INCENTIVE TRUSTS - PART II

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

INTRODUCTION

Occasionally, grantors will want to design a trust that incorporates incentives or disincentives that should be discouraged. Examples are set forth below.

Instant Disinheritance for Violations

It is one thing to discourage a beneficiary from behaving in a certain manner through financial disincentives, such as reducing or otherwise limiting current trust distributions. It is quite another to provide that, should a beneficiary ever engage in a certain behavior, he or she is forever barred from any further benefits from the trust. These provisions are designed to terrorize beneficiaries and they leave no room for learning from mistakes. They are also "litigation magnets" because the disinherited beneficiary has nothing to lose by contesting the validity of the trust provision or the trustee's actions.

Provisions that Violate Public Policy

Provisions that encourage divorce, child abandonment, or illegal or tortious acts, are all against public policy. Not only are such provisions unenforceable, but they place a taint upon the entire trust instrument, encouraging litigation and possibly giving the trustees and the beneficiaries an avenue to disregard other provisions that are well considered but which they find disagreeable or troublesome to administer.

Provisions that Encourage Discord Among Beneficiaries

Beneficiaries will make different value choices that will increase or decrease the amounts distributable to them from an incentive trust. Some beneficiaries will make choices simply to secure trust benefits (or it will appear that way to those who make different choices). Resentment among beneficiaries can be fostered in these situations, particularly if they draw from a single trust fund. To avoid these problems, the grantor should strongly consider creating separate trust shares for separate family lines. First, by separating the financial benefits, one beneficiary's larger distributions do not deplete the resources available to his or her siblings and their descendants. Second, maintenance of wholly separate trusts means that each trust can be accounted for separately. Consequently, one sibling may not be aware that another sibling is receiving more generous payments from his or her trust.

Provisions that Are Impossible to Administer

An incentive or disincentive provision has to work in the real world. It is important to walk each incentive or disincentive provision through as many possible scenarios, and to consider:

  • How the trustee will obtain the information necessary to carry out the provision;
  • Whether the burdens upon the trustee and the beneficiary to carry out the provision might outweigh the intended benefits;
  • Whether there can be any dispute over whether a beneficiary has passed or failed the "test" that is presented by the incentive or disincentive provision and, if so, whether there is a way to resolve the dispute without litigation; and
  • Whether the provision is susceptible to manipulation by the beneficiary to accomplish objectives that are contrary to the purposes of the trust.

Provisions that Can Defeat Other More Important Trust Purposes

In creating an incentive trust, it is critical to keep all of the competing objectives in mind and to make certain that both the drafter and the grantor understand the grantor's priorities. For example, if asset protection is important to the grantor, an uncapped income matching provision may take more out of trust solution than is actually needed by the beneficiary, unnecessarily exposing trust assets to claims from creditors and ex-spouses.

 
FINANCIAL TRAINING FOR THE BENEFICIARY

While every incentive trust will encourage certain behaviors and discourage others, the incentive trust plan can go much further by actually training the beneficiary on proper fiscal planning and management. The following are a few examples of how an incentive trust might accomplish this purpose.

Requiring a Budget for Assistance in Home or Automobile Purchases

It is not uncommon for a trust to authorize a trustee to assist a beneficiary with the purchase of a residence or an automobile. An incentive trust designed to train a beneficiary will go further by:

  • Requiring that the home or automobile be appropriate for the individual's needs and his or her needs and station in life; and
  • Requiring the beneficiary to demonstrate his or her ability to contribute to the purchase price (such as by making loan payments) and to pay other ongoing costs (such as insurance, maintenance, taxes and assessments) from resources outside of the trust. The trustee can appoint someone to work with the beneficiary to put together a budget. A beneficiary who refuses to participate in the budgeting process can be denied assistance.

Requiring a Business Plan for Assistance in Starting a Business or Profession

An incentive trust that is designed to train the beneficiary on financial matters will not just authorize a trustee to assist a beneficiary in starting a business or profession, but will require the beneficiary to do a business plan in order to receive such financial assistance. The trustee could be authorized to hire a business consultant to work with the beneficiary to establish a business plan. The trust agreement may even require the beneficiary to fund a part of the business from resources outside of the trust, such as a small business loan or a line of credit. Again, a beneficiary who refuses to cooperate in the process will have to find funding for his or her venture elsewhere.

Outright Distributions and Test of Results

A cross between incentive planning and financial mentorship is the provision that dribbles out trust assets to a beneficiary and then monitors the beneficiary's use of the distributed funds. For example, at age 35, a beneficiary might be given $250,000 from the trust, free and clear. The beneficiary must then account at some point in the future for the use and investment of the funds. If the beneficiary has been prudent in his or her use and investment of the funds, more might be distributed outright and free of trust. The trust agreement should also be drafted to encourage the beneficiary to seek investment advice and training, either from the trustee or from outside resources recommended by the trustee.

When Enough Is Enough: the Charitable Pour-Over

Even with all of the incentives and disincentives built into a trust agreement, the grantor of an incentive trust often has a dollar figure in mind, more than which no beneficiary, present or future, should ever need. For some people, the "wealth ceiling" is a few a hundred thousand or a few million dollars, for others a few tens of millions. Once the wealth ceiling has been reached, the excess is typically paid over to a family foundation, to named charities, or to charities selected by the trustees or the beneficiaries. Such charitable pour-overs are totally unmotivated by the tax aspects of the charitable gift, as there are very few tax advantages associated with giving to charity a large portion of the corpus of an existing irrevocable trust.

 
CONCLUDING THOUGHTS

Clearly Define Your Goals

While incentive trusts have common themes, they are all ultimately products of the unique concerns the grantor has for his or her family. Therefore, before you instruct your attorney to draft an incentive trust for you, you and your advisors should invest the time to outline your personal goals and values. Careful consideration should be given to whether any of your goals potentially conflict with each other and, if they do, where your priorities lie.

Test the Assumptions and Walk Through the "What Ifs"

Test your resolve before directing your attorney to draft a strongly worded incentive or disincentive clause. If your thinking is, "The trust will match earned income. A beneficiary who does not work should get nothing from the trust," do you really mean it? Would you disinherit a beneficiary who is ill or disabled? Would you disinherit a beneficiary for staying home to raise children? As another example, if you tell your attorney, "If my granddaughter goes back to using drugs, she should be disinherited. I want a drug test every three months, and if she fails, she is cut off for good." Would you disinherit your granddaughter because a drug is slipped into her drink without her knowledge? Even if your granddaughter were to fall off the wagon, would you want her to live on the street, where her health and physical safety are jeopardized? Could she ever redeem herself? What if, after years of substance abuse, your granddaughter recognizes the error of her ways, obtains treatment, and never uses drugs or takes a drink again for the rest of her life? It is critical for you to consider the real world impact of your choices before they become carved in stone.

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