Sizing up a FIT: Tailor a family incentive trust to meet your needs

Estate Planner September/October 2006

As baby boomers grow older in the coming decades, enormous amounts of wealth will pass from one generation to the next. In fact, a 1999 (and reexamined in 2003) report published by the Boston College Center on Wealth and Philanthropy estimates that between $41 trillion and $136 trillion will be transferred by 2052.

Despite the vast sums at stake, surveys show that affluent baby boomers are less concerned about sharing money with the younger generation than with sharing values, a sense of responsibility, a strong work ethic and a commitment to education. To achieve this goal, an increasing number of people are using family incentive trusts (FITs) to shape their legacies by shaping the character of their heirs.

Dangers of unrestricted wealth

There’s a popular misconception that many of the richest Americans inherited their wealth. In fact, the vast majority of today’s millionaires are self-made, and they recognize the importance of earning one’s keep. Many believe that inherited wealth can have a corrupting influence.

And you don’t have to be on the Forbes 400 list to share these concerns. A $2 million bequest that earns a modest 6% return will generate an annual income of $120,000 – more than enough for a child to live off his or her inheritance.

One way to protect your heirs from the temptations of easy money is to limit their inheritance or even to disinherit them altogether. A less harsh approach, however, is to use a FIT to share your wealth with some strings attached.

A FIT can serve many important estate planning goals, such as providing a safety net so your heirs will never end up homeless, providing financial incentives to lead responsible, productive lives, and creating opportunities by lending to or investing in a family business.

Structuring a FIT

You can designate most estate planning trusts – including living trusts, asset protection trusts, insurance trusts and certain charitable trusts – as FITs. Typically, FITs are structured as spendthrift trusts, meaning beneficiaries can’t assign their interests (such as collateral for a loan), and the assets enjoy some protection against creditors’ claims and divorcing spouses. FITs often are set up as dynasty trusts, which allow you to have an impact not only on your children, but also on your grandchildren and later generations. (See the sidebar “Creating a FIT dynasty.”)

You may base distributions from a FIT on virtually any criteria, from obtaining a college or graduate degree to maintaining gainful employment to reaching a certain age. Whatever the criteria, however, you likely want to design the FIT so your heirs can’t live off the trust funds while doing nothing.

You can limit distributions to the trust’s income or provide for distributions of both income and principal. If your children are responsible adults, you can give them unrestricted access to trust funds and provide for the trust to convert into a FIT for your grandchildren.

Typically, a FIT’s income or principal is applied first toward providing a safety net so heirs never will be destitute and next toward incentives to encourage desired behavior. You may use leftover funds to establish a “family investment bank” to invest in family businesses or other worthwhile endeavors.

FIT flexibility

Designing a FIT requires intense planning to ensure that it accomplishes your goals while being flexible enough to avoid unintended consequences and adapt to changing circumstances.

You might provide an incentive to work, for example, by linking trust payouts to a beneficiary’s earnings. But what if success in a beneficiary’s chosen career requires that he or she start with a low-paying or unpaid internship? What if a beneficiary becomes disabled and can’t work? A well-designed FIT should accommodate these circumstances.

You also should consider the fact that living responsibly can mean different things for different people. A FIT that requires beneficiaries to work, for example, may penalize a stay-at-home parent committed to raising his or her children.

A good way to ensure a FIT is sufficiently flexible is to establish general principles for distributing trust funds but to give the trustees broad discretion to apply these principles depending on the facts and circumstances. For a multigenerational FIT, another effective approach is to give beneficiaries a special power of appointment they can use to adapt the FIT to meet the needs and circumstances of their children.

Accentuating the positive

Most experts agree that negative reinforcements are counterproductive. Financial incentives that require a beneficiary to refrain from drug use, gambling or other behavior you deem undesirable can send the message that you’re “ruling from the grave” and can lead to resentment and conflict. Such incentives also may encourage beneficiaries to conceal their conduct and avoid seeking help.

By stressing positive behavior, such as gainful employment or higher education, the negative behavior tends to take care of itself. After all, it’s tough for a substance abuser to hold down a job or stay in school.

It’s also important to avoid “buying” desired conduct. If your daughter wants to work but your FIT offers an enormous bonus if she stays home with the kids, she may feel that she has no choice. It’s better to offer beneficiaries a variety of positive options that make them feel that they can do anything, so long as they do something productive.

Fitting rewards

A FIT is a flexible estate planning tool that allows you to shape your legacy by encouraging your heirs to lead responsible, productive lives. It also helps preserve your wealth for future generations by preventing your children from getting a free ride.

Sidebar: Creating a FIT dynasty

If you want your family incentive trust (FIT) to influence many generations to come, consider setting it up as a dynasty trust. A number of states have relaxed or eliminated restrictions on the longevity of trusts, allowing you to create a trust that, in theory, can last forever.

If you establish a dynasty trust, plan carefully to avoid the generation-skipping transfer (GST) tax. The GST tax was intended to prevent families from avoiding estate taxes in one generation by transferring assets directly to the following generation. It’s a flat tax – on top of any other gift and estate taxes – imposed at the highest marginal estate tax rate (currently 46%) on gifts, bequests or trust distributions made directly to a “skip person.” A skip person is a grandchild or other person more than one generation below you, or a nonfamily member who’s at least 37 1/2 years younger than you.

To avoid GST tax, allocate some or all of your GST exemption (currently $2 million) to trusts you intend or expect to benefit your grandchildren or other skip persons. One of the most powerful tools for leveraging the GST exemption is an irrevocable life insurance trust (ILIT). You can create millions of dollars in tax-free benefits for future generations, but you use only the GST exemption amounts needed to cover contributions for insurance premiums.

Dynasty trusts are complex and require careful planning. Be sure to consult an expert to design a trust that achieves your goals in the most tax-efficient manner.