Drafting Incentive Trusts Nancy G. Henderson Nancy G. Henderson is a Founding Partner, co-managing Partner and the Chair of the Estate Planning Practice Group of Henderson, Cavalry, and Puma & Charny LLP. Ms. Henderson is a fellow of the American College of Trust and Estate Counsel (ACTEC), where she has served on the Program Committee. She is also a Certified Specialist in Estate Planning, Probate and Trust Law (California State Bar Board of Legal Specialization), and presently serves of the California State Bar Estate Planning Law Advisory Commission, which is responsible for writing and grading the legal specialist exam in Estate Planning, Probate and Trust Law. Ms. Henderson is listed in Southern California Super Lawyers San Diego (2008-2015) and was named by Worth Magazine as one of the nation s Top 100 Attorneys (2008-2009). From 1996 through 1999, Ms. Henderson served as a member of the Executive Committee of of the Taxation Section of the California State Bar. 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. 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: 32 ALI CLE Estate Planning Course Materials Journal April 2016
Incentive Trusts 33 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. 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. II. 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
34 ALI CLE Estate Planning Course Materials Journal April 2016 negative or unproductive behavior, or who have other problems that might be compounded by large trust distributions. Some incentive trusts have a further element that is designed to teach beneficiaries how to plan for or manage wealth. A fourth element of an incentive trust may be a charitable pour over ; that is, the distribution to charity of excess annual income or the portion of the trust s value in excess of a certain wealth ceiling. While the possibilities are literally endless, the following are some incentives that have been important to the author s clients from time to time: A. Incentives for Attaining Educational Goals An educational incentive provision may be far more specific than simply rewarding a beneficiary for enrolling in a college or university or obtaining a degree. Certain grade point averages might be mandated, certain types of curricula might be encouraged or discouraged, or benefits might be limited to enrolling in certain types of colleges or universities (or even the client s alma mater). In some cases, a more effective incentive trust provision with regard to education may simply be to permit beneficiaries with certain levels of educational attainment, whenever ultimately achieved, to be entitled to great distributions from the trust, to hold lifetime powers of withdrawal (such as 5-or-5 powers), to possess powers of appointment, or to have more control over the administration of the trust either by holding the power to choose Trustees or to serve as a Trustee. Some Tricks and Traps: In drafting education incentive provisions, it is important that both the client and the drafter consider carefully: (i) how to discourage professional students, that is, the decision by a beneficiary to stay in school as long as possible in order to avoid the need to be financially self-supporting; (ii) whether merely enrolling in a college program without any requirement of performance encourages beneficiaries to do the bare minimum necessary to keep the money flowing; (iii) whether an academic performance standard, if any, gives due consideration for the comparative rigors of one curriculum over another (pottery making vs. pre-med or engineering) or the quality of the educational institution; (iv) whether adequate provision has been made for those beneficiaries who simply are not college material (perhaps due to a mental or physical disability), but who pursue an education that is commensurate with their goals and abilities, or, alternatively, those beneficiaries who pursue a different type of training (such as vocational school) appropriate for their career goals; and (v) where dollar amounts are used to establish a reward system, the appropriate adjustment to those dollar amounts so that they remain meaningful despite changes in the cost of living. Comment on Continuing Education: An adult beneficiary may wish to go back to school to enhance an important skill or to develop an area of professional expertise. Some incentive trusts therefore authorize the trustee to pay for an educational sabbatical to allow an adult beneficiary to take time off from his or her normal employment to pursue a worthwhile educational goal.
Incentive Trusts 35 Trusts that permit or encourage educational sabbaticals of this nature usually limit the number of sabbaticals that can be taken within a given time frame (such as once every ten years), as well as the length of a sabbatical. B. Income Matching A close runner up in the popularity contest in incentive trust drafting is the income matching provision. This provision requires or authorizes the trustee to make distributions to a beneficiary in an amount which matches the beneficiary s earned income, in whole or part, often subject to a cap on total distributions. Some Tricks and Traps: As straightforward as the concept may sound, income matching provisions are difficult to draft. A well drafted provision must address numerous variables and practical problems, and the final product can and should differ based upon each client s specific objectives. Just a few of the drafting issues are set forth below: 1. How is Earned Income Defined? Not all beneficiaries will be employees who receive W-2 forms by January 31, enabling the trustee to make a full matching distribution within 65- days after the end of the calendar year. 1 Beneficiaries may be self-employed or members of a partnership, or they may assist a spouse in his or her business, but not take a substantial salary from the business in order to minimize self-employment taxes. A beneficiary who was gainfully employed may be temporarily disabled and receiving disability insurance payments as a substitute for wages. Does the trust s definition of earned income adequately address these types of situations? 2. Adjustments on Tax Returns. Frequently, income matching provisions look to amounts reported on the beneficiary s tax returns to determine the proper distribution. If tax returns are the basis upon which earned income will be determined, what happens when the return is audited and the amount of earned income is increased or decreased? 3. What About the Spouse s Income? Should earned income include the income of the beneficiary s spouse, particularly if the beneficiary chooses to stay home to care for children or dependent adults? 4. Does the Provision Reflect the Client s Values? Will the earned income provision reward the beneficiary who is a successful stock broker or a sports superstar over the beneficiary who is an award winning educator? What about the beneficiary who has an unusual windfall in a given year (such as a one-time bonus or commission, or the receipt or exercise of stock options)? Is matching this windfall what the client had in mind? 1 This is the time period after the end of a calendar year during which income distributions can be made from a trust and still be treated as having been made in the prior calendar year for fiduciary income tax purposes. See Internal Revenue Code 663(b).
36 ALI CLE Estate Planning Course Materials Journal April 2016 5. Penalizing Disabled Beneficiaries. While it is admirable to encourage financial self-sufficiency, due consideration should be given to the possibility that some beneficiaries may be unable to produce substantial income, or any income for that matter, because of mental or physical disability, or perhaps because he or she must tend to a disabled spouse or other family member. C. Provisions Related to Marriage and Family 1. Provisions Related to Marriage. Marriage provisions are by nature touchy. The simplest and least controversial is a provision authorizing the trustee to pay for wedding or honeymoon expenses provided the beneficiary is of at least a certain age. An additional wedding present might be provided to a beneficiary who waits even longer to marry, for living separately from his or her fiancé prior to marriage, or for marrying within certain parameters. Provisions that encourage a beneficiary to marry within a particular religion or ethnic group should be thought through carefully, however, as they may violate public policy, which would be void. Marriage related provisions may also be designed to encourage a married couple to weather the inevitable storms and to stay together, such as by providing both the family member spouse and the in-law a gift upon certain anniversaries. Other provisions might provide regular payments to a spouse, or survivorship benefits if the beneficiary predeceases his or her spouse. Most such provisions terminate upon the cessation of the marriage. Tricks and Traps: When a trust provides benefits to a spouse of a beneficiary, and if those benefits will terminate if the individual ceases to be the beneficiary s spouse, care needs to be taken to insure that the right people are disinherited for the right reasons. Requiring the couple not be divorced will not address spouses who live separately but who are not yet divorced, or who may never actually divorce for religious, family, tax, or other reasons. If the test is married and living together as husband and wife, there is a risk of disinheriting the spouse who does not live with the beneficiary because one of them is in a nursing home or because one of them must live elsewhere for business, educational or other reasons. One also needs to consider alternative relationships and whether to include domestic partners or other forms of same gender committed relationships within the definition of a spouse unless and until there is universal acceptance of same-sex marriages such that it is a choice that can be made without undue burden on the couple. 2. Requiring Estate Planning or a Prenuptial Agreement. Some clients attempt to twist a beneficiary s arm into doing personal estate or pre-marital planning by withholding benefits until proof of such planning is provided to the trustee. Of course, almost any planning done by the beneficiary in order to obtain a distribution can be undone by the beneficiary after the distribution. Therefore, if the client s goal is asset protection, the better approach is to keep a beneficiary s inheritance in trust and only make consumable distributions. On the other hand, if the client s goal is to encourage good planning in whatever manner the beneficiary