Central to the concept of perpetuating family wealth is the idea that underutilized capital should be transferred directly to current family members or into a vehicle that will benefit future generations. I like to define underutilized capital as assets a client does not expect to consume during his or her lifetime.Economists use the term highest and best use when describing the value of an asset. This term is also used in tax law and is important for the concept of underutilized wealth. Many of our clients created their wealth through businesses and personal efforts. Typically, when they were running or creating their businesses, their return on capital was double-digit; sometimes as high as 25 percent. The ability to sustain these high returns on capital for extended periods of time is one of the reasons these clients created wealth. Unfortunately, as business assets mature, are sold and exchanged for a stock portfolio or other form of investment, the return on capital often drops precipitously. This is particularly true in our current low interest-rate environment, where corporate and municipal bonds are producing as little as 2 or 3 percent. While stock portfolios may increase yearly by double-digit amounts, historic performance in the stock market has generally been 8 - 9 percent. This pales in comparison to the 15 - 20 percent growth business owners were able to achieve year after year. As a result, we often find families of wealth with very large stock portfolios producing minimal annual income.In a typical scenario, a client creates wealth, then retires and lives off that wealth, with the expectation that only upon their death will they transfer the wealth to a lower generation or extended family members. It is during this period of "retirement" that we question the concept of retaining this underutilized capital. The production of income also enters this equation. If a $10 million stock and bond portfolio is only creating 2 percent income and dividends, this may be sufficient for the progenitor to live on. The question is whether tying up $10 million of capital to generate $200,000 of income is the most efficient use of this capital from a "family wealth" perspective.Presuming the capital is appreciating, but the income as a percentage of capital is not, do the eventual estate tax consequences of holding this appreciating asset justify the retention of the capital? Many of the sophisticated planning strategies we employ allow us to transfer these assets and have the progenitor retain the income in one of several forms. Grantor retained annuity trusts, sales to detective grantor trusts, and other strategies part with capital but retain cash flow from the transferred assets. The capital is then able to appreciate outside of the taxable estate of the progenitor.Presuming a progenitor is willing to part with capital, but retain cash flow from the transferred assets, the question becomes how to best deploy that capital within the family. Is there an entrepreneur in the younger generation able to employ his or her energy, intellectual and emotional capital to the progenitor's now transferred wealth? If so, could this result in an increased rate of return, benefitting the family? There might be other uses for transferred assets that may benefit the family as a whole. Allowing family members to borrow from a trust or other entity to which the progenitor has transferred assets could allow the family member to start a business, pay off debt, or pursue educational opportunities not available without the willingness of the progenitor to offer this capital for use by the family members. In any such process, the extended family members who borrow from, take distributions from, or otherwise use and handle the transferred wealth must understand their duty to the family-at-large by returning the borrowed or distributed capital back to the family.The simplest example of transferring wealth is the loan concept. The progenitor establishes a trust for the benefit of nuclear or extended family. A young entrepreneur borrows from the trust with favorable terms to establish a new enterprise. That entrepreneur then returns the borrowed principal to the trust in the form of note payments. This strategy maximizes this asset in the trust for the benefit of future generations or other members of the family. The note payments also create income or "cash flow" to the trust, which the progenitor can use for his or her living expenses.Another example would be a young entrepreneur who may take a portion of the wealth (even while it is in trust) and establish a company or enterprise within the trust. The trustees would invest in the enterprise and the entrepreneur would essentially work for the trust, perhaps with the intention of buying the business from the trust in the future. In these situations, the trust should expect a serious return on the investment. This increase in the capital base of the trust can then be deployed for the benefit of other family members. If the entrepreneur is successful, the family's overall wealth will increase substantially.Advisors should keep this concept in mind as they examine their clients' portfolios. Particularly in our very low interest rate environment, many wealth holders have underutilized assets which may be increasing in value, but not creating substantial income. In addition, depending on family circumstances, there may be better uses for a portion of the family's wealth than sitting in low income producing stocks and bonds, which appreciate in value and increase potential estate taxes. Such assets may fail to fully utilize the family's intellectual, emotional and financial capital.
