WEALTH TRANSFER
When 'irrevocable' trusts aren't

How to influence a trustee while you're still alive—
and after you're dead

BY MIKE COHN

Wendell and Carolyn are successful family business owners in their mid-60s concerned about how their wealth may influence their three adult children and five grandchildren. They understand entrepreneurship and hard work; they want their values and their financial assets to provide opportunities for future generations but they also worry that inherited wealth may have unintended, and negative consequences.

"We don't want future generations to be trust fund babies," says Carolyn.

Their attorney has recommended a Multi-Generational Irrevocable Trust, funded with current assets, but the irrevocable part has caused Wendell and Carolyn to procrastinate. Our firm was engaged to work with their attorney and address their concerns.

There are many advantages to creating, and funding, an irrevocable trust – assets transferred to the trust (and properly re-titled) are not included in Wendell or Carolyn's estate for estate tax purposes. Assets in the trust are not subject to creditors, or claims of divorced ex-spouses.

As long as the assets remain in trust, they may also avoid estate taxes at children’s and grandchildren’s deaths. The Multi-Generational Irrevocable trust has been called a family bank since it can become the core entity for holding the family's wealth.

Assets are typically sold, or gifted (or both) during lifetime to the Multi-Generational trust and include discounted family business stock, real estate (especially if held in a family limited partnership), life insurance, and other assets. For example, if the trust is an income-tax defective trust, a sale of family business stock to the trust, by Wendell and Carolyn, in exchange for a promissory note, can be structured so the sale is not an income-taxable event to Wendell and Carolyn.

In theory, and in practice, irrevocable trusts cannot be changed once they are created. However, there are a number of provisions that Wendell and Carolyn should consider for their trust that provides flexibility to them and future beneficiaries. These provisions must be designed into the trust at the outset, since once the trust is signed, changes can only occur if permitted under the trust terms.

Involve Adult Children in the Process
We encourage our clients to involve adult children in early discussions about the trust, educating them about possible provisions, including future responsibilities they may have---the trust is for their benefit so the more engaged they are, the greater the likelihood that the trust will work as intended.

Include a White Paper describing Family Values and Goals for Future Generations
The Trust is a legal document. Rarely is there a personal "connection" for beneficiaries to know what the grantors (Wendell and Carolyn) were trying to accomplish. Trustees may be asked to make future decisions by relying solely on the language in the Trust agreement.

Wendell and Carolyn decided to involve their three children in developing a "white paper" so future generations could feel connected to the current generation, understand the family's values, and the purpose for the trust [see insert]. The White Paper can be included as an addendum to the Trust; trustees would be encouraged to look to the White Paper for guidance in decision making.

Letter of Wishes
After the Trust has been signed and funded, Wendell and Carolyn (for their lifetimes) can exert their influence through Letters of Wishes to "assist" trustees with decision making. The Letter of Wishes concept dates back to the Magna Carta. A Letter of Wishes is a written request to the trustee suggesting how she might deal with changing circumstances and events.

Although the Letter of Wishes is not binding upon the trustee (because if it were, trust assets would be brought back into Wendell and Carolyn's estate for estate tax purposes), the trustee will usually respect the grantor’s wishes. When the grantor or Trust Protector (described below) also has a power to remove the trustee (and appoint a successor), then the trustee may be fired if the trustee ignores the grantor's request, and someone more sympathetic appointed instead.

Trust Protectors
A Trust Protector is a special trustee, independent of both the grantor and the regular trustee, and given specific powers under the Trust Agreement. For example, the Trust Protector may have a power to remove the trustee (with the grantor having a power to appoint the successor). A Trust Protector may be able to change a grantor trust to a non-grantor trust (so that the Trustee would pay income taxes on the Trust's earnings instead of Wendell and Carolyn), substitute assets, or even grant special powers to beneficiaries.

Investment Committee
A separate Investment Committee comprised of beneficiaries and others can manage the trust's financial assets by hiring investment managers, create and maintain the trust's investment policies, and vote family business shares owned by the trust. With the use of such a committee, beneficiaries can be more actively involved and potential trustee conflicts are reduced.

One possible scenario: Wendell and Carolyn sell some of their family business shares to the Trust now (to freeze a portion of their estate), and enter into a buy-sell agreement with the Trustee to purchase the remainder of the shares at Wendell's death. This could provide Carolyn income (after Wendell's death), while giving the investment committee control of the company.

Broad Trustee Powers
When the trust is initially drafted, trustees may be given broad powers to add or delete beneficiaries, change the timing of distributions to beneficiaries, and even the types of assets that are distributed to beneficiaries. For example, a Letter of Wishes can request the trustee to use those powers to add a beneficiary such as a (later created) family foundation, or equalize children by allocating family business stock to those who are active in the business and other assets to those who are not active.  

Flexibility can be incorporated in additional ways :

• Autonomy for Beneficiaries. Wendell and Carolyn created (and funded) separate accounts (called "sub-trusts") for each of the adult children, to let them have some immediate responsibilities for a portion of the assets (and as a way to "test" their ability to partner with one another);
• Responsibilities. The adult children can be responsible for managing some of the trust's assets (e.g. a portfolio of real estate) and/or sit on the trust's investment committee (for marketable securities);
• Family Philanthropy. Charities can be added (as additional beneficiaries) if Wendell or Carolyn wanted to direct some of the trust assets (or income) to a family foundation or to other charitable interests;
• Productivity Standards. Distributions from the trust to children, or future beneficiaries, can be tied to earnings or accomplishments in careers (entrepreneurship, public or community service, the arts); similarly, language can discourage unproductive beneficiaries by withholding distributions. Beneficiaries with substance abuse problems may find their distributions directed to a treatment center instead of to them personally.
• Entrepreneurship. Ttrustees can fund family ventures including helping beneficiaries purchase existing companies or start up new businesses – often subject to the submission of an acceptable business plan to the investment committee or the trustee.
• Community Service. Beneficiaries can be encouraged to provide community service both in time and talent, which could be supported by additional distributions from the trust.  

Redefining "Income" for Distributions
Most trusts define "income" for determining distributions to beneficiaries as net income received by the trustee. Since Wendell and Carolyn's trust assets would mostly be in raw land and family business stock, there may be significant value, but not much current income for a surviving spouse, or for next-generation beneficiaries. A need for greater income may put pressure on a trustee to sell assets and use traditional income-producing securities while sacrificing long-term appreciation (for future beneficiaries).

To eliminate a conflict between current and future beneficiaries' needs, Wendell and Carolyn decided to use a "total return" concept for distributions and direct their trustee to treat the trust portfolio as a whole rather than focusing on individual assets. While various formulas can be used to define how distributions are calculated, the goal is generally to distribute a percentage of trust assets based on their underlying value, rather than how much net income is created.