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Successful entrepreneurs seek to protect their assets from the claims of creditors and preserve those assets for the benefit of their families. They are also often concerned that their wealth will have a negative influence on their children’s or grandchildren’s motivation to be productive citizens of the world. Establishing trusts may address some of these concerns. However, conventional trusts tend to exacerbate the problems of children or grandchildren who aspire to a lavish unearned lifestyle. For this reason, incentive trusts have become increasingly attractive to prosperous parents who seek to communicate their values to their children or grandchildren and prevent them from becoming dependent upon the family’s accumulated wealth. Traditional trusts provide a method by which parents can administer assets for the benefit of their children and future generations of their family; save estate, gift and generation-skipping transfer (GST) taxes; and protect assets from the claims of the creditors of the trust beneficiaries. However, many parents also want to prevent their descendants from becoming dependent on trust assets and turning into nonproductive “trust fund babies.” They are aware that second- or third-generation children with access to substantial wealth often become dependent entirely on their parents’ legacies, and contribute little, financial or otherwise, to their families or society. Concerned that trust fund babies often display low productivity, suffer from low self-esteem and lack integrity, these parents aim to employ their wealth in a more dynamic fashion to benefit and preserve their families. Incentive trusts incorporate provisions to promote and reward productive behavior as well as the tax-saving and asset-protection provisions included in traditional trusts. Traditional trusts typically authorize a trustee to distribute trust assets irrespective of the manner in which trust beneficiaries conduct their personal affairs. By comparison, incentive trusts are typically specifically tailored to promote the grantor’s values and goals, and require that the beneficiaries adhere to the performance standards the grantor established to be entitled to trust distributions. Incentive trusts are especially attractive to entrepreneurial parents who earned their wealth. For these parents, the incentive provisions serve as a form of “financial parenting” that can be tailored to suit their individual concerns. Entrepreneurial parents generally have a different work ethic than their children, but are typically satisfied with their children’s values and ethics. However, these parents often are concerned that their grandchildren have grown up in a very privileged environment and, as a result, the grandchildren see little direct connection between work and reward. For these reasons, incentive trusts generally provide for fixed distributions to the children and delay implementation of the incentive provisions until the grandchildren are eligible for distributions. The trust agreement is the primary governing document of an incentive trust. Parents may achieve their tax-savings and asset-protection goals through an incentive trust in much the same way as with a traditional trust. The “incentive” aspects are incorporated into the agreement through cross-references to family-specific exhibits. The incentive trust agreement should be structured as a perpetual “dynasty trust,” which is fully exempt from the GST tax. It should provide for a family trust that continues in perpetuity, rather than an initial trust that divides into separate subtrusts upon the death of a parent or upon the occurrence of some other triggering event. A statement of purpose The incentive trust agreement should include a statement of purpose and distribution guidelines through which the parents accomplish their goals for their family. The agreement must clearly require that distributions be made in furtherance of the grantor’s statement of purpose and in accordance with the distribution guidelines. As with any dynasty trust agreement, the incentive trust agreement may provide for discretionary distributions of income and principal or limit distributions to only the income, and not the principal, of the trust. Alternatively, a parent may prefer a “unitrust” concept, so that the trustees would distribute a fixed percentage of the value of the trust assets to the beneficiaries, regardless of how much income is generated in a given year. Deciding how and whether to distribute trust income and principal will depend upon the amount of assets contributed to fund the trust, the nature of the assets held by the trust and the parents’ goals for their families. The statement of purpose should include the guiding principles according to which the trustees, above all else, should administer the trust. The statement should be broad enough not to hinder the trustees in administering the trust when unforeseen circumstances arise, but tailored to truly express the grantor’s goals. It should be clear and irrevocable, but nevertheless a statement that reflects human values, not legal principles. The distribution guidelines should be an attachment to the incentive trust agreement and be designed to accomplish the parents’ goals for their family. These guidelines may be the most important part of the trust agreement because they set forth the incentive provisions upon which the entire incentive trust concept is based. As explained by Marjorie J. Stephens in her article “Incentive Trusts: Considerations, Uses and Alternatives,” 29 ACTEC Journal 5, 18 (Summer 2003), the distribution guidelines should provide “a statement of how the family anticipates that the trust would be carried out considering the parents’ understanding and knowledge of their children, the economy, and the world today.” The distribution guidelines should set forth the circumstances under which the grantor expects the trustees to distribute or withhold trust assets in order to provide the trustees a road map for administering the trust. Thus, unlike a statement of purpose, the distribution guidelines must both provide legal guidance and reflect human values. It is impossible to know with certainty what hurdles the trustees will encounter. Moreover, a perpetual trust is likely to continue for a long time. Accordingly, overly rigid incentive provisions can have the unintended effect of paralyzing trustees from being able to adapt trust administration in the face of unforeseen circumstances. This can be especially problematic when narrow incentive provisions are incorporated into a trust agreement that is irrevocable and cannot be amended. Thus, the guidelines’ incentive provisions should evolve over time as the need arises. One of the challenging issues that attorneys often face in drafting an incentive trust agreement is understanding whether their clients want to use incentive provisions to elicit positive behavior, discourage negative behavior or accomplish some degree of both. Many clients have broad notions about the kinds of behavior they want to facilitate or deter, but find it challenging to focus their general ideas into incentive provisions that can actually be administered by trustees. For example, many feel strongly that no children should receive trust assets before they are mature and have proven that they can manage their affairs responsibly. However, the clients may not be able to describe their view of “sufficiently mature” in precise enough terms to be incorporated into an incentive trust agreement. An experienced attorney can help steer clients through the process by helping them draft the distribution guidelines. The grantor should authorize the trustees to amend the distribution guidelines. Generally, incentive trust agreements designate a single administrative trustee to serve during the lifetime of the grantor and his or her spouse. Thereafter, the trust would be administered by an administrative trustee together with a board of trustees consisting of a group of people named in the incentive trust agreement. The administrative trustee, and later the board, is typically authorized to amend the guidelines. The board of trustees The incentive trust agreement sets forth how the incentive trust would be administered. The administrative trustee typically handles the day-to-day affairs of the incentive trust and makes distributions pursuant to the distribution guidelines. The board of trustees decides what the terms of the distribution guidelines should be and how the distribution guidelines should evolve over time, consistent with the grantor’s statement of purpose. The board of trustees also determines the overall policy of the trust concerning investments and other matters. The incentive trust agreement should identify the administrative trustee and the initial members of the board of trustees, and set forth procedures for electing their successors. At least one trustee should be elected by the beneficiaries. If the incentive trust agreement provides for distributions to charity, a charitable representative also should serve on the board of trustees. It also may be prudent to include a tax adviser on the board, as well as the person principally responsible for managing the incentive trust assets. Lastly, parents may want to consider including family counselors, trusted business associates or senior family members on the board of trustees. Under the laws of most states, the members of the board of trustees will be subject to the duties and liabilities typically imposed on fiduciaries. Many brokerage houses, banks and professional firms prohibit their partners and employees from serving as trustees to protect them from potential fiduciary liability. As an alternative, the incentive trust may be established under Delaware law, which could permit a board of advisers (who are not fiduciaries) to direct the administrative trustee in much the same capacity as a board of trustees. The board of trustees should act by vote upon terms set forth in the incentive trust agreement. It controls the distribution guidelines. Accordingly, parents should think carefully about the voting power they want to give to the beneficiaries, through the trustees they elect. In most cases, the trustees elected by the beneficiaries should not constitute more than 40% of the board’s voting members. The incentive trust agreement also should set forth the manner in which the board of trustees operates. At a minimum, the board should meet once a year to review the trust distributions for the prior year and consider whether revisions should be made to the distribution guidelines. The annual meeting of the board should be coordinated with an annual meeting of the beneficiaries. The administrative trustee should prepare a full accounting each year and deliver it to the board of trustees and each beneficiary (or his or her guardian) for review at their annual meetings, together with detailed agendas for their meetings. In this manner, the board’s role is comparable to that of a board of directors of a corporation; the role of the beneficiaries is comparable to that of the shareholders. Likewise, parents may consider authorizing trust beneficiaries to submit special distribution proposals, much like grant proposals, to the board of trustees for consideration at the annual meeting. The board would approve or reject a special distribution proposal based on the members’ interpretation of the statement of purpose and the parents’ goals for establishing the incentive trust. Wealthy people are often philanthropic. Historically, philanthropic individuals have allocated their assets among trusts for family members and separate trusts, foundations or outright bequests for charity, often in a relatively arbitrary manner. However, charitably inclined parents may find the incentive trust to be an attractive vehicle for furthering both family goals and philanthropic goals through one trust. Providing for charity in an incentive trust can be accomplished through a multitude of techniques. Parents may provide that excess net cash flow remaining after the trustees make distributions to family beneficiaries in accordance with distribution guidelines must be paid to charity on an annual basis. Alternatively, parents may limit the total distributions each year to a fixed percentage of the value of the trust assets and direct that net cash flow remaining after distributions are made to family beneficiaries pursuant to the distribution guidelines must be paid to charity. Parents can specify the charitable beneficiary in the incentive trust instrument, authorize a philanthropic committee to select the charitable beneficiaries or provide for a combination of procedures. James E. McNair, Gregory J. Rupert and Cynthia L. Gausvik are tax partners in the wealth-preservation group in the McLean, Va., office of Washington-based Patton Boggs.

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