Today, many of our most sophisticated and focused estate planning clients are concerned not only with transmitting their estates in a tax-efficient manner but also with structuring their estate plans so that the lives of their children (and, perhaps, grandchildren and more remote descendants) are enhanced when they become beneficiaries.
With increasing frequency, estate planning clients express the fear that if their children receive large sums of money or assets having substantial value, they will be deprived of the motivation to be productive and responsible citizens. Worse still, some estate planning clients fear their children may view a large inheritance or the prospect of receiving large trust distributions as an opportunity to engage in negative tendencies and behaviors.
There is, however, a device available to our clients and their professional advisors that can alleviate these fears. That device is popularly known as an “incentive trust.”
Defining the Trust
An incentive trust is set forth in an inter vivos trust instrument or a will and is limited in scope only by the imagination of the estate planner and the c1ient. The vehicle addresses the client’s apprehensions that large inheritances and trust distributions could harm, if not ruin, their children’s lives. The trust is designed not merely as a vehicle for investment management, funds distribution, and, possibly, tax savings but, in addition, as a motivational tool–one that promotes and encourages “good” behaviors and tendencies, and discourages or punishes “bad” behaviors and tendencies.
Statement of purpose
The governing instrument of an incentive trust should contain both a general statement of purpose and distribution guidelines. A general statement of purpose should be composed of language that is non-legalistic in nature and focuses, in a humanistic rather than a technical way, on family values, hopes and expectations.
By way of example, a statement of purpose might express the desires of the parents of trust beneficiaries that, in the absence of unusual or unforeseen circumstances, their children will be well-educated, industrious, philanthropic individuals.
A statement of purpose could make clear that occupational success may be evaluated with reference to one’s dedication to a career that, while not financially remunerative, contributes in a meaningful and material way to the benefit of society. The statement could also indicate a parent’s approval of saving and investing and disapproval of excessive and wasteful consumption and spending.
The legal directions given to the trustee in an incentive trust’s governing instrument with regard to the making or withholding of distributions should be drafted using language that is legally and technically sound. The distribution guidelines (or “performance standards”) should specify behaviors, activities, accomplishments and failures that will result in trust distributions being made to or for, or withheld from the beneficiary.
Encouraging Positive Behaviors
To encourage a child’s academic success, a parent might include in the trust’s governing instrument a provision authorizing distributions for the child’s tuition, room and board, books and fees. The provision could take effect upon the child’s enrollment in an accredited college or university leading to a diploma or degree. The provision might additionally mandate, as a condition to receiving distributions, that the child maintain or graduate with a particular grade point average.
If a parent wishes to stimulate and reward productivity, an incentive trust provision could allow or direct the trustee to make certain payments or distributions to or for the benefit of a child who is employed in an occupation on a full-time basis. If the parent wants to instill a high standard of work-related financial productivity, an incentive trust’s dispositive provisions could be structured to direct the trustee to make payments or distributions to or for the child that match, on a dollar-for-dollar basis, the earnings the child receives from employment. Alternatively, a parent might prefer an incentive trust provision that requires the trustee to make distributions to the child to match the child’s annual savings.
Some parents wish to be specific in encouraging their children’s occupational choices. For example, a parent might include in incentive trust provisions a direction to the trustee to make payments to a child who joins the family business, works the family farm, or starts his or her own business. The incentive trust could also financially reward the child for entering the same business or profession as did the parent or for undertaking what the parent considers a socially redeeming occupation or profession.
A parent may desire to influence his or her child to make certain kinds of “lifestyle” choices and can design the estate plan accordingly. For example, incentive trust provisions may be structured to provide financial motivation to the beneficiary: (1) to get married, (2) to get married but not before reaching a designated age, (3) to marry a person who adheres to a particular religion, (4) to have children, (5) to stay married to and continue living with the other parent of his or her children, or (6) to be a stay-at-home parent.
In structuring the incentive trusts dispositive provisions, the client and the estate planner will need to make basic, but important, decisions concerning how the trust is to operate. For instance, a decision must be made regarding whether distributions will include (1) trust accounting income only (dividends, interest, rents, royalties, etc.), (2) a unitrust amount (a percentage of the fair market value of the trust assets, re-determined annually), or (3) both income and principal.
The greatest flexibility and potential for the trust to influence beneficiary behavior is achieved where the trustee has distributional discretion over both income and principal, but, of course, that approach may be inconsistent with the client’s desires.
Application of Funds for Beneficiary’s Benefit
For an incentive trust to operate to its potential, it will ordinarily be important to authorize the trustee to make payments or distributions to the beneficiary or directly to the providers of goods and services to the beneficiary. For example, where a beneficiary is striving to pursue a college or university undergraduate education but has had substance abuse problems, it may be appropriate for the trustee to make tuition payments directly to the college or university, rather than to direct the funds to the beneficiary, who might be tempted to pursue purposes other than higher education.
Distribution at Stated Ages
The client should determine, with the estate planner’s guidance, whether the incentive trust is to remain intact throughout the beneficiary’s life or only until the beneficiary reaches a designated age, at which time fractional shares or all of the remaining trust property will be distributed outright to the beneficiary.
Some clients will find the prospect of an incentive trust that lasts throughout the lifetime of the beneficiary appealing because the attractive attributes of the trust are extended for as long as possible; as well necessary for the beneficiary. Other clients may feel uncomfortable with retaining so-called “dead-hand” control for an indefinite time. Or they may believe that, when the beneficiary attains a given age, he or she will no longer require the motivation or protection provided by the incentive trust.
Termination upon Failure of Trust Purposes
The client and the estate planner should also consider whether to include a provision in the governing instrument of an incentive trust that could either require or permit the trustee to terminate the trust and distribute the entire trust property to, say, one or more charitable organizations if the beneficiary of the trust fails to meet performance standards for a designated period. Such a provision would recognize the trust is not serving its intended purpose and that trust assets could be deployed more productively.
Incentive trusts are growing in importance in the estate planning arena. That is in large measure because clients are increasingly sensitive to distractions that derail people from having happy and fulfilled lives.
To the extent possible, many clients want to protect their loved ones from the influence of these distractions. Incentive trusts, if thoughtfully conceived and carefully implemented, can effectively and meaningfully motivate trust beneficiaries in positive directions.
Charles A. Redd, J.D., directs Sonnenschein Nath & Rosenthal LLP’s trusts and estates practice in St. Louis, Mo. You may e-mail him at email@example.com. Mary Anne Ehlert, CFP, is president of Protected Tomorrows, Lincolnshire, Ill. She can be reached at . This is an abridged version of a presentation they gave at the MDRT annual meeting in Toronto.