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Designing Trusts for a Surviving Spouse’s Remarriage

gv10209In the 90s, when the Internet was new and Bill Clinton still had more tomorrows than yesterdays, the estate tax exemption was $600,000, an amount even Thomas Piketty might think was rather low.

In that sort of environment, credit shelter trust planning for married couples felt almost mandatory.

We live in a very different world today. The Internet, no longer new, has gone social and mobile. A Clinton third term may occur.

The estate tax exemption is $5.43 million and indexed for inflation – with the result that 99.8% of estates won’t be taxable.

Yet, as we’ve discussed recently, taxes weren’t the only reason to use trusts.

One of the most significant non-tax reasons to use a trust is planning for a surviving spouse’s remarriage.

What are the risks to family wealth when a surviving spouse remarries, and how can using a trust (and designing that trust thoughtfully) reduce them?

  • Asset Leakage to a New Spouse. We’ve covered these risks in depth. Simply put, Kentucky’s elective share statute allows a surviving spouse to elect against their deceased spouse’s will, and instead receive one-half of their deceased spouse’s probate estate (except real estate, in which a surviving spouse has only a one-third elective share).

Here’s why the elective share statute is a problem when a trust wasn’t part of the estate plan: the surviving spouse might get remarried, without getting a prenuptial agreement.

If your spouse has inherited outright from you, and doesn’t get a prenuptial agreement before remarrying, and their second spouse survives, the second spouse has strong economic incentives and the legal right to divert half of the inheritance your spouse received from you away from your descendants.

Does that sound like a good outcome to you? (I’d expect it doesn’t.) continue reading

adam smith 20 pound noteCertainly one of Adam Smith’s core insights in The Wealth of Nations was that incentives matter.

I believe examples are everywhere about how Smith was correct – ranging from California water shortages and student loan debt, to tax policy and white collar crime.

If incentives matter in these areas, shouldn’t they matter in designing trusts that maximize successful outcomes for descendants?

Clients often have an instinct that “incentive trusts” may improve outcomes for their descendants.

While I don’t discourage this instinct, I do try to channel it.

Precisely because incentives do matter, it’s important to design incentive trusts very thoughtfully.

 Incentive trust design begins with several questions:

  • What do you want beneficiaries to become?

Usually, answers center on the general theme of “becoming productive, engaged, flourishing adults.”

  • What do you want beneficiaries to do?

Certain achievements and behaviors tend to correlate with highly successful, fulfilling life outcomes – and clients often want to encourage these.  Examples include the obvious – finishing college and/or graduate school, avoiding debt, working productively, dodging divorce, and staying healthy.

  • What do you want beneficiaries not to do?

There are obvious pitfalls clients want beneficiaries to avoid, often including substance abuse problems, criminal activity, serial failed relationships, and workforce non-entry or failure.

Once a family develops clarity on the key questions above, they and their advisors can consider a wide range of incentive trust design options, including:

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Design Factors For Your Family’s Trust

imageThese are interesting years in estate planning for families in the Upper Middle and Lower Upper Classes. As a high estate tax exemption has reduced the tax-driven imperatives for using trusts to hold inheritances, non-tax applications of trusts come to the fore.

As non-tax issues in trust design assume greater relative importance, what factors should a family consider when deciding whether to use a trust?

If they will use a trust, how should that trust be designed?

To answer these questions, a family should do the best it can to look ahead to its future, and make reasonable (but unavoidably imperfect) estimates of what its future might look like.

That takes us back to the Quadrant at the heart of a Life Cycle approach to estate and financial planning, with its four domains of Facts, Forecasts, Life Stages, and Unexpected Events.

Life Cycle Estate and Financial Planning Quadrant

The decision whether or not to use a trust to hold an inheritance begins with a family’s Facts.

  • Who would be receiving the wealth?

The array of options includes the obvious, but thinking about the beneficiaries is the right place to start.

Common potential inheritors include a widow(er), a surviving spouse and children, adult children, nieces or nephews, parents, siblings, and/or charities.

  • What will the trust’s funding level be?

Funding is a tremendously important Fact underlying good trust design.

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Design Options for Education Trusts

Boarding School Cross Country MeetI often work with “Wealth Creators” who have built substantial wealth themselves, most notably as founders of companies or early-stage employees at startups.

I also work with “Inheritors” managing wealth built in prior generations for the benefit of descendants.

Although every instance has unique aspects, in general, I find that Wealth Creators have conflicted feelings about what being Inheritors will mean for their descendants.

They often tell me they don’t want their children to have “too much” wealth.

Obviously, this presents a difficult question: how much wealth is too much? Answers to that question vary.

Amidst that variance, a very common instinct is that even if they aren’t confident about whether their children (or, instead, charity) should receive the bulk of their wealth, they do want to leave assets in trust to pay for their descendants’ education.

This instinct makes a tremendous amount of sense, and I never discourage it.

Education is a critical component of human capital formation, and human capital has often been the unique element in why any particular Wealth Creator built such success.

If funds are going to be left in trust for descendants’ education, what should the key provisions of those trusts be?

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pebble beach concoursDuring an estate or trust administration, it’s easy to divide and distribute financial assets. Distributing tangible personal property (such as furniture, collections, artwork, jewelry, etc.) can be much harder.

Executors, trustees, and beneficiaries are usually very surprised by how little household goods and personal property are worth in an estate administration context.

Nonetheless, simply because property isn’t economically valuable doesn’t mean it might not have substantial emotional and sentimental value.

This makes it all the more important to be thoughtful about ways to thoughtfully avoid conflict, expense, or even litigation relating to personal property.

There are several ways to approach these issues.

The simplest approach (but in my experience, one that is not that common) may be to sell all of the property and divide the proceeds as directed in the estate plan.

Positives of this approach include transparency and fairness, because sale proceeds can be accounted for, and money can be divided easily.

Negatives include the typically low sale value of the property, and a lost opportunity to preserve its sentimental value within the family.

A far more common approach is to “work it out” among the family.

The executor or trustee might ask beneficiaries which items they want and see if a consensus appears. If a particular item is a focus for more than one family member, a bit of trading might occur, or (in extreme cases) those items might be sold.

This approach often sorts itself out with surprising speed and not that much fuss.

Its advantages include keeping items in the family that family members want.

Disadvantages may arise if one beneficiary is particularly pushy, and another is conflict-avoidant. In these instances, items may be distributed, but bad feelings among beneficiaries may simmer afterwards.

Families use a “draft pick” approach less frequently, but this offers the opportunity for increased fairness, and a structure that may reduce conflict.

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Avoiding Family Fights In Estate Administration

1962 VolvoEstate administration can be a frustrating experience for families and their advisors, because it’s an occasion when families fight. Sometimes the fights are necessary, and unavoidable. Many other times, to a detached observer, the fights seem silly.

Whether justified (or not), whether necessary (or not), conflict makes estate administration cost more (even when litigation doesn’t occur). When tensions boil over into litigation, costs skyrocket.

Because I think preventable conflict is wasteful, I want to offer some perspective on some of the most predictable conflict triggers in estate administration, along with suggestions for how clients and their advisors can reduce the risk of some of these pitfalls.

Pitfall: End of a Dependent Child’s Financial Support

Many clients have children with very divergent career and life incomes as adults (for more on this, see here). It’s not uncommon for one child to be much less economically secure than his or her siblings. Sometimes the cause is downsizing that ended a career early. Other times, it’s serially unsuccessful entrepreneurship, divorce(s), and/or unresolved addictions.

This sort of child (let’s call them, bluntly, a “dependent” child) has often received financial support from parents that other siblings don’t receive in similar amounts.

In extreme situations, the dependent child continues to live at home with his or her parents and “help” them with various home maintenance and aging issues, often in return for access (direct or indirect) to the parents’ pension income, Social Security, and retirement account required minimum distributions.

Invariably, the dependent child will view financial support he or she received as “gifts,” while his or her siblings will view the same transfers as “loans.”

In a perfect world, aging parents of dependent children would keep clear records clearly proving whether the transfers were gifts or loans. In the real world, those records are usually incomplete or nonexistent.

When the alleged loans aren’t documented, and a sibling other than the dependent sibling is named executor, estate administration can turn into an ugly “witch hunt” that in some ways seems like an effort by the executor to punish a dependent child for having been unsuccessful or irresponsible.

On the other hand, when the dependent child is named executor, any undocumented loans (that weren’t really gifts) are very unlikely to ever be repaid.

Solutions: When a client has a dependent child that receives financial support, keep careful records clarifying whether the support is a gift, a loan, or an advancement against a future inheritance.

Consider not having a dependent child serve as executor, and consider the risks a more financially successful child serving as executor might seek “payback” against a dependent child.

Consider whether use of a bank or trust company executor or co-executor might better preserve sibling relationships.

Pitfall: The Family Home Becomes a Long-Term Holding

Estate administrations often last much longer than they should because children cannot agree about what to do with their parents’ house (particularly if they grew up there and are sentimentally attached to it).

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