THE RISKS OF OUTRIGHT DISTRIBUTIONS AND GIFTS
August 5, 2016
By Cory Howes
In estate planning, we hear it all the time: a carefully planned estate is quickly squandered by spendthrift heirs or just as badly by other life circumstances of the survivors of the deceased. If you’re planning on leaving outright, no-strings-attached inheritances or gifts to your beneficiaries, you’re practically inviting disaster.
What Can Go Wrong with Outright Distributions or Gifts?
There are many risks with outright distributions or gifts. First, judgment creditors can seize or garnish a beneficiary’s inheritance to satisfy their claim, even if the claim is a “frivolous” lawsuit. On this same tip, bankruptcy courts can seize a bankrupt beneficiary’s inheritance to pay creditors and costs.
Also, you should consider the event of an heir’s incapacity. Guardianship courts can impose “living probate” if a beneficiary currently or later becomes incapacitated. If the beneficiary doesn’t effectively plan for this event, then a court could end up controlling the inheritance.
Finally, let’s think about one of the most common events we see among the general population: divorce. A divorce court might award some or all of a beneficiary’s inheritance to a soon-to-be ex-spouse. In effect, you’d have someone leaving your family getting a slice of your estate on the way out!
Many clients are unaware of these and other risks of outright distributions or gifts. Thankfully, there are solutions. Let’s take a look at one such solution that alleviates the risks of outright distributions or gifts: the lifetime protection trust.
What’s a Lifetime Protection Trust?
A lifetime protection trust is the solution to the problems created by outright distributions or gifts. It is a mechanism that allows clients to pass assets to beneficiaries in continued trust rather than outright or staged gifts (such as one-third at 30, one-third at 35, and the remainder at 40).
A lifetime protection trust is built into your estate plan and is created upon your death. After your death, the trust holds assets for the next generation, while providing direction and control during the beneficiaries’ lifetimes. In this regard, they are common to similar trust vehicles called dynasty trusts, used by the super-wealthy.
Also, note that these trusts are discretionary in that successor trustees are not required to distribute income and/or assets in rigid ways. Instead, it gives successor trustees the power, within limits, to adjust the timing, direction, and percentage distributions of income and assets in light of contingencies that could not have been known at the time the trust was initially funded (often at the death of the client). For example, maybe one of the children or grandchildren is a spendthrift, has a substance abuse problem, or has special needs. The discretionary element allows for flexibility toward that person. The discretionary distribution standard is also where the asset protection features of the trust come from.
Speaking of trustees, one significant advantage of this type of trust is that the beneficiary can be the trustee of the trust. Many clients who want their children to be able to control their own inheritances, but want to provide asset/creditor/divorce protections for the inheritance, utilize this type of trust and name their beneficiaries as trustees upon reaching a certain age. However, it is important to note that state law will largely govern how much protection trust assets receive when a beneficiary is trustee, so you should discuss this with an experienced estate planning attorney as well as your children.
Let’s review the six primary benefits of a lifetime discretionary trust:
1) Protection from Liabilities
An inheritance that goes directly into the beneficiary’s pocket is readily available to pay the beneficiary’s liabilities from a car accident, in bankruptcy, or after a lawsuit. A properly structured lifetime discretionary trust will protect the inheritance from the beneficiary’s liabilities and provide a place for long-term safekeeping.
2) Protection from Divorce
An inheritance that goes directly into the beneficiary’s pocket can be considered marital property and subject to division during a divorce (state laws vary on how much protection inheritances receive with regard to divorce). A properly structured lifetime discretionary trust will keep the inheritance out of the hands of the beneficiary’s soon-to-be ex-spouse.
3) Protection During Incapacity
An inheritance that goes directly into the beneficiary’s pocket could become inaccessible if the beneficiary becomes incapacitated and may require court intervention to gain access. An inheritance held inside a lifetime discretionary trust will allow the successor trustee, chosen by your client, to manage it for the benefit of the incapacitated beneficiary without any court involvement.
4) Protection for the Bloodline or Charity
If you leave property to a beneficiary outright, what happens to that property at the beneficiary’s death is controlled by his or her own estate planning (or lack thereof). An inheritance that goes directly into the beneficiary’s pocket can easily be wasted on fast cars, expensive shoes, and extravagant vacations or squandered by the beneficiary’s spouse or children. An inheritance held inside a lifetime discretionary trust will be protected and invested for the benefit of the lifetime beneficiary and go wherever the trustmaker wants it to go (such as to grandchildren or a favorite charity) after the lifetime beneficiary dies.
5) Protection from Estate Taxes
An inheritance that goes directly into the beneficiary’s pocket may be subject to estate taxes after the beneficiary dies. A properly structured lifetime discretionary trust can shelter the inheritance from estate taxes after the beneficiary dies.
6) Protect Valuable Illiquid Assets from Premature Sale
A lifetime discretionary trust can allow for valuable, illiquid assets to be sold in a more relaxed way (possibly for a better price), or even to continue developing over many decades. Examples of relatively less liquid assets include certain investment real estate, private equity positions, and some other alternative assets. Their relative illiquidity may mean a forced sale would fetch far less than the assets are worth. A properly structured and managed lifetime discretionary trust can provide better management of these assets.
While lifetime discretionary trusts aren’t for everyone—the smaller the value of the trust, the less cost effective it is to maintain over time—they can be effective vehicles against the pitfalls of outright gifts and distributions when many factors, such as the beneficiary’s age, the value of the assets that will be used to fund the trust, and the expenses involved in managing the trust during the beneficiary’s entire lifetime are taken into consideration.