March 7, 2023
Incentive Trusts - Do They Actually Work?
“The parent who leaves his [child] enormous wealth generally deadens the talents and energies of the [child] and tempts [them] to lead a less useful and less worthy life than [they] otherwise would.” – Andrew Carnegie
Most estate plans skip the idea of using incentive distribution provisions to induce behavioral changes in the estate beneficiaries. A common estate distribution regime uses milestone ages, e.g., 25% at age 25, 50% at age 30, and the balance to be distributed at age 35. While this distribution pattern is easy to understand, some individuals still worry that the scheduled distribution of an inheritance will act as a disincentive towards work, savings, or unwittingly expose the distributed inheritance to the beneficiary’s creditor claims or loss in a future divorce.
Other individuals who worry about their estate being distributed “too much, too soon” will tend to view the distribution of their wealth on their death as an opportunity to incentivize work, force disciplined savings, or simply use a trust to protect large inheritances from attacks by creditors or former spouses. These individuals are thus more interested in using an incentive trust to distribute their wealth to their loved ones.
Incentive trusts can be used in a variety of situations to alter the behavior of a beneficiary. Common topics that are associated with an incentive trust might include: (i) to encourage educational pursuits, e.g., reward a college or advanced degree with an accelerated trust distribution; (ii) to promote industry or employment, e.g., encourage work by matching the beneficiary’s earned income with a trust distribution; (iii) to adopt religious beliefs, or to marry another who follows a specified religion, e.g., pay for a wedding or honeymoon if the spouse is of a particular faith; and (iv) to inculcate morals, family values or healthy living habits, e.g., address the abuse of drugs, alcohol, gambling, or other abusive or addictive behaviors by using trust distributions to provide treatment and rehabilitation.
Examples of various trust provisions that are used to incent specific behaviors in beneficiaries, or lifestyle changes, include:
- Direct the trustee to distribute money to pay for a wedding or accelerate distributions when a beneficiary marries;
- Direct the trustee suspend trust distributions if the beneficiary is in a divorce;
- Authorize only discretionary distributions by the trustee to prompt the beneficiary to wait to marry until the beneficiary reaches a specified age;
- Reward a beneficiary with an increased trust distribution who marries a person of a particular religious faith;
- Authorize trust distributions to charities identified by the beneficiary, or authorize distributions for the beneficiary’s philanthropic work, e.g., the beneficiary is employed by a charity;
- Authorize extraordinary distributions by the trustee to enable the beneficiary to start his or her own business, contingent upon the beneficiary furnishing the trustee with a viable business plan that the trustee deems likely to succeed; or
- Reward a beneficiary with an enhanced distribution based on the hours worked by the beneficiary for a charity.
However, problems also come with using an incentive trust and its administration.
- An income matching provision might encourage a beneficiary to seek the highest grossing employment and demonstrate productivity, but the same provision would also discourage socially beneficial work, like working as a teacher, missionary, or serve the ministry, professions that serve the community at large, or punish a parent who stays home to care for a disabled child.
- An income matching provision might discourage a beneficiary from starting his or her own business, which often results in low earnings while the business is just starting.
- A new parent beneficiary would never receive a distribution if that beneficiary chose to stay home and raise and care for children rather than become employed and obtain a matching distribution from the trust.
- An incentive trust provisions direct the trustee to only make distributions if the beneficiary is “gainfully employed.” This provision sometimes encourages the beneficiary to engage in ’gamesmanship’ to work a short time solely for the purpose of satisfying the condition to receive a distribution, then quitting employment. This type of distribution condition is also difficult for a trustee to verify, particularly if the beneficiary resides far from the trustee’s place of business.
- What kind of monitoring does an incentive trust require by the trustee? Periodic inquiries from the trustee often provoke a hostile response by the beneficiary.
- Incentive trusts often tend to be viewed by the beneficiary as punitive. Some trusts provide that if the beneficiary does not change their behaviors or the repeatedly fail to meet the conditions imposed, the trust’s income is either added to trust principal, or the income is paid instead to a charity. In some cases, if the condition is not met, then the trust terminates with its assets distributed to other beneficiaries.
- Often subjective terms are used to describe the situation, behavior, or event that is incented. The use of vague terms like necessary or appropriate are susceptible to differing interpretations that can lead to disagreements between the trustee and the beneficiary. Tensions between the two can escalate when it is necessary that the trustee and beneficiary must work well with each other for an extended period of time. Clear descriptions or examples of behaviors (good and bad) are critical for an incentive trust’s effectiveness.
- An incentive trust must also clearly spell out the consequences if a beneficiary refuses to cooperate with the trustee to determine if preconditions to an incentive distribution are met. This requires fairly negative trust provisions in order to address those situations. What happens if the beneficiary refuses to submit to a blood test? What happens if the beneficiary refuses to “go into rehab”? What happens if the beneficiary does not provide a copy of his or her income tax return to the trustee? If one consequence is that the beneficiary’s trust share passes to another family member on a failure to meet a condition, that then creates resentment among the family members, especially if a family member who acts as the trustee that makes this “forfeiture” decision.
The trustee of an incentive trust carries enormous responsibilities to manage the assets held in trust, including the duty to investigate whether the beneficiary meets the trust creator’s expectations. The trustee needs to have the capacity to be able to say ‘no’ to a beneficiary, and also the ability to challenge a beneficiary who attempts to manipulate their situation or deceive in order to apparently satisfy a condition to their distribution.
While many positives can be achieved through the use of an incentive trust, there are an equal number of drawbacks to them. Most parents and grandparents do not want to punish trust beneficiaries for circumstances beyond their control, which is why an incentive trust needs to include some flexibility for the unexpected. For example, a parent does not want to penalize a child who has a learning disability. They would rather encourage their child to get a B instead of an A. The key point is that if an incentive trust is contemplated, it is important to not over-engineer the incentive terms which can result in inflexibility for the trustee charged with administering the trust.