PROTECTING

YOUR CHILD'S INHERITANCE:

 
Using a Beneficiary- Controlled Trust

Financial planning after death includes passing wealth to our loved ones in a manner that protects wealth for generations to come.  In a litigious society, asset protection has emerged as one of the greatest concerns of clients.  Parents are not only concerned about threats to their own wealth while they are alive, they are concerned about protecting their wealth for their descendants.  With divorce and bankruptcy rates as high as they are, it is easy to understand why parents are concerned about the risk of lifetime assets passing to their children’s spouses, creditors, and predators.

Irrevocable trusts set up by parents for their descendants, however, do provide asset protection for the children because the children have not set up the trusts for themselves.

A Case Study:

At her death, grandma’s trust left her property outright to her son, Sean.  Grandma expected that any remainder from her estate would eventually pass to Brandon-Sean’s only child from his first marriage.  At the time of grandma’s death, Sean had recently married his second wife, Wilma.  What happens without proper planning?

If Sean comingles the property with Wilma and they divorce, half of the assets could go to Wilma instead of to Brandon.  If Sean dies without an estate plan, the New Jersey’s intestate law controls.  By operation of law, the inheritance could be split equally between his new wife and Brandon, with Brandon receiving his inheritance outright at age 18.  If Sean inherits outright and has creditor problems, the entire inheritance could be lost to creditors.  However, if grandma had designed her trust estate to go to her descendants in a beneficiary-controlled trust, the assets could be protected from immature beneficiaries, predators, spouses, and creditors.

Four Levels of Protection

Below are the most common distribution techniques parents use to leave assets to their children. See table 1 for a comparison of the advantages and disadvantages.

Four Distribution Techniques for leaving Assets to Children
 

Mandatory Income and Support Trusts require the trustee to make distributions according to the terms of the trust.  Mandatory income trusts require the trustee to distribute income to the beneficiaries.  Support trusts direct the trustee to distribute the trust’s principal and/or income for the health, education, maintenance, or support (HEMS) of the beneficiaries.  Trusts established for descendants do not need to have mandatory distribution provisions.  If they do, the beneficiaries have a demand right, and consequently creditors who “step into the shoes” of the beneficiary can demand distributions from the trust.  The trust usually contains spendthrift language that does not permit the beneficiary to assign future income of the trust, but the mandatory distributions are not protected.

Staggered Distribution Trusts, where assets are held in trust for a child and distributed in intervals or when the child attains certain ages (such as 25, 30, and 35), are used to prevent the child from squandering the inheritance all at once.  Moreover, the child may gain financial maturity as he or she manages successive distributions.  Until the triggering ages are reached, a trustee other than the child typically makes distributions for the child’s health, education, maintenance, or support.  Similar to the mandatory income and support trust described above, if a child is able to demand a distribution a creditor may have the same demanding right.  Furthermore, once the child receives the distributions of income principal, the distributed assets have protection.

Lifetime Beneficiary-Controlled Trusts are the newer, preferred way to leave assets to a child.  The child has access to the parent’s assets almost as if the parents had left them to the children outright, but the assets are protected from the child’s spouse and creditor’s and not included in the child’s estate.

Beneficiary-controlled trusts are created by the parents when they create their own trusts.  The parents’ trust provides that, after the death of the second parent, the child serves as a co-trustee along with an “independent” distribution trustee.  In other words, the parents’ leave assets to the child’s trust, naming the child as co-trustee to handle the investment of the assets and naming a second, independent co-trustee who has complete discretion to make distributions to the child.  According to IRC section 672, an independent trustee is someone other than a spouse, parent, grandparent, sibling, issue, or employee of the beneficiary.  Possible candidates for independent trustee include:  friends, more distant relatives, such as an aunt, uncle, or cousin; professional fiduciaries; or financial institutions.

The child is the beneficiary of his or her own separate trust.  The trust assets are re-titled directly from the parents’ trust to the child’s trust.  If the child becomes a party to a lawsuit, such as a divorce or creditor action, the trust assets are protected because the child does not have the authority and cannot compel the distribution trustee to make distributions from the trust.

A variation on this type of beneficiary-controlled trust allows the child to serve as sole trustee of his or her separate trust.  However, if the child resigns as trustee, he or she must appoint an independent trustee who has complete discretion to make distributions.  The theory is that once the independent trustee is in place, the assets will not be vulnerable because the parent, not the child, established the trust, and the child who is no longer trustee does not have the discretion to distribute income or principal.