In our practice, we are often asked to review a client’s existing will or trust, just to see if it is OK. Most of the time, when the client’s children are grown, the will or trust provides that the children receive their inheritance outright. Often, parents feel that if their will or Living Trust doesn’t provide that their children will get their inheritance outright, the children would be upset.
But my kids are mature adults; I don’t have to leave their inheritance in a trust, is a response I hear frequently. But the little known fact is that a parent can provide a child with a lot more benefits, both tax-wise and otherwise, if the child’s inheritance is held in a trust. Parents can do something for their children that the children cannot do themselves: make their assets more valuable by protecting them from taxation while also protecting them from future events such as failed marriages, lawsuits and bankruptcies.
The estate planning strategy that helps achieve these powerful benefits is sometimes referred to as multi-generation planning, and has its origin primarily as a method of reducing estate taxes for wealthy families as the family wealth passed from generation to generation. The strategy involves the use of a specially-drafted trusts (I also sometimes call them Lifetime Trusts or Beneficiary Controlled Trusts) which provide funds for a beneficiary’s health, education and support, but do not get taxed for estate tax purposes when the beneficiary dies. These trusts, besides escaping estate taxation upon the beneficiary’s death, can be controlled and accessed by the beneficiary for almost unlimited purposes, while providing protection from a failed marriage, lawsuit or bankruptcy. To illustrate the concept, let’s consider a sample case.
Tom and Mary Smith are both aged 55, and have two children. Ann is 30 and Bobby is 25. Tom and Mary’s taxable estate is $4,000,000. They have just completed the design and implementation of a proper estate plan, utilizing the standard bypass trust, so their entire estate can be passed to Ann and Bobby totally free of estate tax, by using the $2.0 million exemption (for Washington State clients) available to each spouse. Now it occurs to the Smiths that Mary’s mother, who is now nearing her 80th birthday, has an estate of almost $1,000,000, which, according to her will, will be split between Mary and her sister. This means that Tom and Mary’s combined estate will increase to $4.5 million, which is more than the amount that can presently be protected from estate tax. (As a matter of fact, it will likely grow much more than that, since Tom and Mary are still working and their investments are doing quite well.) With Federal estate tax rates of 37% to 55% and state of Washington rates topping out at 19%, the added amount will generate a significant tax.
Assuming that Mary’s relationship with her mother is such that they can freely and openly discuss matters regarding her mother’s estate, the potential exists for the family to obtain significant benefits from some relatively simple revisions to Mom’s estate plan. What Mary should do is call her mother and say something like the following:
Mom, would you mind changing your will so that it does not leave me half of your estate? If I inherit $500,000 from you it will increase my estate. What I would like you to do, instead, is to leave my share in trust for me. This special kind of trust will give me the benefit of my inheritance without the tax burden on my estate. If you do this, Mom, whatever portion of my inheritance I don’t spend during my lifetime will pass to your grandchildren totally free of estate tax. Aren’t you glad we had this little talk?
The economic benefits to the family from the use of Lifetime Trusts and multi-generation planning could be astronomical. With estate tax rates potentially being over 50%, you can imagine the increase in a sum of money held in a trust if it can completely escape taxation for an extra generation (about thirty years). Further, through the use of so-called Dynasty Trusts it is possible to create a trust that will benefit all future generations of the family without ever being taxed! Don’t be misled by the term Dynasty Trust; you don’t have to be famous or rich to be a candidate for such a trust. (And if you think the term Dynasty Trust is too presumptuous, we also call them Perpetual Trusts.)
NOTE: The 2001 Tax Relief Act has created a very uncertain landscape for those attempting to plan their estates. With the increase in the Federal estate tax exemption amount to $3,500,000, effective January 1, 2009, (and repeal in 2010), the tax benefits of such trusts have been somewhat reduced, since many estates might never be subjected to estate tax because they will remain below the threshold limit. However, as the law now exists, the increases in the estate tax exemption amount will all disappear in 2011 (unless Congress acts again in the interim) and the exemption amount will fall back to $1 million. Additionally, the state of Washington has their own estate tax with an exemption lower the the Federal level. Thus, many planners still believe that long-term planning to avoid estate taxes is still critically important for families who wish to protect the family wealth for future generations.
You may be wondering if the advantages of this type of planning are worth the hassle of having the inheritance in a trust, as opposed to Mary getting an outright distribution of Mom’s estate. If you think that having property tied up in a trust is burdensome, consider this:
- Mary can be the sole beneficiary of her trust for her entire lifetime;
- Mary can receive all income generated from the trust each year, and spend it on anything she wants;
- Mary can receive distributions from the principal of the trust for anything that comes within the following categories: health, education, maintenance and support;
- Mary can be the Trustee of her own trust. This means she decides how the trust property is invested, and she determines what is necessary for her health, education, maintenance and support. For better asset-protection benefits, Mary should have a Co-Trustee appointed to serve with her.
Does this sound overly burdensome, considering that the property in the trust passes from Mary to her children totally free of estate tax?
Other than tax reasons, there are several other valuable benefits from using the Lifetime Trust strategy for bequests to children and others. Quite simply, it is my opinion that money left in trust is more valuable than money left outright. For beneficiaries who may not be financially responsible or savvy, a trust can assure that the funds left to the beneficiary are wisely invested and used for the purposes intended, and not squandered. Even for beneficiaries who need no such protection because they are completely responsible and trustworthy, money (or any other asset) held in trust can be sheltered and protected from lawsuits, bankruptcies and failed marriages. With proper design and drafting, such trusts can also ensure that the beneficiary has sufficient control and enjoyment of the property left to him or her. Thus, more and more of our clients are structuring their estate plans in this manner, and their children are very grateful.
The above example shows the benefit of the coordination of the estate planning between parents and their children. Unfortunately, this happens less frequently than it should, primarily because it is not unusual for children to be reluctant to speak with a parent about the parent’s estate plan. Children are often afraid that the parent will think that the child is getting too eager to receive the inheritance. It can be a very uncomfortable thing to discuss. However, if it is approached in the right way, as an effort to preserve and protect the family wealth, a well thought out estate plan can be seen as a very positive family exercise, and one that will bring benefits to the family for generations. Lifetime trusts are one very effective way to increase those benefits.