The Power of a Dynasty Trust
Early in the twentieth century, the United States began taxing wealth transfers under the gift and estate tax system. This system was designed to impose tax on each and every generation (father to son, son to grandson, etc.). The very rich soon began to thwart this system by transferring wealth directly to grandchildren, thus skipping a level of taxation. Congress eventually caught on to this strategy and responded with the generation-skipping transfer tax (GSTT). GSTT is an additional tax that’s imposed whenever transfers are made to persons who are more than one generation below the taxpayer (e.g., grandfather to grandson). GSTT is a flat tax imposed at the highest gift and estate tax rate in effect at the time of the transfer (45% in 2007).
Furthermore, most states impose their own transfer taxes. Together, these taxes can take an enormous bite whenever substantial wealth is being handed down, and over time they can erode a family’s fortune. This can be troublesome to individuals who would prefer to have their legacies benefit their own family members. It’s from these circumstances that the dynasty trust evolved.
How does a dynasty trust work?
The law allows generation-skipping transfers to go untaxed up to a certain amount by providing a lifetime exemption (currently $2 million per taxpayer, or $4 million per married couple). Typically, a dynasty trust is funded with amounts that take full advantage of the GSTT exemption. The trust then provides for future generations for as long as it exists. Although the trust assets effectively move from generation to generation, there are no corresponding transfer tax consequences.
To enjoy this tax benefit, access to trust property by the beneficiaries must be limited. You can decide how narrow or broad a beneficiary’s access will be within those limits. For example, if you wish to give a beneficiary as much control as possible, you can name the beneficiary as trustee, and give the beneficiary the right to all income and the right to consume principal limited by “ascertainable standards” (i.e., health, education, maintenance and support). The beneficiary can be given even more control by granting a special (or limited) testamentary power of appointment (i.e., the power to name successive beneficiaries).
On the other hand, if you want to restrict access to the trust as much as possible, you can name an independent trustee who has sole discretion over distributions coupled with a spendthrift provision. The trustee will have full authority to distribute or not distribute income or principal to the beneficiary as the trustee deems appropriate. The spendthrift provision will prevent the beneficiary from voluntarily or involuntarily transferring his or her interest to another before actually receiving a distribution. The greater the restrictions, the less likely creditors or other claimants will be able to reach trust property.
How long can a dynasty trust last?
A dynasty trust can last as long as state law allows. In states that still have a “rule against perpetuities,” the life of a trust is limited to 21 years after the death of the last beneficiary to die (which conceivably could be 100 or more years). Trusts in the states that have abolished their rules against perpetuities can, in theory, last forever.
The bottom line
A dynasty trust can meet the objectives of high-net-worth individuals concerned about intergenerational planning.
A dynasty trust is not a do-it-yourself project, however. See an experienced estate planning attorney for more information.