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By Matthew S. Dana, JD, CPA, CLU, LLM

By Matthew S. Dana, JD, CPA, CLU, LLM

Estate Planning has multiple levels. Session One Notes discusses planning options where one spouse is alive and one spouse is deceased. Session Two deals primarily with addressing various options and considerations when both spouses are deceased and assets are going to pass downhill to Junior.

Certainly, the most common approach and the simplest approach is to simply pass the assets outright, no restrictions, to Junior. But, most likely this is not the best option. What if Junior is a minor? What if he has “Special Needs” and he is receiving government benefits? What if he is a “spendthrift” and can’t manage money? What if he is in Bankruptcy? What if he is in a bad marriage and divorce is probable? What if you would roll over in your grave if Junior subsequently passes the family wealth to a spouse that you despise? I think you get the point.

The better way to pass wealth to Junior is to create a Trust for the benefit of Junior. Obviously, you need to give serious consideration as to who the Trustee of this Trust would be. Maybe it is Junior, but more than likely it is someone independent of Junior (We have discussed that particular issue in some of our other articles).

What can a Trust do for Junior that he can’t do for himself? Well, the biggest thing it can do for Junior is to provide him with Creditor Protection that he can’t create for himself. But you say, well I will give the assets to Junior and Junior can set up his own Trust. Yes, that is true, but the Trust that Junior creates for himself will not have any Creditor Protection. See the law in most states, including Arizona is simple. In order to get Creditor Protection from a Trust, it must be Irrevocable and it must be created “by someone for someone”. In other words, you create the Trust for Junior. He didn’t create it for himself. By using a Trust, you can provide Junior with the economic benefits of the Trust, without the economic liabilities of life and bad decisions by Junior. Yes, I know that Junior is a “good kid”. But, “good kids” still get divorced, have failed businesses, get into car accidents, etc. Given a choice, wouldn’t Junior be excited to know that he has a pot of wealth that he can tap into, but is beyond the reach of Creditors?

And what if we make the Trust for Junior a “Generation Skipping Trust”? First of all Generation Skipping doesn’t mean we are going to ‘bypass” Junior in favor of the grandkids, although some clients may want to do that. But, instead, Generation Skipping means that we are going to “bypass” the IRS with respect to all future generations of Estate Taxes. So, in essence, once we clear the Estate Tax liability of the senior generation, we never have to worry about Estate Taxes again for all future generations, regardless of the politics of the Estate Tax. Without this type of planning, the IRS will “bite the apple” at each generation. The same wealth gets taxed at every death and every transfer between generations. With Generation Skipping, the wealth is only subject to Estate Taxes once, and never again. This makes Estate Planning for Junior much easier than Estate Planning for the senior generation.

Another benefit of using a Trust for Junior is that we could provide “incentives” for Junior to be a high achiever. For example, we provide money in the Trust for Junior to go to College, to start a business, etc. etc. And what if we provide Junior an “incentive”. For example, “Earn a buck and we will give you a buck”. For every W-2 wage earned by Junior, after a certain age, we have the Trust distribute a buck to Junior. Or, what if we give Junior a large distribution from the Trust if he graduates from College. There are many “incentives” that can be built into a Trust with respect to income earned, degrees obtained, etc. etc.

And what if we build into the Trust creator control for Junior based upon more mature ages? For example, the worst thing we can do is say that the Trust terminates when Junior reaches age 35 as most Trusts do. We want the Trust to be in existence for Junior’s entire lifetime. But, maybe we let Junior become his own Trustee when he reaches a certain age, like 35 or 40. We can give him the power to remove the existing Trustee and the power to replace that Trustee with himself. In other words, we aren’t trying to control junior for his entire life. But, we do want to give Junior some “training wheels” and teach him the benefits of the Trust and the operation of the Trust, before we turn over the controls to Junior.

In the meantime, prior to Junior becoming the Trustee, maybe we give him all of the income of the Trust without him asking. This may be better to have the income distributed to Junior, to be taxed at Junior’s lower income tax rates, then to leave the income in the Trust to be taxed at much higher income tax rates.

And maybe when Junior turns 30, we give him a “withdrawal right”. This is the right to withdraw 5% of the principal balance of the Trust, each year. This may give Junior more willingness to have an Independent Trustee. He now knows that he gets all of the income generated from the Trust, along with the right to demand a 5% of the principal each year. And, he knows that at age 35 he has the right to become his own Trustee. Junior now knows that the “training wheels” will come off when he turns age 35. And, anytime up to age 35, the Independent Trustee would have the discretionary power to withdraw more principal for Junior if he has a good cause. And, good cause is defined to be anything related to Junior’s health, education, support, and maintenance.

And finally, what if we give Junior a “Power of Appointment” over the Trust. This gives Junior the ability to dictate who he wants to pass the Trust down to after his death. Remember, this Trust will last the lifetime of Junior. Remember that we want that to give him Creditor Protection and we want the Trust to be a “Generation Skip Trust” to avoid Estate Taxes in Junior’s estate. But, we want Junior to have the ability to have some flexibility to control who he wants to inherit the Trust upon his death. Maybe he wants the Trust to pass to his children, to charity, to his spouse. We can draft this Power of Appointment to be very narrow or we can draft it to be very broad. Maybe you want to make sure the wealth stays in the family and that Junior does not pass it to a spouse. If Junior doesn’t have kids, maybe you want to dictate that the wealth passes to Junior’s siblings. The point is that there is lots of flexibility in drafting this clause to achieve whatever family objective you want to achieve.

At the end of the day, we are trying to convince our clients that Junior is much better off and the family is much better off if the family wealth passes to Junior in a Trust rather than outright distributions. Junior has the benefits of “generation skipping, and of Creditor Protection. You as the client have the benefits of incentives, “training wheels” control beyond the grave. And as mentioned, the Trust can be drafted to be very flexible of Junior or it can be drafted to be restrictive. It is your wealth and your money. You should be able to dictate how and when Junior will receive control over that wealth.

Now, once you are convinced that you want to set up a Generation Skipping Trust (GST) for Junior, there are two ways to create it. First, you can create it as a “Sub Trust” inside of your Revocable Trust, or a SubTrust inside of another Trust that you are creating like a Life Insurance Trust. Under a SubTrust, it doesn’t come into existence until you die. It cannot be funded with assets until your death. In many cases, this is what the client wants and needs. They don’t need the Trust to come into existence until after they have died.

But, what if the client needs to “shrink” their Estate now by making gifts downhill to Junior and his siblings. If the gifts are going to be relatively small, below $15,000 per year it doesn’t make sense to make those gifts into a Trust. But, on the other hand, what if the client is going to be making substantial gifts, gifts of his or her Estate Tax Exemption?  Then those substantial gifts should be made into a Trust for the benefit of Junior for all of the reasons discussed above. That Trust for Junior will be a Stand Alone GST Trust. That Trust is created now. It is funded now by having the Senior generation making gifts for the benefit of Junior into the Trust. By making the gifts into a controlled environment, clients are more willing to make the gifts more substantial. Most clients do not like the idea of making gifts to Junior without the “training wheels”. They are afraid Junior will spend the money on cars, bad investments, etc. But, in a controlled environment, with incentives, and asset protection, etc, the clients are much more willing to make substantial gifts to Junior.

This Stand Alone GST will have its own Tax ID number. It will file its own income tax returns each year. As discussed in other articles, the Income Tax treatment of this Trust is very favorable if the income is distributed to the beneficiaries.

From an Estate Tax standpoint, this Trust is dynamic. Not only do we shrink the client’s estate for Estate Tax purposes, but all of the future growth and appreciation from those assets is out of the client’s estate. If a client is going to use up some of his Estate Tax Exemption, he is better to use it up now on assets that have good upswing. Good growth opportunities. This is much better than holding the assets and having the appreciation occurring in the client’s estate, increasing the Estate Taxes at death significantly.

If you have multiple children, it isn’t necessary to create separate Stand Alone Trusts for each of them. Instead, we can create a “common pot” Stand Alone GST Trust that you can gift assets into. This Trust would be designed to have all descendants as beneficiaries. The income and principal can be distributed to provide for the health, education, and support of these beneficiaries. Distributions need not be equal. Then, at your death, the death of the senior generation, the Stand Alone Trust could then break out into separate SubTrusts, to provide a SubTrust for each of your children. In other words, while you are alive and can whisper into an independent trustee’s ear, a common pot GST Trust can accomplish family goals and objectives. After you die, and can no longer whisper, then the Trust will divide out into separate Trusts to provide one for each child. And those SubTrusts could be drafted differently depending on the needs of each child.

So in conclusion, I had a child once ask me, “Dad, don’t you trust me”? The answer is yes son, I do trust you, but when I die I want to “Trust” you. The benefits of that Trust to that child are good for him and good for you. He achieves Creditor Protection plus the ability to pass Estate Tax-free to the grandchildren, the third generation. You achieve family goals, incentives, “training wheels”, etc. So, don’t take the simple route in your Estate Plan and pass the assets outright to your children and leave it to chance. Take the best route and create Trusts for the benefit of your children.

Matt Dana

The Dana name has become the symbol of a quality Estate Plan in Arizona. It has taken over 34 years to develop and continues to strive for excellence in the Estate Planning community. At its core is Estate Planning lawyer Matt Dana. [Learn more about Matt]

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