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Wednesday November 20, 2019

Article of the Month

How Much is Enough?

Many parents with midsized and larger estates would like to benefit children with an inheritance. An inheritance is not meant to make children worse people, but rather it is given in the hope that they will become better people. Parents who have midsized to large estates have the ability to transfer a substantial inheritance. But the question that quite often arises is, “How much is enough?”

Integrity and Initiative

Parents raise their children with the hope that they will develop good values. While parents cannot compel their children to acquire good values, they can create estate plans that maximize the potential that their children will develop good values. Parents should strive to pass along integrity and initiative to their children. The integrity and initiative strategy, or “I & I” plan, is designed to facilitate the development of integrity and initiative in the children of parents with midsized to large estates. However, these are adult children – how do you help encourage integrity and initiative in adult children?

The inheritance should be stretched out over time. Parents had thirty to forty years of time to learn to make good financial decisions. They often have acquired significant resources over a number of decades. Parents frequently explain that they would not have accumulated a substantial estate without the invaluable lessons they learned during their early years.

Children also need time to acquire successful management skills. There are many stories of children who receive a large inheritance without learning the lessons that made their parents successful. In considering how much to transfer, parents should ask themselves, “If we give our children substantial property without passing along the values we have learned, will this lead to a happy or unhappy story for our children?”

For children who inherit property without inheriting their parents’ values, the story is quite familiar. In 18 to 24 months, the child often reports, “My inheritance is gone. I spent it on boats, cars and vacations and wasted the rest!”

Charitable Remainder Trust

Some parents have substantial estates ranging between $3 million and $18 million. If they have two, three or four children, it is certainly possible to transfer a large inheritance with no estate tax. These parents frequently ask, “How much is enough?”

One very effective way to stretch out an inheritance over time is to create a charitable remainder trust (CRT) for a term of 20 years or the lifetime of a child. A 20-year term trust is also known as a “Give It Twice” trust because it pays an amount to children approximately equal to the funding amount over 20 years and then passes the principal to charity.

With larger estates, many parents will create one trust per child. This strategy allows each child to select his or her trustee, investments and income tax strategy. For larger estates, creating a separate unitrust for each child also increases the prospect of an important transfer for the parents – the “bequest of peace.”

The payout per child will depend on the funding amount for the unitrust. If each child has his or her own CRT with a 5% payout, then $1 million of funding produces a $50,000 payout per year. The payments increase with funding amounts of $1.5 million, $2 million or $2.5 million. These trusts would pay out $75,000, $100,000 or $125,000, respectively, in the first year. Parents with estates ranging from $12 million to $18 million may choose to fund even larger amounts and provide increased income between $100,000 and $250,000 per year per child.

“Provide Everything” versus “Added Economic Security”

Parents generally employ one of two inheritance strategies. These are the “Provide Everything” plan and the “Added Economic Security” option. The “Provide Everything” plan means the child will not need employment or other resources. With an applicable estate tax exclusion amount of $22.8 million for a couple in 2019, estate taxes are not often an issue. The question is which plan will the parents choose for their children?

Professional advisors should implement the plan chosen by their clients, the parents. While there has been no scientific survey on the topic, it is likely that nine out of ten parents will choose the “Added Economic Security” plan when presented with all the facts.

These parents would like their children to be responsible, to save, to have an IRA or other investment accounts and to manage their resources wisely. Parents would like to provide added security so they are sure their children will always have food, shelter, clothing, medical insurance and other resources. But, should the parents provide an additional $50,000, $100,000 or $150,000 per year? The good news about this decision is that parents are generally quite capable of looking at the current lifestyle of each child and understanding how that lifestyle would change with the added income each year.

Increase in Lifestyle

One couple, considering the impact of their children’s potential inheritance, asked, “How much of a lifestyle increase should we provide?” One parent noted, “Well, they already drive a better car than we do.” This lifestyle conversation is an important, healthy part of the estate planning process and can improve the quality and potential success of the I & I plan.

Many families with $3 million to $18 million in total resources will set a target income number between $50,000 and $150,000 per child. In a few cases, the parents will decide to provide added economic security of $200,000 or even $250,000 per year. While these higher amounts are certainly possible, the moderate increases are more frequently selected.

One father and mother were discussing the target income amount that they had agreed upon for their children. The father noted, “With this added income each year, our children will have a very comfortable lifestyle. If we gave more, our son would just buy a bigger boat. If he wants a bigger boat, he should earn it himself!”

Most often, parents set up Type I CRTs, or standard payment unitrusts, with a 5% payout to facilitate an I & I plan to children. The trust will pay the 5% of the value of the unitrust principal regardless of the trust’s income. The income from the trust is limited to a percentage of the total trust value and is paid out over a term of years or the child’s lifetime. This receipt of income over time increases the likelihood of passing along good values to children.

The CRTs may be funded with the target amount through the estate. In some cases, parents will fund a CRT for each child during life and then add the balance of funding from their estate. The benefit of starting the trust during life is that parents can encourage and teach their children to be responsible in their use of the CRT income amounts.

High Income Children & Tax Savings

Some children will be in high-income tax brackets. For these heirs, there is an advanced option that could save hundreds of thousands of dollars in income tax over their lifetimes.

Because a CRT is tax exempt under Sec. 664 (provided it follows a number of basic investment rules), a Flex-FLIP unitrust plus a partnership can be a major tax-saver. With a Flex-FLIP trust, the trustee will use the NIMCRUT structure to minimize income by investing in growth assets in years where the income beneficiary may not require income. In the year the income beneficiary is interested in receiving income, the trustee has flexibility to FLIP the assets to income producing assets and increase the income substantially.

The FLIP unitrust starts as a NIMCRUT. A NIMCRUT is a Type II Trust which pays the lesser of trust income or the unitrust percentage. A FLIP unitrust is permitted under Reg. 1.664-3(a)(1)(i)(c). The trust functions initially as a NIMCRUT, but after a "trigger event," such as sale of a nonmarketable asset, the trust will change the following January 1 to a Type I or standard unitrust.

The trust may be funded in part with a residential lot which has modest value compared to the total trust value. Then, the lot may be sold when the trustee determines that it is better to change from a NIMCRUT to a standard unitrust. Sale of the lot (the nonmarketable asset) is the FLIP trigger event. The FLIP date is the next January 1. On that date, the trust becomes a standard unitrust.

CRT income is defined under Sec. 643(b) and the applicable regulations found in Reg. 1.664-3. Regulation 1.643(b)-1 notes that income shall be defined under the "governing instrument and applicable local law." The unitrust drafter may allocate all recognized capital gain to income.

The assets of a Flex-FLIP unitrust may be transferred to a partnership. With a partnership or single-member LLC, when a trust payout is desired, cash is distributed from the partnership or LLC to the unitrust, and then to the income recipients. The unitrust payout will be part ordinary income and part capital gain.

For a high-income child, the trustee of the Flex-FLIP trust will not sell the lot and the NIMCRUT assets are held by a partnership held by the CRT. The partnership invests the assets and, upon request of the trustee, makes cash distributions to the trust. Under the CRT accounting rules, the trustee will only make unitrust payouts when cash is transferred from the partnership to the CRT. The benefit of this plan is that assets can grow tax-free inside the CRT as long as the child does not need distributions.

The net result is the high-income child can enjoy tax-free growth in the CRT. If the child desires income, the distribution from the partnership to the CRT enables payment to the child. A further benefit is that under the four-tier accounting rules, part of the payment to the child may be a distribution of long-term capital gains. These will, of course, be subject to a lower tax rate.

The Flex-FLIP unitrust with a partnership is also called an “Income Control” unitrust. It is perhaps the best tax-saving strategy available after passage of the Tax Cuts and Jobs Act. Some children with a Flex-FLIP unitrust may save 40% to 90% of the income tax that would otherwise be due with a noncharitable trust. Some leading charitable tax attorneys are actively using this Flex-FLIP “Income Control” strategy to benefit high-income children.

Balance of Estate to Charity

The final decision for parents is the disposition of the balance of the estate. In many cases, after funding the CRTs for an “Added Economic Security” plan, the estate balance is between $2 million and $12 million. Because the children have received an “I & I” inheritance, the balance is generally transferred to a charitable fund.

This fund may be an endowment with a favorite charity, a donor advised fund, a supporting organization or a private foundation. Many donors choose to fund a donor advised fund due to its simplicity and reasonable cost.

This plan accomplishes multiple goals. It gives the children time to learn successful management strategies – which is very helpful in facilitating passage of “Integrity and Initiative.” The children receive a thoughtful inheritance with the desired increase in their standard of living. High-income children enjoy tax-free growth of CRT assets and may take tax-advantaged distributions as needed. Finally, the children are often appointed as advisors for the donor advised fund. Parents are particularly pleased that their children are learning philanthropy and the joy of helping others.

Published November 1, 2019
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Juliana E. Olsen-Valdez, 2018
Carroll Family Scholarship

"Lawrence University is a great place for students looking to embrace their multi-interested approach to learning. As a Geology major, I have spent many long hours in laboratories. But, I have also had the opportunity to organize and lead students on outdoor backpacking trips, help build a stronger community for International students, participate in dialogues on campus initiatives, attend dozens of musical events, and study abroad in a field-based geology program, all while taking classes in a variety of academic spheres on campus. Lawrence, as an institution and student body, creates a collective of learners, listeners, and leaders who are continuously evolving their understanding of the world around them. I am fortunate to have the support of the Carroll Family Scholarship, so that I can say I am a part of this exceptional community too!"

Weiqi "Vicky" Liang, 2019
Marian H. Cuff Endowed Scholarship

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Anthony Cardella, 2018
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Milwaukee-Downer Scholarships and Professorships

Some of the many recipients of Milwaukee-Downer scholarships gather for a photo with Carolyn King Stephens M-D'62 and Marlene Crupi-Widen M-D'55 in January 2014 at the annual scholarship luncheon.

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Dr. Alfred W. and Mrs. Ada F. Gray Scholarship
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Belle Austin Jacobs Scholarship
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Marjorie S. Logan Scholarship
Nellie Maxwell Scholarship
S. Annabelle & Paul McGuire Scholarship
Memorial Scholarship Fund - Milwaukee-Downer
Milwaukee-Downer Class of 1953 Scholarship
Milwaukee-Downer Class of 1955 Scholarship
Milwaukee-Downer Class of 1956 Scholarship
Milwaukee-Downer Class of 1957 Scholarship
Milwaukee-Downer Class of 1958 and 1959 50th Reunion Scholarship
Milwaukee-Downer Club Scholarship
Milwaukee-Downer/Lawrence College Consolidation 50th Anniversary Scholarship
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William M. Ross Memorial Scholarship
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Dr. Elizabeth A. Steffen Scholarship
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Angela Small Fry Intia, 2019
Maurine Campbell Scholarship

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