Incentive Trust

What Is an Incentive Trust?

An incentive trust is a legally-binding fiduciary relationship in which the trustee holds and manages the assets contributed to the trust by the grantor. In an incentive trust arrangement, the trustee must adhere to specific requirements set out by the grantor regarding what conditions the trust's beneficiaries must meet in order to receive funds from the trust.

Key Takeaways

  • Incentive trusts are conditional trusts created to induce positive or specific behavior in beneficiaries by specifying criteria that must be met for disbursement of funds.
  • They are common among wealthy families for parents to ensure that their children do not forget the value of hard work.
  • The role of trustees is extremely important in such estates because the beneficiary is entitled to funds only at their judgemental discretion.

How an Incentive Trust Works

An incentive trust is an inheritance that details specific conditions that must be met by the beneficiaries named in the trust. For example, an investor may wish to leave a certain portion of their estate to a grandchild, but they also don't want the inheritance to reduce the grandchild's drive to pursue a professional career or higher education. By leaving the inheritance funds to the grandchild in an incentive trust, the grantor can specify that the funds are to be dispersed only once the grandchild has obtained an undergraduate degree, for example, or any other legally permissible requirements the grantor may wish to specify.

While estates have always attached bequests to certain conditions, incentive trusts first came into prominence at turn of the century. According to a 1999 article in The Wall Street Journal by Staff Reporter Monica Langley that examines the rise of incentive trusts, called "Trust Me, Baby: Heirs Meet 'Incentive' Arrangements," incentive trusts were introduced into wills by rich parents mainly to avoid "affluenza," or the psychological condition in which rich kids feel entitled to the luxuries of life and do not work towards them.

Incentive trusts come attached with conditions that are specific and related to the circumstances of a particular family. For example, certain wealthy parents may attach their bequests to academic performance or whether or not certain conditions are met (such as visits to doctors for mental health). At times, incentive trusts have also been criticized because their stipulations are relatively inflexible. For example, a wealthy parent's child may not be able to fulfill certain criteria through no fault of their own or, perhaps, may be subject to certain societal pressures that may prevent them from reaching the established goal for them. For example, they may not address issues that occur if the beneficiary becomes disabled. Or, it may be problematic for a stay-at-home mother to reach goals specified in the estate to become eligible for the funds.

The role of the trustee is especially important in incentive trusts because they determine whether criteria pertaining to the disbursement of funds from the estate have been met or not. In certain circumstances, the beneficiary may challenge the estate. However, a court case can be avoided by including language in the will that gives the trustee complete discretion to determine if the criteria are being met.

Roles Identified in a Trust

The grantor is the person who creates the trust, and the beneficiaries are those individuals who are identified in the trust and who will receive the assets. The grantor may also be referred to as the settlor, trustmaker or trustor. The assets in the trust are supplied by the grantor. The associated property and funds are transitioned into the ownership of the trust. The grantor may function as the trustee, allowing them to manage the property in the trust, but it is not required. If the grantor is the trustee, the trust is referred to as a grantor trust. Non-grantor trusts are still funded by the grantor, but control of the assets is relinquished, allowing the trust to function as a separate tax entity from the grantor.

Grantor trust rules allow grantors to control the assets and investments that are placed in a trust. A grantor is taxed on the amount of income that their trust generates. The trust itself is not taxed. In this regard, the tax laws that govern trusts offer individuals a certain degree of protection because tax rates are generally more favorable to individuals than they are to trusts.

Grantors can change the beneficiaries of a trust along with the investments and assets within it. They can direct a trustee to make alterations as well. Grantors can also dissolve the trust whenever they want to, as long as they are deemed mentally competent at the time the decision is made. This distinction makes a grantor trust a type of revocable living trust. However, if the grantor relinquishes control of the trust, it then becomes an irrevocable trust. In this case, the trust itself will be taxed on the income it generates and it would require its own tax identification number (TIN).

Example of an Incentive Trust

The aforementioned The Wall Street Journal article by Monica Langley provides the example of Atlanta Braves pitcher Tom Glavine, who earned an annual salary of $8 million in 1999. When he set up a trust for his children, Glavine had his lawyer insert clauses. For example, his will stated that he would match up to $100,000 of his kids earned income. When he learned that his daughter was interested in becoming a veterinarian, he set aside $200,000 for a veterinarian clinic with the condition that she does well in school.

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