Incentive Trusts

Purpose

Parents and grandparents use incentive trusts to encourage or discourage certain behavior of the trust beneficiaries by using conditional distributions from the trust as an incentive.

Description

An incentive trust is a special type of irrevocable trust that contains objective criteria designed to encourage the beneficiary to attain certain goals (in areas such as financial responsibility, education, entrepreneurship, or philanthropy) or to discourage certain behavior (such as excessive spending, indolence, or self-destructive behavior).

Examples:

• To encourage one’s child to maintain a paying job, a parent can set up a trust dictating that the child gets a matching distribution from the trust for every dollar of his or her earned income (“earn a dollar, get a dollar”).
• To encourage education for grandchildren, a grandparent can set up an incentive trust for the grandchildren’s benefit, so that a trustee only distributes funds to the grandchildren once they graduate from college.
• To discourage substance abuse problems by their children, parents can set up a trust instrument providing that distributions will be suspended if any of the beneficiary children abuse alcohol or illegal drugs.

Suitability

An incentive trust may be appropriate if you are concerned about the potential negative effects of inherited wealth on your children (or grandchildren). Unlike some trusts, which provide for outright trust distributions or discretionary distributions of trust assets to a beneficiary irrespective of personal behavior, the incentive trust is designed to encourage trust distributions based on positive behavior and to discourage trust distributions for negative behavior.

Advantages

• Creates objective criteria for distributions that can be easier for the trustee to administer (as opposed to a broader discretionary standard).
• Encourages desirable behavior/discourages undesirable behavior.
• Allows the parent who knows the children best to set the standards for distribution.

Disadvantages

• It is uncertain whether financial incentives work as intended.
• Strict standards can leave the trustees without flexibility to deal with unforeseen circumstances. For instance, if the standard is “earn a dollar, get a dollar,” what if the beneficiary becomes disabled? What if the beneficiary becomes a stay-at-home parent, or does volunteer work for a charity?
• Trying to anticipate all possibilities makes drafting the incentive provisions difficult.
• Enforcement may be difficult, for example, how would the trustee know if the beneficiary is abusing alcohol or illegal drugs? Access to financial or health records? Will there be mandatory or optional testing?

Funding

When funding an incentive trust, there are no specific assets that are more beneficial than others. The asset allocation will depend on the duration of the trust, the purpose of the trust, and the cash needs and risk tolerance of the parent or grandparent and the beneficiaries.

Bessemer’s View

Although there is much written about incentive trusts, our experience is that very few are actually put into place. A major reason for this seems to be that drafting distribution standards is difficult: Once you try to anticipate all possibilities, the standards become more and more complicated.

While we acknowledge that incentive trusts can work in certain situations, generally speaking, we believe the better approach is to give the trustee broad discretion, but with express guidance from the parent regarding the intended use of the trust funds. This gives the trustee some idea as to what the parent would do if the parent still had control, but allows the trustee to deal with unforeseen circumstances.

This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation, or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.