There’s At Least One in Every Family

Almost every family has at least one, and that’s okay. Don’t try to hide it from your estate planner, because hiding the situation will make things worse than they could be.

Once the fact is in the open, steps can be taken to make things better. The problem I’m talking about is a child who hasn’t developed into the person the parents hoped for, at least not yet. There’s no reason to be embarrassed about discussing the situation with your estate planner. Estate planners hear the stories all the time.

They’re more likely to be surprised and concerned when a client doesn’t acknowledge it. Take comfort that there are actions an estate planner can recommend. There are many types of problem children (or grandchildren). What they have in common is their parents would like to provide some financial assistance, either now through gifts or later through their estates, but aren’t confident the child will make good use of the money or property. The parents don’t want the money to be wasted, corrupt the child, or enable existing bad behavior.

Tell the estate planner your concerns, so the planner can suggest strategies such as these. Make gifts indirectly. Gifts to children are part of many estate plans. Sometimes gifts are made to reduce the value of the estate. Other times they are made because the children can use the wealth now, or the parents want the children to have some experience handling some wealth before they inherit even more.

The tax law encourages lifetime gifts through the annual gift tax exclusion ($17,000 per beneficiary in 2023) and the lifetime estate and gift tax exemption ($12.92 million in 2023). The annual gift tax exclusion allows you to make, without tax consequences, gifts of up to $17,000 per person to any number of people in 2023.

Gifts above that amount to a person during the year reduce your lifetime estate and gift tax exemption. Fortunately, you can make tax-free gifts without giving money or property directly to a person. Instead, you can pay bills for the problem child or purchase things for him or her.

With such methods, you don’t take the risk the cash or property will be used the wrong way. Some people make gifts of family vacations. They might pay all the expenses related to having the family travel to and stay at a nice location for a few days or a week. Others pay for the cost of staying at a nice place but let the family members pay the cost of transportation and perhaps some or all their food and recreation at the location. You can make unlimited gifts when you directly pay for qualified education or medical expenses. Make qualified payments directly to a school or to a medical professional, and you can give an unlimited amount without worrying about gift taxes or how the child might spend cash.

More details about the tax-free gift rules can be found in the March 2023 issue of Retirement Watch. Custodial accounts. When the child is a minor, you can put money or property into a custodial account, known as either a Uniform Gift to Minors Act (UGMA) or Uniform Trust to Minors Act (UTMA) account, depending on the state. The gift qualifies for the annual gift tax exclusion. But the account isn’t in the minor’s control. An adult who you name controls the account, and that adult can be you. I’m not a big fan of these accounts, because the adult is in control only until the child reaches the age of majority, which is 18 in most states. After that, the child has legal control of the account.

Create a family limited partnership (FLP). The FLP is popular because it has two significant benefits. It removes assets from an estate at a reduced gift tax cost, and it allows the parents to control the assets during their lifetimes.

In this strategy, you create a limited partnership and transfer assets to it in exchange for both the general partner and limited partner ownership interests. Then, you give some or all of the limited partner ownership interests to your children. You can transfer these interests at one time or over several years. You and your spouse remain the general partners and make all the key decisions. Because the limited partner interests aren’t marketable and have few powers, they are valued at less than a pro rata share of the FLP’s assets. That reduces gift taxes. The limited partner interests are out of your estate, so that reduces estate taxes.

The IRS doesn’t like FLPs, so you need to work with an experienced estate planner if you want these tax benefits. The FLP is helpful when you have one or more children who aren’t ready to handle wealth responsibly. Because you and your spouse are the general partners, you control what is done with partnership assets. You manage them and decide when distributions will be made and how much the distributions will be.

A problem child has an ownership share and can benefit from distributions but otherwise can’t do much. In addition to avoiding misuse of the assets, the FLP might be a way to help the children learn to be more financially responsible by involving them in the decision-making process.

For the FLP to work long term, you need to establish who will become the general partners after you and your spouse. You probably don’t want to use the FLP to protect the property during your lifetime only to leave it at risk after you pass. Marital agreements. Sometimes the concern is not a family member but is the spouse or the marriage of a family member.

Would you like a big part of your estate to end up in the hands of someone you never knew? That could happen if you give property to one of your children and the property is divided in a divorce. The money could end up with the next family of your former son- or daughter-in-law. A marital agreement, either premarital or post-marital, provides protection against that possibility.

You should want your child and his or her spouse to enter into one that says any gifts or bequests received by one of the spouses remain that spouse’s separate property and are not part of the marital estate. Some people tell the children they won’t make gifts or bequests to a married child who doesn’t have such an agreement. Irrevocable protective or incentive trusts.

Perhaps the most common and comprehensive way to benefit a child or other family member while saving the wealth from potential destructive actions is to put it in a trust with key provisions. There are several different provisions that can be used. These generally are called protective trusts or incentive trusts. Spendthrift clause: This long-established clause says creditors of the beneficiary can’t force payouts from the trust or be paid directly from the trust. Even if the beneficiary is bankrupt, the creditors still cannot invade the trust.

Once distributions are paid from the trust to the beneficiary, the creditors can try to claim them. Not all states allow the spendthrift clause, and some limit it. The state might say the spendthrift clause is effective only for up to $500,000 or so of the trust’s value.

Discretionary clause: This clause gives the trustee discretion to decide when distributions will be made to a beneficiary and the amount of the distributions. This provision can work well when the trustee knows your goals and especially when you provide written guidelines for the trustee.

The discretionary clause can make the trustee and beneficiary adversaries, and you can’t anticipate all possible situations ahead of time and give the trustee guidance on each possibility. So, it is a clause to be used carefully.

A corporate trustee who is not familiar with your family might not be able or willing to use the discretion effectively. It’s likely you would need an individual who knows the family to serve as trustee or co-trustee. See the May 2023 issue for advice on choosing trustees.

Milestone or stepping-stone trust: Trusts with this provision initially distribute only income, not principal. The amount of the income distributions might be limited in the trust agreement. Or instead of making distributions directly to the beneficiary, the trustee might pay for certain expenses on the beneficiary’s behalf, such as housing, education, and medical care. The trust agreement states that when certain milestones are met, the beneficiary might receive higher income distributions or be paid income directly.

Or a portion of the principal might be distributed at each milestone. Typical milestones include reaching a certain age, graduating from college, or being employed for a certain number of years. The milestones are determined by your imagination and goals. Typically, the entire trust is distributed upon reaching a certain milestone or in stages as a series of milestones are reached. An argument in favor of a milestone trust is that it allows the beneficiary to learn how to handle money and to mature in general before receiving the bulk of the wealth. The trust also encourages the beneficiary to establish some independence and become a useful and productive member of society instead of relying on inherited wealth.

Milestone trusts were very popular in the 1980s and 1990s. But they have some shortcomings. It is tough to design a milestone trust that adapts to changing circumstances. The trust also can turn out to be a way for parents to control their children, even after the parents pass away.

The incentive trust also might discourage a child from pursuing activities for which he or she has an aptitude and interest in favor or others that result in higher distributions. For example, some milestone trusts say distributions will be some percentage of the beneficiary’s earned income. That could encourage a beneficiary to pursue a higher-paying career instead of one for which he or she is better suited and would find more satisfactory. Some studies indicate an incentive trust can have the opposite of the intended effects.

Children might feel too much additional pressure to achieve because of the trust. Others view the trust as a sign of disrespect or lack of confidence by the parents.

Emergency clause: This is a variation of the discretionary clause. The trust agreement provides that income and principal will be distributed under some schedule or terms. But the trustee may withhold payments when the trustee considers it to be in the best interests of the beneficiary. For example, the trustee might learn the beneficiary has a substance abuse problem, is deep in debt, is the defendant in a lawsuit, or is undergoing a divorce.

The trustee might deem it prudent to keep money in the trust in any of these circumstances. Some people spell out in the trust agreement the circumstances under which payments should be withheld. Others realize they cannot anticipate every circumstance, so they give the trustee broad, general discretion.

The distributions to the beneficiary resume when the trustee concludes distributions again are in the beneficiary’s best interests. There are no guarantees that the problem child won’t waste money. But if you want an opportunity to help while protecting your wealth, consider these strategies.