The Flexible Inheritance Trust: A Perfect “FIT” for Leaving an Inheritance

When parents embark on estate planning, one of the most important decisions to make is how children inherit from their estate.??This typically means whether a child will inherit outright or whether the inheritance will be held in trust.??Moreover, parents not only have to plan for their death at an old age, but for the possibility of a premature death as well.

A trust is often used when a parent desires for an inheritance to be available for a child’s use and enjoyment, but for another individual (a “trustee”) to manage the assets and determine when distributions are made to the child.??There may be specific reasons that a child should never have control over the inheritance.??For example, a child may be a spendthrift, have creditor problems, suffer from substance addiction, or have a disability or special need.??

Absent these issues, a trust is generally implemented to hold an inheritance until a minor child, or even a young adult, attains a certain age.??The thought process is that delaying the inheritance allows the intended beneficiary to mature before having unfettered access and control over the money.??To that end, it is very common to establish a “staged distribution” trust.??While the inheritance is held in trust, a trustee of the parents’ choosing controls the trust assets and determines when and how distributions are made.??In addition, a staged distribution trust further provides for periodic mandatory distributions up to the point when the child ultimately receives the entire inheritance.??At that time, the trust terminates.??For example, many staged distribution trusts direct the child to receive their inheritance in thirds (e.g., 1/3 at each of 25, 30, and 35 years old).

Yet, trusts have potential benefits other than simply protecting a beneficiary from themself.??If structured in a specific manner, a trust may protect an inheritance from the beneficiary’s creditors, potential ex-spouses, additional impositions of estate tax, and even the possibility that family wealth could wind up outside of the family (e.g., being left to a new spouse of the beneficiary’s widow(er)).??

Balancing protection goals with a parent’s desire for their child to ultimately have unfettered access to the inheritance can be somewhat tricky.??This is because “protection” and “access” are on opposite ends of a balancing scale.??When a trust is structured to have more protection, the beneficiary will necessarily have less access, and vice versa.??Finding the appropriate balance is key, but often leads to varying degrees of complexity.

A Flexible Inheritance Trust may just be the perfect “FIT” to finding balance.??While the structure of a FIT can be customized or even referred to by a different name (it is sometimes called an “Inheritor’s Trust”), the basic premise is the same – (1) the assets remain in trust for the child’s lifetime, (2) the assets can be distributed to, or for the benefit of, the child in the trustee’s discretion, and (3) at a certain age, the child becomes a co-trustee and/or has certain powers to control their own trust.??Here are the main questions to consider when leaving a child’s inheritance in a FIT:

To whom can distributions be made?

A FIT can be structured for the sole benefit of the child, but often includes the child’s descendants as discretionary beneficiaries for greater flexibility and protection.??Indeed, if multiple individuals have a beneficial interest in the trust, it is less likely that the assets could be exposed to the creditors of any one specific beneficiary.??

Alternatively, a FIT can be designed for the sole benefit of the child while giving the child a “lifetime power of appointment.”??Under this power of appointment, the child would have the ability, in their individual capacity and not that of a trustee, to appoint trust assets to their descendants even though such descendants are not “beneficiaries” of the trust; rather, they are permissible lifetime appointees.??This means that the assets could be used for the benefit of the beneficiary’s descendants, but such descendants do not have the rights of a beneficiary (which has its advantages).

How are distributions made?

The trustee has the discretion to distribute the trust assets to, or for the benefit of, any one or more of the beneficiaries as the trustee desires.??This means that the trust is completely “discretionary,” and no beneficiary has the right to compel a distribution from the trust.??This is particularly important in the context of creditor and marital protection.??If a beneficiary cannot compel a distribution from the trust, then a creditor or ex-spouse should be unable to as well (applicable state law may vary on this aspect).

When does the child become a trustee?

As discussed above, many staged distribution trusts begin mandatory distributions at the age of 25 and terminate at the age of 35.??With that in mind, perhaps it makes perfect sense that a child becomes a co-trustee of their own FIT at the age of 25 and must serve with a co-trustee of the parent’s choosing until the age of 35.??At such time, the child could be vested with the power to remove their co-trustee and appoint a new co-trustee of the child’s choosing (other than a parent, descendant, sibling, or subordinate of such child).??

It is up to the parents creating the FIT whether the child is required to always serve with a co-trustee or whether the child may serve as the sole trustee at a certain age, but the latter may sacrifice some of the desired protection.??If a child were serving as the sole trustee and has the power to distribute the trust assets to themself without the consent of another trustee, then a court could potentially compel the child to take a distribution to pay a creditor or ex-spouse.??Conversely, a court would unlikely be able to compel an independent co-trustee to consent to a distribution.??Requiring the child to always serve with a co-trustee affords greater protection because co-trustees must agree as to all distributions.

Additionally, for various tax and asset protection reasons, the child, in serving as a trustee, should be limited to making distributions for an “ascertainable standard” (e.g., distributions only for such child’s health, education, maintenance, or support).??A non-interested, independent co-trustee would have the ability to make distributions for any reason beyond that standard and could carry out other functions of the trust that may cause adverse tax and asset protection consequences if carried out by the child.

Remember, the child can still have the power to remove and replace the co-trustee.??This power gives the child flexibility to indirectly control the trust through a co-trustee of their choosing.

Do the co-trustees have to agree on all decisions regarding the trust?

Maybe. Certainly, the non-beneficiary co-trustee would be required to agree on all distribution decisions to achieve the desired protection.??However, the trust may vest other decisions and authority solely in the child without jeopardizing the protection that a FIT is designed to achieve.??These can include investment decisions, trust transactions, and overall day-to-day management of the trust.

What happens to the FIT when the child dies?

A FIT is designed to exist for the child’s entire lifetime and as such, it is possible, and very likely, that the trust will have assets remaining at the child’s death.??In keeping with the theme of flexibility, the FIT could vest the decision of what happens to the remaining assets in the child by providing them with a very broad “testamentary power of appointment” exercisable under their Last Will and Testament.??Such a power allows the child to direct who receives the remaining trust assets upon their death, including in what amounts or percentages and on what terms (i.e., outright or in further trust).??

The parents can be as restrictive or permissive as they like in defining the scope of the power of appointment.??For example, a very broad power could be exercised in favor of any individual or entity (to avoid adverse tax consequences this would exclude (1) the child, (2) the child’s estate, and (3) the creditors of either).??Alternatively, if the parents desired for all the remaining assets, or a percentage thereof, to remain in the family, the class of permissible appointees could be limited to only descendants of the parents.

Of course, the power of appointment can be designed in almost any manner.??For example, the class of permissible appointees could be broad only if the child has no descendants living at the time of their death.??Or perhaps it would exclude certain trust assets (e.g., interest in a family business that should remain in the family).

Absent a testamentary power of appointment, or the exercise thereof, the trust assets remaining at the child’s death would be distributed in the manner which the parents set forth in the trust.??This is typically done in a “dynastic” fashion where the assets are divided into separate FITs for the benefit for each of the child’s own children or, if there are none, for the child’s siblings, etc. (i.e., the trust assets remain in the family on a “per stirpital” basis).

Concluding Observations

In structuring the FIT, it is important to remain focused on why it is being implemented in the first place – to afford protection with the most access and control as possible.??After all, the child would inherit outright at a predetermined age were it not for the desire to protect the assets.??Remember, while trusts can be structured to give parents restrictive “control from the grave,” the FIT is intended to allow children and future beneficiaries flexible access to the inheritance without the restrictive chains typically associated with trusts.