INCENTIVE TRUSTS - PART I

Managing the Benefits and Burdens of Inherited Wealth with Incentive Trusts Part I
by Nancy G. Henderson

 
INTRODUCTION

For the past several decades, estate planning for affluent individuals and families has focused primarily upon strategies designed to reduce gift, estate, or generation-skipping transfer taxes (collectively "transfer taxes"). The primary objective in this form of planning is to minimize the government's share of your estate to maximize the amounts passing to children and grandchildren.

Certainly, today's affluent parents and grandparents are no more anxious to pay transfer taxes than they were 10, 20 or 30 years ago. Nevertheless, an emerging concern of today's affluent individuals is how to insure that the wealth they have successfully maneuvered through the transfer tax toll booth by using such sophisticated vehicles as grantor retained annuity trusts, family limited partnerships, and charitable lead trusts, will inure to the benefit their children, grandchildren, and future generations of their descendants, rather than bring harm to them.

This article examines the incentive trust as an increasingly popular estate planning tool designed to insure that inherited wealth creates a positive legacy for children and grandchildren, rather than a negative one.

 
WHY AN INCENTIVE TRUST?

The incentive trust is designed to address many of the perceived problems of inheriting wealth, such as:

  • Loss of motivation. As a general rule, people follow a simple law of physics: they take the paths of least resistance to achieve their goals. If you already have access to personal financial wealth, why get up at 5:30 in the morning to go to the office to haggle with supervisors, partners, or customers in furtherance of a business or other endeavor, the primary purpose of which is to make money?
     
  • Lack of self-sufficiency. Related to a loss of motivation is a loss of personal and financial self-sufficiency. Loss of personal self-sufficiency comes from never having to take care of your own basic needs.
     
  • Overwhelming complexity. To address the complexities of wealth management, most people who acquire wealth suddenly must put their faith and trust in many different people to manage their money. Some may even abuse the trust that has been placed in them.
     
  • Guilt. People who acquire wealth suddenly (particularly inherited wealth) often develop a deep sense of guilt over the source of their wealth.
     
  • Loss of self-esteem. Lack of motivation and personal accomplishments, lack of personal and financial self-sufficiency, reliance upon others for one's personal and financial needs, and a sense of guilt, are the perfect recipe for low self-esteem. A lack of self-esteem leads to depression, poor judgments, and general unhappiness.
     
  • Arrogance. A frequent external symptom of low self-esteem is arrogance. Essentially, arrogance is the adult equivalent of being a spoiled child.
     
  • Spendthrift lifestyle. Stories abound of those who acquire sudden wealth who just as suddenly spend or lose it all. It is psychologically easier to spend money that suddenly arrives on your doorstep than to spend money you have had to work hard to earn.
     
  • Addictive and self-destructive behavior. Temporary relief from a low self-image may come for some from the use of alcohol or addictive drugs. Addiction to such substances enhances the feeling of worthlessness, however, and the cycle continues, possibly into more overt acts of self-destruction.

 
THE GOAL OF INCENTIVE TRUST PLANNING

The goal of incentive trust planning is to ensure, to the extent possible, that inherited wealth creates a positive rather than a negative legacy. In the often-quoted words of Warren Buffett,

"The perfect inheritance is enough money so they feel they can do anything, but not so much that they could do nothing."

Although each incentive trust plan is as individual as each grantor and each beneficiary, the following themes carry through most incentive trusts:

Promotion of the Grantor's Value System

Inherent in every incentive trust is the promotion of the grantor's personal value system. The most common value represented in incentive trusts is the grantor's belief that beneficiaries should be employed or otherwise financially self-sufficient. A grantor may also see value in a beneficiary's decision to be a stay-at home parent. The grantor may seek to encourage community or religious service, or even the development of personal talents. A value system can be even more granular in nature, focusing on participation in a particular religion, maintaining a long-term marriage, or involvement in a specific family business.

Breaking the Connection Between Wealth and Loss of Motivation

A specific goal represented in almost every incentive trust is to break the connection between inheriting wealth and a loss of self-motivation. The beneficiaries should not be entitled to rely upon the trust for their every want or need, and should be permitted to experience personal struggles and triumphs. To accomplish this, access to trust funds is usually tied to a demonstration of some type of personal accomplishment, such as educational achievements, income production, or contribution to the community.

Discouraging Unproductive Behavior

Grantors frequently have a mental laundry list of unproductive behaviors that should be discouraged. Common targets are failing to work to maintain one's desired standard of living, substance abuse, failed marriages or failing to provide for one's children, spendthrift behavior, failing to pursue a college education or, conversely, remaining in school beyond that reasonably necessary to obtain an appropriate education.

Financial Training

Although not present in all plans, a goal of some incentive trusts is to provide financial mentorship designed to enable the beneficiary to manage wealth responsibly, to feel in control of his or her financial destiny, and to promote sound fiscal management to the next generation.

Providing a Financial Safety Net

It is rarely the intent of the grantor to leave even the most unproductive and irresponsible beneficiaries out on the street. Therefore, a theme in most incentive trusts is to insure that the basic health and maintenance needs of the trust beneficiaries are met. Trust assets are also typically made available in the event of an emergency or catastrophic event that a beneficiary could not reasonably anticipate or plan for financially.

 
ARE INCENTIVE TRUSTS ETHICAL?

A common objection to the concept of incentive trusts is that they are a more sophisticated (but no less distasteful) form of the "dead hand ruling from the grave." This is, in fact, a correct assessment: ultimately, a person who is no longer alive will determine whether a living person will have access to wealth set aside for his or her benefit. The same can be said, however, with respect to any trust that continues after the death of the grantor, even one that provides distributions for a beneficiary's "reasonable health, education, maintenance, and support," and principal distributions in one-third increments at ages 30, 35, and 40.

Certainly, leaving enormous sums of money to children, grandchildren, or other beneficiaries who are unprepared for it is not good planning. Unfortunately, moving the age of outright distribution from 18 or 21 to age 30 or 40 does not necessarily prepare the beneficiary for the receipt of that wealth.

Without question, the best way for you to prepare your children for an inheritance is for you to personally train the beneficiary, in both word and deed, on matters of personal values, as well as the use and management of wealth. However, incentive trust planning is most often done for beneficiaries over whom the grantor may otherwise have little influence. An incentive trust may be created upon the death of a grantor with minor children in order to insure that at least some of the grantor's values are conveyed to those children as they mature into adulthood. An incentive trust may provide benefits to future generations of unborn beneficiaries whom the grantor may never meet. Even if the grantor's adult children are the beneficiaries, the children may have been raised by their other parent, or they may have been raised by the grantor, who now regrets mistakes made and hopes not to compound them by leaving a large and unrestricted inheritance to these children and their descendants.

 
HOW INCENTIVE TRUSTS WORK

Incentive trusts have at least two basic operative elements. The first element involves one or more financial incentives designed to encourage certain behavior in a beneficiary that the grantor views as "positive" or "productive." The second element is designed to limit distributions to beneficiaries who engage in "negative" or "unproductive" behavior, or who have other problems that might be compounded by large trust distributions. Some incentive trusts have a further element that is designed to teach beneficiaries how to plan for or manage wealth. A fourth element of an incentive trust may be a "charitable pour over"; that is, the distribution to charity of excess annual income or the portion of the trust's value in excess of a certain "wealth ceiling."

 
SOME COMMON INCENTIVE PROVISIONS

While the possibilities are literally endless, the following are some of the more common incentive provisions.

Incentives for Attaining Educational Goals

Traditional trust planning often encourages education by providing support for educational pursuits. An incentive trust goes further by encouraging specific educational achievements. A beneficiary may be entitled to a reward for the successful completion of the first year of college. (For example, the trustee might pay for a summer trip to a destination of the beneficiary's choosing, buy the beneficiary an automobile, or make a fixed payment of some kind.) Additional benefits might be provided upon graduation. A well-drafted educational incentive provision is more specific than simply rewarding a beneficiary for enrolling in a college or university or obtaining a degree. Certain grade point averages might be mandated, certain types of curricula could be encouraged or discouraged, or the benefits may be limited to enrolling in certain types of colleges or universities (or even the grantor's alma mater).

Tricks and Traps

In designing an education incentive provisions, it is important to consider the following:

Avoiding Professional Studentism. Does the provision encourage "professional studentism," that is, the decision by a beneficiary to stay in school as long as possible in order to avoid the need to be financially self-supporting?

Meeting the Bare Minimum to Keep the Money Flowing. Does merely enrolling in a college program without any requirement of performance encourage beneficiaries to do the bare minimum necessary to keep the money flowing?

Comparative Rigors of Curriculum. Does the academic performance standard in the trust (eg., maintaining a B+ or better grade point average) give due consideration for the comparative rigors of one curriculum over another or the quality and difficulty of the educational institution?

Alternative Educational Paths. Has adequate provision been made for those beneficiaries who simply are not college material (perhaps due to a mental or physical disability), but who pursue an education that is commensurate with their goals and abilities, or, alternatively, those beneficiaries who pursue a different type of training (such as vocational school) appropriate for their career goals?

Adult Continuing Education. An adult beneficiary may wish to go back to school to enhance an important skill or to develop an area of professional expertise. The trust might authorize the trustee to pay for an educational sabbatical to allow an adult beneficiary to take time off from his or her normal employment to pursue a worthwhile educational goal. Trusts that permit or encourage "educational sabbaticals" of this nature usually limit the number of sabbaticals that can be taken within a given time frame (such as once every 10 years), as well as the length of a sabbatical and establish a maximum amount of financial support that will be provided for this purpose.

Income Matching

A close runner up in the popularity contest in incentive trust drafting is the income matching provision. This provision requires or authorizes the trustee to make distributions to a beneficiary in an amount that matches the beneficiary's earned income, in whole or part, often subject to a cap on total distributions.

Tricks and Traps

As straightforward as the concept may sound, income-matching provisions require careful thought. A well-drafted provision must address numerous variables and practical problems, and the final product can and should differ based upon each grantor's specific objectives. Just a few of the drafting issues are set forth below:

How is Earned Income Defined? Not all beneficiaries will be employees who receive W-2 forms. Beneficiaries may be self-employed or members of a partnership, or they may assist a spouse in his or her business, but not take a substantial salary from the business in order to minimize self-employment taxes. A beneficiary who was gainfully employed may be temporarily disabled and receiving disability insurance payments as a substitute for wages. Be certain the definition of "earned income" adequately addresses these types of situations.

What About the Spouse's Income? Should earned income include the income of the beneficiary's spouse, particularly if the beneficiary chooses to stay home to care for children or dependent adults?

Does the Provision Reflect Your Values? Does the earned income provision reward the beneficiary who is a successful stockbroker or a sports super star over the beneficiary who is an award-winning educator? What about the beneficiary who has an unusual windfall in a given year (such as a one-time bonus or commission, or the receipt or exercise of stock options)? Is matching this windfall what you had in mind?

Penalizing Disabled Beneficiaries. Although it is admirable to encourage financial self-sufficiency, due consideration should be given to the possibility that some beneficiaries may be unable to produce substantial income, or any income for that matter, because of mental or physical disability, or perhaps because he or she must tend to a disabled spouse or other family member.

Staying at Home to Raise Children

On the flip side of the earned income provision is the provision that openly rewards beneficiaries who forego a career in order to stay at home to raise children. This is typically accomplished by making monthly or other payments to or for the benefit of a beneficiary who is raising children.

Tricks and Traps

The tough call in such a child care provision is how to handle the beneficiary who has children and stays home to raise them in order to be supported by the trust. On the one hand, the payments should be high enough to encourage a working mother or father to choose family over career, at least temporarily, if that is what you value. On the other hand, manipulative beneficiaries may perceive the trust as something of a private welfare program. To address this, the payments might be reflective in some way of the earnings opportunities forgone by the beneficiary.

Charitable Giving

An incentive trust may provide that a certain percentage of the trust income or corpus will be distributed to charity each year, and provide the beneficiary (or a committee of beneficiaries) the opportunity to designate the charitable recipients. Alternatively, the trust might match personal charitable contributions made by the beneficiary. The income tax and transfer tax aspects of each of these options should be carefully considered before drafting such a provision, however. When the dollar amounts are significant, it may be more efficient to create a separate charitable trust or a family charitable foundation for this purpose.

Contribution to Society

Some trusts reward, or at least provide financial assistance to, beneficiaries who choose to make a positive contribution to their communities, either by volunteering their services, or by choosing a career which is important to society or personally rewarding to the beneficiary, but which provides only modest compensation (such as teaching, social work, or working for a church or other nonprofit organization). The trust might authorize the trustee to supplement the income of such beneficiaries or to provide such beneficiaries occasional luxuries (such as a vacation or a new car) which they could not otherwise afford.

Religious Pursuits

Some incentive trusts reward beneficiaries who agree to provide their children a certain religious training or upbringing. A trust might, for example, fund a sabbatical for a religious mission, pay for religious training or ceremonies, or otherwise support a religious objective.

Provisions Focusing on Marriage

Marriage provisions are by nature touchy. The simplest and least controversial is a provision authorizing the trustee to pay for wedding or honeymoon expenses provided the beneficiary is of at least a certain age. An additional "wedding present" might be provided to a beneficiary who waits even longer to marry, for living separately from his or her fiancé prior to marriage, or for marrying within certain parameters. Provisions that encourage a beneficiary to marry within a particular religion or ethnic group should be thought through carefully, however, as they may violate public policy.

Marriage related provisions may also be designed to encourage a married couple to stay together. These provisions often involve financial incentives for a beneficiary's spouse. For example, the trust may provide direct financial benefits to a spouse who remains married to a beneficiary, including survivorship benefits, but cuts these benefits off when the marriage ceases.

Taking Care of Disabled Family Members

In some cases, a grantor's greatest concern is who will take care of a physically or mentally disabled child, an elderly friend or relative, or other person who presently relies upon the grantor for such care. A trust may be drafted to provide substantial benefits to a beneficiary who rises to the challenge. Care must be taken, however, to insure that the beneficiary is properly discharging his or her duty to the disabled person. Further, the trust provision should be drafted to protect the beneficiary who fails to work in order to take care of the disabled person. Upon the death of the disabled person (or if the disabled person's conservator should determine it would be in the disabled person's best interests to be institutionalized or placed in a facility designed for the disabled person's special needs), the benefits to the former caretaker should continue for a period of time sufficient for the caretaker to re-enter the job market.

Avoiding Traffic Violations

Grantors may be concerned that a beneficiary's imprudent driving habits will cause damage or injury to the beneficiary or others. They may attempt to tip the balance in favor of good driving habits by make payments to beneficiaries who have clean driving records at the end of any given year, or by providing a car to the beneficiary that can be taken away if the beneficiary has too many tickets, accidents, or even parking violations.

Requiring Estate Planning or a Prenuptial Agreement

Some grantors attempt to twist a beneficiary's arm into doing personal estate or pre-marital planning by withholding benefits until proof of such planning is provided to the trustee. Of course, almost any estate or pre-marital planning done by the beneficiary to obtain a distribution can be undone by the beneficiary after the distribution. Therefore, if the grantor's goal is asset protection, the better approach is to keep a beneficiary's inheritance in trust and only make consumable distributions. If, on the other hand, if the grantor's goal is to encourage good planning in whatever manner the beneficiary deems appropriate, then the grantor might authorize the trustee to pay for legal or other estate or financial planning services, both for the beneficiary and the beneficiary's spouse or fiancé.

Encouraging Relationships with Extended Family

In the mobile society in which we live, it is not unusual for families to be spread around the country, or even the world. A grantor may wish to encourage closer bonds between family members by insuring that there are funds available for family members to get together on an annual or other basis.

Coping with Divorce or Other Family Problems

Based upon a grantor's own life experiences or perhaps just an innate sense of reality, a grantor may specifically authorize the trustees to make distributions to or for the benefit of a beneficiary to defray the multitude of expenses that can surround a failing or failed marriage, including, for example:

  • Distributions to assist a beneficiary to initiate or defend divorce or custody proceedings or to initiate a child support collection action;
  • Distributions to assist a beneficiary to obtain temporary housing when marital problems are an issue or where the beneficiary is concerned for his or her safety due to domestic abuse; or
  • Distributions to allow the beneficiary or the beneficiary's dependents to receive qualified professional counseling concerning the marriage and the beneficiary's family.

 
DISCOURAGING NEGATIVE OR UNPRODUCTIVE BEHAVIOR: "DISINCENTIVE" PROVISIONS

The flip side of encouraging positive behavior is discouraging negative behavior.

Substance Abuse or Other Addictive Behavior

A trust may be drafted to cut off benefits to a beneficiary who has substance abuse problems, other than those benefits necessary to secure treatment and to insure that basic living needs are met. Upon learning that a beneficiary has substance abuse problems, the trustee is typically instructed to make payments directly to service providers rather than to make payments to the beneficiary, who may use the distribution to purchase drugs or alcohol.

Lack of Financial Self-Sufficiency

If a beneficiary has never made a serious attempt to support himself or herself, he or she may be entitled to no more than the most basic of benefits designed to keep the beneficiary fed, clothed, sheltered, and with appropriate medical care.

Lack of Fiscal Responsibility

Trust distributions may be limited as to a beneficiary who spends everything he or she receives or who has substantial debts. The provision, however, should not punish a beneficiary who is suffering financial problems not from imprudence but rather misfortune. Also, a provision discouraging wanton spending habits may collide with other trust provisions. For example, simply because a beneficiary is a high-income earner does not mean the beneficiary has any fiscal restraint.

Creditor or Ex-Spouse Problems

Few grantors want trust funds to be paid out to a beneficiary if the ultimate recipient of those funds will be a creditor or an ex-spouse. The trust agreement may therefore provide that, notwithstanding any other provision authorizing distributions, no distributions should be made if the ultimate beneficiary will be an ex-spouse or a creditor rather than the intended beneficiary.

SEE PART II OF THIS ARTICLE, which discusses incentive provisions to avoid and providing financial mentorship.

Circular 230 Notice: In accordance with IRS Treasury Regulations, we are required to notify you that any tax advice given herein (including attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties that may be imposed by any governmental taxing authority or agency or (2) promoting, marketing or recommending to another person any tax related matter.