Journal of Financial Planning: May 2023
David Haughton, J.D., is a team lead and an advanced planning consultant at Commonwealth Financial Network (www.commonwealth.com). With the firm since 2018, David provides estate, trust, charitable, education, business, and Social Security planning support to the firm’s affiliated advisers. He also plays a key role in tracking and interpreting legislation affecting individual taxation and financial planning. He is a graduate of UMass Amherst and earned his J.D. at the Massachusetts School of Law. He is admitted to the Massachusetts and New Hampshire bars, as well as the U.S. District Court for the District of Massachusetts and the U.S. District Court for the District of New Hampshire.
Advisers often plan based on the details of a balance sheet rather than on the client’s unique values and goals. Estate growth, tax mitigation, and asset protection are hallmarks of financial planning for business owners. But that doesn’t mean there is a one-size-fits-all approach to assist them with transitioning their business interests and preserving their legacy.
A client’s values, aspirations, and philanthropic tendencies are missing from a net worth statement. And without knowing this essential information, you could waste time and energy analyzing strategies that are inapplicable to your client.
Get to Know the Client, Not Just Their Possessions
Clients come from a variety of backgrounds and have a set of values acquired over their lifetimes. Many of these beliefs assisted them in building successful businesses. Without having a detailed discussion with the client and uncovering their values, we are destined to try to impart our own principles into their planning.
Undoubtedly, many advisers have gone far down the planning road only to turn around when they learn the client’s goals do not match the assumed objectives of a “typical” client. Charitable trusts or donor-advised funds (DAF) can be powerful tax mitigation tools, but if the client is not charitably inclined, those options may need to be left on the shelf in favor of strategies more aligned with their priorities.
During my time as an attorney, I recall a client who owned a group of rental properties. He intended to transition the property management and, ultimately, the ownership to his son. The buildings had a very low tax basis, so there would be a huge capital gain if he were to sell them. He lived in Massachusetts, so he was primarily concerned about reducing his potential Massachusetts estate tax liability. He wanted to explore gifting the property to an irrevocable trust outside of his estate for his son’s benefit, so it would no longer be a part of his taxable estate when he died.
After comparing the anticipated capital gains tax liability from a sale and the potential estate tax savings yielded from gifting the asset from his estate, I determined that—from a tax perspective—it would not be prudent to gift the property. The primary concern from a planning standpoint was that the step-up in basis would be lost if the property was gifted to an irrevocable trust. And if the son were to sell the properties after the client’s death, he would have a capital gains tax bill in excess of any estate tax savings as a result of the strategy.
The client was informed of the recommendation, and his response was somewhat shocking. He said, “No, you don’t understand. I don’t want him to sell it. I want him to keep it. And if selling it would be painful from a tax perspective, then that will be an incentive to never sell it.” That one conversation really changed the way I viewed planning. I learned that you could impart your wisdom all you want, but what matters most are the client’s priorities and goals.
Get to the ‘Why’ Before the ‘How’
The net worth statement contains essential information to create a financial plan, but learning what is important to the client is just as critical. And to get to the “how,” you need the “why.”
For example, when a real estate agent is assisting a client in buying a house, they can’t solely look at the budget. They need to know what type of house and neighborhood the client desires, its proximity to key locations, or if the prospective homeowners want a yard. Otherwise, they are doomed to show the client several properties with little appeal, resulting in wasted time and resources. The same can be said for a financial planner.
Providing the right balance. Clients often have conflicting goals that are difficult to balance. They will say, “I want my plan to be simple, but I want to pay as little in taxes as possible,” or “I want one of my children to inherit my business, which represents 70 percent of my wealth, but I want all of my children to get an equal share of my total estate.” Getting to know the client helps balance these competing goals in a way that satisfies them. The following questions are key for identifying what specific planning options fit the client.
- What principles have you developed regarding money, and what principles would you like to pass on to the next generation?
- How do you feel about your children’s ability to manage wealth?
- How do you feel about your children’s spouses?
- Which children do you envision being a part of the business? For those who won’t be involved in the business, do you want to equalize their eventual inheritance?
Having a set of values-based questions when meeting with a client can ensure that no stone is left unturned, financially and emotionally, when deciding on a financial plan that makes sense.
Creating unique solutions. Perhaps you have a client who is philanthropic and wants their children to have that same mindset. The client’s business income is increasing yearly, and they would like to reduce their personal tax bill. To do so, the client regularly donates directly to their favorite charitable organizations.
This is an effective tax mitigation technique, but it doesn’t fully encapsulate the client’s goals. In this case, instead of donating directly to charity, it may be wise for the client to use a DAF, naming their children as grant advisers capable of making charitable grants from the DAF. This choice would reduce the client’s tax bill just like donating directly to charity, but it would have the added benefit of getting the children involved in charitable giving. As a bonus, the funds that are not directed to charity could be invested to grow the DAF to act as a family foundation (without the cost and complexity of an actual private foundation).
Sophisticated Strategies Require Time and Attention
While it is critical to create a plan centered on the client’s overarching goals and values, it is also important to know whether the client has the sophistication and motivation to enter into a complex transaction that requires ongoing maintenance.
Let’s take a business owner whose goal is to transition their business interest to their child while protecting it from the child’s creditors and minimizing estate taxes. A good planning approach could be to carry out the discounted gifting of the client’s business interest through a family limited partnership (FLP) with an intentionally defective grantor trust (IDGT) as a limited partner. This could be an effective estate freeze technique that protects the assets. It also helps ensure that the grantor can further reduce their estate by paying the tax liability of the IDGT from personal funds, while the client retains control of the management of the business.
The purpose of this planning approach is to accomplish the client’s goals, and the documents are drafted and executed with their estate planning attorney. But, a year later, the client comes in for their annual review, and you discover they have been depositing draws from the LLC directly into their personal checking account rather than the FLP. This result effectively renders the plan useless, as prying eyes of the IRS would render it all “smoke and mirrors” due to the client’s failure to observe the requisite formalities of the strategy.
Keep it simple. Could this have been avoided by giving the client clear instructions to follow and affirming they understood the administrative requirements of the strategy? Perhaps. What’s more likely is that those preparatory communications were part of instructions that came with the executed documents, and the client was not prepared for or realistic about the time and effort necessary to open the required bank accounts and flow the funds of the business through the proper channels.
This scenario shows why knowing your client and their appetite for complexity is crucial. While some of the most intricate strategies yield the greatest protection and savings, failure to effectively administer the strategy year over year may not make the plan worthwhile. Guiding a client toward a plan that achieves their goals in a manner they can realistically accomplish is key. A financial planner can only do so much hand-holding through the process. If the client lacks the constitution to execute the plan, a more simplistic approach may be warranted.
Consider the risks. In this specific case, offering a more basic approach, such as outright gifts of LLC interest to the child, would be more palatable. But with simplicity comes more risks that the client should be aware of. In this instance, discounting the value of the gift due to lack of control and marketability may invite the IRS to contest the validity of the discount. Additionally, the child’s interest could be deemed a marital asset in a divorce. Further, there could be less creditor protection, as the child’s LLC interest would likely provide charging order protection but not the relatively bulletproof protection a discretionary trust may offer. Finally, the assets would be included in the child’s estate for estate tax purposes.
Given these downsides, this may not be the optimal planning approach. But, clients who do not want the burdens of a complex strategy may accept lesser benefits and additional risks as the price for a more simplistic approach.
Individualizing the Client Experience
Reasonably, you can only know so much about your client. But if you understand them on a personal and behavioral level, you will be able to direct them toward the most effective financial planning strategy. Having a process in place to uncover the essential characteristics of your client, other than their net worth, will help you provide them with a uniquely indispensable financial planning experience.
Commonwealth Financial Network, Member FINRA/SIPC, does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.