Irresponsible kids – another challenge for retiring baby boomers
“Incentive to guarantee a healthy nest egg for the grandchildren”, The Weekend Australian, 22 September 2011.
Perhaps the greatest tragedy of the proverb “from shirtsleeves to shirtsleeves in three generations” is that it need not happen at all if you put the right structures in place.
The ancient proverb follows the cycle of wealth that is built by one generation, taken for granted by the second and finally destroyed by the third.
Almost every culture in the world has its own version.
With substantial improvement in financial markets still some way off, many investors face the possibility that they will not be able to pass on enough wealth to even make it to the third generation unless they give careful consideration to how it should take place.
Ninety-five per cent of family members outside the first generation of wealth creators spend more than they make. The reasons can be broken down into a number of categories.
The first is receiving too much too soon. In this scenario, it is not unusual for inherited wealth to dissuade the next generation from developing their talents.
Often they have had it too good for too long and there is no incentive for them to strive for more.
Another problem is that on the death of the matriarch or patriarch, the family business can suffer through a power struggle between those left behind. The loss of a singular vision for a business is not unusual in this circumstance, which can have serious consequences.
There are several mechanisms that those facing retirement can use to overcome these perceived problems.
One is implementing an incentive trust.
Although popular in the US, incentive trusts are in their infancy in Australia. They are designed to encourage appropriate behaviour in financially irresponsible beneficiaries.
For example, a father could insert a provision in his business trust deed that the son complete a university degree before any capital or income distribution be made, or before shares be issued or before his directorship be granted.
The trust could have a provision that it pay the child one dollar for every dollar that the family business (or a particular division) exceeds its key performance indicators, encouraging interest in the business and its performance.
Although careful drafting is required to deal with public policy and trustee discretion issues, the popularity of these sorts of arrangements is growing.
Testamentary trusts could also play a role. They can reduce the child’s income tax, and protect their inheritance against divorce, bankruptcy and substance abuse.
They also can avoid an unintended loss of government benefits in certain circumstances.
A third avenue for protecting wealth transfer that many business owners are unaware of is
the use of business succession agreements.
Consider our hypothetical example of business partners Peter and Wendy, who ran recruitment firm P&W Recruitment Pty Ltd.
When Peter died his wife, as executor of his estate, offered to sell Peter’s half share of the company for a fair price to Wendy.
She declined and set up her own business.
Across a period of six months she succeeded in capturing 90 per cent of the company’s clients and P&W became worthless.
Wendy effectively gained Peter’s share for nothing. Had Peter’s wife (and, for that matter, Peter himself) ensured a tax-effective business succession agreement was in place, Peter’s wife would have received her inheritance in full.
Beneficiaries also should be made aware of self-help mechanisms. A useful one to know about is the estate proceeds trust, commonly known as a post-death testamentary discretionary trust.
It is a trust established following a person’s death for the purpose of receiving property from the deceased person’s estate.
Under present tax legislation, a person receiving property from a deceased individual has three years from the time of death to transfer property to the estate proceeds trust.
It is different from a testamentary trust in that an EPT is established by the beneficiary who has received the property from the deceased person’s estate, whereas a testamentary trust is established by the deceased person’s will.
An example of how an EPT could work is where Fred died and left $1 million to Wilma.
On advice, Wilma established an EPT and transferred $500,000 of this amount to the trust.
Wilma was then able to distribute income and capital to the couple’s two children to meet all their expenses.
The children are taxed at adult rates and Wilma will be able to receive up to $56,000 each year for herself and the two children tax-free.
The above legal structures, with appropriate changes, can be used to ensure that there is enough left over for the grandchildren’s school fees or other expenses that the baby boomers’ own children may be likely to face.
It is a matter of identifying the expenses and dealing with them in the way you want before the opportunity passes you by.