from the november advisor

Inheritance Planning

Thinking outside the box: Non-tax motivations for trust planning

by Morgan Scott

Mr. Scott is director of Advanced Marketing, The Prudential Insurance Company of America, Newark, N.J. Connect with him by e-mail:

Much has been written about estate planning in our current tax environment where, let’s face it, most of us may no longer have many clients with estate tax exposure because of the current exemption amounts. Some commentators and planners have advised us to stop using the phrase “estate planning” in favor of phrases such as “wealth transfer planning”. The reason being that estate planning brings to mind estate tax problems and mitigation (which we’ve established are non-existent for most Americans), where as wealth transfer planning is sufficiently vague to encompass all sorts of end of life concerns.

However, to focus on the federal estate tax – or its absence – as the primary concern in estate planning is to overstate the problem. It is not always a question of how much money a client’s estate owes in taxes and fees, or how much can be ultimately transferred to one’s heirs, but rather how the distribution of funds itself is handled. After all, many clients –affluent or otherwise – are not only concerned with the net amount of wealth transferred to their heirs, but also with what amount of wealth may prove toxic to the beneficiary. Put more simply: many families are concerned that a large inheritance will harm their heirs over the long run.

It is this concern that we will attempt to address in this article. The use of trust planning should not be limited to those families who are wealthy enough to be subject to the federal estate tax. The controls that a properly drafted trust document can provide after death (perhaps long after death) may be able to protect beneficiaries from themselves, provide a financial safety net, and encourage certain behaviors while discouraging others.

These techniques are not new or cutting edge, but they are extremely useful in helping clients pass on their wealth in an orderly and dignified manner. What many clients want is non-financial in nature: peace of mind. By suggesting the inclusion of irrevocable trust planning in your client’s wealth transfer plan, you can help your client know that their legacy is protected and that their wishes can be carried out with specificity over the long term.

Below we will explore some creative concepts and ideas that can be incorporated into your client’s wealth transfer plan.

The “Head Start” Trust

This trust planning concept is based on the idea that family members/beneficiaries should be able to support themselves and live a life independent of trust funds, but still receive assistance at critical junctures in their lives. For instance, trust funds could be made available for education expenses (not only undergraduate, but perhaps graduate school and private secondary school as well), or a down payment on the beneficiary’s first home.

Trust as “Retirement Plan”

Similar to the “Head Start” model, this trust is designed to provide the beneficiaries with support, but without draining their initiative or by turning them into “trust fund babies”. However, as the “head start” model provides for trust funds to be made available at junctures earlier in life, the trust as “retirement plan” is intended to provide a safety net for retirement later in life. This would allow for trust beneficiaries to pursue careers that may not lead to significant wealth accumulation (the arts, social services, charitable works, etc.) without the fear of being destitute during retirement.

Once the beneficiary has reached a predetermined retirement age, the trustee can begin making distributions for health, education, maintenance and support. While not for everyone, this type of trust may provide for a longer period of time where trust assets are being invested, and hopefully being built up significantly. Therefore, this type of trust, when appropriately funded, may be able to service the retirement needs of multiple generations of beneficiaries.

Behavioral Modification/Incentive Provisions

...many families are concerned that a large inheritance will harm their heirs over the long run

One area of trust drafting that has received much attention lately is the area of incentive and disincentive provisions. These provisions are included in a trust to guide or otherwise encourage certain behaviors (and discourage others) by the beneficiaries. As stated earlier in this article, one common concern among clients is that by having a trust, their beneficiaries will be spoiled and will ultimately be “poisoned” by the inheritance they receive. The dreaded “trust fund baby” scenario. Here are some provisions that we have found to be popular.

  • Milestone distributions: the beneficiary will receive trust distributions for accomplishing certain goals. E.g, graduating college, having a child, etc.
  • W2/1099 Limiting Provisions: the trustee may not make distributions in excess of what a beneficiary earns himself/herself in a given year. This is intended to promote initiative and industry in beneficiaries, and effectively prohibit them from living off of trust distributions alone.
  • Random drug testing: a trustee may be permitted to hire a third party to administer random drug tests as a precondition for receiving trust distributions.
  • Philanthropic incentives: a trust can be drafted to have the trustee match distributions to the beneficiary’s charitable giving on an annual basis. These could be distributions to the donor/beneficiary, or matching contributions to the charity itself. The trust could also have provisions giving the beneficiary a power to appoint a certain amount of trust assets to charity each year.

As you have probably concluded by this point, trusts are flexible instruments that can be drafted to suit a variety of client needs. Indeed, as long as the particular provision is not prohibited by law or against public policy, the client and her team of advisors can be incredibly creative in how they structure the trust. Just as important as the drafting of the trust itself, is the funding of the trust. Here again, most clients do not have a federal estate tax issue, but that does not mean that we can disregard taxes in their entirety. Depending on the client’s state of domicile, there may be the risk of state level death and inheritance taxes. In addition, federal income tax management in trust planning should be a high priority. Particularly with those trusts that may have an extended growth period where income is reinvested into principal.

Trusts pay income taxes at roughly the same rates that individuals do. The tax brackets themselves, however, are compressed to such a degree that trustees of irrevocable trusts have to pay taxes at the highest marginal rate of 39.6% on all income over $12,150 a year (2014 bracket, indexed for inflation). Long term capital gains will also be taxed at the highest amount of 20%, and investment income may also be subject to the 3.8% Medicare surtax. As you can imagine, it is not difficult for investment income to exceed $12,150 in any given year and that this would cause trust assets to be eroded by federal income taxation. This is what is known as the “tax burn”.

It may behoove the trustee and their investment advisor to consider those investments that have income tax characteristics that are beneficial in nature. Consider permanent life insurance, which has for many years been a popular choice for trustees. Life insurance cash values (to the degree cash accumulates in the policy) are tax deferred, cash values can be taken via partial surrenders and/or loans on a tax advantaged basis, and the death benefit is also income tax free. Assuming insurability, and the existence of a life insurance need, a permanent life insurance policy may provide a number of benefits when used within an irrevocable trust.

The next time you’re consulting with a client concerning their wealth transfer plan, don’t assume that trust planning and estate tax exposure are synonymous. Planning with trusts should not be limited to estate tax mitigation or avoidance. When properly drafted, a trust can mitigate a variety of non-tax concerns that are all too common amongst our clients. What is important to note is that there is almost always “more than one way to skin a cat”, and by thinking outside of the box, you may be able to better serve your clients needs and help meet their wealth transfer goals.