June 2, 2015
Some of my estate plan clients are concerned not only with transmitting their estates in a tax-efficient manner, and with the protections a trust affords, but also structuring their estate plans such that the lives of their children (and, perhaps, grandchildren and more remote descendants as well) are truly enhanced when they become beneficiaries. Those estate plan clients are concerned that, if their children are in a position to receive large sums of money or assets having substantial value, they will lose their motivation to be productive and responsible citizens. Worse still, some estate plan clients are concerned their children may view a large inheritance, or the prospect of eventually receiving a large inheritance, as providing their children with the opportunity and even tacit encouragement to engage in negative tendencies and behaviors. There is, however, a device available to my estate plan clients that can go a long way in alleviating these types of fears. This device is popularly known as an “incentive trust.”
An incentive trust is a special type of trust limited in scope only by the imagination of the estate planner and the client. The incentive trust is designed to address the client’s apprehensions that large inheritances and trust distributions could harm, if not ruin, their children’s lives. The terms of an incentive trust are carefully constructed an drafted to effectively provide the Trustee the necessary discretion and parameters to make distributions to or for the benefit of the trust’s beneficiary at times and under circumstances in which the distributions would encourage or reward specific behaviors and activities my client has defined as positive, and to withhold such distributions at times and under circumstances in which the beneficiary’s receipt of such distributions would enable or encourage him or her to engage in certain defined negative or destructive behaviors or activities.
In short, an incentive trust is a trust that is designed not merely as a vehicle for investment management, funds distribution and tax savings but, additionally, as a motivational tool that promotes and encourages “good” behaviors and tendencies and discourages or even punishes “bad” behaviors and tendencies.
STATEMENT OF PURPOSE
There are a number of hallmarks of a well-designed incentive trust. The governing language of an incentive trust should contain both a general statement of purpose as well as explicit distribution guidelines. A general statement of purpose should be comprised 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, and philanthropic individuals.
A statement of purpose could make clear that occupational success is not necessarily to be measured by the amount of money earned by the child, but may also be valued with reference to the child’s dedication to the career that, while not a high paying career, contributes in a meaningful and material way to the benefit of society at large.A statement of purpose could also indicate a parent’s approval of saving and investing and disapproval of excessive and wasteful consumption and spending.
In contrast with the general statement of purpose, the actual legal directions given to the Trustee in an incentive trust should be drafted using precise language that is legally and technically sound. The specific distribution guidelines, which might be thought of as “performance standards,” should specify, as clearly as possible, those behaviors, activities, accomplishments, and failures that will result in trust distributions being made to or for or withheld from the beneficiary.
Encouraging Positive Behaviors. If a parent wants to encourage a child’s academic success, a provision might be included in the governing instrument of a trust for that child that would authorize distributions for tuition, room and board, books, fees and, perhaps, other purposes upon the child’s enrollment in an accredited, recognized and reputable secondary school, college or university and his or her actively pursuing a full-time course of study leading to graduation or to a diploma or degree. Such a provision could be further refined to require, as a condition to receiving certain distributions, that the child is maintaining or graduates with a particular grade point average.
Some type of bonus for the child might be mandated in the event the child in fact graduates or receives the diploma or degree within a specified period of years, graduates “summa cum laude” or is inducted into Phi Beta Kappa. The parent may be particularly fond of a certain educational institution or want the child to pursue a certain kind of education (e.g., an undergraduate major in History, law school, etc.). A clause in the incentive trust’s governing instrument may direct the Trustee to make specified distributions to the child if the child attends or graduates from the preferred educational institution or successfully pursues the type of education favored by the parent.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 wishes 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 amount of earnings that the child receives from employment as proven by the child’s annual Form W-2 or other appropriate documentation. A parent who is more concerned about a child’s spending habits than the child’s sloth might prefer an incentive trust provision that requires the Trustee to make distributions to the child to match the child’s annual savings rather than his or her earned income.Some parents wish to be specific in encouraging their children’s occupational choices. For example, a parent might include in the incentive trust provisions a direction to the Trustee to make a payment or payments to a child who joins the family business, works the family farm or starts his or her own business (perhaps, in this last case, directing the Trustee to match seed capital infusions that the child secures from third parties).
Alternatively, the parent might want his or her child to enter the same business or profession as did the parent, or to undertake what the parent considers a socially redeeming occupation or profession, and the incentive trust can financially reward the child for so doing. If a parent wants to steer a child into a public service occupation, such as religious work, government service, work in the Peace Corps or work for a charity, the parent’s incentive trust provisions for that child could direct the Trustee to provide a stream of periodic payments to the child to supplement his or her relatively low employment income. The trust might be structured to provide the child from time to time with funds for extra benefits that the child would not otherwise be able to afford, such as a nicer home, a new automobile, vacation travel, etc.
If a parent wishes to promote extracurricular public service, a child’s right to receive trust distributions might be explicitly tied to the child’s being able to demonstrate to the Trustee’s satisfaction that the child spends a certain number of hours each year working, without pay, for charitable organizations or doing charitable work.
A parent wanting to encourage a child’s charitable giving could include a provision in an incentive trust’s governing instrument requiring the Trustee, whenever the child makes a documented contribution to a charitable organization, to make a matching distribution (subject to certain limits) out of the trust to the same organization.
A parent may desire to influence his or her child to make certain kinds of “lifestyle” choices and can design his or her 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.b. Discouraging Negative Behaviors. Criminal activity, excessive spending and excessively generous gifts may be effectively discouraged through using an incentive trust. Trust distributions to an incentive trust beneficiary may be reduced or eliminated in cases in which the beneficiary is charged with or convicted of committing certain categories of offenses, has a lavish lifestyle that could not be maintained without support from the trust or makes large gifts to individuals or charities that he or she could not independently afford to make.
If a parent is concerned about his or her child’s possible predilection to abuse drugs or alcohol, an incentive trust’s distributions may be conditioned upon the child’s being able to prove to the Trustee, on a specified periodic basis, that the child is drug or alcohol-free. Provisions are sometimes included in incentive trusts that require beneficiaries, as a prerequisite to receiving distributions, to attend counseling sessions or to submit to periodic blood and urine tests in order to prove lack of drug and alcohol use. A beneficiary’s failure or refusal to submit to blood and urine analysis may be stated in the incentive trust provisions to be the equivalent of failure of the test. Similar provisions could be designed to induce a beneficiary to refrain from tobacco use.
An incentive trust provision might specifically direct withholding of distributions to or for a beneficiary during any period of time in which that beneficiary is actively participating in or under the influence of a cult.
Verification of a Beneficiary’s Attainment of Standards. The governing instrument of an incentive trust should explicitly recognize that the Trustee will often need to have access to records or documents produced by or in the possession of the beneficiary or third parties in order to determine whether the beneficiary has satisfied a given performance standard, Examples of such records or documents include the beneficiary’s Forms W-2, the beneficiary’s federal and state income tax returns and the results of the beneficiary’s blood and urine analysis. The instrument should state that any failure or refusal by the beneficiary to provide, or fully to cooperate with the Trustee in obtaining, such records or documents that the Trustee reasonably concludes he, she or it requires in connection with determining whether the beneficiary has met a given performance standard shall be considered the equivalent of failure to meet such standard.
INCENTIVE TRUST MECHANICAL DETAILS
Income and Principal Distributions
In structuring the incentive trust’s dispositive provisions, the client and the estate planner will need to make some rather basic, but important, decisions concerning how the trust is to operate. For instance, a decision must be made regarding whether distributions that are to be made or withheld, in the Trustee’s discretion, depending upon the beneficiary’s compliance with the trust’s prescribed performance standards, shall be distributions of:
Trust accounting income only (dividends, interest, rents, royalties, etc.)
A unitrust amount (a percentage of the fair market value of the trust assets, redetermined annually); or
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
Further, for an incentive trust to operate to its maximum positive potential, it will ordinarily be important to authorize the Trustee, when making payments or distributions that support or reward the beneficiary’s laudable behaviors, to make such payments or distributions either to the beneficiary or directly to the providers of goods and services to the beneficiary.
For example, where a beneficiary is honestly striving to pursue, say, a college or university undergraduate education but has had substance abuse problems in the past, it may be appropriate for the Trustee to have the latitude to make any tuition, as well as room and board, payments pennitted by the trust’s governing instrument directly to the college or university in which such beneficiary is enrolled rather than to put the funds to be used to make tuition and room and board payments in the hands of the beneficiary where such funds might serve as too great a temptation to pursue purposes other than higher education.
Distribution of Trust Property When Beneficiary Reaches 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 (2) a unitrust amount (a percentage of the fair market value of the trust assets, redetermined 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.
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 the enunciated performance standards for some designated period of time, e.g., five years. Such a provision would be in tacit recognition of the notion that, at some point, it should be acknowledged that the incentive trust is demonstrably not serving and cannot serve its intended purpose, so the assets of the trust may as well be deployed in an alternative productive fashion.
Application of Funds for Beneficiary’s Benefit. Further, for an incentive trust to operate to its maximum positive potential, it will ordinarily be important to authorize the Trustee, when making payments or distributions that support or reward the beneficiary’s laudable behaviors, to make such payments or distributions either to the beneficiary or directly to the providers of goods and services to the beneficiary. For example, where a beneficiary is honestly striving to pursue, say, a college or university undergraduate education but has had substance abuse problems in the past, it may be appropriate for the Trustee to have the latitude to make any tuition, as well as room and board, payments pennitted by the trust’s governing instrument directly to the college or university in which such beneficiary is enrolled rather than to put the funds to be used to make tuition and room and board payments in the hands of the beneficiary where such funds might serve as too great a temptation to pursue purposes other than higher education.
Addressing Exceptional Circumstances. Exceptional circumstances beyond the beneficiary’s control may arise from time to time that would effectively prevent the beneficiary from meeting one or more of the performance standards imposed by the trust’s governing instrument. When drafting incentive trust provisions, it should be recognized that such circumstances should not give rise to punitive actions by the Trustee. For example, an incentive trust beneficiary may, through no fault of his or her own, become disabled, and the disability may truly impede that beneficiary from being an economically productive and self-supporting member of society.
In such a case, it would be inappropriate and unfair if the trust instrument required, or even permitted, the Trustee to withhold distributions solely because the beneficiary failed to meet a full-time employment threshold for receiving distributions. To cite another example, an incentive trust beneficiary may well possess both the intelligence and the work ethic to be financially successful in the world of business but may choose to forego earning a high personal income in favor of devoting his or her talent, time and effort, for relatively low pay, in working for a social service agency or charitable organization, teaching in an urban school or serving as a member of the clergy. Most clients would probably agree that, if a child makes a choice to become and works hard to excel as a school teacher, employee of a social service agency or charity or clergy member, an incentive trust’s dispositive rules should not operate to disadvantage or punish that child for making such a laudable, selfless choice.
Precision Drafting of Standards. In the design and creation of incentive trusts, a couple of principles having paramount importance must not be overlooked. First, since so many of the concepts that are addressed when formulating performance standards are extremely subjective, it can be a daunting challenge to develop and precisely articulate objective criteria against which to measure whether the trust beneficiary is meeting a given performance standard. The person drafting an incentive trust’s dispositive provisions must respond to the challenge successfully in order to provide the Trustee with the tools to determine, in an accurate, consistent and fair manner, whether the beneficiary is or is not entitled to receive a payment or distribution.
Many examples of this dilemma could be offered, but here are just a few. What is encompassed by the term “full-time employment” or “employed on a full-time basis”? Does it mean forty hours of work each and every week for 52 weeks a year, or could a beneficiary be considered to be employed on a full-time basis if he or she consistently works forty hours per week but takes a couple of weeks’ worth of vacation in a given year? Should a beneficiary whose right to receive trust distributions depends upon not using drugs or alcohol be considered to have failed that performance standard if the beneficiary drinks a beer or two while at a sporting event with friends or takes an extra sleeping pill every now and then?
If a beneficiary marries an individual who was born into a household in which the parents belonged to a particular religious denomination, or is nominally a member of a particular religion, but hasn’t attended a service or actively participated in many years, can that individual be considered part of that denomination or religion when interpreting trust terms that condition certain distributions to the beneficiary on his or her marrying a person of a particular faith? What does it mean to be a member or subject to the influence of a “cult”? What one seemingly reasonable individual might characterize as a dangerous, fanatical sect another might view as a demanding, but true, religion. These sorts of issues, when timely recognized and addressed, are generally not insurmountable, but, if the potential pitfalls of incentive trust administration are not anticipated, and interpretive problems ensue, an incentive trust can operate in a manner that dictates unfair and surely unintended results. In such a case, it is virtually inevitable that a lengthy and expensive court battle will ensue.
Trustee Discretion. Second, for an incentive trust to operate reliably, consistently and as intended, the governing instrument must explicitly confer on the Trustee great latitude and discretion to make the judgments that must be made in the administration of an incentive trust. It must be recognized and accepted that precise drafting of objective criteria by which to evaluate and determine attainment of inherently amorphous standards, as important as such drafting is, has its limits. To enable the administration of an incentive trust to proceed as the client intended in cases in which the enunciation of objective criteria for making distributions has fallen short, it is vital that the Trustee have substantial discretion to make choices, judgments and decisions as and when circumstances arise that were unforeseen and, perhaps, unforeseeable, when the incentive trust was assembled.
In particular, the governing instrument of an incentive trust should authorize the Trustee, when determining whether the beneficiary is qualified to receive or disqualified from receiving a payment or distribution, to make the determination in his, her or its sole, absolute and unfettered discretion, the exercise of which discretion shall not be subject to challenge by the beneficiary. If the trust instrument so authorizes the Trustee, the Trustee will ordinarily be able to proceed in making distribution decisions without fear of being second-guessed by a court so long as the Trustee does not act in bad faith, fraudulently or arbitrarily. Additional governing instrument provisions that would help to ensure that a recalcitrant beneficiary cannot defeat the underlying purposes of the trust include provisions that: (1) direct indemnification of the Trustee out of trust assets and holding the Trustee harmless in connection with any and all acts or omissions undertaken in good faith; and (2) make clear the trust settlor’s intention that the Trustee’s attorney’s fees and associated expenses incurred in defending beneficiary-initiated litigation against the Trustee shall be fully paid from trust property but that the beneficiary’s attorney’s fees and expenses incurred in bringing and prosecuting an action against the Trustee shall not be paid to any extent from trust property.
COMPLEMENTARY INCENTIVE TRUST OBJECTIVES
Asset Protection. In developing incentive trust dispositive provisions, it is important for the estate planner not to lose sight of other valid and important purposes that the client may intend the trust to fulfill. For example, the client may want and expect the trust not only to motivate the beneficiary to achieve stated goals, live in accordance with a particular moral code and avoid certain behaviors but also to serve as an effective financial management vehicle by which to protect assets held in trust from potential claims of the beneficiary’s creditors and, perhaps, the beneficiary’s spouse in the event of a legal separation or a dissolution of marriage.
In a case in which an incentive trust is intended to facilitate achievement of such additional “asset protection” objectives, it would be important to design the trust’s dispositive provisions that are primarily focused on encouraging or discouraging certain behaviors so that they do not inadvertently make it easier for the beneficiary’s creditors or spouse to attach and ultimately obtain assets from the trust. One excellent way to preserve the effectiveness of an incentive trust as an “asset protection” vehicle is to include a provision in the trust’s governing instrument stating that, during any period in which the Trustee has determined that the integrity of the trust is threatened by claims of any creditor of the beneficiary or the beneficiary’s spouse, any and all standards for distribution are suspended, and, during such period, any and all distributions to or for the beneficiary shall be made, if at all, in the Trustee’s sole, absolute and unfettered discretion.
Exclusion From Beneficiary’s Taxable Estate. In addition, the client may well intend an incentive trust to be a receptacle of assets whose value will not be included in the taxable estate of the beneficiary at his or her death. Ordinarily, if the only Trustee of a non-self-settled trust is an independent Trustee and the beneficiary of the trust does not hold an overly broad power of appointment, the value of the trust assets will not be included in the beneficiary’s taxable estate.
If, however, the beneficiary of the trust is, say, a Co-Trustee and, as such, can participate in decisions to make discretionary principal distributions to himself or herself that, upon meeting certain performance standards, would be permissible for purposes broader than for his or her health, education, maintenance or support, the entire value of the trust property would be includable in the beneficiary’s taxable estate. Care must be taken in the drafting of incentive trust dispositive provisions to avoid such an unintended and potentially disastrous result.
An excellent method for helping to ensure that the value of an incentive trust’s assets will not be inadvertently includable in the beneficiary’s estate for tax purposes is to include a provision in the governing instrument which explicitly supersedes any and all contrary provisions and states that the beneficiary shall in no event participate in any decision to make principal distributions to himself or herself other than for his or her health, education, maintenance or support.
SELECTION OF INCENTIVE TRUST TRUSTEES
Among the most important features of incentive trust design is the careful selection of the initial Trustee and the successor Trustees of the trust. It is extremely important that appropriate initial and successor Trustees be designated to carry out the important, difficult and often thankless task of enforcing the performance standards built into the incentive trust. Not just anyone can do this job. Obviously, the incentive trust beneficiary, acting alone, would be a totally inappropriate Trustee. Designating the beneficiary as the sole Trustee of his or her own incentive trust would be analogous to engaging a hungry fox to guard a chicken coop with an open gate.
Depending upon the personalities and fortitude of a given family member, it may or may not be appropriate to designate that family member to serve as a Trustee of an incentive trust for, say, that family member’s sibling. In evaluating whether a family member of an incentive trust beneficiary would be an effective Trustee, the client should carefully consider whether that family member may succumb to the pleas, or threats, of the beneficiary if and when he or she fervently begs for, or demands, trust distributions.
In the final analysis, it would seem that the ideal Trustee of an incentive trust in almost all circumstances is a completely independent party. Such an independent party, generally, would be either an individual who is very strong-willed and has the highest level of integrity or a high quality, experienced institutional Trustee. Remember, however, that even the best qualified, most committed individual Trustee imaginable could become incapacitated or die before the beneficiary dies, and so the designation of excellent quality successor Trustees is quite crucial. Often a combination of an individual Co-Trustee working along with a corporate Co-Trustee works well.
A critical aspect of incentive trust Trustee selection not to be overlooked is that, beginning early in the planning process, the active input and involvement of the prospective Trustees should be solicited. The intended Trustees then have ample opportunity both to offer comments and suggestions as to how the incentive trust might operate most effectively and to indicate, at least preliminarily, whether, if called upon to act, they would accept the appointment. Much of an incentive trust’s anticipated beneficial effect may be lost if the “ideal” Trustee, when asked to step in and serve, refuses to do so.Related to the important question of who should be designated as initial Trustee and successor Trustees of an incentive trust is whether to include a provision, often seen in modem trust instruments, enabling the removal and replacement of Trustees.
Trustee removal and replacement provisions vary widely both in terms of who holds the removal and replacement powers and under what stated circumstances the removal and replacement powers may be exercised. In general, Trustee removal and replacement powers are highly desirable because they can facilitate a change of Trustees when most or all interested parties, except the incumbent Trustee, can plainly see that such a change is in order. Within the context of an incentive trust, however, a Trustee removal and replacement provision, if not carefully circumscribed, can operate to defeat entirely the purpose of the incentive trust. If the beneficiary unilaterally holds the removal and replacement powers and can exercise such powers at will, the beneficiary may be able to remove and replace Trustees successively until he or she finds the “right” person or institution who will submit to his or her pleas or demands for distributions.