Wealth is difficult to amass but easy to squander. This worries some affluent parents, so they are transferring assets to their heirs with strings attached. With a $5 million lifetime gift tax exemption in place for 2011 and 2012, parents are transferring significant amounts to their children and grandchildren now instead of leaving it to them at death. However, parents realize that putting such wealth in the hands of their heirs could be folly if the heirs lack self-motivation, strong work ethics, financial savvy and core values. To encourage positive behavior, some parents are funding incentive trusts, which dictate whether their heirs will actually receive any of the money earmarked for them.

An incentive trust requires the beneficiary to meet certain milestones defined by the trust creator, or grantor, to receive distributions of income and principal. Typical milestones include maintaining a given grade point average while in school, graduating from college, obtaining full-time employment and becoming actively involved in philanthropy. For example, the trust may state that the trustee will make annual distributions equal to the beneficiary’s earned income.

An incentive trust can provide numerous benefits to the grantor. If structured as an irrevocable trust, it is an effective means of transferring assets and future earnings out of the grantor’s estate, thus escaping estate taxes. For many grantors, however, the tax benefits of establishing such a trust are secondary. These individuals are often attracted to its non-tax attributes, such as using the trust to establish a legacy, a way of passing on core values to younger generations. The trust can also serve as a motivational tool, encouraging beneficiaries to obtain a certain level of education or to seek gainful employment, which might not occur if the child grew up with money and developed a strong sense of entitlement.

However, incentive trusts can have unintended consequences. Beneficiaries may not develop the value system the grantor was attempting to enforce through the trust. They may even adopt negative behavior to game the system. This may include doctoring college transcripts or creating fake diplomas or pay stubs to meet the distribution requirements of the trust. If the grantor does not clearly define her intentions, beneficiaries may be penalized for pursuing low-paying careers, such as becoming elementary school teachers, or for deciding to be stay-at-home parents, if trust distributions are tied to their salaries. Entrepreneurial or other professional aspirations may be crushed if trust distributions require participation in the family business, pushing beneficiaries to pursue careers in which they may have no interest. Such ill-considered provisions can cause resentment by one or more beneficiaries toward the grantor for trying to control their lives well into adulthood. They can also cause some beneficiaries to resent their counterparts who have accomplished trust requirements necessary to receive distributions. Often, these unintended consequences are the result of trusts that are inflexible and difficult to administer. » Read more: Do Incentive Trusts Encourage Responsibility?