After Mort Spahn and his wife, Shirley, sold their chain of toy stores they began working diligently on their estate plan. As part of the plan, Mort, 70, and Shirley, 66, wanted to do something for their four grandchildren, ages 2 to 8. They set up an irrevocable generation-skipping trust for them, transferring $2 million from the sale of the business to the trustthe total that can be passed tax-free under the generation-skipping exemption.
The Spahns wisely chose an irrevocable trust as a way to transfer assets out of their estate and provide a secure future for their grandchildren. At a conservative 5 percent annual rate of return, the trust in 22 years, when their oldest grandchild is 30, will contain almost $6 million.
The grandparents had two serious concerns about how the trust would be managed, however. They wanted to be sure that the grandchildren would use their future wealth responsibly and not, as Mort joked, grow up on the slopes of Aspen or Vail. They also did not want the trustee they had appointeda respected trust companyto make only conservative investments (for example, low-interest CDs or Treasury bills).
Once created, an irrevocable trust cannot be changed. So the Spahns had to think through some of the issues that might be faced by the trustee in future years, and to build into the trust instrument specific measures to protect their grandchildren.
Our discussions with the Spahns and their lawyers focused on four issues that are often overlooked in designing an irrevocable trust. What follows are some of the ways we decided to address those issues in the trust instrument:
If the trustee is an individual, what happens if he or she is not meeting investment performance standards, dies, or becomes incapacitated? If the trustee is a corporation, what happens if the institution goes bankrupt? And what happens if a beneficiary moves to another state? Can the trust be transferred to a bank in that area if necessary?
The simplest way to avoid these risks is for the creator of the trust to retain the right to remove or switch trustees. But such a provision may trigger an IRS claim that the trust assets belong in the grantors estate. Therefore, the Spahns named a trust protector to monitor the administration of the trust.
The trust protector should not be someone who is too close to the family or does business with the trustee. The Spahns chose a niece, a respected tax attorney who is about the same age as their daughter. She has the power to remove the existing trustee and appoint another if the trustee is not adequately representing the beneficiaries interestswhen, for example, the trust assets are earning sub-par interest or when a beneficiary has moved and is having trouble dealing with an out-of-state bank that administers the trust. The trust protector may never have to exercise this power, but her very presence tends to keep the trustee on his toes.
How could Mort and Shirley encourage their grandchildren to spend the trust proceeds responsibly and reward them for academic and creative accomplishment?
A grantor may want to include provisions allowing special distributions from the fund when, for example, the beneficiary earns a graduate degree, does outstanding work in the arts, or makes significant contributions to the community. The Spahns trust includes very specific rewards: $10,000 for graduating from college; $15,000 for making Phi Beta Kappa; $25,000 for a law or medical degree; $10,000 for winning a major award in the fine arts.
The trust instrument can also permit the trustee to reward beneficiaries who are succeeding as entrepreneurs or investors with their own funds. As an incentive for venturing, the special distributions might be designed to match investment earnings or business gains made by the beneficiary.
Like most generation-skipping trusts, the Spahns provides for a sprinkling of payments to their grandchildren over a period of years. The four grandkids are to receive a total of six disbursements, spread out in five-year periods, starting at age 35. Since most of the grandkids career needs are concentrated roughly in the years between ages 23 and 35, the special disbursements are provided in this time frame.
What if a beneficiary wants help from the trust in launching a venture?
While grantors are often entrepreneurs who appreciate the risk of starting a business and the difficulty of obtaining capital, very few trusts have provisions for loans that would make it possible for the grandkids to follow in their grandparents footsteps.
By writing an explicit provision in the trust authorizing such disbursements, the Spahns have ensured that the trustee will consider loaning money to the grandchildren for new ventures. Since they have four grandchildren, moreover, they have structured the trust so that no one of them can borrow a disproportionate share of funds to start a business, thereby jeopardizing the inheritance of the others. In the beginning years the $2 million will be kept in one fund for more efficient asset management; after the grandparents deaths the trust will be divided equally into four individual trusts.
The Spahns have written other specific requirements for a loan in order to prevent a depletion of the funds, for example: 1) A beneficiary is eligible for a loan only if he or she is turned down by two commercial banks; 2) he or she is required to present the trustee with a business plan; 3) instead of loaning the money directly, the trustee may choose only to guarantee loans from other institutions; 4) start-up capital from the fund will be loaned at the prime rate of interest, guaranteeing a respectable return to the fund but also offering the borrowers a reasonable rate for a new venture. Finally, a minimum amount of money must be kept in the trust at all times as a safety net, in case the beneficiaries ventures fail.
What if a beneficiary develops a self-destructive habit, such as a drug, alcohol, or gambling addiction, which threatens to dissipate the trust benefits?
Most trust provisions direct the trustee to distribute trust assets to a beneficiary for health, education, and support. However, the provisions are not usually specific enough to cover all-too-common situations such as substance abuse.
The Spahns trust allows the trustee to withhold distributions in such cases. If the beneficiary questions the decision, there are provisions for drug testing and arbitration. When distributions are stopped, the trustee may instead use the funds for the beneficiarys treatment and rehabilitation. The distributions can be paid to a medical institution or clinic until the beneficiary is cured of the habit and discharged. Then the distributions resume.
In todays complex and fast-changing world, many irrevocable trusts fail to meet the future needs of beneficiaries, much less create vehicles for grandparents to pass on values. The trusts must be structured with enough flexibility to reflect and respond to changing family needs and financial conditions.
Mike Cohn is president of The Cohn Financial Group in Phoenix, consultants specializing in ownership succession and wealth transfer.