You want to ensure your estate is transferred in a tax-efficient manner and your wealth transfer does more good than harm. For some people, this may mean spending their wealth while they’re still alive, since they believe future generations benefit from creating their own wealth. Or, this could mean committing most of their wealth to charity.
But, for most people, 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 your 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 potential 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, you may choose more powerful means to offset the potential negative consequences of inherited wealth.
You may want your children to earn their inheritances. You 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, if you want to encourage a child or grandchild to pursue post-secondary education, you may direct the trustees to make distributions only if the beneficiary attends, or graduates from, a post-secondary institution. Or, if you wish to encourage a child or grandchild to participate in the family business, you may direct the trustee to make distributions only if the beneficiary is working full- or part-time in the company.
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, you 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 your goal is to discourage what you consider 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
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 your 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 for you 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 you would likely not anticipate for your child.
Consider the soft or emotional side of the equation as well. Efforts to foster what you deem good behaviour (or to discourage bad behaviour) could backfire, resulting in rebellion or alienation. You 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.