LIn part I, we discussed the reasons for the changing nature of estate planning. We argued that many wealthy clients are examining their estate plans with four primary goals:

  • To protect their families from ever being destitute.
  • To provide incentives and opportunities to their families.
  • To avoid providing an unearned, non-working lifestyle to their heirs.
  • To minimize intra-family conflicts.

This article is designed to give planners the flavor of how modern-day estate planning techniques can be structured to achieve those goals. While the techniques are generally not new, what is new is the emphasis and use of these techniques to meet non-tax objectives, such as restraining an inheritance. It should be noted that the various techniques discussed can have multiple purposes. For example, a generation-skipping trust can be drafted with the primary goals of building a safety net for family members, minimizing transfer taxes, and creating incentives for heirs to be productive and contribute to society. That same trust might also restrict the ability of future generations to live a lavish, unearned lifestyle.

Perhaps the single worst thing a client can do to his family is to fail to provide for his death or incapacity. At a bare minimum, virtually every client should have certain basic documents, such as a will, living will, health care power of attorney, and general power of attorney. One important legacy that a parent should leave is to dispose of assets in a manner designed to minimize potential family conflicts; i.e., leaving a legacy of relationships rather than a legacy of conflict. This perspective should be at the core of any estate plan.

Reducing Conflicts

The attention paid to personal property after its owner’s death is often disproportionate to both its focus in the pre-death estate plan and its appraised value. For example, we had a client who, 10 years before her death, told her son that he would inherit an old grandfather clock. A few months before the client’s death she also promised the clock to her daughter. After the mother’s death, as the son started to take the grandfather clock out of his mother’s house, the children got into a dispute over the clock that escalated into a fistfight. In the end, the clock was broken in the altercation and today the siblings barely speak to each other.

To the extent that the client wants a particular asset to go to a particular person, the client should provide a legally enforceable document that passes that asset to the heir. This is especially important when assets are being transferred to more remote heirs, such as family friends or remote cousins. Clients should also be strongly encouraged to talk to their children about which assets the children want to receive upon their parents’ death. Because the parents resolve the conflict, any long-term damage in the children’s relationships may be minimized.

Furthermore, clients should document the ownership of their assets. For example, if a daughter lent her mother a china cabinet, it needs to be documented that the cabinet belongs to the daughter. In the absence of such contrary information, it will be presumed that it belonged to the person in whose home it was found. This is a particularly important issue in second marriages.

The choice of decision makers is one of the most important determinations a client can make. These choices can either avoid or create conflict. In selecting fiduciaries and power holders (i.e., decision makers upon incapacity), the client often does not focus on the potential for conflict. For example, the use of a highly emotional family member to make medical decisions is likely to breed problems, while choosing a control freak to make property and asset decisions upon incapacity may not be a good choice either.

Because clients cannot bequeath their children, a guardianship decision can be attacked by other family members. The client should address this issue directly by telling family members who has been selected to raise any minor children. If there are strong reasons that certain family members should not obtain custody (e.g., a history of sexual or alcohol abuse), the client may want to create documents submittable to the court apart from the will reflecting why the client did not want those family members to obtain custody. Moreover, we generally advise clients not to use the same person as guardian and trustee.

The choice of trustee is one of the most important decisions a client can make, especially for discretionary trusts. Choosing an estranged child as trustee for a stepmother is not advisable.

Another source of conflict is ownership of family businesses and properties. Due to a combination of family conflicts and the confiscation from an estate tax, few family businesses survive into the third generation.

In the course of my practice, I have found two consistent certainties which might be added to Benjamin Franklin’s much-quoted aphorism: “But in this world nothing can be said to be certain, except death and taxes.” Both certainties assume that the owner of a closely held family business has family members who may continue to operate the business after the owner’s retirement or death. These two certainties are:

  • The equity value of the business is not an asset; rather it is a liability waiting to happen When the business owner intends to pass a business to family members, the equity value provides no significant benefit to the owner. In most cases, when the issue is properly addressed, the owner is really interested in control of the entity and its income. Numerous approaches–such as deferred compensation, family partnerships, and trusts–allow the income and control of the business to be separated from the equity, and then to have the equity passed on to family members using various valuation adjustment techniques. By retaining ownership to death, the owner may lose the ability to not only discount the present value of the business, but also cause the family to pay estate taxes on the appreciated value of the business.
  • Conflicts are inevitable between operators of the family business and family members who are outsiders Many entrepreneurs intend to pass down their businesses to designated heirs who will run the business after the entrepreneur’s death or retirement. But because the business is often the largest single asset of the estate, the owner may also pass ownership in the business to other family members. Conflicts will inevitably develop, particularly between those who operate the business and those who do not work in the business. This is not a matter of “good” and “bad” family members. It is a simple matter of having different life goals. The solution lies in setting up a structure to ensure that those in the business own and control as much of the business as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. This planning process traditionally must be done during the entrepreneur’s lifetime so the entrepreneur can dictate the terms to family members.

The Restraint Continuum

Parents often feel caught between two extremes: providing a sizable inheritance to heirs (to their potential detriment) or providing a majority of the inheritance to charity (and thus substantially disinheriting family). The simplistic fallacy in this approach is that most planning is not done at the extremes, but rather somewhere in the middle.

Increasingly clients are calling upon their advisors to provide them with mechanisms to reduce access to their assets by their heirs. These “restrained inheritances” are designed to place a gatekeeper between the heir and the asset. The restraints that can be placed on inheritances might be perceived in terms of a “restraint continuum.” On one end of the spectrum 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 extremes lies a restraint continuum of restrained inheritances.

The restraints are typically designed to accomplish a particular client goal, such as protecting a child in a bad marriage from the consequences of a divorce. The fine-tuning of the restraint will reflect the particular values of the client and the tax ramifications. There are a number of reasons a client might be considering such restraints, including:

  • Protecting a heir in a problem marriage
  • Providing for a second spouse, whileassuring that the client’s descendants ultimately inherit the client’s assets
  • Protecting a handicapped or disabled heir
  • Protecting heirs from the questionable judgment of a parent, such as an ex-spouse
  • Placing a gatekeeper on the inheri-tance of a known spendthrift
  • Creating incentives and opportunities for heirs, without supporting a lavish, unearned lifestyle
  • Delaying distributions for young heirs
  • Influencing the behavior of heirs
  • Providing a safety net to future gene-rations to replace the potential loss of governmental benefits.
  • Keeping control of the family business in the hands of those operating the business, while still providing support to those outside the business.

The nature of the restraints in inheritance is a direct result of the client’s goals. The constraints may be structured in a number of ways, including delaying benefits until a designated future date, placing control of an inheritance in the hands of another decision maker, giving a third party the discretionary judgment to decide on distributions to an heir, setting objective criteria for heirs to receive trust benefits (e.g., going to college and maintaining a 3.0 average), limiting the right to benefit from part of an asset (e.g., through a family limited partnership), or denying rights to a part of an asset, such as future value of the asset (e.g., a charitable remainder trust).

Using a Safety Net

Probably one of the most restrictive approaches involves the use of a safety net because distributions are generally only made when the heir is destitute. Among the mechanisms used in this approach are spendthrift trusts, which restrict the ability of any beneficiary to assign or otherwise transfer his or her beneficial interest in the trust and restricts the right of creditors of a beneficiary to demand payment of income or principal to satisfy the obligations of the beneficiary. A spendthrift trust, combined with the trustees’ rights to make discretionary income or principal distributions to any beneficiary, is often the best approach. Trustees can be left to use their judgment in deciding when distributions are in the best interest of a beneficiary.

Another tool is the family limited partnership, which has long been used as a device to separate control of an asset from the right to receive the earnings of the asset. A client may place responsible family members in charge of the family LP, allow them to operate the partnership, and decide when and how distributions are made to the limited partners. Another technique is to allow voting control of a corporation to be separated from the equity ownership in the entity. If the entity is taxed as an S corporation, a family limited partnership, or a limited liability corporation, an agreement may allow for minimum required distributions of income to owners to cover taxes incurred from the allocation of the entity’s income.

Restricted Trust Inheritances

The manner in which clients can restrict wealth transfers is as broad as the imagination of the planner and the client. Obviously, the safety nets described above also serve as a means of limiting the access of an heir to a family’s wealth. By nature, any inheritance placed in trust is restricted in some manner. Among some trust possibilities are staggered trust distributions. Few heirs are ready to handle a substantial fortune at an early age. Because of this, many estate planners provide for staggered trust distributions to young heirs, allowing them to mature over time as they receive their inheritance. For example, a trust might provide that an heir receive 10% of an inheritance at age 21, 20% of an inheritance at age 26, 30% of an inheritance at age 30, and the remainder at age 35. This delays the heir’s ability to control the asset until (it is hoped) the heir has acquired the maturity to manage the money. In most cases, the trustees would have authority to make discretionary income and principal distributions to the heir during the term of the trust.

Another technique is to use charitable remainder unitrusts, which have long been used to minimize an heir’s access to an inheritance. For example, a charitable remainder unitrust instrument might provide that the heir receive a 7% annual return on the trust assets for life, with the balance passing to a charitable beneficiary named by the trust grantor. The heir’s ability to control and manage the trust assets can be minimized or eliminated in the trust instrument. Other techniques include:

Transfers to Minors Many clients provide gifts to minors in custodial accounts. However, they may have inadvertently created the wrong incentive. For example, we recently had a client who had funded a custodial account for a grandchild for more than 15 years. When the grandchild reached age 21 (after bouncing in and out of college), he went to the custodian and demanded the $200,000 that was then in the account. When asked why, he told the family he wanted the funds to go to Europe to “discover himself.” Legally, the child owned the funds, and the custodial account created an incentive to leave, not attend college. Both a 2503(c) Minor’s Trust and a custodial account generally require distribution by age 21. In lieu of a trust or custodial account that terminates at age 21, a Crummey trust can be established for a minor. Unlike the minor’s trust, the trustee of a Crummey trust can have broad discretion on distribution of income and principal. If an account has already been created, consider making all needed distributions from the previously established account to reduce its value as much as possible before age 21, and make future gifts to a Crummey minor’s trust.

Dynasty Trusts A dynasty trust is a generation-skipping trust designed to exist for the maximum period permitted by applicable state law–the so called Rule Against Perpetuities. Because these trusts are irrevocable, many believe they must be inflexible. But that is not the case. Through creative and flexible drafting, a living document can be flexible enough to change its terms over many generations.

The Family Bank The majority of today’s millionaires were entrepreneurs who created their own wealth. One part of the new planning approach is to develop a mechanism by which a family trust can provide sources of capital (by loan or investment) for heirs. The central issue with such decisions is an evaluation of a proposed loan or investment. Few entrepreneurs would want to fund the latest multi-level marketing fad, but may be willing to provide capital for worthwhile family businesses.

Influencing Behavior

What tools are available to accomplish the goal of influencing the behavior of known or even unknown heirs? Obviously the above tools that provide for safety nets and restrict control of an inheritance will affect an heir’s behavior, but many clients want to more directly impact the behavior of heirs. All these approaches require a thoughtful review by the client of the alternatives and a focus on the behavior that is important to the client–something that often requires significant soul searching. Among the techniques are:

Family Incentive Trusts are designed to create opportunities and provide minimum protection to a family without giving future generations an unearned lifestyle. The trust is typically a dynasty, irrevocable, discretionary trust that provides benefits across future generations. Unless truly destitute, no family member can live off the trust funds. The terms of a FIT vary widely, but generally involve one or more of the following approaches:

The trust is designed first to provide a safety net to heirs, second to provide an incentive for desired activities, third to match earned income, and last, to pay any remaining income to one or more charities. No family member can live off the trust income. The safety net may include help for medical, educational, or long-term care needs, or to help destitute heirs. The corpus may be a capital pool from which any family member can request loans or capital investments in their business.

Charitable Responsibility and Involvement Some clients have conveyed substantial assets to private foundations, donor-directed funds, or supporting organizations. In the case of foundations and supporting organizations, family members can run the charity and receive reasonable compensation for their work efforts, without being able to spend the underlying dollars in the charity. The nature of the charity’s ownership of the funds encourages the family’s active involvement in socially beneficial activities (i.e., the making of grants to worthwhile charitable purposes). Other approaches are also available. For example, one of our clients has his grandchildren do the review and on-site inspections of grant requests for the family foundation and requires the grandchildren to submit proposals to the board of the family foundation. He pays each grandchild for the work they perform.

Education Funding We frequently see clients transferring lump sums into educational trusts for the benefit of less wealthy family members. For example, a wealthy brother may transfer $200,000 into a trust to educate his nieces and nephews. The nieces’ and nephews’ attendance at college is encouraged by the creation of the trust, but those who do not want to go to college may receive no trust benefits.

Mentoring Perhaps as a result of the number of inheritances lost to mismanagement, more and more clients are beginning the financial training of their beneficiaries at an early age. This planning process typically involves not only understanding financial management and administration, but also goes to issues of how a beneficiary views the family’s wealth and themselves. A number of organizations have been established in the last several years to deal with the negative effects of inherited wealth. A related approach gets children involved in charitable activities early in their development. In many cases this approach has less to do with charitable benevolence than providing a perspective of how others live and the stewardship responsibility of wealth.

Adding Balance

By necessity, the concept of a restrained inheritance must include a discussion of how balance can be brought into the overall plan. While restraining the inheritance may make sense, giving unbridled power to a third party could be just as damaging to the family and the client may want to give some counterbalancing power to heirs. The document should also create flexibility in the plan, such as allowing beneficiaries to remove trustees from office, and giving heirs limited powers of appointment to determine how their own heirs will inherit the family wealth.

Should every estate plan include an approach to influence the behavior of heirs and restrict an inheritance? Obviously not every estate plan needs to accommodate these approaches, but in the appropriate circumstances, the approaches can be a useful part of an overall estate plan. Do these techniques ensure that there will be no family conflicts in the future? No, any plan should be structured with the expectation of possible conflicts. Finally, do these techniques assure “good” heirs? There is no such thing as a perfect estate plan. However, this approach is designed to directly address the concern that an unearned, potentially conflict-laden inheritance may do more harm than good to your family.