Wealth is hard to accumulate but easy to squander. This worries some wealthy parents, so they are transferring assets to their heirs with conditions.

With a lifetime gift tax exemption of $5 million in effect for 2011 and 2012, parents are passing significant amounts on to their children and grandchildren now rather than leaving them at death. However, parents realize that putting that wealth in the hands of their heirs could be foolish if the heirs lack self-motivation, a strong work ethic, financial literacy, and core values. To encourage positive behavior, some parents are funding incentive trusts, which dictate whether their heirs will actually receive part of the money allotted to them.

An incentive trust requires the beneficiary to meet certain milestones defined by the trust creator, or grantor, in order to receive income and principal distributions. Typical milestones include maintaining a given grade point average while in school, graduating from college, obtaining a full-time job, and being actively involved in philanthropy. For example, the trust may provide that the trustee will make annual distributions equal to the beneficiary’s earned income.

An incentive trust can provide numerous benefits to the grantor. If structured as an irrevocable trust, it is an effective means of transferring future assets and earnings from the grantor’s estate, thus avoiding estate taxes. However, for many grantors, the tax benefits of establishing such a trust are secondary. These individuals are often drawn to their non-tax attributes, such as using the trust to establish a legacy, a way to pass on core values ​​to younger generations. The trust can also serve as a motivational tool, encouraging beneficiaries to obtain a certain level of education or seek gainful employment, which might not happen if the child grew up with money and developed a strong sense of entitlement.

However, incentive trusts can have unintended consequences. The beneficiaries may not develop the value system that the grantor was trying to impose through the trust. They may even adopt negative behavior to game the system. This may include altering college transcripts or creating fake diplomas or pay stubs to meet the distribution requirements of the trust. If the grantor does not clearly define their intentions, beneficiaries can be penalized for pursuing low-paying careers, such as becoming an elementary school teacher, or for choosing to be stay-at-home parents, if distributions from the trust are tied to their salaries. Entrepreneurial or other career aspirations can be crushed if distributions from trusts require participation in the family business, pushing beneficiaries into careers in which they may have no interest.

Such ill-considered dispositions can cause one or more beneficiaries to resent the grantor for trying to control their lives well into adulthood. They can also cause some beneficiaries to be upset with their counterparts who have met the trust requirements necessary to receive distributions. Often these unintended consequences are the result of trusts that are inflexible and difficult to manage.

Key Elements of a Successful Incentive Trust

A few key elements are needed when creating an incentive trust to increase the likelihood that it will achieve the grantor’s goals and avoid alienating beneficiaries. The first is good communication. It is essential that the grantor communicate clearly with the trustee and beneficiaries about the goals of the trust and their expectations for achieving them, thus reducing the possibility of disagreements and misunderstandings.

Specificity is also imperative. If distributions from the trust are to be based on a beneficiary’s earned income, the trust must define “earned income” in detail. You must also specify, for example, whether other factors can be considered for a self-employed beneficiary minimizing net income by maximizing retirement plan contributions to reduce self-employment taxes. Otherwise, the beneficiary would be penalized for effective tax planning.

The trustee must be able to obtain the information necessary to implement the terms of the trust. For example, the trust must authorize the trustee to request a copy of the beneficiary’s income tax return directly from the Internal Revenue Service or the accountant who prepared it, to ensure that the beneficiary has not tampered with the information that determines the distributions from the trust.

The grantor must provide some flexibility to the trustee so that they can adhere to their intentions as circumstances change. Even a trust with very detailed provisions will not be able to account for everything that might happen, so the trustee must be able to use his or her discretion when the trust is silent on an issue. If the beneficiary becomes disabled and can no longer work, for example, the trustee should be able to make distributions to cover health care and living costs if no such provision is made in the trust.

Finally, the incentive trust must contain provisions that indemnify the trustee when making discretionary decisions that are in line with the intentions of the grantor but contrary to the wishes of the beneficiaries. Otherwise, the trustee would be powerless for fear of being sued by the beneficiaries, resulting in the beneficiaries controlling the trust. This would defeat the purpose of creating it.

Result Oriented Trust

As parents, do we really want to dictate our children’s life choices? I certainly don’t, and I doubt most Sentinel readers want to either. We hope that through effective parenting, our children will learn to make good decisions in later life. In many cases, parents create incentive trusts to encourage the development of strong money management skills, so their children don’t squander what parents have worked so hard to accumulate. If this is the primary goal, an incentive trust may be the wrong tool.

Many estate planning attorneys do not like incentive trusts, even when they are well written. They believe that such trusts often fail to motivate beneficiaries to develop the behaviors that parents want. In addition, they say that incentive trust provisions typically specify unreliable benchmarks for determining whether beneficiaries have met grantors’ goals. After all, graduating from college or holding a full-time job doesn’t guarantee that someone will manage your financial affairs responsibly.

Jon Gallo, an estate planning attorney with Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, prefers to write “results-oriented trusts.” These focus on and reinforce the desired results rather than the process by which they are achieved. rooster; his wife, Eileen Gallo, Ph.D.; and James Grubman, Ph.D., borrowed the concept from the business management practice called Results-Oriented Work Environment (ROWE). In such an environment, employees are financially rewarded based on completing a specific goal, not the number of hours it took them. This motivates valuable employees and exposes underperformers. Because the model does not specify a structure or methodology that employees must use to achieve the goal, it encourages them to develop certain skills and behaviors while giving them autonomy to make their own decisions.

A results-oriented trust has four main components:

• Discretion. It should be structured as a discretionary trust. It should not contain incentive provisions that tie distributions to specific behaviors.
• Mission status. The trust must contain a mission statement that details the intent of the grantor with respect to the objectives to be achieved. The mission statement should also address matters such as the level of flexibility given to the trustee, the desire to educate or prepare the beneficiary so that they can achieve the stated goal, and the management of risks that may arise from developing the skills to do so.
• Guidelines. The trust must provide guidelines, but not requirements, that focus on the learning outcome and demonstration of desired skills by the beneficiary. The trustee will evaluate the results to determine if discretionary distributions should be made from the trust.
• Communication. Similar to an incentive trust, there must be open communication about the provisions of the trust between the grantor, the trustee, and the beneficiary. All parties should be aware of the guidelines and how the trustee can exercise discretion when making distributions. This may include providing the beneficiary with a copy of the trust document for review.

Results-oriented trust can be structured to focus on any goal. If the grantor is concerned about the beneficiary’s ability to make sound financial decisions, the trust may tie distributions to the heir’s demonstration of financial skills and nothing more. The mission statement would likely define the grantor’s values, encourage the beneficiary to pursue the education necessary to develop financial literacy, and describe the trustee’s role as a mentor in preparing the beneficiary to manage the wealth he will receive. The guidelines would provide recommendations for acquiring basic skills essential for productive money management, such as the ability to live within one’s means, save a portion of income, understand and manage credit and debt wisely, keep proper accounting of own finances, understand how to manage assets personally or by delegation responsibly, and generate income to cover expenses in excess of trust distributions.

Such a structure gives beneficiaries the freedom to make their own decisions regarding their careers and other life choices while developing the skills necessary to manage wealth effectively. This results-oriented concept can be used to create trusts that encourage the development of entrepreneurial skills and philanthropic initiatives as well.

Whether in business or in life, we are all focused on results. As long as no one engages in unethical behavior, we should be satisfied that the objectives have been achieved. So you’d be better off creating a trust that rewards your adult children for achieving results than using the money to control every aspect of their lives.