Family Incentive Trusts Dynamic New Approach Employing Trust Distributions to Communicate Family Values and to Promote Productivity and Performance in Beneficiaries

It is a situation that many parents and grandparents, particularly those with significant wealth, dread: the trust fund baby.  Think of Benjamin Braddock in the classic film The Graduate.  A young man just out of college, with his whole life--and his parent's money, as the film suggests--ahead of him.  Why not float around a pool all summer?  Who needs plastics, anyway?

For some children of wealth and privilege, and the parents who raise them, such a crisis of motivation can be very real--and certainly not a laughing matter as portrayed in The Graduate.  Today, many wealthy individuals are employing strategies to prevent the sort of lack of motivation sometimes found in children of wealth.  And ironically enough, the tool they use is the trust fund--the very thing that sometimes creates problems in the first place. How do they do it?  By establishing what's known as a Family Incentive Trust.

Traditional trusts accomplish three principal goals: they provide a method by which parents can administer assets for the benefit of their children and future generations of their family, save estate, gift and generation-skipping transfer ("GST") taxes, and protect assets from the claims of the creditors of the trust beneficiaries. However, many parents also want to prevent their descendants from becoming dependent on trust assets and turning into non-productive "trust fund babies".  These parents are aware that second or third generation children with access to substantial wealth often become entirely dependent on their parents' and grandparents' legacies, and contribute little, financial or otherwise, to their families or society.  Concerned that trust fund babies often display low productivity, suffer from low self-esteem and lack integrity, these parents aim to employ their wealth in a more dynamic fashion to benefit and preserve their families. Incentive trusts incorporate provisions to promote and reward productive behavior as well as accomplish the tax-saving and asset protection provisions included in traditional trusts.

Traditional trusts typically authorize a trustee to distribute trust assets irrespective of the manner in which trust beneficiaries conduct their personal affairs.  By comparison, incentive trusts are typically specifically tailored to promote the grantor's values and goals, and require that the beneficiaries adhere to the performance standards the grantor established to be entitled to distributions from the trust.

Incentive trusts are especially attractive to entrepreneurial parents who earned their wealth.  For these parents, the incentive provisions serve as a form of "financial parenting" that can be tailored to suit their individual concerns.  Entrepreneurial parents generally have a different work ethic than their children, but are typically satisfied with their children's values and ethics.  However, these parents often are concerned that their grandchildren have grown up in a very privileged environment, and as a result, the grandchildren see little direct connection between work and reward.  For these reasons, incentive trusts generally provide for fixed distributions to the children and delay implementation of the incentive provisions until the grandchildren are eligible for distributions.

Structure of Incentive Trusts

The trust agreement is the primary governing document of a family incentive trust. Parents may achieve their tax savings and asset protection goals through an incentive trust in much the same way as with a traditional trust.  The "incentive" aspects of the trust are incorporated into the agreement through cross references to family-specific exhibits. The incentive trust agreement should be structured as a perpetual "Dynasty Trust" which is fully exempt from the GST tax.  The agreement should provide for a single trust that continues in perpetuity, rather than an initial trust that divides into separate sub-trusts upon the death of a parent or upon the occurrence of some other triggering event.

The incentive trust agreement should include a Statement of Purpose and Distribution Guidelines through which the parents accomplish their goals for their family.  The incentive trust agreement must clearly require that distributions be made in furtherance of the grantor's Statement of Purpose and in accordance with the Distribution Guidelines. As with any Dynasty Trust agreement, the incentive trust agreement may provide for (i) discretionary distributions of income and principal, (ii) "unitrust" distributions equal to a percentage of the value of the trust assets, or (iii) distributions of only the income, and not the principal, of the trust. Deciding how and whether to distribute trust income and principal will depend upon the amount of assets contributed to fund the trust, the nature of the assets held by the trust and the parents' goals for their families.

The Statement of Purpose should include the guiding principles according to which the trustees, above all else, should administer the trust. The Statement of Purpose should be broad enough not to hinder the trustees in administering the trust when unforeseen circumstances arise, but tailored to truly express the grantor's goals.  It should be clear and irrevocable, but nevertheless a statement that reflects human values not legal principles. The Statement of Purpose may provide family background information, such as anecdotal explanations of how the parents acquired their wealth and why they believe in certain values.  For many families, however, the statement will be more succinct.  As an extremely simple example, a Statement of Purpose might read as follows:  "The purpose of this trust is to ensure that the descendants of John and Mary Smith will be well provided for, and to promote productivity, morality, integrity, cooperation and philanthropy among their descendants."
 
The Distribution Guidelines should be an attachment to the incentive trust agreement and be designed to accomplish the parents' goals for their family. The Distribution Guidelines may be the most important part of the trust agreement because they set forth the incentive provisions upon which the entire incentive trust concept is based.  As explained by Marjorie J. Stephens in her article entitled "Incentive Trusts:  Considerations, Uses and Alternatives", 29 ACTEC Journal 5 (Summer 2003), the Distribution Guidelines should provide "a statement of how the family anticipates that the trust would be carried out considering the parents' understanding and knowledge of their children, the economy, and the world today."

The Distribution Guidelines should set forth the circumstances under which the grantor expects the trustees to distribute or withhold trust assets in order to provide the trustees a road map for administering the trust.  Thus, unlike an incentive trust's Statement of Purpose, the Distribution Guidelines must both provide legal guidance and reflect human values. It is impossible to know with certainty what hurdles the trustees of a trust will encounter.  Moreover, a perpetual trust is likely to continue for a long time.  Accordingly, overly rigid incentive provisions can have the unintended effect of paralyzing trustees from being able to adapt trust administration in the face of unforeseen circumstances.  This can be especially problematic when narrow incentive provisions are incorporated in a trust agreement that is irrevocable and cannot be amended.  Therefore, the incentive provisions in the Distribution Guidelines should evolve over time as the need arises.

One of the challenging issues that attorneys often face in drafting an incentive trust agreement is understanding whether their clients want to use incentive provisions to elicit positive behavior, discourage negative behavior, or accomplish some degree of both.  Many clients have broad notions about the kinds of behavior they want to facilitate or deter, but find it challenging to focus their general ideas into incentive provisions that can actually be administered by trustees.  For example, many clients feel strongly that no child should receive trust assets before he or she is mature and has proven that he or she can manage his or her affairs responsibly.  However, the clients may not be able to describe their view of "sufficiently mature" in adequately precise terms to be incorporated into an incentive trust agreement.  An experienced attorney can be of great help in steering clients through the process by helping them draft the Distribution Guidelines.

The grantor should authorize the trustees to amend the Distribution Guidelines.  Generally, incentive trust agreements designate a single Administrative Trustee to serve during the lifetime of the grantor and the grantor's spouse.  Thereafter, the incentive trust would be administered by an Administrative Trustee together with a Board of Trustees consisting of a group of persons named in the incentive trust agreement.   The individual Administrative Trustee, and later the Board of Trustees, is typically authorized to amend the Distribution Guidelines.

The incentive trust agreement sets forth how the incentive trust would be administered. The Administrative Trustee typically handles the day-to-day affairs of the incentive trust and makes distributions pursuant to the Distribution Guidelines. The Board of Trustees decides what the terms of the Distribution Guidelines should be and how the Distribution Guidelines should evolve over time, consistent with the grantor's Statement of Purposes. The Board of Trustees also determines the overall policy of the trust concerning investments and other matters. The incentive trust agreement should identify the Administrative Trustee and the initial members of the Board of Trustees, and set forth procedures for electing their successors.  As with the designation of the Administrative Trustee, there is no fixed formula for deciding who should serve on the Board of Trustees.  However, in every case, the Administrative Trustee should serve on this Board, together with at least one trustee elected by the beneficiaries.

If the incentive trust agreement provides for distributions to charity (i.e., by requiring that income not otherwise distributed to the individual beneficiaries in accordance with the Distribution Guidelines be paid to charity), a charitable representative also should serve on the Board of Trustees. It may be prudent to include a tax advisor on the Board of Trustees, who would either be an attorney or an accountant, as well as the person principally responsible for managing the incentive trust assets.  To that end, if the trust corpus is comprised of interests in a closely held business, that person might be the chief executive officer or chief financial officer of the business.  If corpus consists primarily of real estate, that person might be the asset manager.  Or, if the incentive trust holds securities, the financial planner or a representative of the trust company, bank or investment house might serve on the Board of Trustees.  Lastly, parents may want to consider including family counselors, trusted business associates or senior family members on the Board of Trustees.

Under the laws of most states, the members of the board of trustees will be subject to the duties and liabilities typically imposed on fiduciaries. Many brokerage houses, banks, and professional firms prohibit their partners and employees from serving as trustees to protect them from potential fiduciary liability. As an alternative, the incentive trust may be established under Delaware law, which could permit a board of advisors (who are not fiduciaries) to direct the Administrative Trustee in much the same capacity as a board of trustees.

The Board of Trustees should act by vote upon terms set forth in the incentive trust agreement.  The Board of Trustees controls the Distribution Guidelines.  Accordingly, parents should think carefully about the level of voting power they want to give to the beneficiaries, through the trustees they elect.  In most cases, the trustees elected by the beneficiaries should not constitute more than 40 percent of the voting members of the Board of Trustees.

The incentive trust agreement also should set forth the manner in which the Board of Trustees operates.  At a minimum, the Board of Trustees should meet once a year to review the trust distributions for the prior year and consider whether revisions should be made to the Distribution Guidelines.  The annual meeting of the Board of Trustees should be coordinated with an annual meeting of the beneficiaries.  The Administrative Trustee should prepare a full accounting each year and deliver it to the Board of Trustees and each beneficiary (or his or her guardian) for review at their annual meetings, together with detailed agendas for their meetings.  In this manner, the Board of Trustees' role is comparable to that of a board of directors of a corporation; the role of the beneficiaries is comparable to that of the shareholders.

Parents may consider authorizing trust beneficiaries to submit special distribution proposals, much like grant proposals, to the Board of Trustees for consideration at the annual meeting.  A special distribution proposal may solicit financial support to enable a beneficiary to pursue an internship, new business venture, missionary activity, artistic endeavor or other matters not addressed by the existing Distribution Guidelines.  The Board of Trustees would approve or reject a special distribution proposal based on the members' interpretation of the Statement of Purposes and the parents' goals for establishing the incentive trust.

Wealthy people are often philanthropic.  Historically, philanthropic individuals have allocated their assets among trusts for family members and separate trusts, foundations or outright bequests for charity, often in a relatively arbitrary manner.  However, charitably inclined parents may find the incentive trust to be an attractive vehicle for furthering both family goals and philanthropic goals through one trust.

Providing for charity in an incentive trust can be accomplished through a multitude of techniques.  Parents may provide that excess net cash flow remaining after the trustees make distributions to family beneficiaries in accordance with Distribution Guidelines must be paid to charity on an annual basis.  Alternatively, parents may limit the total distributions each year to a fixed percentage of the value of the trust assets and direct that net cash flow remaining after distributions are made to family beneficiaries pursuant to the Distribution Guidelines must be paid to charity.

Parents can specify the charitable beneficiary in the incentive trust instrument, authorize a Philanthropic Committee to select the charitable beneficiaries, or provide for a combination of procedures.  As a general rule, trust income will be calculated in accordance with generally accepted fiduciary accounting principles interpreted under the applicable state law, such that dividends and rents will be allocated to income while proceeds from sales or refinancings of assets will be allocated to principal.  A parent may prefer a "unitrust" concept for his or her incentive trust, so that the trustees would distribute a fixed percentage of the value of the trust assets to the beneficiaries, regardless of how much traditional income is generated in a given year.

Goals an Incentive Trust Can Accomplish

Distribution Guidelines can be drafted to accomplish almost any goal.  As every parent has a unique set of values, an attorney who is asked to draft an incentive trust should first set out to address those values. Since an incentive trust is essentially a surrogate for the parents, designed to emulate the terms on which parents would personally administer the trust assets, the draftsman must begin by gaining a broad understanding of the parents' priorities. This is best accomplished by securing the parents' answers to a series of questions.

1. What values do the parents want to promote and how should the trust promote them?

How would the parents administer the assets they plan to transfer to the incentive trust, if they were to live forever?  Many parents share similar goals of ensuring that their descendants will be productive, happy, fulfilled and well provided for. What sort of monitoring would the parents engage in to determine whether descendants are worthy of distributions?  Would age be a primary concern?  Would hard work, involvement with charities, education, commitment to family, or some other factor be of significant importance? What are the parents' priorities?    Only with a complete understanding of the parents' goals can the attorney translate the plan into succinct Distribution Guidelines.
 
2. What Incentive Provisions Should be Included in the Incentive Trust Agreement?

Do the parents want provisions concerning education in the incentive trust agreement? Parents often desire to promote education, but hesitate to make outright gifts to their descendants for fear that they will waste the funds and forego schooling.  Incentive provisions can work well in such instances, by directing the trustees to pay for the education of the beneficiaries up to a level specified by the parents.  The Distribution Guidelines may set a performance standard (i.e., a 1.75 grade point average) that beneficiaries must achieve in order to receive continued support.  The Distribution Guidelines also may provide for levels of support (i.e., room and board of up to two times the cost of on-campus housing for students).

Do the parents want provisions concerning internships in the incentive trust agreement? Distribution Guidelines can provide interesting "internship" opportunities for trust beneficiaries.  A typical dilemma for many young people entering the work place is that they cannot get a start on their ideal careers without experience, but cannot afford the salary sacrifices necessary to gain experience through internships.  Distribution Guidelines can authorize living expense stipends for beneficiaries completing internships that provide valuable experience but limited or no pay.   If the trust holds a family business, the Distribution Guidelines may set forth the terms and conditions upon which a family member would participate in internships within the company, to gain experience and better understand the family's business before securing additional experience outside the company.

Do the parents want provisions concerning income matching in the incentive trust agreement? For adult beneficiaries, the Distribution Guidelines may provide for payments based on a sliding scale.  Essentially, the beneficiaries' work is assigned numerical values for its social value and compensation level.  The trustees would then make distributions to the beneficiaries under a mathematical formula incorporating the social and salary values of each beneficiary's profession, limited by a numerical cap.  For example, a beneficiary in a profession with a low salary but high moral value (for example, a guidance counselor for children with special needs) may be entitled to a trust distribution equal to three or four times his or her salary.  A beneficiary in a high salary profession with less moral value (for example, a tax lawyer or investment banker) would receive a lower multiple, subject to the cap.  In rather simplistic terms, beneficiaries would be encouraged to pursue their individual goals to either 'contribute to society' or 'generate additional family wealth', while still being able to live in the same neighborhood.

If the parents include incentive compensation provisions of this type in their Distribution Guidelines, they must also anticipate the effect of a beneficiary leaving the workplace to care for children.  Since most parents who create incentive trusts wish to support descendants who choose to raise families, it may be appropriate to consider household income when a beneficiary chooses to stay at home.  Therefore, if a beneficiary leaves the workplace to care for her children, moral and salary values could be assigned by reference to her spouse's profession for purposes of determining trust distributions.  Alternatively, the Distribution Guidelines could look to the historic distributions paid to the beneficiary, adjusted to account for inflation.  In all other cases, moral and salary values would be assigned solely based on the beneficiary's performance.

Do the parents want provisions concerning crisis and counseling in the incentive trust agreement? Distribution Guidelines can authorize distributions, in the discretion of the trustees, to help beneficiaries in crisis situations, such as divorce or separation, or during periods of involuntary unemployment.  They also can authorize distributions to provide counseling for beneficiaries suffering from marital, substance abuse or any other personal problems.  The Distribution Guidelines may also assist young beneficiaries with college placement and career counseling assistance.

Do the parents want other typical distribution provisions?  Distribution Guidelines typically provide for other less controversial distributions, such as payments for (i) health insurance and unreimbursed medical expenses, (ii) support of beneficiaries with special needs, and (iii) maintenance of vacation homes and other family assets.  Distribution Guidelines also often entitle beneficiaries who retire after attaining a specified age (i.e., 55) to annual payments equal to the average distributions they received in recent years, increased by the applicable Consumer Price Index factor.

Do the parents want provisions that "punish" a beneficiary's bad behavior?  In many cases, "punishing" provisions designed to discourage negative behavior (for example, substance abuse) by prohibiting distributions to beneficiaries who engage in such behavior are unnecessary if "encouraging" provisions are properly drafted.  For example, a parent wishing to discourage substance abuse might be tempted to include a provision that allows (or requires) the trustees to withhold distributions from beneficiaries known to be engaging in such abuse.  The parent also might wish to require the trustees to consult with other family members to ascertain which beneficiaries, if any, are engaging in substance abuse.  However, if the "encouraging" provisions of the trust agreement provide for distributions that reward positive behavior, such as hard work and productivity - behaviors that a substance abuser is unlikely to exhibit - the prohibition on distributions to substance abusers should be adequately addressed de facto by the more encouraging incentive provisions.  Moreover, such punitive provisions would discourage a beneficiary from asking the trustees for assistance with appropriate counseling before his substance abuse reaches a crisis stage.  Shaping behavior through encouragement is often more effective than controlling behavior through punishment, so attorneys and parents should be wary of "punishing" provisions.