Wealthy grandparents and parents have learned to fear trust fund babies — and with good reason. Trust fund babies are infamous for leading pointless, consumer-oriented, slothful lives. Based on our experience during the past 25 years, roughly 80 percent of the third-generation rich do not work: and this is not necessarily a good thing. Robbed of the incentive to earn a living, heirs too often work at nothing at all; taking no risks; overcoming no challenges; creating, learning and producing little. They wind up unfulfilled, suffer from poor self-esteem and regrettably often lack integrity. But there are ways to help and motivate the children of great wealth. And ironically, one tool you can use is the trust fund itself.
A family incentive trust (FIT) allows grantors to accomplish all of the normal objectives of establishing a trust. At the same time, an incentive trust enables the grantors to convey their values and foster education, close family ties, productivity, stewardship and philanthropy in future generations of their family. For many wealthy entrepreneurial parents, particularly those who built the family's wealth, an incentive trust is an ideal solution to one of the biggest — and seldom openly discussed — challenges of wealth: the effects of wealth on future generations.
At its core, an incentive trust is a traditional discretionary trust, further defined to allow the grantor to specify behaviors of the beneficiaries the grantor wishes to influence, promote or discourage. The concept gained some notoriety at the apex of the late 1990s technology boom, and was addressed in a 1999 Wall Street Journal article1 and a 2000 presentation before the Heckerling Institute.2 But early versions of the incentive trust suffered from being insufficiently thought out and inflexible. Some of the practical problems we encountered with our first and second generation incentive trusts included providing no support for an ambitious young journalist who was offered an internship by a prestigious Manhattan publisher, and potentially awarding a professional cheerleader a 1,000 percent increase in her distributions when she developed a close relationship with a Pro Bowl running back.
Incentive trusts are not estate-planning techniques with broad mass-market appeal. Instead, they are attractive primarily to individuals who built very successful businesses (which they may still own, may have sold, or could have taken public). About 70 percent of our clients who fall within this profile have established perpetual trusts with incentive distribution provisions as the centerpiece of their estate plans. Accordingly, incentive trusts offer creative solutions to problems of great concern to these very important clients.
An attractive feature of an incentive trust is that it can be drafted to accomplish almost any goal. Because every client has unique values, the attorney drafting FITs should first ask clients to describe their goals and explain how they would like the trustees to administer the assets they plan to transfer to the incentive trust.
Of course, every parent wishes his children and succeeding generations to be productive, happy, fulfilled and well provided for. But with an incentive trust, there are specific issues to address: What sort of criteria would the parent use to determine whether a beneficiary should receive distributions? Should age be a primary consideration, or should some other factors also be considered, such as hard work, accomplishment, stewardship of family assets, charitable involvement, commitment to education, or dedication to family?
Because an incentive trust essentially serves as a surrogate parent, designed to simulate the terms on which parents would personally administer trust assets and make distributions to their children and grandchildren, an advisor must begin by gaining a broad understanding of the parents' priorities. Only with a complete understanding of the parents' goals may a lawyer translate the plan into succinct distribution guidelines.
How exactly does an incentive trust achieve its objective to help motivate beneficiaries? It not only creates certain goals that beneficiaries must attain to qualify for trust distributions, but also allows the beneficiaries to play a significant role in the administration of their trusts. Such “financial parenting”3 protects the value of the assets as surely as it fosters in succeeding generations the values of the person who originally earned those assets.
Values — of hard work, entrepreneurship, integrity, and contribution to society and philanthropy — are particularly important to what Tom Brokaw has dubbed the Greatest Generation (those raised during or soon after the Great Depression), which has reached the age at which succession planning is a necessity. This generation often finds incentive trusts appealing. Incentive trusts also are increasingly popular among younger parents — such as the high-tech and entrepreneurial millionaires — who may be mapping the future of younger children who have not yet reached adolescence.
In view of the funding considerations, a grantor typically establishes an incentive trust for the benefit of his spouse, children and future generations of his family. In our experience, most grantors view their spouse as a partner who played a critical role in the growth of the family's business, and generally provide the trustees broad discretion to distribute income and principal to the spouse. Further, grantors often do not become truly successful until their children are mature adults and some of the children may be significant participants in the success of the family's business. Thus, while the children's values and commitment to work typically differ from the grantor's, most grantors are relatively comfortable with their children's drive, ambition, productivity and work ethics. However, grantors often are concerned that their grandchildren are growing up in an environment of extraordinary privilege, where the grandchildren see relatively little connection between work and its rewards.
For these reasons, incentive trusts typically employ three different distribution strategies that evolve over the term of the trust:
Phase One — Complete discretion to distribute among beneficiaries and charities: During the lifetime of the surviving spouse, the trustees of the incentive trust typically have broad discretion to distribute income and principal of the trust among: (1) the surviving spouse; (2) children; (3) grandchildren; and (4) charities.
Phase Two — Fixed distributions to children and charities: Upon the death of the surviving spouse, the trustees of the incentive trust are typically required to distribute a fixed amount (which may be a percentage of the income generated by a business or real estate portfolio) to the grantor's children and pay the balance of the distributable net cash flow to charities designated by the grantor and the children.
Phase Three — Incentive distributions with balance to charities: During the final phase, the trustees typically pay: (1) routine expenses, such as education costs, the costs of maintaining family homes and facilities, medical expenses and special needs; (2) incentive distributions in accordance with the distribution guidelines; and (3) all remaining net cash flow to charity.
The primary governing document of an incentive trust is the trust agreement, with the family-specific guidelines incorporated by reference to exhibits — namely, a “Statement of Purpose” and “Distribution Guidelines.”
A statement of purpose sets forth the principles under which the trustees must administer the trust. Much like the tablets Moses brought down from Mount Sinai, a statement of purpose sets forth general moral and philosophical principles that are effectively set in stone and fixed for future generations. The principles are generally broad enough to provide trustees discretion in administering the trust when unforeseen circumstances arise but specific enough to truly express the parents' goals for their progeny. Although clear and irrevocable, the statement of purpose above all should reflect human values, not legal principles.
For example, a grantor's primary purpose for creating the trust may be to promote productivity, independence, responsibility, confidence, leadership, stewardship and philanthropy among his beneficiaries. To that end, his statement of purpose may require trustees to administer the trust in a manner that encourages education, recognizes achievements, promotes entrepreneurship and rewards hard work by the beneficiaries.
The distribution guidelines form perhaps the most important part of an incentive trust. These guidelines outline the incentive provisions upon which the incentive trust concept is based, and provide an overview of the circumstances under which the parents expect the trustees to distribute or withhold trust assets. Think of the distribution guidelines as a road map for administering the trust.
The initial terms of the distribution guidelines are defined by the grantor. The distribution guidelines are flexible, and may be changed from time to time consistent with the statement of purpose by unanimous vote of the trustees. In this fashion, the distribution guidelines would evolve over time, to respond to changes in the family, the business, the economy and future events.
Often, parents will require that the income generated by an incentive trust remaining after the distributions to the beneficiaries be paid to charity, which may be a family foundation. By naming a charity as a residuary beneficiary, the parents establish financial priorities for the incentive trust consistent with those of the family: basic needs are met first, incentive distributions come next, and remaining resources are devoted to philanthropy.
Parents typically wish to promote education. The distribution guidelines may direct trustees to pay for beneficiaries' education up to a specific level. Performance standards or levels of support for room and board also may be specified.
Young people often face the “Catch 22” of not being able to secure a job in their chosen profession due to lack of experience; but of course they can't gain experience without a job. Internships are often a good way to gain that experience. The distribution guidelines may provide supplemental financial support to a beneficiary who undertakes a low-paying (or uncompensated) internship. If the trust holds an interest in a family business, the distribution guidelines may be coordinated with a shareholders agreement that sets forth terms and conditions by which young family members may participate in internships within the company, to gain experience and better understand the family's business before securing additional experience outside the company.
By far, though, the most common guidelines are income-matching provisions. For adult beneficiaries, the distribution guidelines may provide for income payments based on a graduated scale. Essentially, the beneficiary's employment is evaluated to determine its social value and salary potential. The income-matching distribution to the beneficiary turns on a formula incorporating social and salary values for various types of professions, typically limited by a numerical cap. Income-matching provisions are more tailored than the guidelines for education and internships.
A beneficiary in a profession with a low salary but high moral value — a guidance counselor for children with special needs, for example — may be entitled to a trust distribution equal to three or four times his salary. A beneficiary in a high salary profession with less social value, such as a tax lawyer, may be entitled to a distribution that matches her salary, subject to the cap. Quite simply, an incentive trust set up this way would encourage beneficiaries to be productive and pursue individual goals that contribute to society or generate additional family wealth, while maintaining the standard of living to which they have become accustomed.
Distribution guidelines may authorize distributions to help beneficiaries in crisis situations, such as divorce or separation, or during periods of involuntary unemployment. The guidelines also may authorize distributions for counseling in the event of personal problems such as marital discord or substance abuse. Young beneficiaries may seek career or college counseling.
Distributions guidelines also may provide for less controversial distributions, such as payments for health insurance and unreimbursed medical expenses, support for beneficiaries with special needs, maintenance of vacation homes and other family assets. Beneficiaries who retire after reaching a specified age may be entitled to annual payments equal to the average distributions they received in recent years, increased for inflation. So, for example if a beneficiary's average annual incentive distributions over the prior five years have been $300,000, he would receive that amount each year after his retirement, adjusted upward each year by an inflation factor.
Caution should be exercised in drafting punitive provisions, those designed to discourage negative behavior such as substance abuse, by prohibiting distributions to beneficiaries who engage in such behaviors. Punitive provisions may be counter-productive, and may contribute to driving wedges into the relationships among family members as well as the relationships between the beneficiaries and the trustees. For example, a parent wishing to discourage substance abuse might be tempted to include a provision that allows or requires trustees to withhold distributions from beneficiaries known to be substance abusers. The parent also may require periodic testing or direct trustees to consult with other family members to ascertain which beneficiaries, if any, are abusing substances. Such a provision may cause a beneficiary to be more secretive about his negative behaviors, and not pursue counseling or treatment that could be helpful. Most beneficiaries would find the testing insulting, and would resent family gossip about their habits. In the long run, shaping behavior through encouragement is often much more effective than seeking to control behavior through punishment.
During these first two phases, the incentive trust may be administered by a single, independent trustee. This trustee would typically be subject to removal and replacement by the surviving spouse, and later by unanimous vote of the children.
An incentive trust agreement typically requires that additional trustees be appointed when the eldest grandchild becomes eligible for incentive distributions. This board of trustees may be comprised of the administrative trustee, one or two beneficiaries, one tax advisor (either an attorney or an accountant), and the person principally responsible for managing trust assets. If the trust provides for distributions to charity, it may be appropriate for a representative of the charity to serve on the board of trustees, perhaps in lieu of a tax advisor. Because the board would have the authority to amend, interpret and implement the distribution guidelines, grantors should think carefully about the level of voting power they wish to give the beneficiaries who serve as trustees. Appointing a representative of the charity to serve as a trustee may be an effective check and balance to the influence of the beneficiaries.
The board should meet at least quarterly, with one meeting coordinated with an annual meeting of the beneficiaries — to review trust distributions and consider revisions to the distribution guidelines. The administrative trustee should prepare a full accounting each year, circulated prior to the annual meeting for review by the board of trustees and the beneficiaries.
As with a traditional trust, the administrative trustee would perform the ministerial function of administering the trust's day-to-day affairs, such as overseeing the investment portfolio and determining daily adjustments, writing checks, and preparing accountings. The board would guide strategic planning and make broad discretionary decisions. It may be helpful to think of the board of trustees as functioning much like the board of directors of a corporation, with the beneficiaries in the role of shareholders. So, for example, the board of trustees would advise the administrative trustee regarding distributions to make to the beneficiaries pursuant to the distribution guidelines. The board of trustees would update and revise the distribution guidelines from time to time, consistent with the statement of purpose. In addition, the board would establish the long-term investment policies for the trust.
To be effective, an incentive trust must be funded with the bulk of the grantor's assets. Theoretically, the incentive trust could be funded with testamentary bequests, but the grantor's generation-skipping transfer (GST) tax exemption would be insufficient to exempt the incentive trust from GST taxes, and thus distributions to grandchildren and subsequent generations would be subject to significant GST taxes.
In our practice, the grantor typically establishes a perpetual incentive trust, makes a contribution to it, allocates a portion of his GST tax exemption to it, and reserves administrative powers that cause the incentive trust to be taxed as a “grantor” trust for income tax purposes. The grantor then sells closely held businesses or real estate interests to it, valued subject to minority and marketability discounts.
Initially, the bulk of the income generated by the family business or real estate portfolio is devoted to servicing the debt or making the annuity payments to the grantor. However, within a few years after the sales, mature family businesses and real estate portfolios typically generate sufficient income for the incentive trust to make the payments due to the grantor and distributions to its beneficiaries.
The grantor may also consider establishing a charitable lead unitrust (CLUT) as part of her estate plan. In that event, the incentive trust may be the remainder beneficiary of the CLUT's GST-exempt assets.
THE RIGHT CHOICES
One could criticize incentive trusts as ruling from the grave. But any parent who is successful in building substantial wealth will have significant influence over his children and grandchildren. The right question is: What should that influence be?
All things considered, incentive concepts in trust and estate planning are here to stay and, when executed correctly, are ideal ways for wealthy parents to influence the behavior of those who will reap the benefits of their wealth, perhaps several generations removed. Ideally, of course, young people always will make the right choices, regardless of the benefits — and temptations — associated with a trust fund.
But we don't live in an ideal world, and sometimes even the brightest kids raised carefully by parents who set a fine example need a little guidance. Today, an incentive trust is an option that wealthy parents can employ to help pass along their ideals about family values, philanthropic responsibility, and work ethics to their children and grandchildren.
- Monica Langley, “Trust Me, Baby: The House, the Money — It'll All Be Yours,” Wall Street Journal, Nov. 17, 1999 at p. A-1.
- Howard M. McCue, III, “Planning and Drafting, to Influence Behavior,” 34 Univ. of Miami Inst. on Est. Plan., 600 (2000).
- “Financial parenting” is a phrase coined by Monica Langley in her article. Langley, supra note 1.