Sophisticated clients want to ensure their estates are transferred in a tax-efficient manner. They’re also looking to ensure their wealth transfers do more good than harm. For some clients, this may mean spending their wealth while they’re still alive, since they believe future generations will benefit from creating their own wealth. For a select list of ultra-wealthy people, this could mean committing most of their wealth to charity.
But, for most wealthy clients, responsible wealth gifting involves structuring the transfer carefully.
Trust vs. outright distribution
In many cases, making an outright distribution to one or more beneficiaries may not be the wisest option. This is particularly true where the beneficiaries are young or lack financial acumen. Where significant wealth is involved, estate professionals generally recommend testamentary trusts to facilitate the actual transfer. Trusts are one of the most flexible estate tools, and can be tailored to fit the family’s particular needs and situation.
For example, a fixed income stream, coupled with staggered capital distributions, may allow a beneficiary to mature into their wealth. Distributing funds this way can teach the beneficiary how to manage money. It also provides an ideal opportunity to allow the beneficiary to learn from their choices and potentially mistakes. The trust may include language encouraging the (adult) child to work with a particular wealth advisor as a means of developing financial literacy and discipline. Such trusts often allow a beneficiary to encroach on (i.e., spend) the capital for certain worthwhile purposes, such as pursuing a post-secondary education or the purchase of a home. But, if significant sums are involved and a beneficiary’s maturity or work ethic is in doubt, a parent may choose more powerful means to offset the potential negative consequences of inherited wealth.
For some clients, merely deferring estate distributions is not enough; instead, they want their children to earn their inheritances. They can do this through an incentive trust, which is a trust containing specific conditions a beneficiary must satisfy in order to receive funds. Incentive trusts are designed to reward or encourage certain positive behaviours, and/or discourage certain negative behaviours. For instance, a client who wants to encourage a child or grandchild to pursue post-secondary education may direct the trustees to make distributions only if the beneficiary attends, or graduates from, a post-secondary institution. Or, a client wishing to encourage a child or grandchild to participate in the family business may direct the trustee to make distributions only if the beneficiary is working full- or part-time in the company.
Where a client wants to encourage gainful employment, distributions may be contingent upon the beneficiary providing proof of employment to the trustees. Where the goal is to reward hard work or productivity, trust payments may be tied to attaining specified income thresholds, or the trustee could be directed to match trust distributions to the salary earned.
At the other end of the spectrum, a client may choose to encourage a beneficiary to work in the charitable sector, volunteer or do community work. In this case, the trustee may be directed to provide an income stream based on hours worked or contributed to allow the low-earning beneficiary to maintain a lifestyle they could not otherwise afford. In a similar vein, a trustee may be directed to make periodic payments only where the beneficiary has a child (or children) and opts not to re-enter the paid workforce.
Incentive trusts can also be used when the client’s goal is to discourage what he considers to be certain negative behaviours. For instance, the terms of a trust could direct the trustees to pay funds to a beneficiary only if the trustees are provided with proof that the beneficiary is now drug-free or abstaining from alcohol.
Mind the limits
Clients interested in establishing an incentive trust need to know there are limits. The law has evolved to limit how far a testator may rule from the grave. Certain conditions may be deemed invalid for public policy reasons. Examples of conditions found unacceptable include requiring a beneficiary to divorce her current spouse or to marry a person of the same race. If such provisions exist, the court may strike them and consider the beneficiary eligible for distributions from the trust.
Conditional trusts, including incentive trusts, must be carefully considered and drafted. Such trusts pose both technical and soft challenges. On the technical front, the condition(s) must be clearly articulated and not open to interpretation; otherwise, they may be open to legal challenge. The trust must also set out what would happen should the conditions not be met. Whether the condition is obtaining a law degree or attaining the age of 25, a well-crafted trust will specify what would occur if the beneficiary fails to meet the condition.
In most cases, an alternate beneficiary (a person or charity) is named in the event the condition is not satisfied. Failure to provide what is generally termed a “gift-over” may result in a partial intestacy or in the condition being struck down, thereby frustrating the testator’s intention. Serious consideration must also be given to the verification process. Enrolling in or graduating from a specified institution should be easy to prove. A condition that requires class attendance would be trickier to monitor. Conditions requiring sobriety or abstention from drugs could also prove awkward to monitor.
Inflexibility is perhaps the greatest disadvantage of incentive trusts. It may seem eminently reasonable to a client to make receipt of an inheritance conditional. But what if the beneficiary suffers a catastrophic injury that prevents them from attaining either goal? Or what if staying married and having a child means suffering through an abusive relationship? Having to choose between a dream job and completing a university degree is another example of a situation your client would likely not anticipate for his child.
Clients should consider the soft or emotional side of the equation as well. Efforts to foster what a parent deems good behaviour (or to discourage bad behaviour) could backfire, resulting in rebellion or alienation. Clients also need to take into account that money is not the sole, or even the most significant, driver of behaviour. It would be naïve indeed to assume that the promise of a trust fund distribution could be powerful enough to defeat the scourge of addiction, or to transform a less-than-ambitious child into an industrious worker.
In theory, incentive trusts can prevent heirs from being demotivated or spoiled. But, in practice, the negative consequences may outweigh the benefits.
Choosing the right trustee
Clients opting to create an incentive trust should give careful thought to the person (or company) nominated to manage the trust, since appointing an appropriate trustee is crucial to the plan’s success.
In addition to the standard duties and responsibilities, the trustee will be responsible for deciding whether or not the conditions have been met and funds should be distributed. In most cases, an independent, objective trustee is more suited to the role than a family member.
Elaine Blades is director, Fiduciary Services, at Scotia Private Client Group.
Originally published in Advisor's Edge Report
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