Wealth is difficult to amass but easy to squander. This worries some affluent parents, so they are transferring assets to their heirs with strings attached.
With a $5 million lifetime gift tax exemption in place for 2011 and 2012, parents are transferring significant amounts to their children and grandchildren now instead of leaving it to them at death. However, parents realize that putting such wealth in the hands of their heirs could be folly if the heirs lack self-motivation, strong work ethics, financial savvy and core values. To encourage positive behavior, some parents are funding incentive trusts, which dictate whether their heirs will actually receive any of the money earmarked for them.
An incentive trust requires the beneficiary to meet certain milestones defined by the trust creator, or grantor, to receive distributions of income and principal. Typical milestones include maintaining a given grade point average while in school, graduating from college, obtaining full-time employment and becoming actively involved in philanthropy. For example, the trust may state that the trustee will make annual distributions equal to the beneficiary’s earned income.
An incentive trust can provide numerous benefits to the grantor. If structured as an irrevocable trust, it is an effective means of transferring assets and future earnings out of the grantor’s estate, thus escaping estate taxes. For many grantors, however, the tax benefits of establishing such a trust are secondary. These individuals are often attracted to its non-tax attributes, such as using the trust to establish a legacy, a way of passing on core values to younger generations. The trust can also serve as a motivational tool, encouraging beneficiaries to obtain a certain level of education or to seek gainful employment, which might not occur if the child grew up with money and developed a strong sense of entitlement.However, incentive trusts can have unintended consequences. Beneficiaries may not develop the value system the grantor was attempting to enforce through the trust. They may even adopt negative behavior to game the system. This may include doctoring college transcripts or creating fake diplomas or pay stubs to meet the distribution requirements of the trust. If the grantor does not clearly define her intentions, beneficiaries may be penalized for pursuing low-paying careers, such as becoming elementary school teachers, or for deciding to be stay-at-home parents, if trust distributions are tied to their salaries. Entrepreneurial or other professional aspirations may be crushed if trust distributions require participation in the family business, pushing beneficiaries to pursue careers in which they may have no interest.
Such ill-considered provisions can cause resentment by one or more beneficiaries toward the grantor for trying to control their lives well into adulthood. They can also cause some beneficiaries to resent their counterparts who have accomplished trust requirements necessary to receive distributions. Often, these unintended consequences are the result of trusts that are inflexible and difficult to administer.
Key Elements Of A Successful Incentive Trust
A few key elements are necessary when creating an incentive trust to increase the likelihood that it will achieve the grantor’s objectives and avoid alienating beneficiaries. The first is good communication. It is essential that the grantor communicate clearly with the trustee and beneficiaries about the objectives of the trust and her expectations for accomplishing them, thus reducing the potential for disagreements and misunderstanding.
Specificity is also imperative. If trust distributions are to be based upon a beneficiary’s earned income, the trust must define “earned income” in detail. It must also specify, for example, whether other factors can be considered for a self-employed beneficiary who minimizes net income by maximizing retirement plan contributions to reduce self-employment taxes. Otherwise, the beneficiary would be penalized for effective tax planning.
The trustee must be able to obtain the information necessary to implement the terms of the trust. For example, the trust should authorize the trustee to request a copy of the beneficiary’s income tax return directly from the Internal Revenue Service or from the accountant who prepared it, to ensure that the beneficiary has not manipulated the information that determines trust distributions.
The grantor must provide the trustee with some flexibility, so that he may adhere to her intentions as circumstances change. Even a trust with very detailed provisions will not be able to account for everything that might happen, so the trustee must be able to use discretion when the trust is silent on an issue. If the beneficiary becomes disabled and is no longer able to work, for example, the trustee should be able to make distributions to cover health care and living costs if such a provision is not listed in the trust.
Finally, the incentive trust should contain provisions that indemnify the trustee when he makes discretionary decisions that are in line with the grantor’s intentions but are counter to the beneficiaries’ desires. Otherwise, the trustee would be powerless for fear of being sued by the beneficiaries, resulting in the beneficiaries controlling the trust. This would defeat the purpose of creating it.
As parents, do we really want to dictate our children’s life choices? I certainly don’t, and I doubt that most Sentinel readers wish to, either. We hope that through effective parenting our children will learn to make good choices in adulthood. In many cases, parents create incentive trusts to encourage the development of strong money management skills, so their children do not squander what the parents have worked so hard to accumulate. If this is the primary objective, an incentive trust may be the wrong tool.
Many estate-planning attorneys dislike incentive trusts even when they are well drafted. They believe such trusts often fail to motivate beneficiaries to develop the behaviors that parents want. Further, they say that incentive trust provisions typically specify benchmarks that are unreliable in determining whether beneficiaries have met the grantors’ objectives. After all, graduating from college or maintaining full-time employment does not guarantee that someone will manage his financial affairs responsibly.
Jon Gallo, an estate-planning attorney with Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, prefers drafting “results-oriented trusts.” These focus on and reinforce desired results rather than the process by which they are achieved. Gallo; his wife, Eileen Gallo, Ph.D.; and James Grubman, Ph.D., borrowed the concept from the business management practice referred to as the Results-oriented Work Environment (ROWE). In such an environment, employees are financially rewarded based on completing a specified goal, not on the number of hours it took. This motivates valued employees and exposes underperformers. Because the model does not specify a structure or methodology that employees must use to accomplish the goal, it encourages them to develop certain skills and behavior while providing autonomy to make their own decisions.
A results-oriented trust has four main components:
- Discretion. It must be structured as a discretionary trust. It should not contain incentive provisions that link distributions to specific behaviors.
- Mission statement. The trust must contain a mission statement that details the grantor’s intent with regard to the goals to be achieved. The mission statement should also address matters such as the level of flexibility granted to the trustee, the desire to educate or otherwise prepare the beneficiary so that he may achieve the stated objective, and the handling of risks that may be encountered in developing the skills to do so.
- Guidelines. The trust should provide guidelines, but not requirements, that focus on the result of the beneficiary learning and demonstrating the desired skills. The trustee will evaluate the results in determining whether to make discretionary trust distributions.
- Communication. Similar to an incentive trust, there must be open communication about the trust’s provisions among the grantor, trustee and beneficiary. All parties must know the guidelines and how the trustee may exercise discretion when making distributions. This may include providing the beneficiary with a copy of the trust document for his review.
The results-oriented trust can be structured to focus on any goal. If the grantor is concerned about the beneficiary’s ability to make sound financial decisions, the trust can link distributions to the heir’s demonstration of money skills and nothing else. The mission statement would likely define the grantor’s values, encourage the beneficiary to seek the education necessary to develop financial knowledge, and outline the trustee’s role as mentor in preparing the beneficiary to deal with the wealth that he will receive. The guidelines would provide recommendations for acquiring core skills essential to productive money management, such as the ability to live within one’s means, to save a portion of income, to understand and manage credit and debt wisely, to maintain an adequate accounting of one’s finances, to understand how to manage assets personally or by delegating responsibly, and to generate income to cover spending in excess of trust distributions.
Such a structure provides beneficiaries with the freedom to make their own decisions regarding their careers and other life choices while developing the skills necessary to manage wealth effectively. This results-oriented concept can be used to create trusts that encourage the development of entrepreneurial abilities and philanthropic initiatives, as well.
Whether in business or in life, we are all focused on results. As long as no one is engaging in unethical behavior, we should be pleased that the goals have been attained. Therefore, you will be better served to create a trust that rewards your adult children for achieving results than to use money to control every aspect of their lives.
Shomari Hearn, CFP®, EA, is the client service manager for Palisades Hudson Financial Group LLC, in charge of its Florida practice. He is based in the firm’s Fort Lauderdale office, and regularly meets with Palisades Hudson clients across the United States and abroad. For additional information about Mr. Hearn, please see his complete bio.