Incentive Trusts: Can They Work For You?

Incentive trusts, like other trusts, are established by a grantor who names a trustee and funds the trust with the grantor’s assets. The difference between incentive trusts and other trusts is that distributions are made only when a beneficiary achieves certain contingencies — such as attaining a college degree or getting married — that are established by the trust.

The trust is created with such stipulations to try to ensure that heirs cannot squander their inheritance quickly. For example, a college-bound beneficiary might be allowed access to a certain amount after they successfully complete a school year. An additional amount might be awarded if the beneficiary maintains a certain grade point average, when they graduate or upon some other definable or legal event. The contingencies are up to the donor.

The downsides

The positives of incentivizing beneficiaries are easy to see, but there are potential negatives, such as:

• A beneficiary may not be able to meet a specific contingency through no fault of their own. For example, suppose a beneficiary who can receive a distribution only upon successful completion of a school year falls ill and cannot complete the semester. Even though they could use (and might need) the distribution to pay for health care, the funds would not be distributable.
• The trustee (who may or may not be the grantor) has ultimate discretion about whether contingencies have been met.

These negatives can be eased somewhat by drafting the trust with more general milestones, such as reaching set ages (e.g., one-third of the estate to be distributed at age 21, the second third at 30 and the final third at 35) or certain life events (getting married, buying a house, etc.). These alternatives allow the beneficiary to become more mature before coming into a sizeable inheritance.

Many people hope to encourage positive life choices through incentive trusts. Unfortunately, they do not always work as intended. A beneficiary who is addicted to drugs or gambling, for example, may still attain the contingency. To protect against such eventualities, the grantor can include a provision authorizing the trustee to withhold distributions under this type of circumstance until the beneficiary can prove, for example, that they have successfully undergone treatment.

Revocable or irrevocable?

Another important consideration is whether the trust is revocable or irrevocable. Here, the defining feature is who is named trustee:

• If the grantor is named as trustee of the trust, the trust is deemed a revocable grantor trust. The grantor thus retains control of the assets in the trust, can change the beneficiaries and can even dissolve the trust. The grantor is taxed on the income generated by the trust but the trust itself is not taxed.
• If someone other than the grantor is named as trustee, no changes can be made to the terms of the trust, which becomes an irrevocable trust. The trust is considered a separate taxable entity and consequently is taxed on the income it generates.

Side letter

The grantor may include a non-legally binding document, called a side letter, along with the trust. Including this document can ensure that the trustee has guidelines regarding distributions and clearly understands the grantor’s wishes.

This article provides general information only. When it comes to estate planning, every plan is based on its own unique facts and circumstances. Getting advice from a qualified professional is paramount.