Wednesday, June 29, 2011

Can Successful Entrepreneurs Use Incentive Trusts To Help Their Kids?

In his article, "Should You Leave It All to the Children?," Richard Kirkland quotes Warren Buffett for having said, “The perfect amount of money to leave children is enough money so that they would feel they could do anything, but not so much that they would do nothing.” In that same article, Minnesota native and famous entrepreneur, Curt Carlson, was quoted as saying, “There’s nothing people like me worry about more—how the hell do we keep our money from destroying our kids?”

Incentive trusts are a type of trust, often for the benefit of children, that make distributions or allow for withdrawals based on defined incentives. For example, if a child graduates from an Ivy League college, they can withdraw 10% of the trust principal, or if a child earns up to $100,000 per year, the trust will match that income.

Often, first generation wealth holders—or, in many cases, the entrepeneur that built the business—want to use incentive trusts to protect the money they intend to pass on to their children and impose some kind of control after their deaths. Incentives may seem like a good way to inspire your children to act and participate in society the way that you would want them to after your death, but often incentive trusts don’t work or may even backfire. Evidence suggests that money is helpful in controlling people, but not necessarily internally motivating people. Individuals subject to incentives will rarely go beyond the incentive benchmark.

For example, if you match income up to $100,000, very few people would ever strive to earn more than $100,000 or would ever start a business where the earnings may be more uncertain or less than $100,000 for a period of time. In addition, what might seem like a good incentive, like attending an Ivy League school, doesn’t actually ensure that the child will graduate or do anything with the degree. Some children may view the incentive as impossible, so they never try. In other cases, the trustees end up spending years in litigation with the child who demands distributions from the trusts that are outside of the incentives. This may be good for lawyers like my colleagues who handle these types of claims, but it is rarely good for the child or the family. Finally, drafting a trust agreement that perfectly insulates the trustee, yet makes the incentive clear and enforceable, is difficult if not impossible in most circumstances.

The bottom line is this: Trusts don’t develop values on their own. Incentives don’t usually work in the way we want, and may unintentionally cost the child ambition and potentially drain the trust in litigation fees. Try your best to impose good financial habits, charitable inclinations, and financial sense during your child’s life. If you can’t, and you are worried about how your children may spend their inheritance or manage a business in their trust, limit the amount they receive or ask your estate planner to give a professional trustee (a non-family member) unfettered discretion to make and withhold distributions.

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