Parents often find it difficult to discuss their wealth — and what will happen to it when they die — with their children. For many families, discussing death is considered to be a bad omen. For others, there may be a concern that being too transparent about family finances could lead to conflict and result in strained family relationships. Whatever the reason, the end result of failing to openly communicate about family wealth tends to be the same: unnecessary taxes, costly estate settlement fees and the very discord that the family sought to avoid. By not clearly detailing their intentions or preparing their children to receive the family's wealth, parents risk outcomes that will meaningfully erode the value of their estate.
So what can be done to avoid these unfortunate outcomes? We have observed three key steps that every family can take to successfully transfer their wealth from generation to generation.
Open communication and the trust that it builds are the basis for sustaining family wealth.
Parents shouldn't wait until their children are older to begin involving them in family financial planning. Preparing children for the coming wealth is critical, and parents should take advantage of any teachable moments that arise throughout their children's lives. By gradually including children in these discussions over time, children can learn, understand and eventually participate in decisions about the family's wealth.
It may also be wise to enlist the aid of a wealth expert from outside the family to help facilitate productive communication. They can lead the family through communications exercises aimed at helping each member identify their personal communication style, as well as the preferred styles of the rest of the family. This can give family members the ability to participate with confidence and to understand how best to interact with one another.
An outside coach may also facilitate exercises that help families discover shared values and develop a family vision or mission. These shared passions form the basis for joint activities in areas ranging from family philanthropy to family venture capital initiatives, allowing multiple generations to work side by side and share in decision-making. Such points of agreement are the building blocks for strong family bonds that will be critical in keeping the family together during tough times, like when a family member passes away.
Family values tend to be tested over time. Andrew Carnegie, the famous American industrialist, is often credited with popularizing a proverb that speaks to the challenges of maintaining familial wealth: “From shirtsleeves to shirtsleeves in three generations." What it means is that wealth earned by the first generation is often squandered by the time the third generation passes on, essentially bringing the family right back to where it started.
Indeed, we often encounter families in which the beneficiaries are unable to properly manage the wealth they have inherited. In some cases, it's due to behavioral or psychological issues. More often than not, this stems from decisions made by the older generation about the family's level of involvement with the wealth. Older family members who insist on making the bulk of the decisions themselves and who keep younger family members out of the loop may be setting the stage for future dysfunction. In these cases, it should come as no surprise that younger family members, as trust beneficiaries with little understanding of how the wealth has been managed and no experience in managing it, may lack both the skills and the self-worth to live happy and productive lives.
The sad saga of the Vanderbilt family illustrates this phenomenon. Cornelius Vanderbilt created a $100 million fortune by pioneering new forms of transportation, from steamships to railways. He placed his eldest son, William Henry, in charge of managing the family's finances. Though William Henry was a good steward of the wealth, he retained full control of it. His siblings, children and other relatives, who were beneficiaries of the ample family trusts, had no insight into how the wealth was managed and no say in key financial decisions.
By the time Cornelius' grandchildren passed away, the family's luxurious New York mansions were being sold and the family was virtually penniless. Lacking an understanding of the family's heritage or core values, the younger Vanderbilts were unable to grow or even maintain the family wealth. The money ultimately was viewed not as an asset, but as a burden. William K. Vanderbilt, Cornelius' grandson, lamented that “inherited wealth is a real handicap to happiness… it has left me with nothing to hope for, with nothing definite to seek or strive for."
Even with open lines of communication and a clear, collaborative decision-making process in place, there are challenges that families may not be able to face on their own. An outside perspective can be useful, providing the family with independent, objective and impartial advice, free of the emotion or sentiment that family members might bring with them into financial discussions.
Hiring a corporate trustee can help ensure that a family's wealth is managed and distributed appropriately. If the family wishes to retain some input, they can include a family member as a co-trustee — although, legal and tax considerations usually limit the authority of family members over distributions from a trust.
For estates that contain intangible assets that are hard to value, such as music and movie rights, royalty interests and memorabilia, the corporate trustee, as a disinterested party, can help protect the beneficiaries over the long term. Emotional attachments to certain items can lead to rifts among family members and even litigation. Furthermore, underestimating the value may have disastrous consequences for the overall estate plan. For example, Jackie Onassis' personal effects sold for significantly higher prices than had been expected, causing a much higher estate tax than anticipated. As a result, a large charitable trust was never able to be funded.
Consider this scenario: two families, the Hamiltons and the Smiths each have a net worth of $35 million, and both families have invested their wealth in similar ways.
The Smith parents retain full ownership of their wealth, which means that all income generated during their lives is taxed at their high personal income tax rate. The Hamilton parents, however, have enlisted a professional advisor to create a plan that would enable them to transfer their wealth to their children in the future.
They employ three common estate planning techniques:
Assuming that both the Smith and Hamilton parents die after 20 years, the Smith's heirs will receive $72 million (their parents having incurred $40 million in estate taxes). The Hamilton heirs will receive $103 million (their parents having incurred only $14 million in estate taxes).
It is important to note that this example illustrates just one of countless combinations of vehicles that a family could use. The specifics vary for each family, depending on the size and composition of their assets, the ages and financial status of the younger generations and the parents' appetites for aggressive vs. conservative structures.
In modeling this scenario, we assumed both families were residents of the state of Florida and were taxed at the highest federal bracket, including the 3.8% Medicare surtax on net investment income where applicable. The private business interest grew from $8 million in year 1 to $14 million in year 10, a compounded annual growth rate of about 5.8%. The business interest had an assumed cost basis of $0 and the shares were non-voting. The business generated 8% in annual income, which was assumed to be taxed as ordinary income. In calculating the annuity payments for the zeroed-out GRAT, we assumed a 25% discount on the value of the $8 million closely held business interest, a §7520 rate of 1.80% consistent with June and July of 2016, and annuity payments growing at 20% per year. Income in excess of the required annuity payment was accumulated and modeled separately as liquid investments in a Diversified Growth with Income strategy. At the GRAT's termination, all remaining assets were assumed to be transferred to a separate, irrevocable trust outside of the Hamiltons' estate with grantor trust taxation. The investment strategy for this second irrevocable trust mirrored the Fully Diversified Aggressive Growth strategy of the initial $10.9 million intentionally-defective grantor trust (IDGT). The $16.1 million investment management account (IMA) followed a Fully Diversified Growth with Income strategy consistent with the Smiths'. The irrevocable life insurance trust (ILIT) assumed flat, $112,000 annual premiums over the 20 year period consistent with prevailing market rates for comparable $10 million face value, second-to-die, insurance products for couple, each age 55. Each of the Hamiltons' four children were beneficiaries of the ILIT, and the Hamiltons used gift splitting and Crummey powers in the trust to avoid any annual taxable gift.This illustration does not consider many other planning opportunities, including but not limited to Generation-Skipping Transfer tax (GST tax) planning, charitable giving strategies, asset protection strategies, or business transfer strategies alternative to the GRAT which might avoid inclusion of the business interest in the grantor's estate should the grantor die before the GRAT's termination. To calculate the estate tax liability after 20 years, we assumed no growth in the current federal estate tax exemption equivalent amount of $5.45 million per person, and that the Smiths and the Hamiltons have estate plans in place which leave assets to the surviving spouse in a manner that will qualify for the federal estate tax marital deduction (such that only the surviving spouse's estate will owe estate tax).This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. ©2016 The Bank of New York Mellon Corporation. All rights reserved.