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Robert F. Sharpe, Jr. explains how clients can combine their love for their heirs with the desire to help them be responsible.
Much has been written about the growing concentration of wealth in the United States and much of the rest of the world. Comparisons to the pre-Depression years of the roaring 20s and England before World War I are increasingly common.1
Not only have the wealthy become wealthier in recent years, but also more of the wealth in the United States will pass over time free of tax at the federal level and under most states’ laws. With a minimal amount of planning, a wealthy couple can now transfer $22.8 million free of federal tax, and over 60 percent of Americans live in states that impose no estate transfer taxes.
The preservation of a stepped-up basis at death under the Tax Cuts and Jobs Act of 2017 (the Act) further assures that more of the wealth will never be subject to a levy on capital gains when realized by heirs.
Increased estate tax exemptions, if continued over time, will ensure that the concentration of wealth intensifies and gives rise to a new class of wealthy young heirs. The fact that many Baby Boomers married and had children later in life than previous generations also means that individuals who in the past inherited substantial wealth in their 40s and 50s may now be passing that wealth to their children who are in the 25-to-40 age range when they receive their inheritances and less prepared to manage their new-found wealth.
Even before they inherit from their parents or grandparents, however, an increasing number of young people are growing up in the midst of the wealth created or inherited by their parents, especially in an economy in which much of the new wealth is being created in the high tech industry spawned by relatively young entrepreneurs in Silicon Valley and other centers of technological innovation.
The Rise of Affluenza
The term “affluenza” first surfaced in the 1970s to describe the negative impact of affluence on those who aren’t adequately prepared to shoulder the responsibilities of wealth. In recent years, the term has been more frequently associated with the debilitating effects of wealth on younger people and even successfully put forth as a defense against serious criminal charges.2
One of the greatest challenges facing those who amass significant wealth after rising from humble beginnings is the desire to give their children the benefits that can derive from that wealth without depriving them of the satisfaction of realizing their personal potential. As Warren Buffett famously put it, “You should leave your children enough so they can do anything, but not enough so they can do nothing.”3
But fortunately, the ill effects of affluenza can be prevented or in some cases even cured by the integration of philanthropic training with effective estate and financial planning.
Giving Heirs a Start in Life
One of the earliest experiences in my career was the work I did for a wealthy individual who came from a family noted for its multi-generational wealth creation and the philanthropy it had made possible. This individual didn’t suffer from affluenza and was a pillar of his city’s philanthropic community.
He’d inherited $1 million from his grandparents in 1953 and had parlayed that sum into $100 million by the early 1980s. Today, that $1 million has grown to an estimated $500 million or more.
His estate plan was very simple. He decided to leave each of his two children $1 million, adjusted for inflation from 1953 to the time of his death. In 2019, that would amount to $9.5 million or a total inheritance of $19 million to his children. The remainder of his estate was bequeathed to a number of philanthropic interests including a family foundation that would be administered by his children and a number of other individuals he named.
His thinking was that he’d been given a significant, though limited, amount of capital in relation to his grandparents’ wealth to begin his business career. He believed his children should start at the same place he did. What they did with their inheritance was their own choice, but they were made aware early in life that regardless of the extent of his wealth, there was a limit on the amount they could expect to receive.
In past years, it might have required that $38 million or more be left to his children pre-tax with the remaining funds transferred to philanthropies. In the wake of the Act, the $19 million wouldn’t exceed the threshold of the amount a couple can leave free of federal tax and, as a result, more would be available for philanthropy than before.
Providing Initial Capital Flow
In other cases, a parent, grandparent or other relative might wish to have his children or other heirs receive an inheritance while he’s still living—albeit a limited amount. Further, rather than giving a lump sum to heirs, the inheritance would be staged over time.
This can be accomplished in a number of ways. One of the most tax-effective ways is through the use of a term-of-years charitable remainder trust (CRT).
For example, a 70-year-old parent might create a charitable remainder annuity trust (CRAT) that makes annual payments of 5 percent of the amount initially used to fund the trust. The trust is funded with low yielding securities valued at $2.5 million with a cost basis of $1 million. The trustee liquidates the securities free of capital gains tax inside the trust and reinvests the proceeds in a more balanced portfolio.
The trust will make fixed payments to a 35-year-old child of the donor of $125,000 per year for a period of 15 years. The parent in this case would be entitled to an immediate charitable income tax deduction of $1.05 million. There would be a taxable gift of approximately $1.45 million, which could be offset by a portion of the parent’s $11.4 million lifetime gift and estate tax exemption.
As an added benefit, much of the income will be taxed when received by the child at favorable capital gains rates under the tier structure of income reporting for CRTs.
The child is told that she’s receiving her inheritance in the form of income totaling $1.875 million payable over 15 years, and she’s free to spend or invest those funds in any way she sees fit. If she invests half the income, she’ll have a tidy nest egg at age 50 when the income ends. Alternatively, she could use the funds for various purposes, including to help meet educational expenses for her teenage children, fund the start of a business or retire a mortgage over 15 years.
At the termination of the trust, its remaining assets will be distributed to a donor-advised fund (DAF) created by the parent with the child as the advisor.
The child is told that the remainder of the parent’s estate will be left to charities of the parent’s choice, and she’ll receive nothing further from the estate regardless of the wealth of her parent at death.
The parent’s desire is that the child will use the funds received from the CRAT wisely and will appreciate the privilege to make a difference in society through grants from the DAF in her later years.
Giving a Child a Finish
In other cases, a parent or grandparent may wish to fund an heir’s education and/or invest in an initial business venture but thereafter provide no inheritance for some period of time.
Suppose an 80-year-old self-made multi-millionaire grandparent worth in excess of $50 million would like to eventually leave $5 million to a grandson who’s currently 25 years old. The grandparent doesn’t want the grandson to inherit the $5 million until he’s 55 years old, some 30 years in the future. The grandparent is aware that his life expectancy is approximately nine years. The odds are that he won’t live until age 110, and he’d like to delay the grandson’s inheritance until age 55, regardless of how long he should live.
To effectuate his desires, he creates a $5 million charitable lead annuity trust (CLAT) that will make fixed payments of 5.25 percent or $262,500 each year to qualified charitable interests for 30 years. This would fund charitable gifts of $7.875 million. Half of the charitable distribution each year would go to charitable recipients named by the grandparent, and the remainder would be directed to a DAF for which the grandson could advise distributions.
The grandparent is deemed to have made a taxable gift of $5 million to the grandchild in the year the trust is funded. It’s offset by a charitable gift tax deduction of $5 million resulting in no tax, because the present value of the $7.875 million in charitable gifts offsets the gift amount.
The grandson is informed of this plan and told that he’ll be able to make charitable gifts of up to $131,250 each year, but he won’t otherwise inherit anything from his grandparent until he’s age 55. In the meantime, he’s to make the most of the education his grandparent provided him and “learn to fish before his pond is stocked.”
This same plan could be very useful for young wealth creators. I’ve seen trusts such as the one described above established by a 35-year-old beneficiary of a public offering of a high tech enterprise who created such a trust for a 10-year-old child to benefit at age 40 after helping to distribute the funds originating from a lead trust during high school, college and young adulthood before receiving a tax-free inheritance.
Some believe that philanthropy is an innate trait in certain individuals while others believe it’s learned and can be inculcated in behavior by creating conditions that require the activity. As the pioneering 19th century American psychologist William James, the brother of novelist Henry James, famously observed, “Do we run because we are afraid or are we afraid because we run?”4
One might also ask, “Do we give because we are philanthropic, or are we philanthropic because we give?” Some believe the latter and some the former. Many of the world’s enduring fortunes from the Medicis to the Rothschilds to the Rockefellers have been based at least to some extent on the premise that early training in philanthropic activities is the basis of responsible management and stewardship of capital over generations.
Better Late Than Never
Another way for older parents of means to encourage their children to work an entire career before receiving an inheritance is to provide for a charitable gift annuity (CGA) that begins making payments at around retirement age, perhaps age 65.
Take the case of this married couple: The husband leaves $4 million in a qualified terminable interest property (QTIP) trust that provides for a surviving spouse. At the widow’s death, the trust provides that the remainder of the trust be used to fund a CGA for each of four children that will begin to make payments to them at age 65 or immediately if they’re beyond the age of 65 at their mother’s death.
While there will be no estate tax savings for this couple due to increased exemptions, the funds left in the form of the CGAs will continue to grow tax free in the annuity reserve funds of the charity for the period of time between the age of the children at the mother’s death and age 65. In addition, a large portion of the payments are received by the children free of tax as a return of the investment in the contract for the period of time equal to their life expectancy when payments begin.
If one or more of the children predecease their mother, the remainder of the QTIP trust will be used to fund larger annuities for the surviving children.
Putting It All Together
These are just a few of the myriad of ways that philanthropic planning can be combined with other estate and financial plans to preserve wealth and transfer it to heirs in ways that encourage the development of personal habits that may result in the prevention and/or cure of affluenza.
I’ve worked with more than one wealth creator who had no desire to leave wealth to heirs who might become idle rich and make no contribution to society. On the other hand, they didn’t want to completely disinherit their heirs and wanted to provide inheritances to their families in ways that may make their lives easier but not effortless.
Fortunately, planners have tools at their disposal to creatively address the conflict wealthy individuals may feel between the desire to give their heirs the opportunities to effect positive change with the wealth they inherit and the desire to avoid the ill effects of affluenza.
Helping clients discover and implement the plans that best meet their desire to combine their love for their heirs with the desire to help them be responsible while contributing to the betterment of society can be one of the most rewarding aspects of estate and financial planning.
Endnotes
1. Andrew Keshner, “America’s 1% hasn’t had this much wealth since just before the Great Depression,” MarketWatch (Feb. 13, 2019), www.marketwatch.com/story/its-been-almost-a-100-years-since-the-americas-1-had-so-much-wealth-2019-02-11.
2. www.nytimes.com/2016/04/14/us/teenager-who-used-affluenza-defense-is-sentenced-to-jail.html.