Ignorance is not bliss. Ignorance causes problems.
After interviewing several thousand high-net-worth families, The U.S. Trust Study of the Philanthropic Conversation found that one-third of respondents (31%) would switch to a new advisor if that advisor could talk to them meaningfully about philanthropy.
Think about that for a second. One-third of affluent families would switch to a new advisor if that individual was more adept than their current advisor at helping them give their money away. It has nothing to do with investment returns, asset allocation or finding hot alternative investments. It has to do with understanding the client’s values and seeing the whole picture.
But advisors tend to focus on solutions – and how they get paid for recommending or implementing those solutions. Okay. I understand we all have to make a living. I understand charitable planning can be complex and requires a lot of study. But many advisors don’t want to tackle anything new, and that mindset will only come back to haunt them in the long run.
Finally, there’s the fear of asset migration (for wealth advisors) or loss of a longtime tax client (for CPAs) if assets are redeployed or outcomes aren’t ideal. If you think charitable planning will result in lower fees under your AUM business model, then you’ll find plenty of reasons not to recommend it to your clients. But if you do charitable planning properly, it will boost your business, not reduce it. You’ll have assets that can often stick around for multiple generations through various types of trusts, foundations and charitable funds. Plus, once clients spread the word about how well you integrated philanthropy into their overall financial plan, the referrals are likely to roll in.
As the trusted advisor, guess what? That’s on you.
As you start to move upstream from tax prep and financial statements to wealth advisors and estate planning, it’s critically important to get to know the teenage and young adult children of your clients. Why? Because research shows you’ll have a significantly better chance of continuing to work with those families. According to the latest Nuveen Wealth Inheritor Research Study, four out of five wealth inheritors (80%) who first meet the family advisor as a child or teen will decide to keep working with the advisor – compared to just 54 percent of those who first meet the advisor as an adult or young adult. With trillions of dollars in wealth set to transfer in the next two decades, isn’t it worth getting to know NextGen among your clients?
What’s not covered in the study, unfortunately, is how few families even have discussions with their children about family finances and wealth. That’s not only the family’s fault; it’s also on you as their most trusted advisor.
When it comes to engaging the next generation of your clients’ families, Nuveen’s client retention numbers seem much higher than what I’ve seen throughout my 40-year career. But let’s give researchers the benefit of the doubt, because I’m sure the methodology was rigorous. As the researchers concluded: “Advisors should look for such opportunities to connect with children and teens by including younger generations in social events” and by taking time to understand their interests to form “genuine connections.” I agree. But what studies like these keep overlooking is that building rapport with young inheritors (and presumably retaining them as clients) is not enough. We need to prepare young inheritors to receive their windfall and the responsibility that comes along with it as record numbers of Boomers retire and/or exit their businesses.
Anyone who’s a fan of the TV show “Succession” knows how dangerous inherited wealth can be without proper context and training. How do you set up clients so that their inheritance doesn’t disable them? As Warren Buffett famously said, he would give his children “enough money so that they would feel they could do anything, but not so much that they could do nothing.”
Unfortunately, I’ve found that way too many advisors, including accountants, have little or no relationship with the kids of their clients. They don’t meet with them. They don’t talk to them. They don’t include them in discussions with the parents. They don’t ask how they can bring the kids in or make them aware of what’s coming or how to make them responsible. Instead, they just drop a large financial windfall in the children’s lap and hope for the best. How do we let parents understand how vitally important this is? These are questions that keep my team and me up at night. I wish more advisors felt the same.
Enter Facilitators: Real World Example
In my practice, we bring in professional facilitators to work with families to prepare the kids to receive the wealth. We prepare them to be responsible with their windfall (however large) and to understand the magnitude of it. For many families, we create “family governance structures” and “family mission statements.” There are many other ways for advisors to work with high-net-worth (HNW) families, especially as their wealth becomes significant.
During the early stage of our planning engagement with a HNW family, the parents conceded that none of their three children were financially responsible. Of course, the family’s planning was designed to distribute their estate outright to the children by the time each turned age 35. Ultimately, we implemented a much more effective and disciplined plan. We brought in a facilitator to explain the planning changes to the children and began a dialogue with the kids about the impact of their wealth. After some initial reluctance the kids agreed.
Both parents are active in local charities, holding key leadership roles. Yet, they had never discussed the “why” of their giving with their children. That alone was a good starting point for further family discussions.
Today, after three or four facilitated family meetings, the parents are seeing a real change in both the actions and attitudes of their children. They now have a deeper understanding of the financial windfall coming their way and the responsibility that comes along with it.
For all family meetings and discussions, we suggest not only having facilitators on hand, but making sure the rules for engagement are established. It’s common for the matriarch or patriarch of the family to tell everyone else what to do and how to do it, especially if they were the originator of the family’s wealth. But most families aren’t likely to have discussions like these on their own; they need to be moderated by an impartial third party, so the meeting doesn’t devolve into a shouting match around the holiday dining room table.
If families don’t have frank and open discussions about their wealth, with next steps and action items to follow, you can easily have unintended consequences. The kids can blow all the money or bicker constantly or just stop talking to each other. I’m not suggesting that wealth advisors must become facilitators or family wealth counselors, but they certainly have the ability to spot the issues. It’s up to the advisor to bring issues to the surface and talk to the family about them and see if they could benefit from facilitation.
A Rock-Solid Estate Plan Isn’t Enough
A HNW family that you work with might have top-notch estate planning attorneys who can draft airtight trusts to transfer family wealth and greatly mitigate tax erosion. But if the plan is to dump a ton of money into kids’ laps without preparing the kids to receive it, the kids are highly likely to squander the money and/or squabble with each other. It’s like having an elite quarterback on your football team who can throw the ball 70 yards down the field with pinpoint accuracy. If none of his receivers knows how to catch the ball, the team won’t be successful and ultimately the quarterback won’t be considered any good.
For CPAs, it’s not just about getting your clients’ kids to stay with you; it’s about getting the kids to think about what to do next when it comes to their inheritance. When I give talks to advisors, I tell the audience never in my 40-year career have I heard a family elder say: “When I die, I want to be sure my kids never talk to each other again.”
I know that sounds ridiculous. But when you look at how many families set their plans up and keep them cloaked, that’s exactly what could easily happen. I’ve worked with families in which siblings stop speaking to each other because one took a family portrait that the other one wanted. Or one child got Mom’s fine china or jewelry and the other one didn’t. Or the siblings living close to their late mother swooped in and took everything out of their parents’ house before the out-of-town siblings could arrive. Imagine what happens when large amounts of inheritance are involved. The situation is likely to get worse as there’s less and less communication between family members and they don’t live near each other anymore.
When it comes to inheritance, kids not only need to be prepared to receive it but should have the ability to voice their concerns and suggest ideas. What 22-year-old is ready for $100,000 suddenly in their bank account, let alone several million dollars? Once the money transfers, it’s likely to trigger questions like “What can I buy now?” and “Where can I travel next?”
As the Nuveen research showed, seven out of 10 inheritors (69%) who are working with an advisor prefer to oversee some aspects of their financial plan personally. “This underscores the importance of a teaching relationship to support them in making informed decisions,” researchers asserted.
And because you know the financial situation of your clients so well, you’re in a unique position to do that. When you pair a highly skilled wealth receiver with a highly skilled wealth quarterback, there’s no limit to what they can accomplish.
That’s where you come in.
Help Wealthy Clients Pass on Philanthropic Values to Their Children
With an estimated $30 trillion transferring to the next generation in the coming decades, it’s not just billionaire kids who need to be properly educated and prepared to handle their family’s wealth responsibly, it filters down to the seven- and eight-figure net-worth crowd – the core of your client roster.
It’s Not Just the Billionaires
Again, billionaires aren’t the only people of means who should be worrying about passing on the right philanthropic values to their children. One couple I work with has a net worth of about $20 million. They’ve been telling their attorney that they don’t want the kids to know how much money they have. Well, they have a magnificent home in Northern California and another one on Lake Tahoe. The kids aren’t stupid. They know their family is well off. So, keeping the kids in the dark about money is idiotic. The best thing you can do for your kids is to prepare them to inherit responsibly one day – not keep them in the dark. The matriarch and patriarch of another well-off family in Florida told me point blank: “We don’t trust our kids with the money.” So, I asked them: “When are you going to be able to trust them, and how are you going to get to a level of trust if you never talk to them?” They couldn’t answer me.
I’ve found this uncomfortable silence to be just as common for families with seven- and eight-figure net worth as it is for billionaires. As I’ve said hundreds of times in my seminars, parents would rather talk to the kids about sex than money. And they don’t like to talk about sex. We’re doing a disservice to our kids. We’re not schooling them about money. We’re not teaching them the right values. We’re not teaching them how to ensure their charitable giving is making an impact for the causes and organizations the family supports. So, the kids start squabbling, or they end up helpless, hopeless and taken advantage of by all kinds of misguided people spreading misinformation in their social circles and social media accounts.
Uncomfortable Conversations
Whether you’re a CPA, wealth advisor or financial planner, it’s time to start having uncomfortable conversations about wealth transfer with your clients and their kids. Don’t allow the parents to say: “I don’t want my kids to know what we have.” You need to push back. You need to ask them directly: “What’s going to happen if you don’t prepare your kids to inherit your family’s wealth some day?”
You may want to ask the adult kids to meet with you (with or without the parents). I’ve facilitated many family meetings in which we’ve talked about the various trusts and entities that hold family assets and the amounts of money that have gone into those structures. Again, your clients aren’t fooling their kids by keeping their wealth hidden from them. The kids see your clients paying for everyone to fly first class on family trips. They stay at nice resorts. The kids know there’s money. Either they’re going to be prepared to receive it or they’re not. It’s up to the parents to teach the kids about the methodology behind the inheritance plan and to instill their family values in them. What’s the reasoning behind the planning? What are we trying to accomplish? Why is a trust located in Nevada? Why is money being distributed or not being distributed? How can we make the biggest impact with our wealth? That’s where you come in. You may want to enlist the services of a facilitator.
Here are a few reputable organizations to help you find a facilitator:
Again, with an estimated $30 trillion in wealth set to transfer over the coming decades, the need for this kind of intergenerational financial literacy and “wealth responsibility” will only become more pronounced for all types of successful families. I realize discussions about family wealth are uncomfortable for many parents, so they tend to back away. It’s not that they don’t care; they just don’t know how to approach the conversation. So, they default to the “ignorance is bliss” mindset. Trust me, ignorance is not bliss. Ignorance causes problems. As a trusted advisor, it’s your job to prevent these important discussions from getting swept under the rug.
I’ve never once had a family leader tell me: “Randy, after I die, my hope is that my kids never talk to each other.” But when you look at how their estate plans are set up, it’s no surprise the kids become estranged from each other. For instance, they name the eldest child as the trustee for the youngest. They seem to favor one child over the other. They specify who gets which assets and heirlooms without asking the children or discussing it with them. Or they make the child who runs the family business an equal shareholder with the non-working siblings. All of these decisions breed resentment.
All this anxiety and family discord comes back to parents not talking to their kids about the responsibility that comes with their family’s wealth. They haven’t found a way to communicate with each other without causing friction or reminding them of childhood wounds. The other reason this is so important is because research shows NextGen tends to be very generous and more charitably inclined than most older generations.
Prepare the Next Gen
As advisors, we spend so much time helping clients protect and transfer their wealth to the next generations, but we too often forget to prepare NextGen to receive it. As mentioned earlier, your team might have the best quarterback in the league, but if you don’t have receivers who can catch the ball when he throws it, you won’t make it very far down the field.
That’s where you come in, coach! Don’t be late for practice.
Beyond the Donor Advised Fund
Don’t overlook pooled income funds and charitable remainder trusts.
Too many of the estate plans I review every year don’t come close to expressing the grantor’s true wishes for their estate, regardless of net worth. I’m not going to point the finger at estate attorneys. They can work only with the facts they’re given. The disconnect usually happens with the advisors who are working with the grantor throughout the year. More specifically, the breakdown has to do with financial incentives and lack of education about charitable planning.
As mentioned earlier, one-third of successful families would switch to a new advisor if that individual was more adept than their current advisor at helping them give their money away. It has nothing to do with investment returns, tax outcomes, asset allocation or finding hot alternative investments. It has to do with understanding the client’s values and seeing the whole picture.
And when clients mention words like “philanthropy” or “charity” or “giving,” too many advisors default to the donor-advised fund (DAFs). DAFs have their time and place, but too often there are better solutions for your successful client that frequently get overlooked.
Beyond the DAF
I had separate calls the other day with two entrepreneurs who had just sold their businesses for eight figures each. When I asked them why they put $1 million or $2 million of the proceeds into a DAF, they said their advisor told them they could get a “tax deduction.” But that’s the only thing they could do with the proceeds. I’m sure the advisors had their clients’ interests in mind. But defaulting to a DAF whenever clients mention philanthropy is like defaulting to high-risk tech stocks whenever a client asks about investing. It’s one solution but not the only solution.
I also think advisors default to DAFs because there’s not much of a learning curve involved. DAFs are simple to set up, simple to administer and available at most major financial institutions.
In many cases, a DAF is a convenient place to park money you have earmarked for charity. You get an immediate tax deduction for parking there and you don’t have to give away all your money at once. And because a professional administrator (financial institution, university, charity, etc.) administers the DAF, it can often send funds directly to your client’s intended charities without your client having to write checks all day long or sift through mountains of giving pleas. Each institution has different rules and gift acceptance policies, but DAFs can be a huge time saver, and very helpful for year-end tax reporting.
Unfortunately, with a DAF, you’re just giving money away. The family gets no other benefit.
So, I asked the two owners: “Suppose there was a solution that could get you the same tax deduction but also benefit your family at the same time?” And they both looked at me strangely. “No one ever told us we could do that!” they exclaimed. Again, I’m not bashing DAFs, but there are many other ways to accomplish the same goals for your clients, with often better long-term outcomes.
Take the pooled income fund (PIF). PIFs are essentially charitable trusts that “pool” together irrevocable gifts from one or more individuals, or a family. Like the more common charitable remainder trust (CRT), a PIF is a type of split interest trust. There’s a gift to a charitable trust. There’s income back to the donor. And there’s an ultimate gift to charity at some point in the future.
If you take a little time to learn about PIFs, you’ll find they produce a much larger charitable income tax deduction than a CRT does. Plus, there’s much more latitude in how the money can be invested. And because of the way PIFs are structured, you can run income for
multiple generations – something you can’t do with a CRT. Many of the PIFs we’ve set up are for two, three, even four generations of beneficiaries. For more about PIFs, see my article, “Pooled Income Funds Explained.”
Case Study
Let’s say you have a client, Larry Jones, who’s received an offer of $10 million for a property he owns. Let’s assume he depreciated the property down to zero over the years and is looking at $10 million in capital gains. As a California resident, Larry’s tax is going to be about $3.7 million (37%) when you factor in the federal capital gains tax, plus state income tax and maybe the net investment income tax. So, Larry would have $6.3 million left in his estate. He should be able to live on the income, right?
There are three common scenarios I see:
1. The “no plan” plan. Here a well-meaning advisor tells Larry he can take 4 percent a year (about $250,000) for living expenses. Assuming his estate is taxable, what’s left of the $6.3 million is going to shrink by 40 percent when Larry dies. Not much of a plan, is it?
2. Establish a CRT. A CRT is a “split interest” giving vehicle that allows taxpayers to make contributions to the trust and be eligible for a partial tax deduction, based on the CRT’s assets that will pass to charitable beneficiaries. Larry can sell the property inside the CRT, avoid the capital gains tax and receive income from the entire $10 million. Because the CRT has a “forced” payout minimum of 5 percent a year, that’s $500,000 a year in income – twice what he’d be earning with the no-plan plan.
However, Larry can run the CRT for only one generation – that is, during his and his wife’s lifetimes. If he dies the next day after she does, or if he and his wife suffer a fatal accident, that $10 million is gone from his estate, and his children get nothing. To avoid that terrible outcome, conventional wisdom is to buy second-to-die life insurance to replace the asset in the estate. Of course, such a policy at Larry’s advanced age could cost $100,000 a year.
Now he’s making gifts to a trust and using up his exemption. What most people don’t realize is that when money comes out of the CRT, some portion of it will be taxable at the capital gains rate. Essentially a CRT works like an installment sale.
3. Establish a PIF. Suppose instead, Larry transferred the $10 million property to a PIF. Here he can name his children and grandchildren as “successive income beneficiaries.” When Larry and his wife pass on, their children will get income from the PIF for as long as they’re alive and then their children (the grandchildren) will get income as long as they’re alive.
Even better, there’s no forced payout like there is with a CRT (see 5% above). Only the earned income must come out. Further, there’s a special structure my firm has devised for PIFs that can give Larry 4 percent tax-free income for the rest of his life, as well as for the rest of his children’s and grandchildren’s lives. So, Larry is now getting 4 percent of $10 million ($400,000 a year). Because the income is tax-free, he’s essentially earning almost double after California state taxes are factored in.
So, what happens to the money after three generations have passed on? The money simply goes to the charities that were named by the donor and falls under the DAF rules.
Who will benefit?
As the old saying goes, “There are three types of people you can leave your money to: your family, the IRS or a charity (pick two out of three).” You never hear that individuals choose the government. But that’s who your charitable beneficiary is by default. I think you can do better, and so can your clients.
PIFs are essentially charitable trusts that “pool” together irrevocable gifts from one or more individuals or a family. As mentioned previously, an irrevocable trust is intended to be permanent. It cannot be revoked without involving the beneficiaries or an independent fiduciary. Under Internal Revenue Service regulations, the charitable income tax deduction for a PIF is calculated by using a complex formula based on the highest rate of return on the assets within the PIF over the prior three years.
Higher Deductions
According to the IRS, if a PIF has existed for less than three taxable years immediately preceding the year in which a transfer is made, the highest rate of return is determined:
1. First, by calculating the average annual applicable federal midterm rate (as described in Internal Revenue Code Section 7520 and rounded to the nearest 2/10ths) for each of the three taxable years preceding the year of the transfer.
2. Second, by reducing the highest annual rate by 1 percent to produce the applicable rate. (The Fed simply publishes the rate in November or December for the following year.)
With recent rates extremely low, income tax deductions are being pushed proportionately higher. While giving to charity isn’t typically motivated by the income tax deduction, it doesn’t hurt to have a larger deduction.
Real World Example
A business family recently brought me in to help them negotiate the sale of their $5 million S corp enterprise. The family was very generous and wanted to commit $2 million of the proceeds to charitable purposes after the sale was completed. The family’s advisors were attempting to use a CRT to help them accomplish their charitable goals and save some taxes at the same time. However, they overlooked a few important things. First, CRTs aren’t qualified S corp shareholders, and second, the S corp status would be revoked if the company stock was contributed to the CRT.
While this wasn’t inherently bad, the significant issue – as in many private sales – was that the buyer didn’t want to purchase the stock of the S corp. Instead, the buyer wanted to purchase the assets because of the more favorable tax treatment of the goodwill and other assets that can be depreciated, unlike stock.
There didn’t seem to be a good way for both parties to win. However, a post-sale contribution to a new PIF indicated that a $2 million cash contribution would produce around $1.7 million of deduction at the current ages of the family member/donors. The deduction would offset a great deal of the income tax liability created from the asset sale and would avoid complications and headaches for the advisory team. The buyer would be able to purchase assets (not stock), and the seller would get the full asking price they wanted.
Further, recent opinions about what constitutes “pooling” for the sake of qualifying for PIF status has led several commentators to agree that “more than one” life is enough. That is, a new PIF can be established for a very targeted group of donors who may have a specific investment policy they want the beneficiary (or beneficiary’s investment manager) to follow.
While it might seem problematic for a charity to maintain many different pools, current technology makes it a lot easier than it used to be. Furthermore, charities must become more creative and flexible to attract donors in today’s highly competitive giving environment. And there are several donor-friendly and advisor-friendly organizations that see a tremendous opportunity.
PIFs vs. DAFs and CRTs
Numerous surveys show donors want more flexibility and control – a trend supported by the explosive growth of donor-advised funds. However, DAFs don’t return any income to the donor. And while CRTs allow the donor to receive income, they often fail the 10 percent remainder test because of the donors’ ages. Including one’s children in the CRT is almost always out of the question. PIFs stand somewhere in the middle. Like CRTs, PIFs return income to the donor, plus they have no 10 percent remainder qualification, which allows a multigenerational income opportunity. Finally, PIFs provide a sizable tax deduction.
While income in a PIF is often limited to rents, royalties, dividends and interest – the typical charitable trust accounting definitions of income – there’s a recent school of thought arguing that some post-gift gain on the invested assets should be counted as income as well. Certainly, short-term gain shouldn’t be an issue. Some trustees may be willing to allow a portion of the long-term gain (usually less than 50%) to be allocated to income. This should greatly stabilize or normalize cash flows and make the PIF more like a CRT. Additionally, PIFs are not tax-exempt trusts like CRTs are, so skilled investment advice is quite important.
Conclusion
Establishing a new PIF is relatively inexpensive from the donor perspective. If any fees are incurred, they’re likely to be more than offset by the PIF’s tax deduction and the capital gains tax that was avoided via the PIF. I’m not saying you need to have an “e-PIF-any,” but CPAs and other advisors should always take the time to become more knowledgeable about strategies that help them better advise their clients. As always, I’m happy to take questions and will try to assist.
