Protecting Your Child’s Inheritance

Parents are becoming increasingly concerned with what will happen to assets they leave to their children through trusts, wills, and beneficiary designations. The recent economic downturn has left many children unemployed or underemployed. Further, there has been a noticeable culture shift in the younger generations toward instant gratification. These two factors have produced a younger generation with a growing amount of unpaid bills and other creditor issues, and rising incidents of divorce.

Although these parents believe it is appropriate for their children to pay their creditors, they would like their children’s inheritance to provide long-term economic stability. The good news is that estate planning techniques are available to protect assets for younger generations.

1.   Trusts.

Most people are aware that a trust may be used to avoid probate and to minimize the impact of the federal estate tax. Less well-known is that a trust may also protect against the claims of a trust beneficiary’s creditors.

Under the new Michigan Trust Code, effective April 1, 2010, certain trusts now offer more clearly defined levels of creditor protection. Generally, there is a trade-off between (a) a beneficiary’s right to demand or assign trust assets, and (b) the right of a beneficiary’s creditor to reach the trust assets [see the table below for more details].

2.   Buy-Sell Agreements.

Many clients who own a family business entity (such as a limited liability company, S-corporation, closely-held C-corporation, or a partnership) begin to transfer ownership of the entity to their children before death. Clients may want to consider how their entity structure protects against the claims of an ex-spouse or creditor of an individual owner. For example, does the entity’s governing instrument preclude automatic substitution of a new owner without the consent of the current owners?

In addition, clients may want to consider implementing a buy-sell agreement between and among the owners. This could be a stand-alone document or it could be part of the organizational documents of the entity. While the exact terms of a buy-sell agreement vary depending on the needs of each client, many contain provisions restricting the transfer of an interest in the entity in the event of an owner’s death, divorce, or bankruptcy. Often, the buy-sell agreement calls for an optional or mandatory buy-out of the interest by the entity or by the other owners at some previously agreed- upon value or at an appraised value.

3.   Individual Retirement Account (IRA).

Naming a child as a beneficiary of an IRA may allow the child to "stretch" out the distributions from the IRA over her life expectancy, resulting in favorable income tax treatment. This could be problematic if the child is facing bankruptcy. The law is unsettled as to whether an inherited IRA is exempt from a debtor’s bankruptcy estate. A bankruptcy court recently held that an inherited IRA receives the same protection as any other IRA created by the debtor. However, another bankruptcy court previously reached the opposite conclusion.

Further, an inherited IRA does not protect against a "spendthrift" child who voluntarily withdraws funds from the IRA, quickly depleting this resource. A client who is worried about his or her child’s spending habits could consider leaving the IRA assets in trust. Only a specialized trust will still allow the child to stretch out the IRA distributions. If you have substantial IRA assets and are concerned about a spendthrift child, we can discuss these specialized trusts with you, and develop a plan to meet your needs.

4.   Marital Agreements.

Clients may wish to encourage a child to execute a pre- or post-marital agreement. A marital agreement clarifies the separate property of each spouse, and defines what each spouse is entitled to in the event of a divorce or death. Separate property could include family businesses or an expected inheritance, thereby protecting these assets from claims of a child’s spouse. A marital agreement may be especially important for a second marriage or if either party has children outside of the marriage.

• Read Full Fall 2010 Estate Planning Insights