Are you concerned about your wealth spoiling your heirs? Do you want to ensure your accumulated wealth and legacy promotes positive behavior and achievement? If you are fortunate enough to have accumulated wealth that can benefit your heirs, these are often questions that we encounter as wealth advisors.
Understanding Incentive Trusts
To address some of these concerns, incentive trusts have evolved as a powerful tool in modern estate planning. An incentive trust is a trust that controls distribution of assets based on specific conditions or behaviors met by the beneficiary. Setting up an incentive trust encourages productivity and helps your heirs understand the values you want for your children and future descendants.
Incentive trusts can promote positive behavior, such as achieving educational or career benchmarks, developing philanthropic goals, learning financial responsibility and management or maintaining sobriety. Incentive trusts also help you align your values with wealth and help ensure your legacy reflects your beliefs and desired outcomes for your family. They should be drafted by a qualified estate planning attorney in a highly tailored way to your family needs, values and goals.
As with any other irrevocable trust, you as the grantor or settlor are the person establishing the trust. The trustee has a critical role, as the trustee is the person or entity responsible for managing the trust and determining whether the conditions or behaviors of the incentive trust have been satisfied. The trustee must be diligent, impartial, and capable of making potentially difficult decisions. The beneficiaries are your heirs named in the incentive trust who may receive distributions if they have satisfied those conditions or behaviors. Though incentive trust beneficiaries may feel controlled or resentful, you should discuss these potential feelings and focus on your positive intent for setting up the incentives designed to promote your family’s long-term growth and happiness.
Types of Incentive Trust Distributions
The types of incentives you can promote are wide and varied- the only real limitation is that certain behaviors can be challenged by beneficiaries in court if they are against public policy. For example, provisions that encourage illegal acts, discrimination or actions that undermine core societal values such as promoting divorce may not be enforceable. Below are just some of the types of conditions and behaviors that incentive trusts can promote:
- Career/Income-based: Distributions matching salary earned by a beneficiary or upon reaching a certain salary or professional milestone. This is probably the most common approach and is sometimes called a “W-2 Trust” (because the beneficiaries receive distributions equal to the amount shown on the Form W-2, which is a tax form that summarizes their yearly compensation income).
- Education-based: Distributions upon a beneficiary earning a degree or graduating from college or law school/medical school/business school.
- Philanthropic: Distributions matching a beneficiary’s charitable contributions or upon a beneficiary establishing or managing private foundation.
- Marital/Family: Distributions upon a beneficiary’s marriage (but cannot promote conditions that violate public policy such as marrying within a certain race or religion) or having children.
- Behavioral: Distributions upon a beneficiary maintaining sobriety each year.
- Financial Literacy: Distributions upon a beneficiary completing personal finance courses.
Discretionary vs. Objective Conditions
An important consideration when discussing incentive trusts is determining whether conditions should be discretionary or objective. For example, behavioral provisions could include “maintaining sobriety as proven by annual drug testing”, or “maintaining a healthy lifestyle” which can be trickier to measure and very subjective. To promote financial responsibility, the incentive trust could provide distributions be made upon “completing 10 hours of personal finance courses” or “making wise financial decisions”. An incentive trust with objectively determinable conditions is easier to administer, as there is relative certainty as to when trustees can make distributions to the beneficiaries. Incentive trusts with discretionary objectives can be more flexible and account for circumstances outside the beneficiary’s control that incentive trusts with objective conditions cannot. However, the trustee will have to rely on discretion that the beneficiaries may object to, which can lead to unhappy beneficiaries, disputes and potential lawsuits against the trustee.
Guiding the Excise of Discretion
As the settlor of the trust, you could try to provide clarity and avoid such disputes by guiding the exercise of discretion. You could provide written instructions within the trust document (“precatory” language which is not binding but allows you as the settlor to express your intent) or in a writing separate from the document (a so-called “letter of wishes”). These expressions of intent may exonerate trustees that follow these instructions and help beneficiaries better understand the rationale behind the trustee’s actions, both of which can mitigate the risk of litigation.
At the end of the day, the decision as to whether to use discretionary or objective conditions probably depends on the type of behavior you are trying to incentivize and the value you are looking to promote by incentivizing that behavior. Some behaviors and conditions are inherently easier to determine and measure than others, so most incentive trusts have a mix of both objective and discretionary conditions.
Adjusting to Evolving Circumstances
You should consider whether incentivized conditions in an incentive trust may become outdated or irrelevant. Your experienced estate planning attorney should build in mechanisms for modification or give the trustee discretion to decant to a new incentive trust with updated provisions to reflect changing circumstances.
In Conclusion
Before meeting with your estate planning attorney to set up an incentive trust, you should think about the goals and values you want to instill, how to communicate the idea with your heirs and whether you have a trustworthy individual or institution to serve as trustee. Incentive trusts can help you create a meaningful and impactful legacy for your family. We are happy to discuss whether an incentive trust is right for your unique situation.
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