Estate Planning Considerations - Part 2 of 3 - Rodgers & Associates

Estate Planning Considerations — Part 2 of 3

Estate Plan

In my last newsletter, I brought up the potential problems of leaving a large amount of wealth to your heirs. Many people who suddenly acquire wealth do not keep it very long if they have not learned how to manage it ahead of time. Some of them end up in a worst financial position several years later. This is not the kind of legacy we want to leave to our children​.One possible solution is to leave some or all of our wealth to your children in trust. There are several different types of trust that can be used. This week I want to talk about a couple of them.

Dynasty Trust

A dynasty trust is sometimes known as a generation-skipping trust (GST) although I want to make a distinction. I think of a GST when the goal is to leave money to your grand­children. A dynasty trust is used to provide income and support for your children and to pass those same benefits on to future gener­a­tions of your family. Your wealth remains in the trust protected from estate taxes, the conse­quences of divorce, creditors and uncon­trolled spending. The income it generates remains in the family for gener­a­tions.

With a dynasty trust, your children never take ownership of the assets. This is an important principle that allows the assets to avoid the estate taxes. Your children will be respon­sible for paying income taxes on the distri­b­u­tions they receive. Any income earned within the trust that is not distributed will be subject to income taxes paid by the trust itself.

A key feature of this type of trust is the term. The trust is intended to last as long as you have descen­dants. The laws of many states do not allow trusts to last in perpe­tuity. The law typically states that the duration of the trust is limited to the lives of the benefi­ciaries plus 21 years. Seventeen states have since acted to modify or eliminate perpe­tuity laws permitting the trust to continue for very long times and in some cases – forever. You don’t have to live in one of seventeen states to set up a dynasty trust that will avoid the perpe­tu­ities law. However, the trust has to be estab­lished in one of these states and abide by that state’s laws.

A signif­icant benefit of this trust is the ability to protect the assets from creditors, bankruptcies, lawsuits and divorce. Your heirs may be very respon­sible and marry respon­sible spouses. Unfor­tu­nately, you never know what will occur during the lifetime of your heirs. You don’t want to leave wealth to your children thinking there will be plenty of money for your grandchildren’s education only to have them lose it to a lawsuit or through a divorce.

You set up the trust and provide guidance in the trust document for how the trust will operate and set the rules for distri­b­u­tions. The benefi­ciaries will be your descen­dants. You could specify the number of gener­a­tions you want to cover or leave it open ended for as long as there are depen­dents. Any balance remaining can be passed to desig­nated charities.

The trustee handles the opera­tions of the trust and should not be a benefi­ciary. A profes­sional fiduciary such as a bank or trust company should be selected to serve. The distri­b­u­tions will be governed by the terms of the trust. Generally, you will specify a certain percentage and allow for additional distri­b­u­tions for health, education, and support of your benefi­ciaries.

When consid­ering a dynasty trust you should give careful thought about the length of time you envision the trust to last. There are important drafting consid­er­a­tions for the dynasty trust so you will need to use an estate planning attorney that is familiar with this type of document. The trust will need to qualify under the parameters permitted by the Rule against Perpe­tu­ities that allow trusts beyond a specific duration. You also want the trust to be struc­tured in a way that avoids the transfer taxes beyond the initial amounts. Complex tax questions, including the appli­cation of GSTT require the partic­i­pation of profes­sionals skilled in this type of trust law.

A dynasty trust may be the single most powerful way to create a legacy that reaches gener­a­tions in the future. If this is your goal, a dynasty trust could become central to your overall estate planning strategy.

Incentive Trust

An incentive trust is designed to encourage or discourage certain behaviors by using distri­b­u­tions of trust income or principal as an incentive. This type of trust sets fixed condi­tions for access to trust funds as opposed to a typical discre­tionary trust that often leaves such decisions up to the trustee.

A typical use for an incentive trust might encourage a benefi­ciary to complete a degree or pursue the training necessary to enter a profession. The trust could also be set up to discourage certain behavior such as abstain from substance abuse. The trust may award the benefi­ciary an amount of money from the trust upon gradu­ating from college. Another incentive could be to have the trust pay a dollar of income from the trust for every dollar the benefi­ciary earns.

You might find it helpful to think of an incentive trust as a condi­tional inher­i­tance for your benefi­ciaries. You want to leave a proportion of your wealth to a grand­child. However, you don’t want the grand­child to use this money to live on and avoid pursuing a profes­sional career or a college education. The incentive trust permits you to specify that the funds are only to be dispersed once the grand­child reaches the objective you estab­lished.

Incentive trusts can be as restrictive as you want them to be, as long as the restric­tions imposed are not illegal — for example, you could not specify that your grand­child must divorce his/her current spouse to receive an inher­i­tance.

A common restriction relates to the benefi­ciary’s age. Many people do not want a child to receive income or principal from the trust until he or she reaches a more mature age. Trust distri­b­u­tions are postponed until the child reaches age 25, 30, or whatever they decide. Hopefully by staggering distri­b­ution of funds over time, the child will learn how to manage money respon­sibly. At the very least, this strategy elimi­nates the possi­bility of your child blowing his or her inher­i­tance all at once.

There are several drawbacks to this type of trust. Your benefi­ciary may resent the control you are trying to exert over their lives. It could also cause resentment towards other benefi­ciaries that don’t have require­ments or whose require­ments are easier to obtain in their opinion. Health issues could arise making the achievement of your bench­marks impos­sible. You also don’t want to punish your heirs for choosing to be stay-at-home parents.

The key to a successful incentive trust is good commu­ni­cation. It is extremely helpful to discuss your inten­tions with your heirs and the trustee to assure your objec­tives are clear. You don’t want your incen­tives to backfire. An incentive trust can be an effective estate planning tool to encourage education, philan­thropy, a strong work ethic and to develop sound financial management skills.

The dynasty trust and incentive trust are just two of the strategies we can use to develop an effective estate plan. Next week we will look at other types of trusts you can use to pass on your legacy.

Rick’s Insights

  • Laws exist in most states that prevent a trust from lasting in perpe­tuity.
  • Any trust that passes wealth down the blood line past your children is referred to as a gener­ation skipping trust.
  • The most common “incentive” provision found in trusts is the age requirement that must be met before assets are dispersed.

Continue reading: Part 1, Part 3