Many estate owners are concerned about what will happen to the wealth in the next generation and the effects the inheritance will have on their heirs, making how to leave wealth to the next generation one of the most difficult estate planning decisions.
Wealth is accumulated and preserved for the next generation at least partly to enrich the lives of loved ones.
But there are many stories of heirs wasting or mismanaging inheritances and other stories of inheritances changing heirs for the worse.
Several different types of trusts are available to avoid these negative consequences. Each has advantages and disadvantages, causing them to fall in and out of favor with estate planners.
Some of the trusts are known as incentive trusts while others are protective trusts.
Incentive trusts became very popular in the 1980s and 1990s with creative and detailed variations.
Incentive trusts appeal to parents who are concerned children who inherit outright might not lead successful, productive lives. The children might not be equipped to manage the wealth, or it might have negative effects on their values and lead to destructive behavior. The parents are aware of research concluding that depression, anxiety, and substance abuse are more likely among children of wealthy families than those from the middle class.
An incentive trust, also known as a milestone trust, makes income and wealth available to beneficiaries as they meet goals or benchmarks.
For example, trust distributions might match or be a multiple of income earned by the beneficiary. Or a trust might distribute a fixed percentage of its principal as the beneficiary reaches certain ages, provided the beneficiary has met goals such as being employed or otherwise being productive (such as by doing volunteer work or pursuing education).
Distributions might be conditioned on the beneficiary avoiding destructive behavior and not wasting previous distributions.
The terms of an incentive trust are limited primarily by the goals and imagination of the person creating the trust. Some incentive trusts have fairly elaborate formulas and standards regulating distributions.
Yet, some research as well as the experience of some estate planners indicate incentive trusts could have the opposite of the intended effects.
Most people don’t respond to financial incentives and disincentives as much as is assumed by creators of incentive trusts. The pressure caused by the amount of money at stake increases anxiety and adversely affects the behavior and decision making of the heirs. The effects are worse if the person already was unsure of how to handle wealth.
The incentive trust also can be viewed as an attempt by parents to continue to control their children from the grave. Some believe the existence of such trusts makes it harder for the children to become independent and self-sufficient adults.
There also can be unintended effects. Suppose the trust distributions are based on the income earned by the beneficiary. The beneficiary has an incentive to seek a high-paying career though the beneficiary’s talents and interests might be in a field that pays less. The trust also discourages public service and volunteer activities.
Protective trusts have been around much longer than incentive trusts. Protective trusts are more flexible than incentive trusts and give the trustee more discretion.
The trust might direct income and principal to be distributed on a schedule. For example, a beneficiary might receive only income until age 25. Then, a portion of the principal is distributed.
After that, income from the remaining principal continues to be distributed each year until the beneficiary reaches age 30 or 35. Then, the rest of the principal is distributed.
But the trustee can suspend distributions at any time it is in the best interest of the beneficiary. The trust creator often leaves the trustee written guidance indicating when distributions should be suspended.
Typically, distributions are suspended when there are indications the beneficiary has a problem with gambling, creditors, or substance abuse. Distributions also might be suspended if the beneficiary drops out of school or the work force. (It’s a good idea not to be too precise in the guidance, because none of us can predict the future.)
The distributions can resume when the trustee believes that is in the best interest of the beneficiary.
A protective trust can give the trustee full discretion over distributions.
The trustee can take into account a range of factors, including income taxes and the beneficiary’s nonfinancial situation.
Distributions can be turned off, increased, or decreased at the trustee’s discretion, following whatever guidelines the trust creator left.
A disadvantage is the trustee could essentially become a surrogate parent, monitoring the beneficiary’s choices and at times attempting to change them.
The selection of the trustee is key to the success of a protective trust.
The trustee must understand the creator’s goals and reasoning and be able to apply them in changing circumstances and have regular and open communication with the beneficiary.
The trustee also must learn the beneficiary’s goals and must understand how the beneficiary responds to goals and incentives and whether they encourage the desired behavior or cause anxiety or other negative consequences.
Sometimes multiple trustees are the best choice. A professional or corporate trustee handles the investments, administration, and tax returns. One or more co-trustees who know the family make decisions about distributions.
Either type of trust should be begun while the creator is alive, and the creator should fully discuss the goals and reasoning with the beneficiary as early as possible. The grantor’s goals and motivation should be stated clearly in the trust agreement.
The creator and trustees should keep in mind that the main goal is for the beneficiary to develop internal motivation to become self-supporting and not want to be fully supported by the parents’ or grandparents’ wealth.
The trust should be structured to support the beneficiary’s decision making and independence but in ways that adapt to the beneficiary’s personality and interests.
The parent or grandparent creating the trust should be clear about the amount of wealth involved. Failing to disclose the trust’s value often is taken as a sign of lack of trust or confidence in the beneficiary.
Indeed, it’s often best for children or grandchildren to know fairly early in life the general scope of the family’s wealth and the plans for it so that over time they’ll become comfortable with the idea and learn how to manage and spend money. That potentially reduces the possibility of anxiety and other traits associated with “sudden wealth syndrome.”
Probably most estate planners now recommend avoiding the black and white rules of the traditional incentive trust. The beneficiary is less likely to make good decisions and become independent when he or she knows failure will result in a complete loss of income.
Instead, assume there will be failures and mistakes and structure the trust to support the beneficiary after a failure while allowing the beneficiary to learn the consequences of mistakes.
Even when a beneficiary is unemployed or struggling, the trust should make distributions to support therapy, nutrition counseling, physical fitness, education (even unconventional education), and the like.