Two factors are converging to cause certain clients to consider creating family banks in 2012. The first is the phenomenal success of estate-freezing gift strategies (primarily, grantor retained annuity trusts and sales to intentionally defective grantor trusts) that were put in place during the early months of 2009. The success of those strategies has caused a shift of assets to children from parents that has far exceeded expectations and, in many cases, has left parents satisfied that their children are provided for in all events. The second is the ability to make direct, simple gifts of up to $5 million per donor, free of gift and generation-skipping (GST) taxes, for the remainder of this year. Many of those clients who believe they have provided sufficiently for their children and feel they still have excess capital are now implementing family banks with their $5 million (or $10 million with a spouse) exemptions to provide capital for future business ventures, public-spirited projects and human capital development.
What is a family bank?
A family bank is a trust (or non-profit, not-tax-qualified organization) that’s funded for a customized set of purposes, with the expectation that its flexible design will financially support one or more of the following types of activities:
- Business, active investments and career opportunities of particular interest to individual family members and relatives; and
- Public policy advocacy and personal philanthropy that’s more flexible than would be permitted for a tax-qualified charity.
A family bank makes capital available for purposes that blend personal and family values and promote active family participation in both wealth building and helping others, without being confined to traditional models for organizing family wealth or philanthropy. A family bank also provides a means for younger generation family members to learn decision-making and financial matters from hands-on practical experience.
Unlike a personal trust, the family bank is not intended to fund extraordinary personal consumption or even living expenses, per se, and there is no sense of economic entitlement. Similarly, the family bank is not intended to fund traditional charity, because, unlike a tax-qualified charity, there are few constraints on the family’s ability to define the use of funds, whether to finance profit-making endeavors or public-spirited projects.
Equally important, the family bank is not intended to function as a so-called “incentive trust;” there is no “if you do x, then you get y” formula. (In fact, one could call it the anti-incentive trust.) The family bank is a pool of capital available to family members and others who demonstrate that they can put that capital to productive use. That demonstration is required initially, prior to receiving any assistance–similar to a grant or loan application process–and is required on an on-going basis, thus promoting accountability.
Why would a client create a family bank?
Our clients who have created Family Banks1 often do so because they believe that opportunities to control or use capital to build businesses or careers, improve the lives of family members and others, and expand human knowledge can be more satisfying than other, more personal, uses for excess family wealth. These clients believe that, through financial support and mentoring in decision-making, they can foster commitment and active participation by their family members in building wealth or helping others and can provide a user-friendly process for family members to receive multi-generational mentoring (whether from the client’s peers or qualified family members themselves).
What does a family bank look like?
Each family’s application of this idea can be different and, indeed, should be customized for its own agenda. The structure must accommodate tax costs, but not allow tax issues to limit use of the funds, as is the case in most family wealth structures today. Listed below are certain common elements inherent in most family bank structures.
- Structure– as noted, our clients have created family banks using trusts as the basic platform. There is an administrative trustee that is responsible for meeting certain basic requirements (filing tax returns, arranging for custody of assets, etc.), as well as an independent protector responsible for replacing fiduciaries that aren’t performing properly. Decisions regarding whether and to what extent to grant applications for funds and ongoing monitoring of prior grants (including investments) are handled by a committee of specially appointed peers, colleagues and qualified family members, who possess, in the aggregate, the necessary investment and mentoring skills and relationships with the family.
- Funding –this year, simplicity has appealed to clients and, thus, our clients funding a family bank have done so with simple, direct gifts of liquid assets and venture capital investments that no longer have capital commitments or vesting issues. Thus, they have funded their respective family banks at little or no gift tax cost and without future GST tax consequences. In each case, there is no charitable deduction to reduce or avoid taxes.
- Taxation– The family bank is subject to U.S. federal income taxes, and distributions to applicants are taxed to the beneficiaries as income, just as in a personal trust. Loans to individuals are subject to the usual tax rules for intra-family loans, while direct investments in new businesses are treated most favorably (as one would expect). All this is manageable, but taxes are the cost of flexibility.
- Reporting– the family banks we have created are so-called “quiet trusts” and, thus, the broad groups of individuals that are beneficiaries are not entitled, under the Uniform Trust Code, to receive reports or accounts. Instead, those reports are sent to the protector who is responsible for acting on behalf of those individuals.
In crafting the “how” of a family bank, there are certain fundamental questions that the client must answer:
- Should funding money-making enterprises or careers that are expected to be sufficiently lucrative to enable the recipient to repay all or some part of the funds (as if a loan on “soft” terms) be the only permissible use of funds or simply a priority use of funds?
- If not limited to funding money-making enterprises or careers, should the purposes nonetheless be limited to careers or activities that would allow the recipient to be reasonably self-supporting, at least at a level that supports a modest life style, albeit without the ability to repay the original funds out of earnings?
- Should the individuals who benefit be limited to family members or include non-family, such as friends, community leaders, business associates and deserving individuals who would, nevertheless, not qualify as a “charity case” (for a tax-qualified grant from a private foundation)?
- Should funds be disbursed with a strong view toward preserving and enhancing the trust funds with returns from successful projects, or should it be expected that, over the course of time, the risk and other characteristics of funded projects will tend to reduce the size of the trust funds (unless there is an extraordinary success on a given project)?
These are difficult questions, but the process of clients answering these questions is important for their families to have a long-term, healthy relationship with, and understanding of, the family’s resources. Moreover, there are risks inherent in the family bank structure: if operated improperly, the family bank could become an “incentive trust,” used to control conduct rather than promote commitment, creativity and family and community values. Potential conflicts can arise between personal use of funds for enhancing careers of family members vs. funding the dreams of others in less fortunate circumstances, because of the powerful temptation to use “family” money for experimenting with business ventures and careers in order to conserve “personal” money for future personal use. These risks are readily manageable with thoughtful design of the family bank and sufficient built-in flexibility and adaptability.
1. Many of these clients are successful entrepreneurs who believe that the process of succeeding in a business is one of (if not the) most gratifying and meaningful experiences life has to offer. But, these clients also include members of families that were exceptionally successful several generations ago and that have successfully instilled in the older generations a sense of stewardship of the families’ financial and human capital resources.