Inheriting Wealth? Avoid the Pitfalls of Prosperity

Wealth transfers are happening more than ever before, and next-gen inheritors have a significant role to play in ensuring their success. But inheritance planning, whether the result of a gift made during life or at death, can be a tall order. Inheritors must balance the wishes of the prior generation, their own goals and values, and potentially differing views of fellow beneficiaries. On top of that, there are tax implications to consider. With the steps below, you can navigate the complexities of a wealth transfer and astutely manage your inheritance.

A Three-Pronged Approach to Inheritance Planning

DISCOVER

As an inheritor, how can you harmonize others’ expectations with your own financial priorities? Start by assessing the goals of everyone involved. For instance, using facilitated exercises, family members can come together to explore the original intent behind the transfer and the core values that were meant to guide it. When it comes to inheritance planning, some questions you might ponder include:

• Did the transferor intend for the recipients to continue owning or growing the transferred assets, like a family business or home? If so, how should the responsibility for managing the asset be shared?
• Was the transfer meant to provide for specific individuals or needs? Is there a process in place for decision-makers to assess those needs?
• How does each recipient view the wealth in terms of their personal goals? Do they want to use it to support certain endeavors or aspects of their lifestyle, and how might these goals impact family investment decisions?
• What are the family’s shared values, and how can decision-makers use the transferred wealth to support those values?

PLAN

Next, it’s time to pinpoint where everyone’s goals and circumstances overlap—and where they don’t. For instance, if the purpose of transferring a family-owned business is to let the next generation run it, how should decision-makers handle differing levels of interest among younger family members? By recognizing sources of potential conflict early on and engaging the right advisors to create a shared understanding, the family can promote harmony and cohesion in inheritance management.

Consider the Bhat family. Mr. and Mrs. Bhat previously transferred equal shares in their family business to three separate trusts—one for the benefit of each their children, Reva, Ajay, and Kimaya. However, after engaging in several facilitated discussions, Kimaya realized that her siblings didn’t share her enthusiasm for the business. She worried that their continued involvement in management decisions might lead to a less-than-ideal outcome for everyone involved.

After consulting with counsel, Kimaya presented her siblings with two proposals:

1. Kimaya’s trust can purchase the family business interests from her siblings’ trusts for $6 million each, or
2. the trusts can recapitalize the business into voting and non-voting interests in a way that allows Kimaya to retain managerial control while her siblings continue to benefit as “silent partners.”

A key part of inheritance planning is assessing the potential long-term financial impact of your options. In this case, Reva and Ajay asked their advisors to project the growth of their portfolios if they invested the $4.57 million after-tax sale proceeds¹ at different asset allocations, compared to continuing to own the business and assuming growth at its historical average (Display).

 

After comparing the after-tax results, Reva decided to move forward with selling her trust’s business interest. She was comfortable with a 70/30 asset allocation designed to deliver similar results to retaining her business interest, while also enabling her to build a portfolio that aligns with her personal interests and goals. Meanwhile, Ajay opted to remain a silent partner as he felt more at home with the risks of the family business than those of a potential market downturn.

IMPLEMENT

Beyond personal values, inheritors should review their existing financial plans to identify potential pitfalls that may arise from the influx of assets. For example, how will such assets impact your portfolio in terms of diversification and liquidity? Our research shows that the likelihood of experiencing a peak-to-trough loss of 20% to 30% increases significantly when a stock represents more than 20% of an investor’s overall portfolio.

For that reason, a newly created concentrated stock position may require careful monitoring—or even sale and reinvestment—to achieve your preferred risk-adjusted return. What’s more, investments that come with transfer restrictions or capital calls may impact your liquidity levels and require a shift toward more liquid positions elsewhere in your portfolio. Lastly, as part of inheritance management, you might revisit your philanthropic goals. Some inheritors choose to pursue new giving strategies with their newly expanded balance sheets, while others may look to continue a larger family legacy by honoring key donations.

It's also vital to review your tax-planning strategy, especially when it comes to potential income or estate tax obligations. For example, let’s return to Reva and her trust. After selling her trust’s interest in the family business, Reva consults with her estate planning counsel to determine how best to grow her estate while minimizing her own heirs’ future tax liabilities. Her counsel points out that Reva does not have a federally taxable estate since her inheritance is held in a trust that is excluded from transfer tax at her death. The only downsides? Income taxed inside the trust will face a potentially higher income tax rate and property left in Reva’s trust won’t benefit from a “step up” in its income tax basis when she passes away.

To address this, Reva’s counsel suggests that she distribute income from the trust to take advantage of her lower personal tax rates. These distributions will also increase Reva’s taxable estate so that she can use a greater share of her lifetime exclusion from federal gift and estate tax, thereby eliminating capital gains tax on assets passing to her beneficiaries. But how can Reva find the sweet spot for the purpose of  inheritance planning? She needs to find the level of distributions that would allow her to take full advantage of the step-up without triggering an estate tax liability at her death.

To calculate this, her advisor forecasts the growth of both her trust and personal assets over time and compares it to the growth of Reva’s lifetime exclusion from estate tax, adjusted for inflation (Display). They determine that distributing the trust’s income won’t push the size of Reva’s estate above her lifetime exclusion amount, meaning her estate can take advantage of the step-up without paying additional tax. With these projections in hand, Reva and her counsel create a plan for regular trust distributions and agree to revisit the approach if federal gift and estate tax law changes down the road.

The Secret to Successful Transfers

When wealth is transferred to loved ones, there’s a leap of faith that they’ll use it to further shared goals and values. However, without the right guidance, integrating transferred wealth into a beneficiary’s decision-making and lifestyle can be challenging, even for the most sophisticated individuals. Your Bernstein Advisor can help your family learn more about how to leverage transferred wealth to ensure success in a succession plan.