protecting a child in a bad marriage.
  • Protecting a handicapped heir.
  • Protecting heirs from the questionable judgment of their parents or step-parents.
  • Placing a gatekeeper (i.e., trustee) on the inheritance of a spendthrift.
  • Delaying distributions for young heirs.
  • Influencing the behavior of heirs.
  • Creating opportunities and incentives for family, while restricting their absolute control of the inheritance.
  • Providing a safety net to future generations to replace the potential loss of governmental benefits.
  • Keeping control of the family business in the hands of those operating it, while still providing support to those outside the business.

The constraints may be structured in a number of ways, including:

  • Delaying benefits until a designed future date (e.g., when the child reaches 30).
  • Placing investment control in the hands of a more sophisticated decision-maker.
  • Using the discretionary judgment on distributions of someone other than the heir–using the subjective judgment of the third party.
  • Setting objective criteria for heirs to receive trust benefits (e.g., going to college, reaching 30, etc.).
  • Limiting the right to income, equity or appreciation (e.g., a charitable remainder uni-trust).

Understanding restrained wealth planning is impossible without understanding the basic nature of an asset. Virtually any asset has four primary components that can be appropriately divided in the planning process. These components are:

Control. Often the most important element to the client is the ability to control the asset. For example, even when he makes gifts to family members of company stock, a closely held business owner generally wants to retain control of the business decisions (e.g., the payment of income and benefits, or employing family members). A general partner owning only a 2% interest in a family limited partnership may still control the operations of the partnership, but may not have a significant portion of the allocated income, current equity, or future appreciation generated by the partnerships assets.

The trustee of a generation-skipping trust controls the trust, but normally is prohibited from using trust assets for his personal benefit.

Income. In many cases, the donor wants to retain the right to receive income and other present benefits from the asset. For example, the recipient of a charitable remainder annuity trust has a right to income, but may not share in the current equity, or future appreciation. A generation-skipping trust may provide an income right to a spendthrift child, while restricting his ability to benefit from the trust assets.

Current Equity. The current equity value of the asset (i.e., what the owner would receive if the asset were sold) is the third element. While a general partner may control a family limited partnership with a 2% equity share, the vast majority of the partnerships current equity value is normally owned by the limited partners.

Future Appreciation. From an estate tax perspective, future appreciation may be the most important element. A charitable lead trust can provide for family to receive the appreciation in the trust asset, while eliminating the current right to the trusts income.

The proper division of these four basic components lies at the core of virtually all planning strategies. If clients can understand these parts, they may make the difficult decisions planning requires.

The concept of a restrained inheritance should never end without discussing some of the ways that balance and flexibility can be bought to the overall plan.

While restraining the inheritance may make sense, giving unbridled power to a third party could be just as damaging and, often, the client wants to give some counter-balancing power to heirs. For example, granting a person a “Limited Power of Appointment” can provide significant flexibility to the planning process.

Assume a client creates a lifetime unified credit GST trust for the benefit of his wife and minor children. He is concerned that the trust has no flexibility to deal with issues that may exist when his children are older (e.g., they develop alcohol or drug problems). The spouse could be given a limited power of appointment to reconfigure the trust for the benefit of the grantors descendants at any time before her death–adding flexibility to the plan.

An example may help. Joe and Betty have a 31-year-old daughter, who has one child and is in a marriage that seems headed for divorce. They are concerned that to the extent their daughter inherits from them, the assets may ultimately pass to a disfavored son-in-law. They are specifically concerned their daughter might be pressured into placing any inheritance in a joint account with her spouse.

The only way to keep the child from retitling assets is to place the assets in a vehicle that does not permit such retitling. A trust is probably the best technique to take away the potential pressure to retitle assets. Obviously, the trust would also have spendthrift trust language eliminating the access of creditors (including divorcing spouses lay claim to those assets).

The document probably should not have language in it that says, “If my daughter divorces that bum, she can receive all of the trust fund.” But it may be advisable to provide that the trustees have the ability (in their absolute discretion) to terminate the trust at any time and then have a side conversation with the trustees to terminate the trust if a divorce occurs.

Another example: A widowed client has no intention of providing a significant inheritance to her children and believes she has already provided significant asset transfers to them during her life. However, the client is concerned that she does not see any significant charitable involvement by the family and believes it would be in their best long-term interest to begin such involvement. If the assets were sufficient, the client might consider a family foundation or the creation of a family supporting organization beneath a local community charity.

Such entities might provide an ongoing income stream for the family members to manage the charitable endeavors while restricting their personal benefits from most of the income and the corpus of the fund.

Moreover, the client might provide that her grandchildren are designated as the persons to do the grant request reviews, placing them in contact with people and needs they might not ever have otherwise interacted with. If the client wanted something less involved, she might look at a donor-directed in which the family members could direct the distributions, but receive no personal benefits or income as a result.

Restraints on inheritance have been with us for generations. What is new is clients increasing focus on such restraints as a pivotal part of their estate plan for the family members. We as planners are going to have to develop new and innovative ways not only of addressing these often unstated concerns, but also, communicating solutions in an uncomplicated manner. The restraint continuum may be one of the tools available for this perspective.

Some pivotal questions remain unaddressed: Is it wise for a client to even consider placing restraints on inherited wealth? Will the restraints create more harm than good? Arent these restraints just a ruling from the grave? The discussion of these largely philosophical issues are beyond the scope of this article, but are addressed in detail in articles at www.scrogginlaw.com.

John J. Scroggin, J.D., LL.M. is an estate planning attorney in Roswell, Ga. and author of “The Family Incentive Trust,” published by the National Underwriter Company. He can be reached via e-mail at jeff@scrogginlaw.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.