Shirtsleeves to shirtsleeves, clogs to clogs, riches to ruin. These are not just catch-phrases—they reflect a truth that leads to sleepless nights for the wealthy and their advisors: If a client’s wealth succession plan is poor, so too will be their descendants.
There is a responsibility that comes with wealth, and it does not end at death. It starts with proper planning. Hence, here are some fundamental, effective strategies that advisors can put to use to prevent wealth from dissipating through generations.
Give in trust, not outright
Gifts to descendants are best made in a trust. Outright gifts are ill-advised because they are subject to the claims of creditors, settlement with spouses in the event of divorce and mismanagement of the asset directly by the descendants. A trust can appoint an independent trustee to manage the assets, utilize a spendthrift clause to block any attachment by creditors and serve as the pre- or post-nuptial agreement for descendants. Trusts can also negate the need for a descendant to pursue a pre- or post-nuptial agreement. In addition, trusts help avoid the probate court process at death, maintaining privacy and confidentiality for the family. Trusts are also more effective for advisors, as the structure creates more formality, compliance and control over assets in a centralized repository.
Use perpetual trusts
It is imperative that lawyers move beyond standard forms and create customized, long-term trusts. All too often, I see a basic provision that provides for fixed distributions of trust assets at a boilerplate set of ages. This may be woefully deficient to accomplish the objectives of clients with significant wealth. It may give too much too early. For example, giving $5 million outright to a 25-year-old is rarely prudent. The trust provisions should be crafted with the needs of the descendant in mind.
The better approach is to create a perpetual or “dynasty” trust that does not arbitrarily distribute all of the assets at certain ages. Rather, it provides for a descendant as needed throughout his or her entire lifetime and continues to provide for future descendants until the trust is depleted. The difficulty for larger estates is that the wealth usually exceeds the actual needs of the living descendants. Consequently, the trust needs to consider those beyond the second and third generations—planning for centuries and perhaps millennia instead of decades.
Moreover, perpetual trusts can include flexible provisions to accommodate changes in law and circumstances so the trust is relevant and viable at all times. Lastly, from the advisor’s perspective, a perpetual trust leads to a stronger client relationship since the wealth is not splintered among the various beneficiaries.
Use customized ‘best interests’ clauses
It is best to create a distribution clause that is based on the best interests of the descendant at the time, with the “best interests” clause being specifically defined by the clients with guidance from their advisors.
This type of clause is generally used in addition to the typical distribution standard for health, education, maintenance and support (HEMS). The HEMS standard is generally inadequate to provide for the needs of descendants of wealthy private clients.
The “best interests” clause can be as broadly or narrowly defined as clients want, as long as it is within public policy. This allows clients to impart their own preferences and philosophies to the trust as a guide toward future distributions, allowing for a more personal and long-lasting legacy. There are a wide variety of examples of such clauses, and they tend to focus on parameters surrounding distributions for items such as graduations; matrimony and honeymoons; personal or family travel; vehicle purchases; business start-ups; and loans and guarantees, among other things.
The possibilities are limited only by the desires and creativity of the advisors and the clients. Once the distribution events are determined, the amount of funding and terms can be customized as well. The point is to ensure that the provisions embody the long-term objectives of the settlor of the trust since at some point in time the trust will speak for the deceased settlor.
Lastly, distributions should always be discretionary as opposed to mandatory to ensure the assets remain fully protected until distribution. Unfortunately, many advisors are unaware that mandatory distributions of principal and income are not asset-protected and are fully attachable by creditors.
Create a family office
A deficiency of the typical inheritance plan is that the assets are viewed simply as gifts or entitlements. The more effective wealth transfer structure is built upon a business foundation. Utilizing an entity such as a limited liability company, in the form of a family office, to own and manage the wealth will provide clients with the best wealth planning structure. More importantly, it focuses on the wealth as an investment opportunity rather than an inheritance entitlement.
Depending on the size and complexity of the plan, the family office structure can be set up as either a single-family, multifamily or virtual family office.
A single-family office typically has a large and qualified in-house staff to serve all of the family’s needs. In the virtual family office, the client outsources the bulk of the professional functions. In a multifamily office, one service organization serves a number of families. In all models, the structure imposes a level of responsibility and respect for the wealth that helps to institutionalize the family asset pool and promote more reliable, long-term planning.
Establish a family wealth governance document
When utilizing a family office structure, it is imperative that the senior generation creates governance documents that set forth the rules, rights and restrictions surrounding the wealth along with the investment objectives and parameters. These family governance documents create a reliable framework in the form of bylaws, operating agreements or mission statements. Clarity in the governance and wealth management parameters prevents litigation and wealth dissipation in subsequent generations. Governing documents can be very complicated legal agreements or simple family mission statements to make legacy and stewardship intentions known. Not surprisingly, the larger the wealth is, the more likely the documentation will become more complicated.
Begin the rearing of the next generation early
It is a mistake to wait too long to bring younger generations into the fold. Descendants who are educated early and often about the family’s wealth, about the senior generation’s overriding philosophies, about the investment and growth opportunity and about the discipline of the family wealth management platform develop greater respect for the opportunities afforded by wealth.
The advisor plays a critical role in the education process by either directly acting as a teacher for the descendants or by assisting the senior generation in framing the issues and delivering the message.
Focus on philanthropy.
The for-profit aspects of the family wealth structure can be stressful and divisive, but this can be counteracted with a focus on philanthropy. Making charitable giving a formal component of the family wealth proposition unites the family while reinforcing the good side of being financially fortunate. Lessons learned through philanthropy have long-lasting effects on how descendants will care for transferred wealth and increase the likelihood that they will act as proper stewards. Again, the advisor plays an important role here in assisting in the implementation of the proper charitable structure (whether it’s a family foundation, donor-advised fund, supporting organization, etc.) as well as the education of the family members in the integration of the for-profit and the not-for-profit worlds.
Cohesive counsel is a must.
Advisors have to act as a team to successfully structure a client’s wealth plan. Attorneys, accountants, financial advisors, insurance agents, bankers and whoever else is necessary or desirable must work in a cohesive manner in the family’s best interests. A disjointed group of advisors will create gaps in planning that jeopardize the wealth and the senior generation’s planning objectives. The best structures have a true team of collaborative advisors earning more in fees than they would otherwise because they are being given an opportunity to maximize their value proposition for the client. And the clients are better served because they are receiving greater value on the whole and preserving more wealth for the long term.
In the end, the goal is to convert what is otherwise a fleeting inheritance into a perpetual wealth management opportunity for the family. This goal can only be accomplished through proper, coordinated planning. Whatever advisor role you play, it is in your best interests to help build that cooperative structure, as it will serve to protect your client and your own position on the team.
Jim Duggan is an estate planning attorney and partner at Duggan Bertsch LLC in Chicago.
