Trusts & Estates
Wealth Advisory & Planning
March 27, 2023
Incentive Trust Provisions in Estate Planning: Financially Encouraging or Discouraging Beneficiary Behavior
One estate planning approach is the use of what are known as incentive trust provisions that financially encourage or discourage beneficiary behaviors or promote a general philosophy of life. The primary goal of an incentive trust provision is to draft meaningful but flexible provisions as a way of protecting values into the future while allowing heirs the freedom to build their own lives. While the concept has appeal, such provisions are not effective in all cases.
Defining Incentive Trust Provisions
Irrevocable trusts often are used to address pivotal estate planning issues including minimizing intergenerational wealth reduction through taxes and addressing creditors and spendthrift behavior. Distributions to beneficiaries can be mandatory (e.g., the trust automatically pays out income or a percentage of the principal upon attaining a certain age) or designed to be made in the discretion of the trustee. Incentive trust provisions are an additional layer meant to encourage or discourage certain behaviors by conditioning distributions on the beneficiary meeting certain criteria.
The appeal of incentive provisions is the perception that they provide something parents aspire to, but few believe possible, that is, distribution gate keeping that encourages responsible behavior by future generations and minimizes a sense of entitlement to luxuries without a beneficiary having to work for them.
Incentive provisions provide a means for a settlor to instill in beneficiaries a set of values, foster financial education and productivity, and help safeguard against scenarios where wealth could lead to unintended or negative outcomes.
Most Common Incentive Provisions
Incentive provisions generally fall into one of three broad categories that: 1) encourage beneficiaries to pursue education, 2) encourage beneficiaries to pursue a productive career; or 3) reflect the settlor’s values.
Incentive provisions may be constrained only by the goals of the settlor, the creativity of the drafting attorney and legalities. As to legalities, there are few limitations; simply, provisions cannot require a beneficiary to commit a criminal or civil violation or go against public policy.
Provisions may reward a beneficiary for successfully completing each year of college, with an additional award bestowed at graduation. The settlor should clearly define the meaning of terms such as “successful” and “graduation.” Provisions may also provide for graduate school, living expenses during college and smaller luxuries such as a study-abroad program. Similarly, the settlor may want to limit beneficiary spending on education to preserve assets for future generations. For example, an incentive provision may include language limiting the amount spent on education to an amount equal to the room, board and tuition of a state university.
Income and Employment
Trust distributions can be linked to earned income, such that distributions for the year may total one, two or three times a beneficiary’s earned income from employment (often these include a cap, such as matching income each year up to $100,000). Further, language may indicate that distributions are only to supplement, not replace, employment income. Certainly, specificity is required: The settlor must define income and verify employment through, for example, the beneficiary’s W-2, pay stubs or tax return.
Additionally, a settlor may elect to include incentive provisions for beneficiaries with a religious vocation or lower-wage career that benefits society. For example, language could be included to provide for supplemental distributions, extending sufficient financial security to such beneficiaries. These can be structured to provide that the trust distribution will equal the difference between what the beneficiary earns and a stated dollar amount (e.g., $100,000).
House Purchase and Starting a Business
Settlors can include provisions to match a beneficiary’s down payment on either a home or a business enterprise. These provisions could enable the trustee to make the down payment on a (first) home or business, or provide the initial capital to launch a business. In addition, a provision may require the beneficiary to submit a business plan to the trustees prior to any distribution.
Incentive provisions can encourage philanthropic activities. As with other items, the incentive provision may allow for the matching of charitable contributions made by the beneficiary. Or the trust may allow a beneficiary to direct a certain dollar amount or percentage of trust principal for charitable contributions. Finally, a beneficiary can identify a charity to receive some or all the remainder of the trust upon the beneficiary’s death.
An incentive provision can include a caveat that will automatically redirect distributions from a beneficiary with an addiction or substance abuse issue to a care provider or facility, or the provisions pause all distributions to a beneficiary battling substance abuse. However, because substance abuse provisions are difficult to administer, many professional trustees have adopted a policy to not serve over such trusts.
Incentive Provision Drawbacks
The concept of incentive trust provisions is appealing, but their use often is problematic and ineffective. With changing times and social norms, incentives can become outdated and nonsensical in the years after creation. Settlors simply cannot account for all potential eventualities or circumstances.
Incentive trust structures are often inflexible. Rigid standards of behavior to be demonstrated or avoided can have the unintended effect of preventing trustees from adapting trust administration in the face of unforeseen developments.
Experience demonstrates that incentive provisions relating to education and income matching have little correlation with teaching responsible money management. In other circumstances, such a provision can reinforce behavior counter to meaningful societal goals and a beneficiary’s calling in life. For example, a trust provision matching the amount of income earned by the beneficiary may discourage that person from seeking work in a socially valuable but relatively low-paying occupation or perhaps from opting to be a stay-at-home parent. Also, future beneficiaries may be uninterested or unable to attend a traditional four-year college or work at gainful employment due to physical or mental challenges.
Incentive monies can be an ineffective tool in developing the very behaviors incentive trusts seek to encourage in beneficiaries. Some critics suggest that incentive trusts train beneficiaries to do the right thing for the wrong reason, making money a central factor in all the beneficiary’s decisions.
Incentive provisions can be difficult on the trustee. In some circumstances, the provisions can be hard to monitor. For example, imagine if a potential trust required the trustee to ensure that the beneficiary did not have any tattoos or body piercings before making a distribution. In other circumstances, the provisions can raise the risk of litigation by a disgruntled beneficiary. This could lead to the intended trustee refusing to serve, thwarting the settlor’s intended appointment.
Best Practices When Drafting Incentive Provisions
Settlors should keep in mind that a trust may last for generations. In our experience, a well-selected trustee empowered with full discretionary distribution power and capable of serving for a long time is ideal. In some cases, the trust structure can be improved through an added layer via the use of a trust protector or trust advisor. If incentive provisions are desired, we recommend drafting them to allow for flexibility. Here are five recommendations.
- Establish incentive provisions that are guidelines or suggestions but are not binding. For example, a provision that suggests that the trustee consider a discretionary distribution upon the beneficiary graduating from college, starting a business or buying a first home. This is particularly important because modern planning often employs multigenerational trusts which cannot be amended or revoked.
- Incentive provisions should factor in adjustments for inflation and cost-of-living changes. The purchasing power of specified dollar amounts decreases over time due to inflation.
- Settlors of long-term trusts should consider including a limited power of appointment that can be used to allow a beneficiary to modify the plan for future generations to reflect changes in circumstances and intentions.
- A settlor may be unknown to future generations of beneficiaries, such as in the case of dynasty trusts. It can be useful for the settlor to provide guidance within the trust (or nonbinding guidance in a contemporaneously executed side letter) on the settlor’s intent.
- Precision helps provide for more effective incentive provisions. Broad-based statements such as “I want good grandchildren” do little to further the settlor’s goals. Clearly define metrics when a distribution is based on an education or earned income incentive. For example, an incentive to pay a monthly stipend while attending a full-time college student could lead to a never-ending career as a student. This can be prevented with a more specific incentive, such as a specified monthly amount based on fulltime attendance at an accredited institution and maintaining a “B” average while in pursuit of the first bachelor’s, master’s, doctoral, law or medical degree and being on-track to graduate within a reasonable period.
An educated beneficiary typically makes for a better beneficiary. This includes a grasp of the nature and purpose of the trust, as well as the composition of assets and the distribution power vested in the trustee. A capable trustee will be attuned to this understanding, and a key component in creating and implementing an effective incentive trust structure is communication. Our experienced Wealth Planning team is available to discuss your goals and any interest in incentive trust provisions. Additionally, we recommend a thorough discussion with the estate-planning attorney chosen to draft the trust.
This material provides information of possible interest to Glenmede Trust Company clients and friends and is not intended as investment, tax or legal advice. Any opinions, recommendations, expectations and/or projections expressed herein may change after the date of publication. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Clients are encouraged to discuss any matter discussed herein with their tax advisor, attorney or Glenmede Relationship Manager.