Many parents or grandparents with sizable amounts of money to pass on to their heirs are apprehensive about the effect it many have on their children or grandchildren. In some instances, they fear that the recipients will misspend the funds on drugs, fancy cars or failing businesses. In other cases, the fear is simply that their children will lose their drive to achieve and overcome barriers that may present themselves if there's no financial necessity to do so.
At the same time, these parents and grandparents want to provide a safety net to their heirs and enhance their lives in an increasingly insecure financial system. Often, they do so by leaving funds for their descendants in a trust that distributes the funds at certain ages – say, one-third at age 25, one-third at age 30 and the rest at age 35. But some parents set up what are known as “incentive trusts,” which get very specific in their instructions to trustees to ensure that the trust funds support what the trust's creators view as positive behavior and discourage unproductive activities. Such trusts may pay the costs of certain activities, like a college education or advanced degree, or provide rewards for achieving various milestones. Others may withhold distributions when the beneficiary engages in certain negative behaviors or activities, such as drug use or excessive spending.
Here are some ways incentive trusts might be structured:
- Rewards for degrees. Cash amounts that descendants receive on achieving specified educational milestones.
- Matching earnings. The trustee would be instructed to match on a dollar-for-dollar basis the child’s earnings from employment, or, if lavish spending is the concern, the child’s savings.
- Paying for education. Especially with the high cost of private universities today, grandparents often set up funds to help pay for education. Some funds are more expansive than others in terms of what they will cover. Just undergraduate degrees, or also graduate programs? Only for higher education, or also for learning a craft or a trade? Will the fund pay for private school before college? Will it cover educational programs during the summer, including travel overseas? Room and board, or just tuition? Some of the answers will be determined by the size of the fund and how far it needs to stretch.
- Creating a charitable foundation or donor-advised fund. To encourage charitable giving among descendants, an estate plan could require heirs to give away a certain amount every year to a private foundation or to a donor-advised fund.
- Subsidizing public service career or Peace Corps. We live in an increasingly financially insecure world that often forces people to take or stick with careers they don't find fulfilling or don't feel further the public good. Parents or grandparents could fund trusts that don't match all earnings, but just those they feel make the world a better place. This may be hard to define and will, of course, be different from fund to fund. It may include working for any not-for-profit — though some are quite well funded — or teaching or political organizing for certain causes.
- Distribution upon marriage or having a child.
- Matching the downpayment for a house.
- Reward for a period of time being alcohol- or drug-free.
Through these incentive trusts, parents and grandparents hope that their money will go to causes they support. On the one hand, this approach can multiply the benefit of what they pass on. On the other, it may seem to some that the deceased is trying to continue to exercise control much too long after they are gone. Often the older generations split the difference, giving some funds outright to their descendants and leaving the rest in trust.
However, an incentive trust must be carefully constructed, both to ensure that its terms are clear and that it does not violate any constitutional or public policy law or standard. For example, in one case that ended up in the courts, grandparents set up a trust that withheld funds from any grandchildren who married outside the Jewish faith. Two Illinois courts ruled that the clause disinheriting the grandchildren was invalid because it was against public policy by placing a significant limitation on the grandchildren's freedom to marry.
If you are interested in creating an incentive trust, speak to your elder law or estate planning attorney.
For two articles by WealthManagement.com that go into detail about the objectives that may be achieved with an incentive trust and the critical elements of incentive trust design, click here and here.