Business Roundup: Should We Give Incentive Trusts a Fresh Look?
Distribution strategies are highly debated in the circles of attorneys, trust officers, and others. Some are fans of ascertainable standards (thus permitting interested trustees), while others prefer independent trustees with completely discretionary distribution authority.
In a recent article, Steve Oshins did a great job breaking down some issues that often fly under the radar with the traditional “HEMS” (health, education, maintenance, and support) distribution standard – with the recommendation being towards at least an independent co-trustee having fully discretionary distribution powers. This also makes it easier, for example, to decant the trust for reasons I will later discuss (perhaps as an alternative to an incentive trust or a no-contest clause).
The issues in trust design, however, often pop up when we attempt to color between these two distribution standards – especially where a related or interested trustee with a “HEMS plus” standard is involved. This is where the “incentive” trust enters the picture. Incentive trusts often take a carrot and stick approach, allowing expanded distributions to reward positive behavior and withheld distributions to discourage negative behavior. However, I routinely hear stories of why incentive trusts are a bad idea – more so than success stories.
A recent Kitces.com article is pro-incentive trusts, and while some good points are raised in the article, I remain bearish on the incentive trust. The article briefly alludes to this fact, but the incentive trust is only as effective as the choice of trustee. Choice of trustee is often a significant sticking point for clients in the estate planning process, and including incentive provisions may actually do more to inhibit than encourage a client to move forward when confronted with this choice of trustee. And, trustees are rarely chosen by the beneficiary – creating a fundamental bias towards the trustee adopting dated and inflexible views of the maturity and acumen of a beneficiary (especially when older generations build rapport by criticizing the younger generation).
One issue that often flies under the radar is that incentive trusts create fixed, determinable distributions. This type of distribution can erode the creditor protection of the trust, as it allows a creditor to anticipate the “toothpaste leaving the tube” of the trust to make or refresh a claim. And while I am not aware of any cases on point, I wonder whether a creditor garnishing a beneficiary’s wages could have an argument to treat distributions that match earned income as an augmentation of the wage base that could be garnished to begin with.
Maintenance and support are, traditionally, the flimsiest legs of the HEMS stool. But, health and education can be difficult as well, as Christopher Harrison and I discussed in a prior article in Trusts & Estates. What we did not mention is the trickle-down effect of incentive distributions on health and education. For example, a beneficiary receiving a distribution for attaining a certain GPA may be incentivized to stay in school longer, perhaps with less meaningful progress towards a degree (in other words, the Van Wilder path). Many trusts are set up to allow the spigot to remain on for any and all educational and health-related expenses, which can easily mask “luxury” types of distributions.
No-contest clauses can augment the incentive trust. But, the more I read about no-contest clauses, the more I am convinced they are a terrible idea. These clauses are often created to discourage litigation, especially in a carrot-and-stick style incentive trust, but have the opposite effect. They can be weaponized against trustees, as well as beneficiaries having clean hands. Many no-contest clauses are poorly drafted, with little thought towards state-law compliance or even practicality, which exacerbates court scrutiny when confronted with the strict construction of these types of clauses by courts. I am thoroughly convinced that an independent trustee – with the power to completely turn the spigot off – can be a better alternative.
Incentive trusts often have the stated goal of instilling certain “values” in beneficiaries, but we cannot equate behavior with values. Incentive trusts simply encourage or discourage certain behaviors, and as I will later discuss, there is no incentive so great that it can lead a beneficiary to permanently change to adopt desired values overnight. Instead of values, what I believe we should be encouraging is investment in the differentiation of beneficiaries – an outcome that will require a different level of trustee guidance coupled with empathy for broader macroeconomic and media-driven factors to which a beneficiary has been exposed.
But, don’t take it from me. I can provide you with several contacts and references who will discourage the use of incentive trusts. If you would like to hear some of their perspectives, please let me know. Keep in mind, however, that any trust is only as good as the choice of trustee. Ultimately, the most impactful incentive may be the opportunity for a beneficiary to become co-trustee or sole trustee of their trust - which is perhaps where significant attention should be directed in the trust design and drafting phase.
Article Summaries
A “Better” Guide to Estate Plan Funding: Part 1
This is the introduction of a course that, to date, will be my magnum opus. Wealth management is swallowing estate planning, and perhaps the biggest tension behind this shift is funding the estate plan. Yet, funding has shifted from a practical endpoint to a marketing and differentiation buzzword.
This course will be for paid subscribers, and the focus will be a first-of-its-kind multidisciplinary approach to the new principles of estate planning that necessitate leading with funding, instead of finishing with funding.
In this preview, I argue that most Americans now have two parallel estate plans. Nonprobate assets have largely become the purview of financial advisors (especially liquid nonprobate assets), and probate assets/liabilities remain the purview of estate planners. Yet, by operation of law, the nonprobate bucket of assets dominates over the probate bucket – leading to inconsistent estate planning results, and different principles for each parallel estate plan. The opposite can hold true as well - probate liabilities can control some assets in the nonprobate bucket. Funding is simply a method of merging these two buckets, while also merging the complimentary skillsets of advisor and attorney alike.
A Tale of Two Cases: Connelly and Anderson
Ultimately, buy-sell agreements are driven by valuation, and whether we like it or not, valuation is driven by estate and gift tax – with IRC Section 2703 being the starting point. This Code Section has principles that are difficult to debate, and to me the issue in Connelly (along with its split from Blount) were masked valuation cases where this supposed “redemption obligation” theory was given credence independent of IRC Section 2703. But, should the redemption obligation theory have been decided separate from the effects of this Code Section?
I explain why it perhaps should not in this article, while contrasting a recent order denying summary judgment for a similar redemption buy-sell agreement in Anderson. Both cases were based on valuation terms, but each recognized a common theme and question of whether valuation is one-sided or instead a truly arms’ length determination. Perhaps the outcome is not necessarily that buy-sell agreements – especially redemption buy-sells – are flawed, but instead that a majority shareholder or related shareholders make it difficult to argue that all terms of a buy-sell agreement are entered into at arms’ length - including not just valuation, but provisions for termination and amendment (which played a supporting role in Connelly). And, as I argue under IRC Section 2703, federal gift and estate tax values will always drive the ship when the agreement itself or the valuation methodology is not at arms’ length.
AI in Estate Planning: All Questions, No Answers?
I had the privilege of presenting a plenary session with Judge (Ret.) Elizabeth Weishaupl on the ethics of tech and AI at the recent Colorado Bar Estate Planning Retreat. The opinion I offered is that change in the practice of law moves at a glacial pace, and while AI cannot increase this pace, it can perhaps melt the glacier.
Luckily Ryan Gosling did not show up dressed as Beavis during our talk, but just in case that happened, I jotted down some of my thoughts on the business side of things in this article before giving the talk. My diagnosis is that the attorney who does not want to interact with clients, but instead sit back and automate form documents, will perhaps be threatened by AI. But, someone who values the pure role of being a source of counsel and advice will perhaps become more of a unicorn – opening up the possibility of new practice models and fee structures that are supported by AI.
What I have coming down the pike is an examination of “who” pays for, and benefits from, AI and other estate tech. It is often pitched to business owners as an employee replacement, which is framed as being acceptable, but demonized when employees use it to do more with less. This is a fundamental tension that may threaten succession in wealth advisory, legal, and accounting practices.
The Intersection of IRC Section 642(c) and S Corporations: More Than Meets The Eye?
S corporations have an issue when mixed with tax-exempt organizations – they create unrelated business taxable income, which is not tax-exempt. And, both S and C corporations have the issue that appreciated property cannot be distributed without deemed gain recognition – even if shares in the corporation get a step-up in basis at death.
This UBIT issue can rear its ugly head when a trust distributes income to a charity, for purposes of the deduction under IRC Section 642(c). A recent PLR noted that gains recognized by a trust due to a liquidating distribution from an S corporation could be offset by this charitable deduction for trusts. Unlike individuals, this income deduction is unlimited – unless UBIT is involved. In such a case, IRC Section 681 can impose the IRC Section 170 AGI limitations that apply to an individual if the trust has “unrelated business income” - which is not the same as UBTI, but is determined under the same rules. So, in this PLR the IRS served up on a platter the idea that this limitation may apply even though it was not part of the ruling request (which related solely to the application of IRC Section 642(c)).