Story of the Knight and Day Families: The best way to leave property to your children

How To Distribute Wealth To Your Heirs

Most individuals choose to give their children their inheritances directly. Proper trust planning is a golden opportunity to do more for your families. You can provide your families with many generations of protection from: Creditors, Predators, and Estate taxes.


Consider this tale . . .

The Knight Family: John Knight inherited assets directly from his family, so his inheritance was titled in his own name. He owned it.

The Day Family: William Day didn’t inherit anything from his parents. They did leave him assets in trust. He could control and could enjoy the assets and their value as c0-trustee and beneficiary, but his trust owned the property. You might think that John, who inherited his assets directly, would be happier than William, who inherited his assets in trust. But if the Knight family knew what the Day family knew, he would not be. If John could see the future, he would rather control and enjoy his wealth than own it outright. Let’s take a closer look.


The risks in failing to use available planning tools

Estate Taxes: Under current law, the gift and estate tax rate is 40%, for gifts over the basic exclusion amount or “BEA”.  The Federal Government taxes gifts we leave at death over the BEA.  For John Knight, it he leaves the wealth left to him OUTRIGHT to his descendants, that wealth will be taxed again, in each generation that receives the gift outright.

Q: Assuming each generation doubles its inherited wealth, what can happen in three generations ?

A:  Assuming John was left $5 million, that would grow to $10 million; THEN shrink to $6 million (after payment of the 40% tax rate) when it passes to his children; THEN grow to $12 million; THEN shrink to $8 million when it passes to his grandchildren; THEN grow to $16 million when it passes to his greatgrandchildren; THEN shrink to $9.6 million when it passes to his great-grandchildren. Creditor Claims: To make matters worse, anything one of the Knight descendants receiving this property is subject to claims by creditors. Lawsuits can wipe out inheritances long before estate taxes do. Predator Claims: Who are Predators? Predators can come from within the family:  often a divorcing spouse . Unless each family member obtains a prenuptial agreement and diligently keeps inherited property separate from marital property, a soon-to-be-ex-spouse may be entitled to the inherited property as part of the divorce settlement.


Control and Enjoyment without Ownership

Unlike John Knight, William Day’s $5 million is owned by a trust created by his parent’s estate plan, not by William. Even though William can spend all trust income, can use the principal, and can control the trust assets as a co-trustee of his trust, he is not deemed to own the trust’s assets, provided the trust is properly drafted (the terms of the trust must limit William’s access to trust assets to his health, education, support and maintenance).  In practice, these limitations are so slight that William will regard the trust’s assets as his own, even though he does not legally own them. Importantly, You Cannot Lose What You Do Not Own! Because William and his descendants do not legally own the trust assets, those assets are not subject to claims of creditors and predators (divorcing spouses). Estate Taxes: Likewise, since William does not directly own the trust assets, the assets are not included in his estate for estate tax purposes, even though he can direct where they go at his death.

Q: Again assuming each generation doubles its inherited wealth, what will happen in three generations if William’s trust property is held in a properly drafted trust?

A: William’s $5 million will grow to $10 million when he passes the trust assets to his children, ALSO IN TRUST.  (The growth in value is subject to income tax, but not gift and estate tax.)  When they pass the property to their children, the trust assets will not be subject to gift and estate tax.  Thus, avoiding gift and estate taxes eventually insures that a significantly larger amount can be passed to descendants.


There is of course, a catch. The estate-tax-free nature of this type of trust planning did not go unnoticed by Congress. In 1986, Congress enacted a generation-skipping transfer tax (“GSTT”) which applies whenever trust assets pass to “skip persons”, which generally means grandchildren.  However, just as this is a BEA, there is a “GSTT” exemption, which currently is an identical amount as the BEA.  With proper planning, gifts in trust to children and grandchildren will not be subject to the GSTT, so that a “GSTT Exempt Trust” can grow exponentially in value through generations of family members, without being subject to either gift and estate tax or the GSTT.

Updated 12/19/2021