Ethan R. Okura
Hawai‘i Herald Columnist
More Nitty-Gritty Details
This month, I will explain in more detail the potential advantages and disadvantages of generation-skipping trusts, expanding on this topic from my column on p. 14 of the Herald’s Feb. 19 issue.
A Generation-Skipping Trust is a trust that does not end when you pass away. It continues on for one or more generations after your death. It does not “skip” a generation in inheritance (in other words, it does not disinherit your children and leave everything to the grandchildren). The strange name is just short for Generation-Skipping Transfer-Tax-Exempt Trust. That’s why I prefer to call it a Legacy Trust.
Advantages of a Legacy Trust
There are many advantages provided by a Legacy Trust. Among them are the following (some of which I went over in my Feb. column):
Children may be given the freedom to spend any amount or all of the trust income and principal. Children who are beneficiaries of a Legacy Trust may be given the freedom to spend any amount (or all) of the trust income and principal as needed for the health, support in reasonable comfort and education of themselves or their descendants. Even if the children need to spend all of the trust assets for their own support, nothing has to be left to the next generation.
Legacy Trust assets are not subject to the estate tax. Without a Legacy Trust, the assets inherited from parents become assets of the children, so that when the children pass away, those assets are subject to the federal estate tax. If any child saves, invests and at any time has sufficient assets to be taxed by the estate tax, then all of the inheritance received from parents will increase the amount of estate tax at the child’s death.
On the other hand, when assets are inherited in a Legacy Trust, those assets are not subject to estate tax when the child dies, no matter how large those assets grow within the trust.
The Legacy Trust can guarantee that assets will stay in the family. Without the Legacy Trust, a child might inherit assets from a parent, die and then have those assets go to a surviving spouse. The surviving spouse of the child could remarry and leave those assets to a new spouse. Thus, your assets, which you intended to leave as an inheritance for your own descendants, could end up going to a stranger rather than to your own grandchildren. With a Legacy Trust, the child has full use and control of the assets. Yet when the child dies, none of it goes to a surviving spouse, because the child does not own the assets. The assets can be guaranteed to go to your own grandchildren.
Assets can be protected from divorce. If you were to leave assets to your children without a Legacy Trust and if your child ever gets a divorce, it is possible that the divorcing spouse could go after some of those assets. In Hawai‘i, the general rule is that if you leave an inheritance to your child who is married, and if that child gets a divorce several years later, then the appreciation in value of those inherited assets can be subject to the divorce proceedings. For example, if you were to leave a married child an inheritance of $100,000 at the time of your death, and if your child were to get divorced several years later when the asset has grown to $250,000 in value; in a divorce proceeding, the court would generally allow your child to keep $100,000 of the asset, but could divide the $150,000 of appreciation 50/50 between your child and the divorcing spouse.
On the other hand, with the Legacy Trust, the trust assets do not belong to your child, and therefore are not subject to divorce proceedings. Since a family court judge is given fairly wide discretion in divorce matters, if your child has access to large amounts of money in a Legacy Trust, the judge might be inclined to give your child’s spouse a larger share of the marital assets, but still, there is a much better choice of protecting the inheritance which you leave your child if it is in the form of a Legacy Trust rather than outright.
A Legacy Trust can offer asset protection from creditors. If you were to leave an inheritance to your child outright, and if your child were sued and a judgment were obtained against your child, a judgment creditor could go after those assets. On the other hand, with a Legacy Trust, there is a much greater likelihood that the trust would protect the assets from creditors.
In 2013, for instance, a bankruptcy judge in California ruled that all of the assets in a Hawai‘i Legacy Trust (aka “GST,” Generation-Skipping Trust) were protected from bankruptcy creditors. This decision was appealed, but even the Bankruptcy Appellate Panel of the U.S. Court of Appeals for the Ninth Circuit supported the lower judge’s decision to protect the trust assets. In this case, the bankrupt man was a beneficiary of his deceased mother’s Hawai‘i Legacy Trust, and he was even the Trustee with complete control over the trust assets. Under California law, the bankruptcy creditors would have been entitled to at least 25% of the trust assets, but the court applied Hawai‘i law to this case and determined that the Trust assets could not be taken away from the bankrupt man. This case does not guarantee that every Hawai‘i Legacy Trust with the proper spendthrift language will always be protected from all creditors in every situation. Nevertheless, with a Legacy Trust, there is certainly a better possibility of protecting assets from judgments, creditors, and bankruptcy, than there would be without a Legacy Trust.
Disadvantages of a Legacy Trust
Separate income-tax returns must be filed. From the time of your death, when a Legacy Trust becomes irrevocable, the trustee of the trust would have to file a separate tax return for the trust every year in which the trust earns income. Therefore, your child would have to file both a personal income-tax return for your child’s own income and a fiduciary income-tax return for the trust income. In my opinion, the extra expense of filing a second income-tax return is a small price to pay for the many protections offered by the Legacy Trust.
It may be difficult to mortgage property owned by the trust after it becomes irrevocable. As other trusts, a Legacy Trust becomes irrevocable, either upon creation as an irrevocable trust, or in the case of revocable living trusts, upon the death of the settlor. [An irrevocable trust’s terms cannot be amended or terminated without a court order or permission from the grantor’s named beneficiary or beneficiaries. In some cases, a Trust Protector or the Trustee may have authority to make modifications to an irrevocable trust without approval from a court or the beneficiaries.] Most financial institutions do not like to make mortgage loans secured by real estate owned by an irrevocable trust. Therefore, you should not expect to be able to borrow money if you are using property in an irrevocable Legacy Trust as collateral. If such a mortgage is approved, care must be taken to be sure that mortgage payments made do not constitute taxable gifts to the trust.
Your child’s descendants could complain that your child is spending more of the assets than is needed for your child’s health, support in reasonable comfort and education. If your child has very critical children who are willing to sue their own parent, a possible problem with a Legacy Trust is that the grandchildren could accuse your child of spending too much money, thus leaving them the prospect of receiving less when your child dies. As a trustee-beneficiary, your child can spend whatever amounts are necessary for his or her health, support in reasonable comfort or education. The IRS does not police your child to see how much is spent for your child’s support. Probably the only people in the world who could complain that your child is spending too much would be your child’s own descendants. However, those cases are rare, and we would hope that your own grandchildren would not be so untrusting of their own parent. Nevertheless, in the unlikely event that one of your children has such a relationship with her or his own children, the problem can usually be solved by putting in the trust document a “special power of appointment.”
Special Power of Appointment
A special power of appointment is a power that you can give to your child to cause the trust assets to be distributed upon their death as he/she directs in their will. If your child does not exercise the special power of appointment, then upon your child’s death, the trust assets would go equally, in trust, to each of your child’s children, or if your child has no children, then, it would go, in trust, to your child’s siblings, if any. However, by exercising the special power of appointment, your child could cause the trust assets to go to someone other than his or her own child.
The threat of using that power will probably discourage your child’s children from claiming that their own parent is spending too much money. The special power of appointment can be designed to give your child the power to leave the trust assets to anyone in the world other than your child’s creditors, estate or creditors of your child’s estate. That would mean that the child could leave your assets to your child’s surviving spouse, friend, or anyone else.
I generally prefer — and most of my clients also usually prefer — limiting the special power of appointment so that your child can leave the assets in any proportion to any of your descendants, other than your child’s creditors, estate or creditors of your child’s estate.
Under this limited special power of appointment, your child would be able to leave the trust assets remaining upon your child’s death to only one of his or her children instead of equally to all of them; or could give different percentages to each of your child’s children; or your child could leave the trust assets to a brother or sister or niece or nephew of your child, if any. By limiting the special power of appointment so that the trust assets can be left to any of your descendants, it guarantees that your assets will stay within your family line and yet not go to any grandchildren with whom you do not get along.
Separate Legacy Trust For Each Child
A good way to give each child maximum flexibility and control over assets, yet enjoy all of the advantages and protections of a Legacy Trust, is to provide in the trust document that upon your death — or if you are married, upon the death of both you and your spouse — the trust would divide into separate Legacy Trusts so that there is one for each child. Each child can then become trustee of his or her own Legacy Trust, and wield total control over the investment of the assets and over decisions to distribute assets to self or to descendants. The trust would further provide that upon death of your child, instead of the assets going outright to the grandchildren, your child’s Legacy Trust would further divide into separate Legacy Trusts for each of your child’s children. Each grandchild can then have all of the advantages and protections of a Legacy Trust, and also be given a special power of appointment over the trust assets. This process can continue for as long as the law allows. Under Hawai‘i law, this process can go on forever as long as there is a Hawai‘i resident individual or trust company as one of the Trustees of the trust.
It is our opinion that if the trust is properly drafted, particularly with the features of a special power of appointment and separate trusts for each child, that it is better for the child to inherit assets in the form of a Legacy Trust than outright (or receiving the property directly in his or her name).
© OKURA & ASSOCIATES, 2020
Honolulu Office (808) 593-8885
Hilo Office (808) 935-3344
Kauai Office (808) 241-7500
Ethan R. Okura received his JD from Columbia University in 2002. He specializes in Estate Planning to protect assets from nursing-home costs, probate, estate taxes, and creditors.
This column is for general information only and is not tax or legal advice. The facts of your case may change the advice given. Do not rely on the information in this column without consulting an estate-planning specialist.