2. Build Flexibility into Your Plan
The future is unknown. Premature death, disability, natural disasters, significant financial success, addiction, divorce and tax law changes are all possible future events, yet traditional tax planning assumes all families share the same future, goals and values. While advanced estate tax planning is a complex subject matter, less than 3% of failed wealth transfers are due to poor investment, legal or tax advice, according to a study by The Williams Group. The vast majority of failures in this area, where failure is defined as a loss of family control over the wealth, are due to more nuanced causes, like the breakdown of family communication and trust, inadequately prepared heirs and lack of established family mission, values and goals. For these reasons, where wealth preservation is a goal, it is crucial to construct an estate plan that enables you and your family to adjust as circumstances change. Without flexibility, even the most technically sound estate plan may become obsolete in the face of reality.
A resilient estate plan may include some or all of the following features:
Discretionary (rather than mandatory) distributions. A common strategy where an estate plan contains trusts is to direct the trustee to pay some or all of the trust estate to a beneficiary when that beneficiary reaches a certain age or ages (for example, one-third at age 30, half at age 35 and the balance at age 40). A more flexible approach is to provide that the trustee may make a distribution to the beneficiary at any time, for any reason, taking into account the beneficiary’s other financial resources, goals and life circumstances at the relevant time. This way, if, for example, a beneficiary is going through a divorce at age 39, the trustee is not required to make a distribution into a personal account that may end up outside the immediate family. Giving a trustee this much control over a trust fund means that selection of the individual or institution is critical. More on that to come.
Grantor trusts, with the ability to “toggle” the grantor status. Another common estate planning strategy is to create trusts where the settlor, or grantor, of the trust is required to pay the trust’s income tax bill. This is a very tax-efficient strategy because it allows the trust fund to grow income tax-free for the benefit of the trust beneficiaries. This is one way of transferring assets from one generation to the next that is not currently subject to gift tax and will not use up exemption. However, due to changes in circumstances, some grantors decide that they no longer want to be on the hook for a tax bill generated by a trust of which they are not a beneficiary. This may happen because the grantor has spent down her personal assets, because she feels that the beneficiaries of the trust have been given enough or for any number of other reasons. Whatever the reason or change in circumstances, the ability to turn off this tax treatment, thus making the trust responsible for payment of its income taxes, is one way to increase the plan’s flexibility.
Spousal access trusts. Under current law, spouses may transfer an unlimited amount to each other. This “marital deduction” from estate and gift tax merely recognizes a reality of everyday life: Spouses are constantly making transfers to and from individual and joint accounts, changing the title on deeds and transacting together and between one another. The Internal Revenue Service (IRS) has decided that these are not taxable transfers worthy of reporting. However, when an individual makes a significant transfer to a non-spouse beneficiary, the IRS looks to account for and, for transfers over $11.4 million, tax those transfers. For this reason, a common tax-efficient strategy is to transfer up to $11.4 million to an irrevocable trust for a non-spouse beneficiary or beneficiaries (typically, descendants). If, however, the original transferor falls upon hard times and can no longer support herself, that $11.4 million transfer is truly irrevocable. Her children and grandchildren may be wealthier than her (and they may not be interested in sharing)! If, however, her spouse was included as a permissible trust beneficiary, there would be an escape hatch of sorts where the trustee could return assets to the original grantor through a distribution to her spouse. This is certainly not the most tax-efficient estate plan, since assets that were formerly removed from the original grantor’s taxable estate would be returned to her spouse, nor is it an airtight method of “saving” a transfer that was too large (what if, for example, the original transferor divorces the spouse, or the spouse predeceases her). The future is unknowable! However, the peace of mind in knowing that there could be a way to get back assets in the event of a change in financial circumstances can be incredibly valuable.
Precatory (that is, expressing a wish or intention) rather than mandatory language within trusts; letters of intent. Traditional estate plans would sometimes contain carrots for good behavior; for example, for every dollar of income the beneficiary earns, the trustee shall make a “matching” distribution from the trust fund. They also occasionally included sticks in order to discourage “bad” behavior – for example, distributions for uses other than education may be made only once the beneficiary has earned a bachelor’s degree. The values these types of restrictions seek to encourage are objectively good – earning one’s own income is rewarded (by a dollar-for-dollar increase in pay from the trust), and education is important. However, what about a brother and sister, one of whom is a teacher with a low income (but contributing significantly to improvement of local education) and the other a corporate attorney with a high income who has no time to spend it? Were the grantor alive, she might say that these two high-achieving siblings should receive equal distributions, or even that the teacher should receive more, in order to supplement a salary that is not enough to make ends meet in a high-cost city. If the restrictive language is built into the actual trust agreement – the written document signed by the grantor and the trustee – the trustee may have a difficult time modifying the distribution standard. If, however, the trust agreement provides that the trustee may make distributions at any time for any reason, then the trustee is able to make decisions about the use of trust funds using facts the grantor did not have at the time she signed the trust. This again points to the importance of choosing a fiduciary who knows you and your family well and whose judgment you trust. Even more valuable would be a letter from you to that fiduciary explaining in nonbinding (precatory) words what you envision the funds should be used for and providing general guardrails for distributions. For example, “distributions should be made to support entrepreneurial behavior, but requests for this type of distribution should be supported by a budget and business plan.”
3. Select Your Fiduciary with Care
To develop a resilient estate plan, carefully consider who will act as your fiduciary. Given the duties associated with the position – and in the case of a trustee, the level of discretion connected to a flexible, long-term trust – the choice of who will serve in this role, and the amount of information you provide to this individual or institution at the time you create and execute the plan, might be the most important decision you will make throughout the estate planning process.
First, you should understand what your fiduciary’s responsibilities will include. There are many professional and procedural jobs a fiduciary must complete in addition to the perhaps daunting task of managing family dynamics and requests for distributions. Every state has a different set of laws, but in each state, failing to fulfill one’s fiduciary duties can result in a lawsuit and personal liability.
A fiduciary must review and understand the document by which she is appointed – a last will and testament or a trust agreement. This will likely require some guidance from an attorney in the case of an individual fiduciary. The fiduciary must also identify and understand the assets of the trust or estate because she will be responsible for managing those assets, which may be as simple as hiring a financial advisor to invest cash or as complicated as running an operating business until a competent successor is identified. Therefore, it is important to consider what your assets are and who would be best positioned to manage them in your absence. Filing tax returns and preparing accountings of trust and estate activity also fall to the fiduciary and will likely require professional assistance.
On the “softer” side, a trustee is required to act in the best interests of the beneficiaries, to be impartial to the extent there are conflicting interests among beneficiaries and to communicate with the beneficiaries. These duties become particularly relevant where a trustee has authority to make discretionary distributions to one or more beneficiaries. Beneficiaries may request distributions, fight amongst each other about distributions or have differing opinions on how trust assets should be invested – and the trustee may find herself in the middle of these disagreements.
People often name family members as fiduciaries because it is a common choice and because those are the people we trust most; however, in selecting a fiduciary, it is important to consider not only the professional responsibility and liability associated with the position, but also the dynamic you want the trustee to have with the beneficiaries. It may be a family member, or it may be a corporate fiduciary that will not face personal or emotional angst as a result of its objective decisions. One option that represents a middle ground is to give a family member you trust the power to remove and replace a corporate trustee. Whatever your decision, it is good practice to communicate with the person or entity you wish to name to ensure that everyone is on the same page about the role and responsibility associated with the job, as well as the values you wish to pass on to future generations through your estate plan.