*This is a hypothetical case. Any resemblance to real persons or circumstances is coincidental.
Philanthropist Andrew Carnegie left his children roughly 10% of his millions and gave the remainder away during his lifetime.
James and Anita Rusholmme wish they’d gone the same route as the steel magnate. Instead, they continued to fund the dreams of three children who, at 31, 28 and 25, have yet to draw paycheques.
In 1970, James and Anita took over a then-failing drillbit manufacturing operation founded by Anita’s father. They turned the company around amidst one of Alberta’s booms and had the foresight to license their technology to three overseas manufacturers. Their bits are used on land-based and offshore drilling platforms worldwide, and while they sold the company 10 years ago for $90 million, their retention of patent and license rights to various drilling technologies has resulted in a $2-million annual income.
The parents bought their 31-year-old daughter, Emma, an organic farm outside Edmonton. Emma and her partner transport the produce to various farmers’ markets in a pristinely restored 1968 VW Vanagon. The produce sells well but their yields are modest, so the revenues don’t cover the costs of seed, fertilizer, tools and wages for three farm hands. The parents send roughly $7,000 monthly to cover their daughter’s shortfalls.
But Emma’s industrious compared with sister Zoey, 28. The couple bought her a downtown Calgary condo, and currently stipend her dining and shopping habits to the tune of $9,000 monthly. She’s working simultaneously as a freelance marketing consultant and a social media specialist for what she describes as “big-name companies.” The parents are suspicious, since her two jobs don’t appear to pay and require an inordinate amount of expensive socializing. Her social media feeds show her at the city’s hot spots, downing pricey cocktails.
Then there’s youngest child Gerald, a wannabe experimental thrash punk guitarist who squats in the third floor of a warehouse by the Havel River in Berlin, Germany. Gerald told his parents he’s working on a screenplay, but most of his emails consist of requests for money. James and Anita transfer $1,000 to their son’s bank account every five to eight days, depending on how urgent his messages seem.
With no company to pass on, the couple can’t force any of the children to earn their keep by taking roles in the family business. At 69 and 70, respectively, and in excellent health, the couple feel they have a lot of living to do; and they have the means to do it. They feel they’ve set their children up for failure, but are torn because they have plenty of money. The expenses aren’t hurting them, but they want to stop babying their adult children.
As they prepare to draw up a new will, they are open to ideas for how an estate structure can force their kids to take at least some responsibility for their financial futures.
JT: The parents got themselves into this situation by constantly giving their kids money and not forcing them to earn their own, or to respect the money they’re getting. Advisors must first explain to the parents why it’s important to involve the kids in the estate planning discussion—it’ll stop future problems (like sibling rivalry) once the estate is being settled. Then, when the parents talk to their kids, I’d offer to mediate.
CDP: There are also many emotional factors that have to be considered. We’d have to dig to understand the nature of the relationship—past and future. I’d ask them, “What led us to the point that the children don’t take responsibility? And going forward, what will we implement for them to take responsibility?”
It’s clear money doesn’t always incentivize the children, but each has different interests so that could be one way to incentivize them. I’d suggest putting rules in place, and say if you meet X, Y and Z within so many years, there’s going to be a certain benefit. For instance, if we find out [the oldest] daughter’s business isn’t profitable because she lacks experience or knowledge, the parents tell her, “We’ll give you $X this year to take part-time business management courses, or hire a coach.” And, at the end of that year, they require business reports and financial statements. If she agrees and shows some improvement in the business, that’s a good first benchmark. For example, this money could also be inside a small investment corporation. Mom and Dad say, “We need to teach you to start making decisions, so what we’re going to do is have a little investment company. And we’re going to have regular board meetings, where we can guide and teach you how to make decisions regarding money.” It doesn’t have to be an active business.
JT: Another way of teaching kids responsibility is charitable giving. The parents could set up a foundation, and have the children involved in how funds are dispersed. But before suggesting this idea, I’d see if they had any interest in charitable operations. If they do, I’d explain how the foundation works and the tax advantages. In Alberta, if they donate more than $25,000, they’re looking at an almost 50% tax credit. And it doesn’t need to be to one charity—they can spread it across many.
Also, I’d suggest to the kids that their involvement in the foundation could determine what they actually inherit. If they show financial responsibility, then the parents will feel comfortable leaving them with more money.
MU: We’ve got some wealthy clients who’ve set up foundations. The children get some experience in business, being on a board and being responsible for money. And looking at the background of the children, one of them is interested in organic farming, so she might be interested in certain types of environmental issues. The other is a musician, so he might be interested in benefiting the arts. With the level of wealth the couple has, they can certainly afford it.
JT: [Another way to incentivize the daughter] is to invest in her farm in some sort of debt vehicle to protect it against a breakdown with her partner. There doesn’t have to be interest charged on the debt, but there needs to be registered debt so it could be proven that the daughter would owe the parents these funds. Otherwise it would just look like it’s a gift.
The debt vehicle will help determine if they can make it a viable business. They’d have to sit down with her and put together a business plan.
MU: I like the idea of debt. If you’re loaning somebody money, it has a different consequence than a gift. There’s the idea that I expect you to be responsible for it, turn it into something and give it back someday. They should have the daughter sign a promissory note, so it’s clear that it’s a loan. They could say, “We’ve been giving you money, and we’d like to change the arrangement a bit. You’re older now, so you can be more responsible for funds and the way you spend money. We have an expectation that you’ll pay us back.”
JT: And with the middle daughter working in social media, they could ask, “How much do you really need to make this business work?” And then put a ceiling on that amount. As for the kid in Berlin, they should tell him, “You can write a screenplay from Calgary, so come home.” Otherwise, they should consider setting some stipulations on the money they send, including a timeline. For instance, “We’re willing to fund you for another four months. After that, we’re willing to pay for a plane ticket home, and that’s it.”
Asset protection, if needed
JT: As far as an investment strategy, many people believe the rich can afford to take on risk, but in reality they have the luxury of not needing to. They’ve spent their lives amassing wealth and their key goal is to make sure they maintain it.
With them making $2 million a year, they’re never going to have to worry about retirement. And they’ve got enough assets that they’re fairly self-insured. What they may want to look at is what tax consequences there would be on the value of those patents and licenses to their estate.
So they may need insurance to preserve the value of the estate. There’s participating insurance that could pay a tax-exempt dividend, and pay out a death benefit. As the value in the policy increases, so would the death benefit. They could also look at a leveraged insurance policy, which would allow tax savings and shelter some of the income they’re bringing in.
MU: And when that insurance policy pays out on death, you’d get permanent non-tax earnings that were inside that policy, which is a non-term policy. So those assets inside the policy don’t carry that same capital gains tax if you hold it until death, and it’s an advantageous way of sheltering some of your investment earnings from tax. They should pay premiums and continue to fund the investment portion of the policy.
Tax and estate considerations
CDP: They need to determine who’ll be executor. If the children had proven they were responsible with money, they could’ve been executors. But they haven’t, so I’d suggest a third party.
MU: And they should take advantage of rollovers that are available to Canadians when transferring assets and wealth to the beneficiaries of their will. The rollover will reduce tax liability.
So in their case, the $90-million value of the business they sold is probably mostly tax paid. But the royalty stream they’re receiving from the licenses and technology would likely not have been taxed, because they didn’t sell them. The value of those assets, which is probably quite large if they’re getting $2 million a year in cash flow, will be taxed because of the deemed disposition when they die. That’s why they should take the rollover from one spouse to another. If they both die, then whatever the provisions of their will are (likely, it’ll go to a charity or their children), there’ll be a tax liability. They only get a rollover between spouses.
With regards to trusts, there have been some recent amendments to the Income Tax Act that take away some of the benefits (see “Ottawa overhauls trust rules,”). But trusts will make you no worse off than if you move the assets directly to the beneficiaries from a tax point of view. So, I’d suggest using a trust so that some of the income generated within it can be taxed there. It gives you control over where the tax liability is, and where the cash lies and is distributed. This is probably the greater concern until the kids start to show some responsibility—you don’t want all that cash going right into their pockets.
CDP: A trust can also help stagger the wealth they receive so they don’t get all the money at once—a percentage could come to them as they hit certain ages.
There could also be very specific conditions. For instance, if by age 30, the son completes his screenplay, he’ll get the entire amount in the trust. If he hasn’t, then he’ll only receive a certain percentage, and the rest will go to charity. These benchmarks should be based on the children’s desires as well, not just Mom and Dad’s. If the child wants to write, they can’t force him to get an accounting degree.
And the trustee shouldn’t be any of the children. He could be a family friend, or a third-party institution that has the powers to approve expenses on the kids’ behalfs. So if the son wants to go to university, he can get the funds to pay for those expenses.
JT: And I’m sure James and Anita want to make sure that, if there are any future grandchildren, their funds survive to make it to the next generation. We don’t know what’s down the road for those kids. So a trust would help protect assets against potential marital breakdowns, or liabilities that may occur that could dwindle the size of the estate.
They obviously love their kids [and] it doesn’t seem the family is at a breaking point where everyone’s pissed off at each other. But the couple is still young enough that they’ve got a lot of life left to live. Their plan should have the flexibility to change in the future, as they teach their kids some responsibility.
How to protect your affluent clients’ legacy
By Jennifer Poon, Director, Advanced Planning – Wealth, Sun Life Financial
When I read this case study, I’m reminded of the number of affluent clients who, just like the Rusholmmes, are looking to set their children up for success — and empower them to take financial responsibility. At the same time, they want to provide security for their children because they have the means to do so. But what will the Rusholmmes do when they’re no longer here, and when they can no longer control access to these funds? Will their children erode their wealth?
This case addresses the need for affluent clients to look at their legacy and estate plans, and determine how to continue supporting their children.
A solution in these circumstances could be to set up a milestone trust (also referred to as an incentive or stepping stone trust). This allows clients to provide for their children, but will distribute the estate over the years requested, and will reward them when they reach targets outlined by the client.
How does it work?
A milestone trust has a clause that allows distribution of income (or capital) when a certain milestone is met. Examples of these would be graduating from university, on their <x> birthday, being employed for <x> years, establishing a family of their own, etc. The client sets these milestones, so that they can determine why and when their estate will be distributed to their children.
The trust pays out only the income or fixed dollar amount allotted to that milestone — almost working as an allowance. It can also pay for specified expenses, like education fees and medical care costs. Typically the beneficiaries’ basic needs are met, but they’ll be required to meet certain milestones to gain additional income.
When your client sets up their trust it’s important their wishes are communicated to the trustee, and are well documented. They may also want to consider an escape clause. This will prevent funds from being distributed to beneficiaries when the money may be going to waste, or harming the beneficiaries.
You may want to consider setting up the trust while your client is living. The transfer of assets may trigger a taxable gain, but the other benefits provided by the trust could end up outweighing these costs. Plus, if the assets are no longer a part of the estate at death, it could save on probate fees. Putting these plans in place when your client is living could also help them to strategically trigger certain gains at times when they’re in lower tax brackets.
High tax rates:
Inter-vivos trusts are currently taxed at the highest personal marginal tax rate — and most testamentary trusts will follow suit starting January 1, 2016. Once the trust has been established then the trustee would have the ability to distribute or pay income to its beneficiaries — where they would be taxed in their marginal tax brackets. Consider putting the clients in the family trust to take advantage of income splitting. For example, the Rusholmmes may want to consider setting up their children and themselves as the beneficiaries, and pay themselves directly out of the trust for their monthly income.
Originally published in Advisor's Edge Report
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