LAW OFFICES OF OSHINS & ASSOCIATES, LLC

Imagine a world where there are no state income taxes. Imagine a world where there are no estate taxes. Imagine a world where your assets can’t be taken in a divorce. Imagine a world where your assets can’t be taken in a lawsuit. Now imagine that this world can be created for your descendants forever! As the co-authors of AB325, we have made this fantasy world a reality in Nevada, effective December 1, 2002, with the expected passage of AB325.¹ The passage of this Bill will not only give Nevada residents the ability to create the ideal estate planning vehicle, but it will also give out-of-state residents the same ability to take advantage of the new favorable Nevada law by simply using a Nevada trustee or co-trustee and applying Nevada law in the trust document.

Currently, Nevada’s Constitution at Article 15, Section 4 limits a trust’s duration by imposing a rule against perpetuities on all Nevada trusts except those created for charitable purposes. In 1987, the Nevada Legislature codified this rule against perpetuities by enacting the Uniform Statutory Rule Against Perpetuities Act ("USRAP"), NRS 111.103 to 111.1039, prohibiting trusts from lasting in perpetuity.

A number of states have recently changed their laws to permit perpetual trusts ("dynasty trusts") in order to benefit those states by increasing the trust business, assets, and revenue within their borders. This creates a hardship on Nevada residents, who are forced to establish such trusts in other states, and on the Nevada economy as the trust assets leave Nevada’s borders. For several reasons, including combating these hardships, Assemblyman David Goldwater carried the legislation to change Nevada law. The legislation includes A.J.R. 4 that repeals the Nevada constitutional prohibition against non-charitable perpetual trusts and AB325 that statutorily permits residents and non-residents to exempt certain trusts from the rule against perpetuities by "opting out" of the rule. Specifically AB325 states that the rule against perpetuities applies unless the governing instrument specifically states that the rule or the provisions of the code shall not apply to such trust and either the trustee has an unlimited power to sell all trust assets or one or more persons, including the trustees, have the power to terminate the entire trust.

Two consecutive legislatures must approve any change to the Nevada Constitution. Accordingly, Assemblyman Goldwater submitted A.J.R 4 to the 1999 and 2001 legislative sessions, where it passed. Additionally, the people must vote to approve any constitutional change. Accordingly, A.J.R. 4 will be submitted for popular vote in 2002. If approved, the constitutional repeal is effective and AB325 permitting perpetual trusts in Nevada becomes law.

A dynasty trust is an irrevocable trust that continues forever. If generation-skipping transfer tax ("GST tax") exemption is properly allocated to the trust, the trust assets are not subject to estate taxes, divorce or lawsuits. Prior to December 1, 2002 (and on or after such date if AB325 does not become law), modified dynasty trusts can be created under Nevada law which protect the trust assets from estate taxes, divorce and lawsuits for as long as Nevada’s rule against perpetuities allows. Nevada’s current rule against perpetuities allows a dynasty trust to continue for lives in being (an ascertainable list of persons alive when the trust is created or becomes irrevocable) plus 21 years, or for 90 years. Thus, current Nevada law generally provides for the dynasty trust to provide these benefits for approximately 90 to 120 years.

At the time of this writing, fifteen states have either abolished their rule against perpetuities or enacted a statute permitting the grantor to opt out of the rule against perpetuities in the trust agreement. Those states are Alaska, Arizona, Colorado, Delaware, Idaho, Illinois, Maine, Maryland, Missouri, New Jersey, Ohio, Rhode Island, South Dakota, Virginia and Wisconsin. In addition, Florida allows a 360-year dynasty trust, and Washington allows a 150-year (effective January 1, 2002) dynasty trust.

The rest of this article will discuss two alternative structures for the dynasty trust – (1) a Beneficiary Controlled Trust and (2) a Third Party Controlled Trust. Most of our clients will select one of these two structures.

Many of our clients want to leave their property to their loved ones outright, provided that at the time of the gift or bequest the desired recipient is capable of managing the property wisely. For these clients, trusts controlled by those beneficiaries ("Beneficiary Controlled Trusts") are generally recommended rather than outright transfers.

The Beneficiary Controlled Trust concept is fairly simple. It is a trust where the primary beneficiary either is the sole trustee or has the ability to fire any co-trustee and select a successor co-trustee. Typically, control of the trusteeship is coupled with a broad special power of appointment that can have the effect of eliminating any potential interference by remote beneficiaries. Because the primary beneficiary/trustee possesses the ability to eliminate all participation in the enjoyment of the trust assets by secondary and remote beneficiaries, the latter will not be inclined to interfere because their rights could be eliminated.

The Beneficiary Controlled Trust is designed to provide the primary beneficiary with all of the rights, benefits and control over the trust property that he would have had if he owned it outright, in addition to tax, creditor and divorce protection benefits that are not obtainable with outright ownership. The ability to derive more benefits in a trust than one would obtain with outright ownership without giving up control leads one to wonder why trusts are not the vehicle of choice in virtually every estate plan and why Beneficiary Controlled Trusts are not used instead of outright transfers in almost every instance in which the transferor otherwise would be inclined to gift or bequeath the property outright. Furthermore, if this philosophy makes sense for the first generational level of descendants, it logically follows that the trust should be designed as a dynasty trust so that more remote descendants are also given these benefits and protections.

Designing the Beneficiary Controlled Trust

Once it has been decided that a Beneficiary Controlled Trust should be used, the design of the trust to achieve and maximize the desired results becomes important. In its simplest structure, the trust could be designed whereby the beneficiary would be the sole trustee and have the right to any or all of the income, plus access to principal limited to health, education, support and maintenance, plus a broad special power of appointment during life and/or at death to anyone other than the beneficiary, his creditors, his estate, or the creditors of his estate. However, in most instances this trust variation is not recommended because greater flexibility, tax benefits and creditor protection can be obtained using a discretionary Beneficiary Controlled Trust with multiple trustees. By using friendly, independent trustees (or special trustees who could act under appropriate circumstances), certain powers can be woven into the trust agreement that could not exist if there were no independent trustees. This is so because powers that are rather innocuous in the hands of an independent trustee would cause tax and creditor problems if lodged in the hands of a beneficiary/trustee. Use of an independent co-trustee is generally acceptable when one realizes that the grantor may have broad removal and replacement powers as long as the replacement trustee is not a "related or subordinate party" as defined in IRC §672(c).³ Alternatively, such power may be lodged in the hands of the beneficiary.⁴ The use of a discretionary trust, where distributions are subject to the absolute discretion of an independent trustee, has been described as "... the ultimate in creditor and divorce claims protection - even in a state that restricts so called ‘spendthrift trusts' - since the beneficiary himself has no enforceable rights against the trust."⁵

The basic philosophy of this article is that a transfer of property in trust improves the value of the property to the trust beneficiaries. The corollary of that thesis is that distributions from the trust, in the absence of a compelling reason to make distributions, such as onerous income tax consequences, should be avoided. The consequence of making distributions would be to move wealth from a tax and creditor protected environment into one that is exposed. Because of the dynastic nature of the trust, the adverse effect of such leakage would be greatly magnified. It is anticipated that the investment pattern would be designed to enable the trust to realize and optimize the grantor’s goal to avoid transfer taxes and creditor exposure for multiple generations.

The trustee should be encouraged to acquire assets that are expected to appreciate in value for the "use" of the beneficiaries, rather than funding the individual's personal acquisition of the assets. The right to "use" the trust assets may be for any purpose and need not be limited by an ascertainable standard without coming within the general power of appointment proscription contained in IRC §2041 even though the decision to allow the use is in the hands of a person acting in the dual capacity of beneficiary and trustee. Rather than being a power of appointment, use of the trust assets would be akin to a life estate. The trust instrument, particularly where a Beneficiary Controlled Trust is the vehicle of choice, should contain specific language that permits investment in assets such as homes, artwork, jewelry, and business and investment opportunities (whether speculative or not), that have significant appreciation potential. This course of action is generally viewed by purists as being the antithesis of traditional trust investments, but is consistent with the philosophy of the Beneficiary Controlled Trust in that the trust wrapper is employed solely as an enhancement to provide benefits to the trust beneficiary without meaningful restrictions. Since the beneficiary would have unrestricted investment power had he received the assets outside of the trust, it would be consistent with coming as close to outright ownership as possible to permit broad investment powers inside of the trust.

The beneficiaries individually (or by utilization of assets in trusts not protected by the GST tax exemption) are expected to absorb most family expenditures such as food, schooling and vacations. Additionally, trust funds should generally not be expended for consumable assets since use of protected funds in this manner would be wasteful. If the trust were to acquire and own assets such as the beneficiaries' businesses and homes, it would indeed be rare that an otherwise functional beneficiary could not fund the foregoing family expenditures and consumables with property outside of the trust. In fact, it is reasonable to conclude that if a beneficiary could not so provide, the trust alternative would be even more desirable as a creditor protection shield. In order to further protect the beneficiary, rather than making distributions to the beneficiary, the trustee should make secured loans to the beneficiary so that the trust, rather than the beneficiary's creditors, would have priority in case of bankruptcy.

A broad special power of appointment is often given to the primary beneficiary of a trust, particularly if it is a Beneficiary Controlled Trust. A power of appointment is a desirable ingredient in most trusts because it adds flexibility, and permits the trust to be modified in order to deal with changes in the law or family circumstances. Its importance increases when the trust is dynastic because there is a greater possibility of change in family circumstances or tax laws. For many clients, the power of appointment is, and should be, an essential ingredient of the plan. They may not be inclined to proceed with their planning in its absence because of a concern of interference by a complaining beneficiary. The use of a special power of appointment enhances the objective of using a Beneficiary Controlled Trust in that it provides added control in the hands of the primary beneficiary. For example, by giving the trustee broad latitude in investing, including high risk/reward opportunities, it can be anticipated that some transactions will fail. If there were no trust, there would be no accountability to more remote descendants. By coupling the power of appointment with broad discretionary powers in the hands of the trustee/beneficiary, the result would be that the trustee/beneficiary would have the functional equivalent of no accountability with respect to the trust.

If the creator of the trust desires to provide the beneficiary with rights that are as close to outright ownership as possible, the powerholder can be given the power to appoint the property in favor of anyone, in trust or outright, other than himself, his estate, his creditors or the creditors of his estate⁶ without causing estate inclusion. A concern often voiced by dynasty trust candidates and some of their advisors is that they don't want to be irrevocably locked into a trust arrangement forever. A power of appointment that can be exercised by making outright distributions, thus terminating the trust, can easily finesse that perceived problem.

Obviously, not all clients share the foregoing philosophy, and sometimes circumstances preclude or suggest that all power not be lodged in a beneficiary. For such clients, the estate plan should be designed to take into account and reflect the specific variations and desires of the client to accomplish his or her objectives. Illustrations of circumstances where the client would not select a Beneficiary Controlled Trust include situations where the beneficiary is either legally (e.g., a minor) or practically (e.g., inexperienced, disabled, lacking judgmental skills, etc.) incapable or unable to assume managerial responsibility; where the client wants to limit the beneficiary's enjoyment of the property, enabling others to enjoy and share in the wealth; or where the client wants to limit the beneficiary's power of disposition over the property. In such instances, a trust, although not a Beneficiary Controlled Trust, should be considered, even for transfers in which tax considerations are not a substantial factor.

For example, the client might consider a dynasty trust naming an independent individual trustee, corporate trustee, or some combination. While an independent individual or corporate trustee both offer the desired neutrality important in a long-term trust, each offers unique advantages and disadvantages. A corporate trustee offers professional management and may be more aware of changes in tax, trust, and other laws than would an individual trustee. Also, only a corporate trustee provides continuity of management. On the other hand, an independent individual trustee might offer the comfort of more "personal" involvement, and less bureaucracy. The grantor might obtain all these benefits by appointing the individual and corporate trustees to serve together as co-trustees or with bifurcated duties. For example, the individual trustee might have power over trust distributions and the corporate trustee might have power over trust investments, tax preparation, and trust administration. Additionally, the trust could include a trust protector with the power to terminate or amend the trust if changes in tax laws or circumstances make the trust purposes impossible, impracticable, or obsolete. With careful drafting to address tax issues, substantial flexibility exists to craft the appropriate provisions to carry out the grantor’s objectives.

With the passage of AB325 Nevada will join the increasing number of jurisdictions allowing perpetual trusts. Properly drafted, the assets placed in the dynasty trust, and the future appreciation on those assets, remain free of estate and GST taxes in perpetuity. While estate tax savings is a major dynasty trust benefit, even if estate tax repeal becomes a permanent reality, dynasty trusts will likely continue to be the wealth transfer vehicle of choice because of their many other advantages such as divorce and creditor protection or, in certain circumstances, state income tax savings under present Nevada law. If passed AB325 will permit families to give their heirs a secure financial future with as much or as little control, flexibility and asset protection as they desire and for as long as they desire, including forever under Nevada law. Imagine this world. Very soon it will become a reality!

Judith K. Ruud is of counsel with the Law Firm of Perkins Coie, LLP in Boise, Idaho. She has practiced for over 15 years in the area of personal estate and business planning, Judith is well-recognized as having an expertise in these areas, that includes estate/business planning, leveraged gifting, charitable giving, and general wealth transition, particularly for affluent clients. She has published several articles on dynasty trusts, charitable giving and other topics and is a much sought after speaker on estate, business & wealth transition topics, lecturing across the country to professional and non-professional audiences. She is a member of the Idaho Bar and American Bar Association, and serves on several charitable boards in Idaho. Judith can be reached at 208-343-3434 or ruudj@perkinscoie.com.