You'd think that with interest rates at historic lows, assets highly undervalued and the prospect of a permanent estate tax, we estate planners would be deep in tax-planning sessions with clients.
But instead of taking advantage of this perfect storm for tax-driven wealth transfer strategies, many clients are frozen with fear.
Indeed, this is the refrain I'm hearing from clients and fellow advisors across the country: Even the wealthiest are rocked by the current economic news. In fact, the rich may be even more unsettled. After all, they've lost millions. The public may not pity them. But loss is loss. And this loss goes way beyond money.
Let's skip over the dread sparked by fears of a dramatic change in financial and social status. What's going on out there is deeper. Many people have lost faith in the institutions, the professionals and even in family members upon whom they used to rely as advisors and guardians for themselves and for their children.
Just think: Bernard Madoff, now convicted for running the largest Ponzi scheme in U.S. history, not only lost people's entire life savings but also their children's legacies. Often, he was so admired, friends entrusted him with assets held in the trusts created for their heirs.
And it's not just Bernie. Clients may no longer trust investment advisors after loosing half of their net worth this past year. Or after the convulsions in the banking industry, clients may question the trust company that they appointed as trustee of their family trusts. Maybe they're wondering if a relative appointed as guardian of minor children really possesses good judgment after all. And of course, in good times or bad, given the divorce rate in the United states, every future spouse is potentially a future ex-spouse.
No wonder many wealthy clients are thinking about all the risks to their legacies that are not tax-related. These people don't really want to hear about things like grantor retained annuity trusts, charitable lead annuity trusts and sales to intentionally defective grantor trusts.
Instead, if they want to talk to advisors at all, they want to talk about asset protection.
It's a good discussion to have — and even for advisors to initiate at this time. Indeed, the fundamental purpose of estate planning is to protect a client's assets. A good estate plan protects assets from a spendthrift beneficiary. It guards against predators, including untrustworthy or incompetent trustees. The plan may even provide a system of checks and balances by spreading responsibility among various individuals and institutions.
So here's what you can discuss with clients: several non-tax risks they face — and some methods to remediate those risks:
Make sure the children are not stuck with a bad trustee — The long-term success of a well-drafted estate plan depends upon having a decent trustee. But sometimes it's hard to foresee who'll do a good job.
Tell clients that they can protect against bad trustees by having their trust instrument contain a provision for the trustee's removal. The trustee also should be given the power to resign, in case it's a beneficiary's behavior that becomes too hard to handle. Always remember to include a list of successor trustees, which facilitates an efficient change of trustees. A provision also should be included that governs the appointment of a successor if there are no longer any named trustees.
Keep in mind that giving a beneficiary carte blanche to remove and replace a trustee runs a risk that the beneficiary will shop around for the most compliant trustee. Clients should consider requiring multiple family members to agree on the removal and replacement of trustees.
Trust protectors are not only for offshore trusts — Commonly found in offshore trusts, trust protector provisions are increasingly included in domestic trusts. Trust protectors are given oversight powers over trustees. Often, trust protectors are given veto power over trustees' decisions, such as distributions. They also may have the power to remove and replace the trustee. Remember to include successor provisions for the trust protector as well.
Question if all trusts really have to distribute a third of its assets when a beneficiary is 25 years old, half when the beneficiary is 30 and the balance at age 35. Consider alternatives — Many trusts provide mandatory distributions of principal to the children at two or three different ages. Often, clients are told such staggered principal distributions offer a child the opportunity to learn financial responsibility over a period of time, thereby decreasing the possibility that the child will waste the entire inheritance.
But a child may never be able to manage his own financial affairs. Also, making distributions mandatory means losing the protection afforded by holding the assets in trust. There are some good alternatives.
For example, clients can create a lifetime trust for a child with discretionary distribution powers.
A trust may last for a child's entire lifetime. The trustee can be given broad discretion to distribute assets for the child, including the discretion to terminate the trust and to distribute all of the assets to the child. At the child's death, any remaining trust assets can pass to grandchildren unless they need similar protection. To provide some additional flexibility, the child may be given a testamentary power of appointment. For additional protection, the power of appointment may be given to the beneficiary only at the discretion of the trustee, and may be a general or limited power, depending upon whether the trust is exempt from the generation skipping transfer tax.
Discretional powers also can protect against a child's creditors.
Giving the trustee discretionary distribution powers can limit the extent of the beneficiary's interest in the trust. The beneficiary's interest in the trust may be so tenuous that it may not qualify as a property right that is subject to attachment by creditors. In some circumstances, the beneficiary's interest comes into existence only when (and to the extent that) the trustee decides to make a distribution.
In a discretionary trust, the trustee has absolute discretion to pay and apply trust income and principal to, or for the benefit of, the beneficiaries. The trustee's discretion must include the ability to exclude a beneficiary from receiving any distributions or benefit from the trust, so that neither the beneficiary nor his creditor can force the trustee to make a distribution.
A creditor, such as a divorcing spouse, may obtain the same rights to the trust assets as does the beneficiary. If the beneficiary's rights are entirely dependent upon the discretion of an independent trustee, there is considerable protection.
Keep in mind that if a trustee's discretion is limited by standards, such as health and education, the conduct of a trustee of such a discretionary trust can be reviewed by a court and found to be an abuse of discretion.
Protect against children's potential to be irresponsible — Even if a child is irresponsible only once, it may cost him his inheritance. If a trust does not contain a spendthrift provision, the beneficiary may have control over her trust interest. For example, the beneficiary may sell the trust interest or give it away. Also, the beneficiary's creditors may reach the beneficiary's interest to satisfy their claims.
Most clients want to prevent the beneficiary from transferring the trust interest voluntarily or involuntary. So, a spendthrift provision is appropriate in most trusts. The spendthrift provision provides significant asset protection for the trust beneficiary since it precludes both voluntary and involuntary alienation of the beneficial trusts interests.
Protect against divorce; it happens to more than half of us — Clients often fret that a child may make a poor marriage choice. Typically, they do not want this former daughter-in-law or son-in-law to continue as trustee or beneficiary to their child's trust. And they are very concerned that this ex-spouse might receive assets from the family trust.
All estate plans should always assume divorce is a possibility. A trust can include a provision that requires the marriage to remain in effect for a spouse to continue to serve as trustee or to receive trust distributions as a beneficiary. When clients actually want to name a beneficiary's spouse as a beneficiary of the trust, they should consider naming the beneficiary's spouse by reference to a defined term rather than by name (“my son's wife”). By doing this, the beneficiary's spouse is excluded as a beneficiary upon a divorce, and the beneficiary's new spouse is automatically included.
Consider extending a child's interest — A trustee may be given the discretion to extend the trust term beyond its stated termination date. This permits the trustee to hold back an otherwise mandatory distribution of trust assets. An extension provision can be useful when a trust is terminating at a time when the beneficiary is facing a potential creditor. The provision effectively changes the trust to a discretionary trust thereby protecting the beneficiary's trust interest from creditor claims. Keep in mind that the trustee may have the obligation to justify to the beneficiary (and maybe to a court as well) its decision to withhold what would otherwise have been a mandatory distribution.
Consider discretionary trusts for multiple beneficiaries — The trustee may be given discretion to make distributions among a group of permissible beneficiaries. The trust may provide that the trustee has no duty to treat the beneficiaries equally and may permit the trustee to exclude any of the beneficiaries from receiving distributions. This power helps avoid freezing the trust distributions simply because one of the beneficiaries is in trouble with a creditor.
Simple, But On Target
None of these techniques are complicated double back flip GRATs whose exquisite nuance will wow your fellow estate-planning or financial advisors.
But clients will appreciate it if you sense that they are nervous and provide practical ways that they might circle the wagons around the wealth they still have. And, of course, serving clients where they are, rather than where we think they should be, is the essence of good counseling. Only then might they be eased into also considering that now is an excellent time to consider all those tax-saving strategies.
David Jacobson is a director and a trusts and estates consultant at UBS Private Wealth Management in New York