Creating Incentive Trusts To Foster Beneficiary Legacies Without Spoiling The Kids

Author: David Haughton, JD, CPWA®

Guest Contributor

David Haughton, JD, CPWA® is Senior Corporate Counsel at Wealth.com, the industry’s leading end-to-end estate planning platform designed for advisors and their clients. Before joining Wealth.com, David acted as Team Lead, Advanced Planning at Commonwealth Financial Network®, Member FINRA/SIPC. He is a graduate of UMass Amherst and earned his JD at the Massachusetts School of Law. He is admitted to the Massachusetts and New Hampshire bar, as well as the U.S. District Court, District of Massachusetts, and the U.S. District Court, Court of New Hampshire. He is also a Certified Private Wealth Advisor® practitioner.

Read more of David’s articles here.

Growing up, I used to play basketball in my driveway every day. I'd pretend I was my favorite NBA superstar and practice until night fell. However, each spring, my home would need a significant amount of mulch to be spread, requiring a heaping delivery of many cubic yards of mulch. My parents expected me to spread that mulch. So how did my dad motivate me to do so in a timely fashion? He would request mulch be delivered directly under the basketball hoop. Why? Because then I couldn't play until it was all spread. There was no amount of waiting that would have moved that mulch. If I wanted to keep practicing, I would need to spread all the mulch.

Often, estate plans are prepared with the primary purpose of passing wealth to the next generation in the most efficient way possible. Financial planners are often focused on concepts such as tax mitigation and probate avoidance. However, they don't always think of beneficiaries who receive a windfall. And what happens with those beneficiaries when they do?

Studies have estimated that 70% of family wealth may be lost by the second generation and as much as 90% by the 3rd generation. This dissipation of wealth over generations is an issue that isn't always addressed through trust planning, as beneficiaries often receive their inheritances in a manner that permits them to spend the assets freely without much constraint. As the Great Wealth Transfer progresses, advisors feel the collateral damage of this dissipation as a client's family wealth disappears.

Taking from the world of psychology and the incentive theory of motivation, clients may be able to use their estate plan to encourage their beneficiaries to engage in productive and positive behaviors. Much like a parent motivating their child to spread mulch, estate plans can offer tremendous flexibility for a client to include provisions that help incentivize the beneficiary into being a productive member of society (or disincentivize them from not being so). Sometimes referred to as an "incentive trust", clients can use these estate planning tools to encourage beneficiaries to engage in specific activities or behaviors or to adhere to certain values.

How Wealth Is Typically Distributed And When It Can Inhibit A Beneficiary's Motivation For Personal Development

Clients leave assets to the next generation in a variety of ways. Clients typically know who they want to leave assets to, but avoiding taxes and ensuring privacy and efficiency often dominate the planning discussion. Therefore, the decision on how beneficiaries inherit assets may not get the level of attention it deserves.

Outright Distribution

The most common way that clients are likely to leave their assets to beneficiaries would be outright and free of trust. This means that the beneficiary will inherit the decedent's assets without any 'strings attached'. After receipt, the beneficiary may choose where to invest the inheritance, whether to commingle it with their marital assets, and how to spend the funds.

This is certainly the least protective way to distribute an estate. When a person transfers assets to a beneficiary in this manner, they are subjecting the assets to 'whatever is going on' with the beneficiary. So, if the beneficiary is immature, a spendthrift, has substance abuse issues, is going through a divorce, or has any other litany of unfortunate life circumstances going on, then the assets may be at risk of being quickly dissipated once the inheritance is integrated into the beneficiary's personal non-inherited assets.

Staggered Distribution

Another popular way to distribute an estate is to have the distribution staggered based on the lapse of time or by age. For example, a trust may state that a beneficiary is entitled to 1/3 of their inheritance at age 30, another 1/3 at age 35, and the balance at age 40.

While this method can delay the beneficiary's receipt of the assets for some period prior to distribution, upon each distribution of the staggered schedule, the beneficiary would be entitled to the assets just as if it were an outright distribution. Therefore, the various protections a trust could offer (e.g., against creditors, spendthrift behavior, or a divorce decree) would only be limited to the time periods prior to the occurrence of the distribution events.

Discretionary Trust

For clients concerned about a beneficiary controlling their own inheritance outside of the purview of a trust, a discretionary trust is a frequently utilized option. With a discretionary trust, a trustee is entrusted (no pun intended) to make distributions to the beneficiary within the discretionary standards set forth in the trust language. That standard could provide the trustee with full discretion over when and how much the beneficiary receives distributions. Alternatively, it could be tied to a standard for the trustee to follow (e.g., distributions for health, education, maintenance, and support).

A discretionary trust with a third-party trustee is likely to offer the highest level of protection for a beneficiary's inheritance. This is a major reason why irrevocable asset protection trusts need to be structured as fully discretionary trusts because they shield the trust assets from a creditor's reach. Of course, this type of distribution scheme puts a lot of pressure on the trustee to use their judgment in determining when the beneficiary should receive distributions.

Additionally, the trustee typically will not have substantial guidance on employing discretion and may instead do so in a manner consistent with their own values rather than those of the decedent. However, there may be a non-legally binding "side letter" to accompany a trust document that details the client's wishes (discussed in more detail later in this article). Therefore, clients may have the ability to integrate many of the concepts set forth in this article by expressing their desires to the trustee in a clear way (outside of the actual legally binding terms of the trust), while retaining the protections and flexibility of a discretionary trust.

Nerd Note:

 Sometimes, a trust will be drafted with the beneficiary as trustee of their own discretionary trust. The protections offered by this setup are much more limited than those offered by having a third-party trustee. It does, however, provide a convenient way to segregate inherited assets from the marital estate. It also may provide some flexibility for the beneficiary to resign as trustee or appoint a co-trustee in order to enhance protection later on, as the need arises.

Creative Tools To Incentivize Beneficiaries

What's missing from the aforementioned methods of distribution are incentives for beneficiaries to be productive members of society. Although a primary objective of clients during their lifetime may be to maximize the estate they pass on to their loved ones, it is rarely the case that they want the inheritance to demotivate a beneficiary to cease or delay their personal pursuits.

Not only are clients often concerned with the assets they pass on to the next generation, but many also want to ensure that the legacy they leave is comprised of much more than just money. It is unlikely that someone who uses inherited funds to buy something thinks, "That reminded me of Mom and Dad because they left me that money." Instead, legacy is usually related to the impressions left behind that affect how a person carries themself through life.

These impressions can be the lessons, values, and imprints left in the trail of a person's life. As such, clients may seek to ensure those lessons and values continue to be instilled long after they pass and to put provisions in their estate plan in an attempt to remind and incentivize beneficiaries to continue their legacy.

Nerd Note:

While courts generally err on the side of a decedent's wishes when it comes to enforcing trust provisions, clients should be careful not to include provisions in their trust that may be in contravention of public policy. For example (taking it to an extreme), a provision that restricts distributions to a beneficiary if they marry someone of a particular nationality, gender, or race may not withstand a legal contest by an impacted beneficiary.

Academic Achievement Provisions

An inheritance at a young age certainly could be seen to stymie a beneficiary's academic pursuits. Therefore, a potential way to motivate a beneficiary to excel academically could be to somehow require (or encourage) the trustee to tie distributions to educational performance.

For example, just as a parent may reward a child with $20 for each class grade of A and $10 for each class grade of B – a trust can act in a similar way. A trust could reward a beneficiary for advanced degrees or good grades. This runs in stark contrast to the staggered age distribution method mentioned earlier because if the distribution were merely tied to age rather than academic performance, then the beneficiary could forgo advanced education knowing that a large distribution is coming their way regardless of their behavior.

Distributions For Specific Life Events

While a trustee may have broad discretion for when to distribute to a beneficiary, detailing specific instances where a distribution is encouraged or even mandated can be a helpful strategy. Such instances could include a beneficiary's down payment on their primary residence, for their wedding, or to start a business.

Obviously, these types of event-driven distributions can come with caveats. For example, a client may want to put the word "first" in front of some events (e.g., will pay for the "first" wedding). Additionally, the client may want the trustee to have latitude in determining the advisability of certain expenditures from the trust. While a trust may direct the trustee to assist a beneficiary in starting a business, it would likely be prudent to require the beneficiary to have documentation relating to the business plan and viability of the venture for the trustee to review and verify prior to making the distribution.

Tying Distributions To A Beneficiary's Values

An interesting approach to estate planning for beneficiaries is tying distributions to the beneficiary's unique goals, dreams, or values. An inheritance can represent a wealth-changing event that opens up possibilities the beneficiary may not have seen possible under their former income situation and asset makeup. A trust can be a powerful mechanism to encourage a beneficiary to pursue their unique passions by rewarding their efforts toward fulfilling their dreams. Former Hall of Fame baseball pitcher Tom Glavine famously put provisions in his estate plan for his daughter to open a veterinary clinic after learning that she had aspirations to be a veterinarian at a very young age. This type of trust provision is going to be highly dependent on the unique beneficiary and, therefore, could require continual maintenance of the plan to make sure it keeps up with the beneficiary's individualized aspirations.

Income-Based Incentives

A common desire of clients (especially those who personally built their own wealth) is for their children to create their own wealth rather than rely on an inheritance to fund their lifestyle. This is the mindset of many high-profile celebrities and has led many such individuals to leave the bulk of their estates to charity, bypassing the children as primary inheritors. However, many clients are likely not against their children receiving the inheritance – they just don't want them to rest on their laurels; instead, they would rather their children 'earn it'.

An interesting way to incentivize a beneficiary to continue to work would be to include an "income matching" provision in the client's estate plan. This would mean that the more income the beneficiary earns, the higher the annual distribution they would be entitled to from the decedent's estate.

For example, a trust could include a provision requiring a beneficiary to submit their Form W-2 to the trustee each January. The trustee would then be directed to match the gross income earned by the beneficiary for the prior tax year. Clearly, Form W-2 is not the only evidence of earned income; such evidence may actually come from many sources, especially if the beneficiary is self-employed.

Not only could including income-based provisions be a way to incentivize the beneficiary to 'make their own way', but it also could mitigate the dissipation of estates over generations (because the beneficiary would have either increased the generational wealth in their own right through hard work or preserved the estate by not qualifying for distributions due to their lack of motivation to work).

This approach is obviously not perfect, as beneficiaries may fail to work or earn a substantial income for any number of valid reasons other than a lack of motivation. For instance, there should be a provision authorizing distributions for emergencies. Also, promoting charitable endeavors and public service can be taken into account by including provisions that change the distribution calculation if the beneficiary works for a non-profit organization or is engaged in activities that help society.

Charitable Giving

Estate plans can incentivize a beneficiary to engage in personal behavior that increases their rights to distributions while also promoting a beneficiary's philanthropic behavior. Often, clients will draft their estate plan to leave assets directly to individual charitable organizations. However, this type of distribution removes the client's beneficiaries (usually children) from the charitable giving process. To encourage beneficiaries to engage in philanthropic activity, the client could leave assets to a Donor Advised Fund (DAF) and name their children as successor grant advisors rather than leaving the assets directly to charity. With a DAF, the children would be prohibited from benefitting from a pot of money personally, but would instead be in the position to give to organizations that they deem worthy of charitable grants.

Because the DAF is typically managed by the client's advisor, this process doesn't just permit the children to engage in the charitable giving process after the death of the client; it also presents an opportunity for the advisor to have regular interactions with the children to continue the relationship with the deceased client's family.

Tools To Protect Against/Disincentivize Bad Behavior

While a client may wish to get creative to incentivize certain behaviors, the flip side may also be important – how to disincentivize the beneficiary from going down the wrong path.

Withholding Provisions

One way to protect the dissipation of estate funds from the poor life choices of the beneficiary is to include a provision authorizing the trustee to withhold distributions from the beneficiary under certain circumstances. For example, if a beneficiary is engaged in self-destructive behaviors (e.g., gambling or substance abuse) or perhaps going through certain legal issues, the trustee can be given the right to delay distribution to the beneficiary until such time that the trustee is comfortable that the beneficiary is capable of receiving the distribution without contributing to their self-destructive tendency or otherwise benefitting someone other than the beneficiary.

As identifying certain behaviors can be somewhat subjective, the trustee with the power to withhold distributions from a beneficiary can be a highly contentious position to take, which also comes with the risk of litigation. Therefore, it is prudent for the client to ensure that not only do they trust (no pun intended) the trustee's judgment in enforcing such a provision, but also that there are proper guardrails to show that the provisions are designed to be in the beneficiary's best interests.

Accordingly, the trust may require a beneficiary to show evidence that the circumstance or behavior that led to the trustee's decision to withhold distribution has been 'cleared up'. For example, there could be mandatory drug testing/treatment for those with substance abuse issues.

Additionally, if the client wishes the trustee to withhold distribution in certain specific circumstances, it is critical that the trust's language is clear and comprehensive. Let's take the example of a client who wishes to withhold distributions from a beneficiary who "commits criminal acts". Without comprehensive language specifying what constitutes committing a criminal act (e.g., only felonies for which the beneficiary was convicted), this provision could cause confusion and leave the trustee unsure of what does or does not qualify as a circumstance dictating the withholding of a distribution.

No Contest Clauses

Not only do clients often want to disincentivize bad behavior by their beneficiaries, they also want to avoid their estate being subject to frivolous litigation. A primary goal of many estate plans is ease of administration and avoidance of conflict, which can often be achieved by laying out clear wishes in the documents. However, estates are often contested by disgruntled family members for any number of reasons, such as the beneficiary feeling any of the following:

1. That the beneficiary is being treated unfairly;
2. That the documents do not reflect the decedent's wishes;
3. That a sibling or caretaker took advantage of the decedent in their old age and played too much of a role in changing the decedent's estate plan; or
4. That the beneficiary feels that the decedent was not mentally capable of signing the estate plan or did so under the pressure of someone else interested in the estate.

To try to disincentivize a beneficiary of the estate from taking action to contest the estate, a client may wish to include an in terrorem clause in their estate plan, which is also known as a 'no contest' clause. This provision states that if a beneficiary takes any legal action to contest the wishes of the grantor, then they lose their inheritance rights as provided in the decedent's estate plan.

These clauses are not always favored by courts as they tend to discourage valid legal claims by a beneficiary against an estate. However, most states do recognize such a clause as valid and enforceable (to some extent) and can represent a strong deterrent to make a beneficiary 'think twice' about contesting an estate.

Nerd Note:

Clients may take the position of wanting to completely disinherit a person as a beneficiary of their estate and to make sure that person does not contest the estate. However, a no-contest clause would not assist with this goal as the beneficiary would not be inheriting anything if the clients' estate plan was found valid and was respected, so the beneficiary has no incentive not to contest the estate. The no-contest clause is only effective to the extent the beneficiary is given any "skin in the game." In such circumstances, it can be prudent to leave the otherwise disinherited person a small amount of money from the estate. That way, the person would face the choice of taking the small inheritance from the estate or risking the receipt of nothing if they contest the estate and lose.

Trustee Selection And Discretionary Trusts

Many of the options to disincentivize a beneficiary put a burden on the trustee to review documents and exercise a high level of discretion. If a family member is chosen as trustee, some of these discretionary choices could be, at best, awkward and, at worst, contentious. Corporate or individual professional trustees, however, offer an emotionless 'follow the trustee handbook' option for beneficiary distribution decisions.

Corporate trustees are highly cognizant of their potential liability for a breach of fiduciary duty in fulfilling their duty to the beneficiary and, therefore, often systematize their exercise of discretion as much as possible. This means that if a trust states that a trustee may distribute to a beneficiary for their "health, education, maintenance, and control", the trustee will likely have a handbook that specifically defines each of those terms with examples of expenditures that will be within those definitions. While this means that the trustee is more apt to act in a predictable manner relating to distributions, they may not have had enough of a personal relationship with the client to know whether they are adhering to the internal wishes of the decedent (which is why specificity and guidance for the trustee on the parameters of the trustee's discretion is so important).

Alternatively, a personal trustee who is perhaps a family member may use discretion in a much more flexible and lenient manner that may not necessarily align with the intent of the trust.

Bringing This Back To Clients

As with most financial planning topics, advisors stand on the front lines to help guide clients to the most appropriate solutions for their unique goals. Carrying on a legacy of personal values to the next generation certainly represents a key topic to explore with clients. Although advisors themselves may not be able to draft the estate plan, they can play a vital role in uncovering how the client would like their estate plan to be structured and be a key player in the process of implementing it.

How To Introduce This Conversation To Clients

When broaching the topic of legacy, advisors should make sure to ask probing questions to determine any concerns the client has relating to their beneficiary's use of the inheritance (versus merely the most tax-efficient manner to get it to them).

For example, consider the following questions that can help the client clarify why, when, and how they want to leave money to their loved beneficiaries:

• What do you hope the beneficiary will do with the money?
• How do you feel about your beneficiary's ability to manage money?
• Do you have any reservations about the beneficiary's maturity?
• Has the beneficiary displayed any behavioral tendencies that concern you?
• Do you worry that the beneficiary will be disappointed in what they are set to receive from you?

Once the client has a better sense of their priorities, the advisor can assist the client by shepherding them through the estate planning process.

The Role Advisors Should (Or Shouldn't) Play As Trustee Or Investment Manager To The Trust

Advisors typically refrain from acting in the role of trustee or executor for a client due to regulatory scrutiny and prohibitions. However, an advisor can and should still play a key role in assisting the client to identify an appropriate fiduciary to administer their estate. There is a litany of corporate trustee options for a client to choose from in any given area to administer the trust at death. However, in identifying an appropriate partner, the client should be cognizant of the trustee's principles surrounding discretion and whether they are comfortable with the client's distribution provisions.

Additionally, the client should be aware of what role the advisor would continue to play in relation to the trust. Many (if not most) trust companies are in the business of investment management. Therefore, it may be the case that upon the transition of the trust assets to the corporate trustee, the advisor will no longer manage the funds. Certain corporate trustees, alternatively, will enter into arrangements with clients whereby the advisor may continue in their role as investment advisor.

The formality, potential liability, and constraints of this role depend on whether the trust is a "delegated trust" or a "directed trust". Basically, delegated trusts involve an arrangement where the corporate trustee hires the investment advisor and delegates authority to the investment advisor for investment responsibilities. A directed trust bifurcates the role of advisor and trustee so that the advisor may continue in their role as investment advisor with discretion, and the corporate trustee would serve in a purely administrative capacity. The availability of a directed trust arrangement will depend on state law.

Accordingly, a delegated trust arrangement is a more 'traditional' structure whereby the trustee is responsible for overseeing the investment advisor's decisions. In the directed trust model, the trustee is essentially absolved from liability for the advisor's investment decisions because they have little to no oversight responsibilities relating to investments of the trust.

Where/How To Find A Resource To Create Incentive Trusts

Identifying where a client can have an incentive trust created depends on the level of sophistication they are seeking to integrate into the language of the documents. Leveraging online resources and seeking out members of established organizations in the estate planning industry can be helpful in identifying the right attorney or software to assist a client in creating a trust. As I discussed in a previous article, there are several resources for financial advisors to find suitable estate planning professionals. Avvo.com can be helpful in identifying attorneys by region with ratings and reviews. Additionally, organizations like the American College of Trust and Estate Counsel (ACTEC) have stringent requirements for membership where competency can be reasonably inferred.

However, although many of these concepts can be 'hard coded' into a trust document to place the burden on the trust to follow the terms as specifically written, it can potentially result in added costs to administer the trust. Therefore, the client may want to consider whether a more flexible trust (like a discretionary trust) coupled with a side letter to the trustee is a better approach.

A side letter is an informal document written by the client to the trustee that accompanies their trust document. It would lay out the client's wishes regarding how the trustee should exercise their discretion and what priorities they desire the trustee to adhere to in making trust distribution decisions. A side letter could alleviate the discretionary burden on the trustee while still offering the clients a way to make their wishes known (although not as firmly legally binding).

While the letter would lack the formalities of a trust document and have questionable legal standing, it can still be seen as a helpful guide for the trustee rather than an extension of the trust document itself. If this approach is chosen, the language of the trust could be much more flexible and, therefore, require much less custom-personalized trust drafting. This, of course, can reduce the cost and time commitment for implementing a plan and increase the universe of available options for creating a trust (e.g., through the use of estate document generation software).

Estate plans are often seen as conduits to get assets from one generation to the next. However, over their lifetimes, clients build up non-monetary wealth that simply don't belong on their balance sheets. This wealth is comprised of lessons and values that they wish to pass on to future generations.

Although these aspects of a legacy are often intended to be instilled through personal interactions and anecdotes over a lifetime, clients may still want to ensure that certain values continue to be incentivized and not negatively impacted by inherited wealth. Accordingly, by broaching these subjects with the client in the initial stages of the estate planning process, advisors can play a critical role in assisting clients in making sure their legacy is preserved for generations to come.