Taxes and wealth transfer - Trusts wills and estate planning

Learning Outcomes

After reading this article, you will be able to explain key concepts in tax-efficient wealth transfer, the legal mechanics of wills and trusts, and essential estate planning frameworks for CFA Level 3. You will know how trusts and wills function, the rationale for using each, and their tax and control implications. You will also be able to compare typical estate planning strategies relevant to different legal systems.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand practical and legal aspects of taxes and wealth transfer. This article covers the following syllabus topics:

• The rationale and legal basis for trusts and wills in estate planning
• Tax implications for different types of wealth transfer, including gifts and bequests
• Common law and civil law differences in estate and inheritance planning
• Basic mechanics and structures of wills, trusts, and related entities
• How to use trusts and other structures for tax efficiency, control, and asset protection
• Key estate planning objectives: liquidity, control, and intergenerational transfer

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Define the primary differences between a will and a trust in terms of control, timing, and legal effect.
2. Explain why a high-net-worth client might use an irrevocable discretionary trust as part of their estate plan.
3. What are the main tax consequences of gifting assets during life versus bequest on death in most OECD tax regimes?
4. How do forced heirship rules in many civil law countries impact estate planning choices?

Introduction

Efficient wealth transfer planning requires an understanding of tax consequences, legal structures, and practical trade-offs. The CFA Level 3 syllabus expects you to evaluate strategies—wills, trusts, and gifting—for managing succession, tax, and control over family wealth. This article explains how these mechanisms work under different legal systems and tax environments, and it outlines standard planning objectives and tools.

Wills and Probate

A will is a legal instrument specifying how a person’s assets should be distributed after death. It can also appoint guardians or executors and set various directions for an estate.

Key Term: will
A document expressing a person's wishes for asset distribution and guardianship after death, legally enforceable upon probate.

Probate is the legal process for validating the will, appointing executors, and allowing heirs or creditors to claim assets.

Key Term: probate
The court-supervised procedure for validating a will and settling a deceased person's estate.

Not all jurisdictions require probate, but most common law countries do. Without a valid will (intestacy), local law determines the distribution of assets—potentially in ways that conflict with the deceased’s true wishes.

Legal Constraints: Forced Heirship and Law Variations

In many civil law and Sharia regimes, individuals cannot freely leave their entire estate as they wish. Instead, a proportion must pass to certain heirs (“forced heirs”), which directly limits the effectiveness of a will.

Key Term: forced heirship
Legal rules requiring a portion of an estate to be left to specific family members, limiting testamentary freedom.

Common law countries generally allow full testamentary freedom, but some rules protect vulnerable dependents from total exclusion.

Trusts: Purposes and Types

A trust is a relationship in which one party (settlor) grants control of assets to a trustee, to benefit named beneficiaries, using a trust instrument.

Key Term: trust
A legal structure where a trustee manages assets for beneficiaries, according to terms set by the settlor.

Trusts are often used for control, asset protection, and tax planning. Key motivations include:

• Passing wealth to minors or incapacitated persons
• Protecting assets from creditors, marital claims, or legal risk
• Achieving multi-generational control or governance objectives
• Planning for complex families (e.g., blended, global, or with dependents at risk)
• Managing cross-border inheritance and privacy issues

There are multiple forms:

• Revocable vs. Irrevocable: A revocable trust allows the settlor to amend or terminate. In contrast, an irrevocable trust cannot typically be undone, offering better asset protection and tax properties.

Key Term: revocable trust
A trust that the settlor can modify or revoke during their lifetime.

Key Term: irrevocable trust
A trust that cannot be altered or revoked unilaterally by the settlor.

• Fixed vs. Discretionary: In a fixed trust, benefits are defined for each beneficiary. In a discretionary trust, the trustee has latitude over distributions.

Key Term: discretionary trust
A trust where the trustee determines how much each beneficiary receives, within the trust's terms.

• Testamentary vs. Inter vivos: A testamentary trust is created by will, effective after death. An inter vivos (living) trust is established during the settlor’s lifetime.

Key Advantages and Uses

• Tax: In many regimes, irrevocable trusts remove assets from the settlor’s taxable estate, subject to gift or transfer tax at the time of setup.
• Control/Protection: Trusts can prevent heirs from squandering assets or can shield wealth from marital or business claims.
• Asset Location: Properly domiciled trusts may provide privacy or lower exposure to local regime change.

Key Term: asset protection
Legal strategies or structures to shield wealth from creditors, divorcing spouses, or third-party claims.

Tax Considerations: Gifts vs. Bequests

Tax efficiency is central to estate planning. Tax laws vary by country but certain principles are common.

• Lifetime Gifts: Usually subject to gift tax in excess of any annual/lifetime exemptions. Future returns accrue for the recipient, often at a lower income tax rate than if left in the donor's estate.

• Bequests (on death): Usually taxed via estate or inheritance tax, calculated on the value at death (with or without step-up in basis). The entire estate may be taxed at higher marginal rates.

• Relative Value Calculation: The after-tax effectiveness of giving during life compared to bequeathing at death can be formalized as:

  $$\text{Relative Value} = \frac{(1 + r(1-t_\text{recipient}))^n}{(1 + r(1-t_\text{donor}))^n (1-\text{estate tax rate})}$$

Key Term: estate tax
A tax levied on the value of a deceased person’s estate before distribution to beneficiaries.

Key Term: inheritance tax
A tax paid by a beneficiary upon receiving a bequest, depending on local law and kinship.

Key Term: gift tax
A tax imposed on the transfer of assets during the donor's lifetime, usually paid by the donor.

• Annual Exemptions & Step-up in Basis: Many systems apply annual exemptions or allow asset value reset at death, reducing the effective tax when inherited rather than gifted during life.

Civil Law vs. Common Law—Planning Implications

• Common Law: Flexible—wills can leave assets as the testator wishes, and trusts are widely available for control and tax management.
• Civil Law: Forced heirship may apply; trusts may not be recognized. Planning relies on family or charitable entities, insurance contracts, and lifetime gifts within allowances.

Key Term: family or charitable entity
A legal entity (primarily in civil law countries) set up for a stated charitable or family benefit, separate from the founder.

Worked Example 1.1

A client domiciled in France (forced heirship jurisdiction) wishes to leave a business to one child and cash to another but is concerned about forced heirship rules. What planning options are available?

Answer:
Asset equalization can occur during life through allowed annual gifts. Alternatively, the client may set up a family or charitable entity if allowed, or use insurance contracts for accumulation, since death benefit proceeds often lie outside of forced heirship rules. Creating a will specifying assets for each heir is limited by mandatory shares required by law.

Worked Example 1.2

A US-domiciled client considers settling an irrevocable discretionary trust for future generations. What are the key tax and control implications?

Answer:
Assets placed in the trust incur potential gift tax but are excluded from the settlor’s taxable estate. The settlor surrenders control but can define the trust deed. Trustees decide distributions, which may protect assets from beneficiary or third-party claims.

Estate Planning Objectives and Tools

Estate planning seeks to achieve:

• Sufficient income and liquidity for survivors and taxes
• Flexible asset control and protection from claims
• Intergenerational transfer and charitable legacy

Key tools include:

• Wills and probate
• Trusts (domestic or offshore)
• Family or charitable entities or family companies (especially in civil law systems)
• Insurance contracts to provide liquidity or to avoid forced heirship
• Lifetime gifting within tax-free exclusions and careful use of step-up basis rules

Worked Example 1.3

A high-net-worth family with global assets wants to prevent forced heirship in Country A, provide for a vulnerable child, and minimize future taxes. Which combination of structures could help?

Answer:
Use a discretionary irrevocable trust with a protector for the vulnerable child, locate non-domestic assets in a trust-recognizing jurisdiction, and make regular lifetime gifts within annual exclusions. Insurance may provide liquidity. Family or charitable entities may be suitable for philanthropic objectives.

Exam Warning

Beware of assuming that a trust structure is automatically recognized for local tax or succession purposes in every country—many civil law or Sharia jurisdictions may ignore or challenge trusts established offshore for local assets.

Summary

Succession planning in CFA private wealth management requires a clear understanding of the main legal and tax tools: wills, trusts, and lifetime gifts. Each structure has advantages for tax, control, and asset protection, but works differently depending on the legal system and rules on inheritance and tax. Forced heirship and cross-border matters require extra care in choosing effective structures.

Key Point Checklist

This article has covered the following key knowledge points:

• Main distinctions between wills and trusts for estate distribution and control
• The principal types and purposes of trusts in wealth transfer
• Implications of common law vs. civil law (forced heirship) on planning techniques
• How lifetime gifts, bequests, and step-up rules affect taxation
• Key objectives and structure choices in estate planning (e.g., income, control, asset protection, legacy)
• Correct use and recognition of family or charitable entities and insurance contracts

Key Terms and Concepts

• will
• probate
• forced heirship
• trust
• revocable trust
• irrevocable trust
• discretionary trust
• asset protection
• estate tax
• inheritance tax
• gift tax
• family or charitable entity