Drafting Incentive Trusts

Transcription

1 Drafting Incentive Trusts Nancy G. Henderson Henderson, Caverly, Pum & Charney LLP San Diego, Rancho Santa Fe and Los Angeles, California Introduction Concerns about the potentially negative aspects of inheriting wealth have given rise to the concept of incentive trusts; that is, trusts designed to encourage children, grandchildren or others inheriting wealth in trust to be productive or to otherwise adopt some aspect of the settlor s value system. This is typically achieved either through the implementation of carrot and stick provisions or by providing the trustees (or other persons) broad discretion over the timing and amount of distributions from the trust, taking into consideration a potentially wide variety of factors reflective of the settlor s personal values or concerns. While incentive trusts have grown in popularity, consideration must be provided to how such trusts can be effectively administered. The success of these trusts requires clear instructions to the trustee and beneficiaries alike concerning the settlor s expectations and how those expectations are to be carried out, as well as the ability to secure the information necessary to implement the terms of the trust. While clarity and specificity in this regard will provide the trustees and beneficiaries the most guidance and, presumably, the least room for controversy, the most effective incentive trusts will likely impart a great deal of flexibility upon the trustees to achieve the settlor s goals as the circumstances affecting the beneficiaries and the trust estate evolve after the settlor s death. Finally, where appropriate, the trust agreement should contain appropriate exculpatory provisions designed to shield the trustees from liability for exercising discretionary powers contrary to the beneficiaries wishes. This Outline addresses a number of selected issues that should be considered in order to strike a reasonable balance between specificity and flexibility when drafting incentive trust provisions. I. Potential Disadvantages of Inheriting Wealth Clients often come to the estate planner with a mental short list of concerns related to the negative impact inherited wealth could have upon their children and grandchildren. These concerns often drive clients to seek advice on whether to include incentive provisions in their trusts. A. Loss of Motivation. As a general rule, people follow a simple law of physics: they take the path of least resistance to achieve their goals. If you already have access to personal 1

2 financial wealth, why get up at 5:30 in the morning to go to the office to haggle with supervisors, partners, or customers in furtherance of a business or other endeavor, the primary purpose of which is to make money? Going a step back, while in college, why study for an economics exam when you can go out with your friends or even throw a party for them? In fact, if you know you will never need to work to maintain your accustomed standard of living, why go to college at all? Why not travel in Europe for a few years in order to find yourself, and even take along a friend (or your girlfriend or boyfriend) for company? B. Lack of Self-Sufficiency. Related to a loss of motivation is a loss of personal and financial self-sufficiency. Loss of personal self-sufficiency comes from never having to take care of your own basic needs (cleaning, cooking, shopping, bookkeeping) because it is always done for you. Lack of financial self-sufficiency means, if the source of your current wealth dried up, you would be wholly unable to provide for yourself or your family. C. Overwhelming Complexity. The task of managing and maintaining substantial wealth can be overwhelming. The world of finance is complex and the rules change frequently. How should this enormous wealth be invested? How do you sort out the unique but viable planning devices from the scams? Once money has been invested, how do you know whether the funds are being managed properly? To address these complexities, most people who acquire wealth suddenly must put their faith and trust in many different people to manage their money. Some of these individuals or institutions will attempt to educate their clients to enable them to take greater control of their own wealth over time. However, many advisors will not take the time to educate their clients beyond that necessary to maintain their business, leaving the client dependent upon his or her advisors to make most financial decisions. Worse than failing to educate, many of these advisors will abuse the trust that has been placed in them. Bookkeepers embezzle money, investment advisors have hidden personal agendas, trustees engage in self-dealing, and huge sums of money can be lost in a short period of time. The pressure can be enormous and the embarrassment of misplaced trust can be personally devastating. D. Guilt. People who acquire wealth suddenly (particularly inherited wealth) often develop a deep sense of guilt over the source of their wealth. Because they did not earn the money, they often feel they do not deserve it. E. Loss of Self-Esteem. Lack of motivation and personal accomplishments, lack of personal and financial self-sufficiency, reliance upon others for one s personal and financial needs, and a sense of guilt, are the perfect recipe for low self-esteem. A lack of self-esteem leads to depression, poor judgments, and general unhappiness. F. Arrogance. A frequent external symptom of low self-esteem is arrogance. When a wealthy person s self-esteem has hit rock bottom, if he or she has any shred of self-worth remaining, it is most likely based upon material possessions and other displays of financial status. The wealthy 2

3 person with no other source of personal identity places a disproportionate value upon wealth in his or her life, and judges others on the same basis, often openly and vocally. The wealthy person may use his or her wealth as a tool to exert power and control over family members, friends, and business associates. G. Loss of True Friends and Attraction of Others to Money. An arrogant attitude will drive away friends and family with better values who will not allow themselves to be abused, insulted, or manipulated. Even for wealthy people who do not fall into the arrogance trap, old friends may be intimidated by the person s new wealth. (Is my house good enough for the wealthy person to visit? If we go out together, will I have to spend more than I can afford?) These old friends may eventually fall out of the wealthy person s life as well. Unfortunately, like air filling a vacuum, the void old friends leave behind in the wealthy person s life can be quickly filled with human parasites whose sole attraction to the wealthy person is the desire to participate in the benefits of his or her wealth. Of course, if the source of money should dry up, if a wealthier or more generous prospect comes along, or, in the case of a gold-digging spouse, if he or she has stuck around long enough to claim a reasonable piece of the pie in a divorce, they are gone. The wealthy person s lack of self-worth suffers all the more, because he or she can never be certain whether friends are friends out of true affection, or only because of his or her money. H. Spendthrift Lifestyle. Stories abound of those who acquire sudden wealth who just as suddenly spend or lose it all. It is psychologically easier to spend money that suddenly arrives on your doorstep than to spend money you have had to work hard to earn. In addition, spending extraordinary amounts of money is a symptom of low self-esteem, of an identity based upon material things, and the presence of friends who require regular demonstrations of wealth in order to stick around. I. Addictive and Self-Destructive Behavior. Temporary relief from a low self-image may come for some from the use of alcohol or addictive drugs. Addiction to such substances enhances the feeling of worthlessness, however, and the cycle continues, possibly into more overt acts of self-destruction. II. The Benefits of Inheriting Wealth While inheriting wealth can be destructive, there are also many positive aspects of leaving wealth to or for the benefit of a child, grandchild or other object of a client s bounty. If there were not, clients would simply leave their estates to charity. The following are some positive goals clients hope to achieve by passing wealth to their children, grandchildren or other persons. A. Security and Safety. Inherited wealth can provide a child or grandchild security and safety by insuring that she can maintain her accustomed lifestyle despite illness, disability, 3

4 unemployment, divorce, the death of a spouse, or, barring complete economic devastation on an international scale, the ups and downs in the economy. B. Ability to Pursue Opportunities. Wealth can insure that children and grandchildren can pursue educational opportunities and life s other advantages that are commensurate with their talents, drives and abilities. C. Pursuit of Rewarding Activities. Inherited wealth can relieve a child or grandchild from the need to perform routine or repetitive chores, such as cleaning, cooking, gardening, child or elder care, and bookkeeping, and even driving and shopping. This frees the child or grandchild to pursue more satisfying and potentially financially rewarding activities, or to develop talents, aptitudes or interests that are not necessarily lucrative. Inheriting wealth can also allow a child or grandchild to forego employment altogether to stay at home to raise children, to care for dependent adult family members who would otherwise be institutionalized, or to volunteer in his or her community. D. Ability to Help Others. Inherited wealth that provides more than enough for the current and probable future needs of a child or grandchild and his or her immediate family can allow the child or grandchild to help others who are less fortunate. In addition, such wealth provides the ability to make meaningful charitable contributions, giving the child or grandchild a sense of personal pride and community recognition. E. Influence. Wealth can provide a child or grandchild valuable influence within his or her community to accomplish important political or other civic or social objectives. III. The Goal of Incentive Trust Planning The goal of incentive trust planning for most clients is to ensure, to the extent possible, inherited wealth creates a positive rather than a negative legacy. Although each incentive trust plan is as individual as each client, family and beneficiary, the following themes carry through most incentive trusts: A. Breaking the Connection between Wealth and Loss of Motivation. A goal represented in almost every incentive trust is to break the connection between inheriting wealth and a loss of self-motivation. An incentive trust often reflects a client s expectation that the beneficiaries should not be entitled to rely upon the trust for their every want or need, and should be permitted to experience personal struggles and triumphs in order to build character and resilience. To accomplish this, access to trust funds is usually tied to a demonstration of some type of personal accomplishment, such as educational achievements, income production, or contribution to the community. B. Discouraging Unproductive Behavior. Clients frequently have a mental laundry list of unproductive behaviors that should be discouraged. Common targets are failing to work to maintain one s desired standard of living, substance abuse, repetitive failed marriages or failing to provide for one s children, spendthrift behavior, failing to pursue a college education or, conversely, remaining in school beyond that reasonably necessary to obtain an appropriate education. 4

5 C. Promotion of Specific Values. Clients may wish to promote very specific personal values, such as religious training, community involvement, or participation in a family charitable foundation. D. Financial Training. A goal of some incentive trusts is to provide financial mentorship designed to enable the beneficiary to manage wealth responsibly, to feel in control of his or her financial destiny, and to preserve inherited assets separate and apart from marital assets. E. Providing a Financial Safety Net. It is rarely the intent of the client to leave even the most unproductive and irresponsible beneficiaries out on the street. Therefore, a theme in most incentive trusts is to insure that the basic health and maintenance needs of the trust beneficiaries are met. Trust assets are also typically made available in the event of an emergency or catastrophic event that a beneficiary could not reasonably anticipate or plan for financially. IV. Are Incentive Trusts Ethical? A common objection to the concept of incentive trusts is that they are a more sophisticated (but no less distasteful) form of the dead hand ruling from the grave. This is, in fact, a correct assessment: ultimately, a person who is no longer alive will determine whether a living person will have access to wealth set aside for his or her benefit. The same can be said, however, with respect to any testamentary trust, even one that provides distributions for a beneficiary s reasonable health, education, maintenance, and support, and principal distributions in one-third increments at ages 30, 35, and 40. No advisor can reasonably argue that leaving enormous sums of money to children, grandchildren, or other beneficiaries who are unprepared for it is good planning. Unfortunately, moving the age of outright distribution from age 18 or age 21 to age 30 or age 40 does not necessarily prepare the beneficiary for the receipt of that wealth. Certainly, the best way to prepare a beneficiary for an inheritance is for the client to personally train the beneficiary, in word and deed, on matters of personal values, as well as the use and management of wealth. However, incentive trust planning is often done for beneficiaries over whom the client may otherwise have little influence. An incentive trust may be created upon the death of a client with minor children in order to insure that at least some of the client s values are conveyed to those children as they mature into adulthood. An incentive trust may provide benefits to future generations of unborn beneficiaries that the client may never meet. Even if the client s adult children are the beneficiaries, the children may have been raised by their other parent, or they may have been raised by the client, who now regrets mistakes made and hopes not to compound them by leaving a large and unrestricted inheritance to these children and their descendants. V. Specific Incentive Trusts Provisions Incentive trusts have at least two basic operative elements. The first element involves one or more financial incentives designed to encourage certain behavior in a beneficiary that the client views as positive or productive. The second element is designed to limit distributions to beneficiaries who engage in negative or unproductive behavior, or who have other problems that 5