Estate Planning Tools

Various tools exist for the mitigation of wealth transfer taxes. Common tools include:

• Trusts.
• Foundations.
• Life insurance.
• Companies.

This reading will focus on trusts, the various types of trusts commonly used, and their benefits concerning estate planning.

Trusts

A trust is an arrangement made on behalf of a settlor (or grantor), who transfers assets to a trustee. The trustee is the third party who holds and manages the assets on behalf of the beneficiaries. The beneficiaries are the ultimate recipients of the property being transferred.

Trust Types

Revocable Trust: This type of trust allows the grantor the right to reverse or unwind the trust. This generally leaves the grantor responsible for tax payment and reporting. It also tends to leave the assets vulnerable to creditors in the case of a legal proceeding. The benefit of a revocable trust is the ability of the grantor to avoid the probate process.

Irrevocable Trust: Similar to revocable trusts, irrevocable trusts offer the same benefits, but yet offer increased protection of assets and the transfer of tax reporting and liability to the trustee. An irrevocable trust may not be easily changed.

Fixed Trust: These trusts offer distributions to beneficiaries on a set schedule, outlined in the trust documents. Distributions could be monthly, annually, or any other time period desired by the parties involved.

Discretionary Trust: These trusts also make distributions, but rather than a prescribed schedule, the trustee is given some leeway to decide how and when to make distributions. For example, a parent may wish to make distributions to a child, but only on the condition that child remain gainfully employed. It is then up to the trustee to decide what gainful employment means and to verify it is in place before making any distributions.

Main Objectives of Trusts

Control

Trusts allow the grantor to state their wishes in the trust documents, which will ideally be carried out by the trustee. In this way, a grantor may be able to transfer some assets, but without losing full control.

Asset Protection

Assets in an irrevocable trust are not fair game to creditors, as they are not legally owned by the defendant. The same is true of discretionary trusts in that the beneficiary is not legally entitled to the income the trust generates and therefore is not available not creditors in the case of a lawsuit.

Tax Reduction

Income from a trust may be taxed at a lower rate than would be applied to earnings within the trust itself. Valuation discounts offer another method of tax reduction in conjunction with trusts and legal entities.

Foundations

Foundations are legal entities set up to accomplish a charitable or philanthropic purpose. They are very similar to trusts in that they survive the grantor, and carry out their wishes when they are no longer living. One main difference is that a foundation is often seen as a legal person in the eyes of the law, whereas trusts are generally not.

Life Insurance

Life insurance functions similar to trusts in many ways. Instead of moving assets, per se, the policyholder (‘similar to the grantor in the above example), pays insurance premiums on a life insurance policy. The premiums are similar to the assets being moved into the trust in the example above. As the policyholder pays premiums, those premiums act as a periodic transfer of wealth. The funds go to an insurance company that uses the money until a certain life event, such as the death of the policyholder. By this mechanism, the premiums skip the probate process and avoid being counted as part of the policyholder's final taxable estate. An additional benefit, just as with trusts, is that life insurance funds are generally not reachable by creditors in the case of a divorce, bankruptcy, civil lawsuit, etc.

Benefits of Life Insurance Policies

Life insurance is more widely recognized in most jurisdiction and tends to raise less suspicion than trusts. Life insurance is often used to help pay the taxes due on an inherited estate, thereby saving the inheritor from having to come up with lots of cash to pay inheritance tax. In any case, life insurance is a popular and effective means of wealth transfer. It shares much in common with the use of trusts.

Companies

Many companies are designed to have similar benefits. A controlled foreign corporation (“CFC”), for example, is a company whose headquarters are outside a taxpayer's home country in which the taxpayer has a controlling interest pursuant to the home country's laws.

It may be possible to defer taxes on income from assets in a CFC until the earnings are distributed to shareholders or the company is sold or the shares are otherwise disposed of, depending on the jurisdiction. CFC rules are often implemented by countries to guarantee that tax is paid in the country where the beneficial owner lives.

Family Governance

A family's collective process for communication and decision-making is called family governance, and it serves both current and future generations. The primary purpose of family governance is to preserve and grow the family's wealth over the long term by utilizing common values defined by all members of the family. The purpose of family governance is to establish principles for collaboration among family members, preserve and grow a family's wealth, and expand human resources and financial assets across generations. An effective family governance framework will include legal documents, non-binding agreements with family members, and a list of mutually agreed-upon goals and values identified by the members of the family during family meetings.

Family Conflict Resolution

Families that have wealth and own businesses often start the conflict resolution process by drafting a family constitution, a non-binding document that defines the rights, values, and roles of the family members and other stakeholders.

Even though family constitutions and the governance approaches they provide are used by families at the top of the wealth spectrum, the principles involved are relevant to all families. It is important to think about potential conflicts and how they can be handled as part of asset protection and succession planning, no matter the family's level of wealth.

Family Dynamic and Business Exits

When family wealth has been accumulated via a successful (and often generational) family business, some extra considerations are needed when working with a wealth manager. The extra layer of complexity this adds brings rise to the following issues:

• Transition of the business to the new generation: Does the current company owner desire the new generation of the family to operate and control the business, or merely be involved in some capacity? The choice between giving voting and non-voting shares is key here. A founder may decide to pass voting shares to family members who are actively involved in the business and non-voting shares to family members who are not actively involved in the business.
• Sale of the Business: When it comes time to sell the business, many founders suffer from endowment bias. It can be difficult, if not impossible for a wealth manager to convince the founder of the company's weaknesses.
• Timing of the business sale: It is common for business interest to be transferred to a legal entity before the actual sale of the business. This shields the estate from the potential capital gains tax that might be due upon sale. This method also opens the door for valuation discounts.
• Selection of trustees: Trusts are run by trustees, who are tasked with managing the ongoing affairs of the trust. A personal representative van be chosen. This is often someone who is close to the family, and knows the members well. Or a private trust company (“PCT”) may be used. PCTs may be a good choice due to their lower administration costs, plethora of resources, and broader skill set.
• Post-sale considerations: If the running of the family business has brought the family together and given something to bond over, an outright sale of the company may cause some family members to lose some of the bond they developed over the years. For this reason, incorporating some philanthropic goals into the post-sale plan can give family members a reason to unite once more, and increase the social capital of the family.

Contingency Planning

Tax considerations are not the only reason to establish a trust. In fact, if it can be proven that a trust was established for other purposes such as succession planning or privacy, tax authorities may have a harder time proving that tax avoidance was the main motivation for the trust being established. in this way, leaning into the various uses of the trust can strengthen it.

Divorce

Upon the dissolution of a marriage, and in the absence of a prenuptial agreement, each jurisdiction will have its own method for the distribution of assets thereafter. A prenuptial agreement defines the parameters for how assets within the marriage will be distributed upon a divorce. Many jurisdictions, such as the UK, divide assets equally between the spouses in the event of a divorce. This is the prescribed course of action when a prenuptial agreement does not exist. Other legal entities such as trusts can also protect assets in the event of a divorce. For this to work, assets can be placed into a trust before the marriage, and then in the event of a divorce those assets will not be considered common property (accessible by the spouse).

Incapacity

It is a fact that humans are living longer than ever, and living to 100 is no longer the anomaly it used to be. But with this increased life expectancy comes an increased chance of incapacitation. For example, those suffering from dementia will become mentally unable to handle their own affairs. A number of tools exist for dealing with this kind of situation.

• Guardianships: A guardianship, also known as a conservatorship, is a situation in which an incapacitated adult has as ‘care-taker’ put in charge of making decisions on their behalf. A guardianship means that the incapacitated will essentially lose their autonomy. For this reason, courts do not take the decision to grant a guardianship lightly. The legal process can often be lengthy and drawn out. But in the event that the incapacitated has their best interests looked out for by the guardian, the setup is a highly beneficial relationship.
• Power of Attorney (“POA”): This document is similar to a guardianship, but with more limitations. A durable power of attorney document grants decision-making authority to a trusted agent, on behalf of the incapacitated, but only in specific areas defined by the document. There are medical power of attorneys who make medical care decision on behalf of the incapacitated, but would not be able to sell the incapacitated's house for example. A financial power of attorney may be able to access funds in a bank account on behalf of the person they are caring for. Having this document in place can help immensely, but it is not foolproof. Many institutions are leery of granting access to an individual's bank or investment accounts (for liability purposes). For this reason, a POA should be very clearly-written, properly executed, with many original copies, and should still likely be supplemented by other measures. An individuals will also likely need to be officially deemed incapacitated by a physician before the document can go into effect.
• Living wills: Living wills, as described earlier, can give readers directives about what the covered individual would like to have happen in certain scenarios. For example, if the covered individual ends up in a vegetative state, would they like to be kept alive via the use of feeding tubes? A living will is a basic first step that can help loved ones begin to deal the incapacitation of a family member. A living will also includes the disposition of assets upon death. A living will is not comprehensive but is the first step in creating a effective financial and estate plan.

Question

A client forms a trust for her disabled daughter, which is to distribute $1,000 to her on a monthly basis to pay for living expenses, in perpetuity. The daughter is unable to work and will depend on this money when her mother has passed away. This trust can most accurately be described as a(n)?

1. Revocable trust.
2. Irrevocable trust.
3. Fixed trust.

Solution

The correct answer is C.

The trust will distribute income for monthly living expenses to a disabled individual. The question does not mention anything about the trustee using their own judgment as to when and how to make distributions, leaving answer choice C as the correct answer.

A and B are Incorrect. No indication is given as to the revocability of the trust, so there is not enough information to choose either answer choice A or B.

Reading 8: Topics in Private Wealth Management

Los 8 (k) Describe considerations related to managing wealth across multiple generations