If frequency is any indication of the importance of a question, the most pressing issue on most clients’ minds these days is not keeping the tax man at bay but keeping heirs in line. Estate planning strategies now commonly focus on a family vision that expresses the philosophical and moral imperatives of the wealth creators, rather than the minimization of taxes. The issues most current among high net worth clients involve protecting family wealth and encouraging later generations to be productive. A recent survey by U.S. Trust estimated that the top 0.5% of wealthy Americans were concerned that their heirs will be materialistic or naïve about money or will overspend. Where There’s a Will, Dallas Morning News, Feb. 18, 2001. The popular press has highlighted this shift in sentiment with highly publicized stories about famous businessmen and sports figures taking aggressive action to ensure their children do not become dissipated “trust babies,” stains upon the fabric of society.
Most notable among the list of high profile clients who have emphasized the desire to control their children’s inheritances is Warren Buffet. He is famously quoted as saying “[t]he perfect inheritance is enough money so that they feel they can do anything, but not so much that they could do nothing.” This concern is hardly new. Indeed, Commodore Vanderbilt favored one child because he was perceived to be harder working. F. Clark, The Commodore Left Two Sons, American Heritage 17:81-103 (1966).
This article provides a synthesis of the current thinking by practitioners on the transmission of values through wealth transfers. It briefly reviews the structure and timing of transfers but concentrates on a discussion of the various provisions that concerned clients have brought to the drafting table. In addition, it considers the pitfalls inherent in trying to articulate feelings, emotions and philosophies as well as the legal restrictions faced when drafting to modify behavior.
The Times, They Are a’Changing
Clients have become more sensitive to the need for expert guidance through the maze of tax minimization. The analysis behind this is quantitative and closely confined by the restrictions imposed by the Internal Revenue Code, statutes and case law. Countless seminars keep everyone up-to-date on the nuances of the law and the mood of the IRS toward various techniques. Most practitioners find this comfortable territory.
But clients now seek guidance on navigating far murkier waters. They want to know how best to structure gifts and inheritances—not to save taxes, but to influence behavior and convey their values. They want to encourage this and discourage that. Clients answer the question of how much to give away based on what is important to the family, not on the tax cost. Practitioners now need to consult extralegal resources and to understand behavioral models to be able to address these new concerns. The trusty Internal Revenue Code offers no help in this qualitative analysis. The tax tail has ceased to wag the estate planning dog—for the time being at least.
Even researchers do not agree on the exact motivations behind wealth transfers. Some contend that the action is altruistic, a concern for the recipient’s happiness. Others perceive an exchange mechanism at work. Donors offer gifts and cash as enticements to certain behavior. Whatever the underlying psychological motivations of a donor, the client in the office seeks practical advice.
How and When to Give
The common structure for providing incentives to encourage or alter behavior is the trust. Any properly drafted trust is suitable: life insurance trust, credit shelter trust, dynasty or generation-skipping trust. Because the client’s wishes communicate a family ethic or value system, revocable trusts, charitable trusts and inter vivos gifts can also play a part in the overall plan. Combining these vehicles produces a comprehensive approach.
Timing of transfers is critical to meeting the client’s objectives. Economists have found that timing significantly affects the behavior of the recipient. Giving wealth in order to encourage a certain behavior provides little incentive to perform. The response from the recipient can be, “I have the funds already, so why should I exert myself?” Clearly, this is a shortsighted attitude, because future gifts are never guaranteed.
The reverse can be equally unrewarding. Giving wealth after a beneficiary recipient demonstrates certain behaviors can lead to anticipation spending on the recipient’s part. This dilemma is exacerbated when the recipient is an emancipated adult. The donor cannot observe the behavior as readily as when the recipient lives in the home. If, for example, a donor intends the transfer of wealth to supplement salary, the donor cannot determine if the recipient’s underemployment is the result of adverse market conditions or the person’s performance. Ralph Chami & Connel Fullenkamp, The Market Value of Family Values, Cato J., Vol. 16, No. 3 (Winter 1997).
Gravely Speaking: The Issue of Dead Hand Control
The economics of transfers notwithstanding, a more immediate planning choice commonly confronts practitioners: whether to make the transfers while the client is alive or at death. There are various schools of thought about the precedence given to lifetime versus testamentary transfers. One major concern is the questionable advisability of controlling from the grave. Attaching strings to an inheritance consistently has been a source of contention and legal contest. In addition, transfers that take effect on the death of the transferor cannot easily take into account subsequent changes in circumstances.
The classic provision of staggered distributions provides some measure of flexibility. One presumes that the beneficiary will have multiple bites at the apple—the imprudent 25 year old can become the fiscally responsible 30 year old. Commonly, practitioners provide this needed flexibility by giving the trustee broad discretionary powers. This discretion can be a double-edged sword, even when the fiduciary has extensive knowledge of the family’s value system, as in the case of an individual trustee who may be a family member. Too much discretion can lead to family squabbles when the beneficiaries perceive that the fiduciary is too liberal; not enough discretion can frustrate decisions to distribute.
With changing times and social perceptions, incentives that made sense originally can be burdensome years later. Twenty-five years ago, computers were still an arcane science. A grandchild asking for funds to study to become a programmer for a nascent gaming company would have been told to quit playing Pac Man and be serious. To solve this problem, trusts can give subsequent generations the opportunity to take a “second look.” A limited power of appointment can allow the trustee to respond to changing circumstances, both among family members and within society at large.
Corporate trustees regularly re-quire grantors to indicate their intent in documents. The trustee’s concerns about liability become even greater when the dispositive provisions are specifically intended to manipulate or control behavior. In these cases, the drafting lawyer shoulders a great burden in expressing a grantor’s intentions unambiguously and providing appropriate protection to the fiduciary.
Bolts Out of the Blue
This situation becomes especially difficult when the grantor has not discussed his or her intentions with the family. The imposition of conditions dictating behavior without prior warning can compound the distress caused by the death of a parent or spouse. In general, clients seek to provide incentives for advancing education, entering productive careers, maintaining a religious tradition or creating a stable marital relationship. They also wish to discourage behavior perceived as destructive or immoral, such as alcohol or drug use, divorce or remarriage. All of these conditions restrict and disrupt the activities of everyday life. When the grantor has not previously discussed the reasons underlying this control with the beneficiaries, the family can experience profound disharmony. Beneficiaries feel cheated or believe that the grantor did not trust their abilities. This perception of betrayal can be particularly acute when one takes into account the fact that children of wealth, especially sudden wealth, often mistrust other people’s motivations. The surprise of having their inheritance tied to behavioral standards that were not communicated by the grantor while alive can only compound this insecurity and confusion. The best of intentions can backfire, creating even greater impediments to an heir’s ability to succeed.
When the client resists communicating values and wishes to affect future behavior, the attorney must seriously consider the entire situation. The client may indeed not trust the objects of his or her bounty and have every good reason not to do so. But these concerns are perceived differently when the family picture is discussed. Fears for the future of small children differ significantly from the concerns for adults who are perceived as wastrels. A self-made client has a perspective different from the perspective of one who has inherited wealth, but both are anxious to provide guidance to future generations.
Carrot Sticks: Appetizing Ways to Influence Behavior
Most clients seek to encourage behavior, and therefore most provisions take on the characteristics of a carrot. This desire to influence actions can also be manifested as a stick. Howard McCue of Mayer, Brown and Platt, in a paper entitled “Planning and Drafting to Influence Behavior” at the Philip E. Heckerling Institute on Estate Planning in 1999, points out the fine line between guiding behavior and controlling it. The fact that families cannot predict individual behavioral responses, particularly over time, complicates any attempt to control behavior. One of the primary goals in traditional estate planning is to move assets out of the larger estate and into the smaller. Typically, this larger estate belongs to the eldest generation, al-though this may not be the case for the new e-millionaires. If the larger estate belongs to the grandparent, traditional planning favors transfers to people (usually grandchildren) the donor really does not know. It is no matter that conventional wisdom holds that the apple does not fall far from the tree. No one can predict how the youngest member of the family will behave at majority or even middle age. This push to transfer assets that have significant growth potential downstream has fueled the desire for incentives to be added to trusts.
The desire to encourage or discourage behavior takes many forms. Most often clients focus on incentives to make their heirs productive members of society. These incentives often take the form of supplements to a beneficiary’s earnings, either by dollar matching or by specific monetary distributions based on adjusted gross income. A provision matching earnings can unintentionally favor the heir who becomes a highly paid professional, to the detriment of the missionary or the schoolteacher of the family. By the same token, provisions intended as a safety net for the child pursuing a less remunerative profession become a fiscal nightmare for the sibling who becomes a brain surgeon and desperately wants the income to stay in the trust and away from her estate or creditors.
Each silver lining therefore does have a cloud. Practitioners should carefully consider the actual behavior to be encouraged. A client’s desire to promote productivity should not evolve inadvertently into a reward system for amassing more money. One client did present an interesting twist on the motivation to match a beneficiary’s salary. In that case, the client did not desire to reward capitalism per se. Rather, the client presumed that the child who earned more in the outside world was more capable of handling funds intelligently and therefore deserved to have his share distributed faster. The child who earned less needed the continued guidance of the trustee in order to learn how to manage his funds. Clearly, the client’s intention must be examined closely prior to drafting incentive provisions.
Clients also desire to promote what they perceive as a healthy family environment. In that case, preference might be given to the child or spouse of a child who chooses to forgo a career and stay at home with the grandchildren. While this can prevent a dilemma for young parents, the stay-at-home parent may later be ill equipped to enter the workforce when the children are grown. Provisions of this nature should project far enough into the future to provide for that parent once the work of child-rearing is finished, especially if, at that time, there is no spouse to provide added financial security. No client would want his daughter to find herself middle-aged, divorced, with no skills and facing the loss of supplemental cash flow when her youngest child graduates from college.
Education is frequently a primary goal. Incentive provisions can condition distributions based upon grade point average. Determining a realistic target can be difficult, especially for trusts for very young children. The incentive provision should include language that takes into account contingent events such as learning disabilities. A client who insists on incentives to attend a particular school or pursue a specific career presents yet another difficulty. There can be almost no way of determining if the child will be able to meet the admission standards or have the inclination to enter the favored profession.
Clients also wish to affect the lives of their heirs in ways other than fiscally. They seek provisions that encourage marriage, community activity, volunteerism or a specific religious belief. Fostering altruism can take the form of matching charitable gifts or, as mentioned above, providing additional income to the beneficiary who pursues a worthy but low-paying career. More direct forms of encouraging social stewardship can involve active participation in family foundations or charitable trusts.
Incentives to begin a business are also common. In drafting such provisions, practitioners must ensure that the proposed business plan is a sound one. The fiduciary can require the beneficiary to demonstrate the viability of the venture by securing a portion of the start-up costs from third-party capital. In addition, drafters can take a page from “affluenza advisors.” In seeking to guide children toward productive pursuits, parents can arrange a mentoring program with an established business leader. Similarly, the fiduciary can appoint a special trustee versed in the particular industry who can review business plans and oversee development, at least in the near term. Corporate trustees welcome collaboration of this nature. Depending on the business contemplated, the institutional trustee may not have in-house personnel who are familiar with the industry and who have the expertise to evaluate deals adequately and make informed decisions affecting business goals.
Clients can seek to punish behavior considered inappropriate or immoral. Commonly, the client’s concern focuses on abstinence from the usual sins of divorce, drugs, alcohol or tobacco. Again, flexibility is key. For example, the fiduciary must be given latitude to distinguish between actual drug use and the naïve freshman who is slipped something at the frat house.
On the other hand, the client may be concerned to prevent behavior other than that which affects only the beneficiary, such as smoking. Often clients wish to prevent family assets from being dissipated. For example, the client may suspect that any funds given to a particular individual may in turn be given away to an organization considered by the family to be a cult. In the alternative, the client may fear that the beneficiary may break up an important family art collection in order to reap the highest sales proceeds. In the first instance, one solution harkens back to the workhorse spendthrift trust, focusing on meeting the person’s needs by paying bills directly. In the other, the beneficiary could receive only a life estate in the art collection or a trustee could retain title to the art with the discretion to allow the beneficiary to display the works at home. In both instances, the trust contains the individual’s behavior without forcing the client to cut off the beneficiary completely.
On the Other Hand:
Alternatives and Enhancements
to the Incentive Trusts
A trust is not the sole approach to communicating family values or promoting certain behavior. While the client is alive, it is never too late to begin to use other resources to bring the family together. The simplest approach, and one that is especially useful when the client has young children, is outright gifts. Mentoring toward the desired goal and observing how the recipient handles the gift is a powerful teaching method, particularly when the actions of the donor serve as an example.
Another technique enlists the family foundation, a useful tax planning tool, into double duty. Children and grandchildren, spouses, aunts, uncles, nephews and nieces can all participate in the management of an entity designed to promote activities reflecting the greater family ethic. Such an arrangement not only provides a common goal but also presents a real life training ground for the younger members of the family to learn investment strategies. Preparing grant guidelines and reviewing grant requests provides excellent training in evaluating all manner of business plans. Interaction with professionals in the nonprofit world and members of boards of directors allows the active participant to make valuable contacts with other families and business leaders.
Exposing heirs to the decision-making and investment process behind charitable giving can begin very early. A simple charitable lead trust can provide the opportunity to allocate certain sums to children and grandchildren as young as 10 or 11. The profound consideration that children give to this responsibility is remarkable. Given the chance to give away $1,000, one eight-year-old eschewed the chance to be the hero of her scout troop and chose the local soup kitchen instead. She believed the people there needed it more than the troop from a wealthy suburb.
Family limited partnerships, limited liability companies and S corporations are also suitable vehicles to use as learning tools. In these entities and most charitable entities, the client retains control over the assets. They can be drafted to provide flexibility and allow the client to lead the family in “walking the walk” and “talking the talk.”
When fostering a family vision is as important as tax planning, creativity in planning abounds. Herbert Daroff, a certified financial planner in Boston, creates a cocktail of vehicles to form, in effect, a family bank. Linking a family limited partnership or limited liability company with a dynasty trust creates a structure that can lend funds to family members rather than distribute them outright. This allows the family to recycle funds rather than dissipate them. It also provides a mechanism to prevent former spouses from benefiting permanently from the client’s largess. For example, a house mortgaged to the family bank will become an asset of the family again upon default and an ex-spouse will not receive realty paid for by the client.
Getting Carried Away
Little restricts the creativity of clients and attorneys in drafting trust provisions to modify behavior. Assuming that the requirements for valid generation-skipping, marital deduction and other tax-motivated results are met, the drafting attorney has a world of incentives and motivations with which to satisfy the client’s need. However, careful consideration must be given to the request in order not to push the envelope beyond the bounds of public policy. Section 29 of the Restatement (Third) of Trusts states that a provision in a trust is invalid if implementation would be contrary to public policy. Fundamental to any discussion of public policy is the time-honored, common law tenet that an individual is free to dispose of his or her property as he or she sees fit, with or without restrictions or conditions. During the donor’s lifetime, the law does little to intrude into decisions to give property away. The donor can respond to changes in circumstances or be persuaded to another course of action. However, the law is less tolerant of control by a dead hand.
The invalidity of a provision causes the beneficial interest to pass as if the condition had not been imposed. While some courts might try to reform a provision if its adaptation could meet public policy concerns, that is a thin reed to cling to when drafting. When in doubt, a practitioner should provide for an alternative disposition in the event that a condition proves invalid. Otherwise the client’s wishes will be completely ignored. The best course is to avoid any contest to begin with. Here again, understanding the client’s motivations behind asking for certain conditions or restrictions can avoid potential problems.
Clearly, any provision that induces illegal conduct or provides a motivation to commit an illegal act is invalid. Distributions to pay for fines levied for such acts are also beyond the pale. Beyond this, the issue becomes grayer.
Public policy concerns arise most commonly in the area of family relations. Any provision that disrupts a relationship, tends to encourage disruption of a relationship or overtly discourages the formation or resumption of one is usually invalid. Similarly, provisions interfering with a beneficiary’s freedom to marry, limiting the selection of a spouse or unduly postponing marriage are void. This restriction does not, however, prevent the fundamental right to terminate the interest of a surviving spouse or the spouse of an heir upon remarriage. See Restatement (Third) of Trusts § 29, Comment (e).
A trust provision is likewise invalid if it tends to restrain the religious freedom of a beneficiary by providing coercive financial incentives to take up or abandon a particular faith or belief. Provisions can support continued religious commitments, but practitioners should tread carefully around the client’s desire to offer inducements to embrace or reject a faith or set of beliefs. See Restatement (Third) of Trusts § 29, Comment (f). Here again, changing times bring changing attitudes toward the expressions of belief. What the parent or grandparent regards as a “cult” can be a practice that the beneficiary has maintained devotedly for years.
Courts will scrutinize conditions that are intended to induce the choice or abandonment of a career based upon the interest of society in pre-venting excessive influence on a personal decision that can affect others. Incentives to change personal habits or conduct are generally not against public policy unless they are unnecessarily punitive, are unreasonably intrusive into significant personal decisions or interfere with freedom of association. Drafting should also be as clear as possible to avoid being unenforceable for indefiniteness. See Restatement (Third) of Trusts § 29, Comment (g).
A Final Word
Incentive trusts are no substitute for good parenting. However, lawyers, accountants and other advisers are not in the business of psychological counseling. Provisions in trusts designed to encourage or discourage certain behavior can be an effective part of an overall plan to leave a legacy of more than money. By drafting within the restrictions imposed by considerations of public policy and sound tax minimization techniques, the practitioner can address a client’s concern for his or her family. Planning for lifetime participation in the mission and goal of the family through judicious use of family partnerships, charitable lead trusts and foundations can alleviate the need for stringent restrictions on behavior later. Incentive trusts can bolster the vision already communicated and can provide significant safety nets for beneficiaries. This vehicle requires explicit drafting to avoid ambiguity. Sufficient protections and guidance for fiduciaries are a must. Provisions must be flexible to allow for changes in circumstances and society. If nothing else, the discussion itself with clients concerned with their families’ futures may stimulate the communication necessary to meet the need.
Ellen Evans Whiting is a lawyer living in Princeton, New Jersey.