Despite their appeal to many clients, incentive trusts or provisions remain very underutilized. One of the key reasons for this is that they’re somewhat impractical when used with traditional types of trust administration. Rather than relying on one-stop shopping full service1 or delegated trustees2 (traditional methods of trust administration), the best incentive trusts generally require several family members and trusted family advisors to act as distribution fiduciaries, advisors and mentors.
Many families recognize that family goals aren’t the same as philanthropic goals. They also recognize that successful philanthropy can reinforce family values and strengthen a family’s legacy. Consequently, it’s important to them that philanthropy be successfully integrated into the lives of the family to promote both social and fiscal responsibility. Additionally, many families want to leave their children enough money so that they do something, but not enough so that they do nothing. These desires and goals can all be accomplished with properly structured modern directed incentive trusts.
What Are They?
Incentive trusts are typically defined as trusts with provisions to encourage or discourage certain types of behavior and promote family values. Passing values and life lessons to one’s family and others is considered the most important legacy by more than 75 percent of Baby Boomers and their parents.3 However, most people don’t even know the names of their great grandparents, let alone their values.
Many clients and advisors who are critical of incentive trusts view incentive provisions as an effort by grantors to “rule from the grave.” On the other hand, many other advisors claim that there’s little difference between incentive provisions and either distributions based on beneficiaries’ health, education, maintenance and support (HEMS) or principal distributions at various ages, for example, 25, 30 or 35. However, proponents of incentive trusts argue that HEMS and staggered age distributions are imperfect approaches to the transfer of family wealth and values. They view the transferring of large portions of an estate to family members before they’re able to handle the wealth as risky or irresponsible planning.4 Once they’re familiar with the modern directed incentive trust, training and mentoring a beneficiary is generally the preferred approach adopted by many wealthy families.
Meeting the Needs of Boomers
Baby Boomers are expected to transfer $30 trillion to their heirs (mainly Millennials) in the next 30 to 40 years.5 The Millennial generation is projected to be worth $24 trillion by 2020.6 One in three Baby Boomers would rather leave their money to charity than to their families, and 61 percent of wealthy parents aren’t confident that their children are well prepared to handle a financial inheritance.7 Additionally, only 33 percent of wealthy parents have disclosed their wealth to their children. Fifty percent plan to do this when the children are 25 to 34 years old and 25 percent when the children are at least 40 years old. Thirty-three percent of Baby Boomers believe that their children didn’t inherit their family’s commitment to giving.8 Incentive trusts can serve as a powerful mechanism for addressing many of these concerns and ensuring the stability of family wealth for generations to come. Furthermore, more wealthy Baby Boomers and their parents (partially as a result of the modern directed trust) are turning to trusts as part of their estate plans, dramatically increasing the use of trusts from 12.5 percent in 1995 to more than 40 percent today. In light of these trends, combining both the incentive trust and the modern directed trust structure can create a powerful estate-planning vehicle.9
To be successful, these incentive trusts generally need to work with a modern directed trust, which isn’t available in all states.10 These modern directed trusts allow for a distribution committee comprised of both family members and family advisors to direct the administrative trustee as to trust distributions. Consequently, the distribution committee members can act as mentors to the family to ensure that a family’s wishes, as well as its fiscal and social values, are promoted for many generations over long periods of time or even perpetually.11 The directed administrative trustee needs to be sitused in a state with a directed trust statute that allows for the direction of trust distributions from a distribution committee.12 It’s important to note that not all directed trust states allow for distributions to be directed.13 On the other hand, most directed trust statutes allow for direction from an investment committee regarding the investment management of trust assets. Additionally, a trust protector can oversee both committees.14 The protector may have the power to veto or approve trust distributions to beneficiaries. The trust protector may also be empowered to add or remove beneficiaries as well as trustees and fiduciaries. Consequently, as one advisor said, “the Protector can be seen as standing in the shoes of the Settlor for some purposes, although the Protector is not controlled by the Settlor.”15 (See “Typical Structure,” p. 11.)
As families get wealthier, many of them look to use more sophisticated trust administration structures to house the fiduciary functions of a trust, particularly the distribution committee. These structures may also include special purpose entities, trust protector companies and regulated as well as unregulated private family trust companies.16
The distribution committees of these trusts are generally comprised of both family members and advisors who are familiar with family values and consequently able to mentor other younger and future family distribution committee members and beneficiaries. The key ages for beneficiary development is generally recognized to be between 20 and 40.17 Family values can typically be promoted by either external motivation or internal motivation. Whereas the former stems from the pursuit of outward reward or the fear of reproach, the latter is born from enthusiasm, passion and genuine altruism. For many families, the goal is the promotion of family values by internal motivation. Money and material goods are external, and happiness is internal. This is a training and mentoring process for the family and family advisor distribution committee members and consultants.18
These directed incentive trusts usually work best if they have a discretionary versus a mandatory distribution standard. Sometimes, discretionary incentive distributions supplement HEMS distributions. Distributions over and above HEMS are considered tax sensitive and require an independent fiduciary to make the distribution decision.19 Nieces, nephews, brothers and sisters, in-laws, cousins, aunts, uncles and other extended family are all generally considered independent. Lawyers, CPAs, corporate trustees, etc. are also considered independent for distribution purposes. There’s also a question as to whether incentive trusts should be single pot or separate share trusts.20 This decision varies dramatically with each family. Trusts that aren’t structured based on family lines/separate shares can sometimes result in friction if one family line receives more from the single pot trust than another. On the other hand, if there’s a good reason based on the promotion of family values, this may not matter to many families.
Fiscal and Social Responsibility
There are many different ways of structuring the directed incentive trust to promote fiscal and social responsibility.21 Traditionally, many people who’ve attempted to structure incentive trusts have incorporated special trust provisions to encourage or discourage certain types of behavior. Families also draft mission statements and may even videotape and transcribe family goals and values. Additionally, a grantor may also draft a letter of wishes outlining his family values and intent. Many families look to promote external and internal motivations that can influence behavior.
Some of the more popular provisions are:
• Incentive clauses (for example, $2 of trust income for each $1 of W-2 or self-employment income)—encouraging beneficiary productivity (with some exceptions, for example, disability);
• Distribution audit to determine suitability of future distributions—cap distributions based on beneficiaries’ net worth indexed for inflation:
• Assuming that a $7.5 million net worth is enough for a beneficiary to live well, so balance of the trust should help others;22
• Supplemental income for socially responsible professions, that is, artist, musician, teacher, etc.;
• Monthly stipend for stay-at-home parent; also, adult child to care for elderly relative;
• Education costs for family in perpetuity;
• Lump sum received at college graduation and/or advanced degree(s) (depending on quality, academic rigor and college reputation);
• Monthly payments for academic excellence:
• If provision requires minimum 3.0 GPA without additional stipulations regarding courses, beneficiary may choose easier courses;
• Medical costs for family in perpetuity;
• Clause to encourage descendants to stay in marriage while their children are minors—“vest” extra in trust;
• Clause to encourage descendants to get married (wait until certain age, marry “right” person, etc.);
• On marriage, funds to purchase a home or to place down payment on a home:
• Alternatively, buy real estate within the trust for children or grandchildren, and they “use” it tax-free (operates as family time share);
• Divorce protection;
• Floating spouse clause (in-laws): define “in-law spouses” as “spouse I am married to and living with”;
• Deny trust payments unless beneficiary has prenuptial agreement;
• Beneficiary conflict clause—if beneficiary sues, he gets nothing;
• Denial of distributions if beneficiary fails drug test or refuses psychological treatment;
• Family bank: loan to beneficiary (term insurance purchased to provide repayment); and
• Denial or reduction of discretionary distributions if beneficiary doesn’t participate in family meetings about family values, charitable giving, family investments, trust distributions and estate planning and trusts.
Families need to be very cautious regarding possible constitutional and public policy limitations involving incentive provisions and trust distributions dealing with such things as religion, sexual orientation and ethnicity.23
In addition to the types of provisions listed above, many families also require that these non-charitable directed incentive trusts include provisions that either make charitable contributions directly to the charity or permit the beneficiaries to select the charities under guidelines outlined in the trust or by the trust distribution committee.24 Sometimes distributions to private foundations, donor-advised funds, community foundations and supporting foundations are permitted. Generally, if the trust distribution is made directly to the charity, the family can actively be involved with the charity, thus promoting the grantor’s desires, family values and mission statement.25 Additionally, family distribution committee members may make site visits to a charity as well as receive advice from other philanthropists and philanthropic consultants.
Some large non-charitable trusts require trust distributions be made to charity by the distribution committee once the trust reaches a certain fair market value. In other instances, if a beneficiary doesn’t meet certain trust performance standards, some of his potential trust distributions may be directed to charity. Powers of appointment are also given to beneficiaries to appoint trust funds to charities. Additionally, many types of trusts provide for a charitable gift over if no other beneficiaries exist.26
It’s important to note that Internal Revenue Code Section 642(c) permits charitable deductions for distributions made from a non-charitable trust to charity if such a distribution is specifically allowed by the trust. Also, it’s very difficult, if not impossible, to reform/modify a trust to add this provision. There’s an unlimited charitable deduction to the trust, which also shifts the net investment income to charity via IRC Section 642(c). Consequently, charitable distribution provisions are particularly important for directed incentive trusts.27
Trust Distribution Guidelines
John (now deceased) and Eileen Gallo developed a popular approach to promote family values and provide guidelines for the distribution committee regarding trust distributions.28 With this approach, the family distribution committee would make distributions to trust beneficiaries based on their ability to:
1. live within one’s means, that is, managing spending consistent with one’s level of income;
2. manage spending relative to income in a manner that would be consistent with being able to save a portion of income, as needed;
3. understand and manage credit and debt processes, leading to avoidance of excessive debt;
4. maintain reasonable accounting of one’s financial resources;
5. understand and manage one’s personal assets, either using basic investment procedures and principles oneself or delegating these actions responsibly to appropriate advisors;
6. generate income for spending needs if additional resources are required or desired beyond trust distributions;
7. show initiative, engage in entrepreneurship and demonstrate purpose in paid or unpaid work; and
8. use a portion of one’s income and/or financial resources to support charitable activities of one’s choosing.
This is a powerful approach promoting both fiscal and social responsibility, as well as family values. Many beneficiaries may require more tutelage and assistance to attain success with the above approach—consequently, beneficiary mentoring by the distribution committee may be needed.29 This mentoring may involve the following process:
• identifying and articulating learning objectives of the beneficiary;
• designing an approach that will allow the beneficiary to achieve learning objectives within a defined period of time;
• requiring trustee or fiduciary feedback (for example, from the distribution committee) as to the beneficiary’s progress towards the defined objectives; and
• establishing criteria that will evaluate the beneficiary’s success in reaching the articulated learning objectives.
The idea behind this approach is that financial education may be the most successful estate-planning tool in terms of both protecting wealth and promoting social and fiscal responsibility. This approach results in beneficiaries who are motivated, self-sufficient and, in turn, eager to help others. Consequently, ensuring that a beneficiary demonstrates the ability to develop and operate within both a monthly and annual budget as well as establish and maintain a savings account is usually of critical importance to the beneficiary’s financial and philanthropic success.
Serving on a directed trust investment committee that’s responsible for directing the investment management and monitoring of trust assets can also be a very valuable learning experience for family members. Senior family investment committee members, along with their investment consultants and advisors, can mentor younger family members regarding asset allocation, investment management and the monitoring of both financial and illiquid assets. This opportunity can provide a powerful financial education for young investment committee members and beneficiaries.
Change of Situs
Many older existing trusts may change situs to a directed trust state and incorporate these desired incentive provisions via a reformation/modification30 or a decant.31 Consequently, the desire to promote fiscal and social responsibility in the family and pass on family values by using a modern directed incentive trust can be accomplished with both newly drafted trusts as well as older existing trusts, thus, answering an estate-planning need and presenting a powerful opportunity.
1. The full service, one-stop shopping trustee generally handles custody, taxes, investment management, trust administration and trust accounting. This full trustee service model, although popular in its day, has lost quite a bit of momentum since the mid-1990s with the advent of the modern directed trust and the flexibility and control it provides, particularly for wealthier clients.
2. This structure typically involves a family trustee and requires that any trustee delegating his responsibilities must conduct due diligence on whom he’s delegating to and why he believes that the delegation is prudent. The delegating trustee is generally responsible for ongoing monitoring of the co-trustees and/or fiduciaries to whom he’s delegated. The delegating trustee is able to delegate the function, but not the risk.
3. Cindy Perman, “What’s More Important to Baby Boomers Than Money,” CNBC (Feb. 8, 2012), www.cnbc.com/id/46313097; see generally, Al W. King III, “Unique and Creative Trust Planning in Uncertain Times” Western Dakota Estate Planning Council (May 2017).
4. See Nancy G. Henderson, “Managing the Benefits and Burdens of Inherited Wealth with Incentive Trusts,” Denver Estate Planning Council (January 2011).
5. Al W. King III, “Preserving Family Values by Encouraging Social and Fiscal Responsibility with Modern Trust Structures,” Allied Professionals, Orange County, Calif. (September 2017).
9. Al W. King III and Pierce H. McDowell III, “Selecting Modern Trust Structures Based on a Family’s Assets,” Trusts & Estates (August 2017), at p. 50; Al W. King III, “Selecting Modern Trust Structures Based Upon a Family’s Assets,” Boston Estate Planning Council (April 2017).
10. The directed trust is the most popular type of modern trust administration. The directed trust generally trifurcates the traditional trustee role into an investment committee, distribution committee and a directed administrative trustee. Specifically, a directed trust allows individuals who establish a trust with an administrative trustee in the directed trust state to appoint a trust advisor or investment committee, who in turn can select an outside investment advisor(s) and/or manager(s) to manage the trust’s investments. Multiple advisors may be chosen based on different asset classes/diversification. This allows a family to use and deploy Harvard or Yale endowment-type asset allocation, which they might not otherwise be able to do with most states’ delegated trust statutes, as a result of laws, risks, time and costs. Additionally, a distribution committee may be established to determine when trust distributions should be made and to direct the administrative trustee accordingly. Unlike most types of full service and delegated trust administration services, directed trusts aren’t available in all states. Further, some directed states don’t provide for distribution authority (that is, only investment authority). Selected directed trust statutes with both investment and distribution authority are: Alaska Stat. Section 13.36.375; Del. Code Ann. tit. 12 Section 3313; Nev. Rev. Stat. Section 163.5536; N.H. Rev. Stat. Ann. Section 564-B:8-808(b); Tex. Prop. Code Ann. Section 114.0031; Wy. Stat. Ann. Section 4-10-712 and the Uniform Directed Trust Act.
11. See Al W. King III, “Preserving Family Values by Encouraging Social and Fiscal Responsibility with Modern Trust Structures," Purposeful Planning Institute—Fusion Collaboration, Broomfield, Colo. (July 2016); Al W. King III, “The Next Tsunami—Charitable Giving with Non-Charitable Trusts,” Boston Estate Planning Council (May 2016); Al W. King III, “Drafting Modern Trusts,” Trusts & Estates (December 2015), at p. 12.
12. See supra note 10.
14. A trust protector is generally an individual (though a committee of individuals or an entity may serve) with specified powers over the trust. The typical purpose of a trust protector is to provide flexibility to an irrevocable trust. Common trust protector powers include the power to: remove or to replace trustees; veto or direct trust distributions; add or remove beneficiaries; change situs and the governing law of the trust; approve, veto or direct investment decisions; consent to exercise power of appointment; amend the trust as to the administrative and dispositive provisions; approve trustee accounts; add a grantor as a beneficiary from a class of beneficiaries; and terminate the trust. Trust protector statutes vary by state. Some state statutes simply reference the position, while other states also list the powers that may be exercised. Advisors also draft the trust protector functions into trust documents even in states without specific statutes; however, this may not be as strong as drafting trust protector functions pursuant to a specific statute. Ideally, the trust would be sitused in a modern trust jurisdiction to benefit not only from the broad trust protector statutes, but also from the state’s other powerful asset protection, privacy, tax and trust laws.
15. Beth D. Tractenberg, “NEXT GEN: Motivating Children of Means,” Familia Americas Edition, http://familia-americas.com/next-gen-motivating-children-of-means/.
16. Al W. King III, “Drafting Modern Trusts,” Trusts & Estates (December 2015), at p. 12; Al W. King III, “The Private Family Trust Company and Powerful Alternatives,” Trusts & Estates (February 2016), at p. 9.
17. See supra note 11.
19. Typically, a distribution standard that isn’t limited to an ascertainable standard (for example, health, eduction, maintenance and support) is deemed tax sensitive. For tax-sensitive distributions, the fiduciary needs to be a person who isn’t related or subordinate to the grantor or adverse, as defined in IRC Section 672(c). An individual is related to the settlor within the meaning of IRC Section 672(c) if the individual is a brother, sister, spouse, parent, child, grandchild, great grandchild or any person to whom the settlor sends a W-2. See Mark Merric, “Who Can Be Trustee,” LISI Estate Planning Newsletter #1414 (Feb. 8, 2009); Mark Merric, “Who Can Be Trustee II,” LISI Estate Planning Newsletter #1444 (April 13, 2009).
20. A single pot trust is typically referred to as a trust in which all trust assets are held equally for the benefit of each named beneficiary. In addition, a trust instrument may separate each beneficiary’s portion of the trust assets into individual sub-trusts. The sub-trusts create a separate trust for each beneficiary under the main trust instrument, and each sub-trust can have separate investment and distribution advisors, trust protectors, etc. as well as tax identification numbers. Sub-trusts may be useful for certain families, however, they typically have a higher cost of administration when compared to a pot trust.
21. See supra note 11.
22. Robert Frank, “Millionaires Need $7.5 Million to Feel Wealthy,” The Wall Street Journal (March 14, 2011).
23. Advisors drafting such provisions should take caution. Potential constitutional issues may exist as well as state public policy issues, which vary from state to state, for example, see Gordon v. Gordon, 124 N.E.2d 228 (Mass. 1955) (court upheld a provision in a trust revoking a gift to children if they marry outside the Jewish faith) compared with Maddox v. Maddox’s Adm’r, 52 Va. (11 Gratt.) 804, 814 (1854) (holding that provisions requiring that a beneficiary “be a member of any religious sect or denomination” to receive a bequest violated public policy); See generally Roy M. Adams, “Racial and Religious Discrimination in Charitable Trusts: A Current Analysis of Constitutional and Trust Law Solutions, 25 Clev. St. L. Rev. 1 (1976); Aaron H. Kaplan, “The ‘Jewish Clause’ and Public Policy: Preserving the Testamentary Right to Oppose Religious Intermarriage,” 8 Geo. J.L. Pub. Pol’y 295 (Winter 2010); Katheryn F. Voyer, “Continuing the Trend Toward Equality: The Eradication of Racially and Sexually Discriminatory Provisions in Private Trusts,” 7 Wm. & Mary Bill Rts. J. 943 (1999).
24. See supra note 11.
28. See Jon Gallo and Eileen Gallo, “Use and Abuse of Incentive Trusts,” Heckerling Institute on Estate Planning (2011).
29. Professor Victoria J. Haneman, Concordia University School of Law, “Incorporation of Outcome-Based Learning Approaches into the Design of (Incentive) Trusts,” 61 S.D. L. Rev. 404 (2016).
30. The ability to modify/reform an irrevocable trust can generally be inserted into a trust document at its creation. Reformations/modifications may also take place without language in the trust document, if state law permits; for example, Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming provide for such. Reformations and modifications are generally easiest when both the grantor and the beneficiaries are alive and all agree with the reformation/modification.
31. Decanting is the process of appointing trust property from one trust in favor of another trust. Some trusts provide the trustees the power to decant in a trust document. Also, some states have enacted decanting statutes that allow for such power without it being inserted in the trust document; see for example, Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.