Generation-skipping trusts have long offered wealth preservation and asset protection, but state laws limited their duration. Today state barriers are dropping, and affluent clients can create dynasty trusts that will last for generations.
It has long been possible to establish a generation-skipping trust to preserve assets for grandchildren, but in many states such a trust now can be extended in perpetuity, thus keeping wealth in the family for multiple generations. For tax and non-tax reasons, such dynasty trusts can be an important tool for affluent clients, but there are many variables to consider before choosing to set one up.
First, let's consider the benefits. On the tax front, family wealth is preserved because estate taxes are minimized. "A dynasty trust is a family bank, growing over time," says Melissa Langa of the Boston law firm Bove & Langa. "Let's say a grandchild needs money for a mortgage or to start a business. Instead of being subject to the prevailing interest rates of a commercial bank, she can go to the trust and the trust can lend the money at a favorable rate or at no interest at all."
The bank grows even faster if the dynasty trust is structured, as most are, as grantor trusts. Such "intentionally defective grantor trusts" allow trust assets to grow undiminished by taxes because the grantor pays the income tax as it comes due. However, dynasty trusts should not automatically take the form of grantor trusts. Although this strategy benefits the family in the long run, some clients do not wish to pay taxes on income they do not receive, and such wishes should be respected.
In addition to tax relief, dynasty trusts usually provide asset protection. While this can be critical for professionals subject to potential liability claims, it's also important for people worried about possible claims from creditors or a former spouse. "To my mind," says estate attorney Steven Oshins of Oshins & Associates in Las Vegas, "creditor protection and divorce protection are more important. If you lose the assets to a creditor, there's no estate tax anyway."
Until recently, two factors curtailed widespread use of dynasty trusts: state limits on trust duration and federal limits on the exclusion from generation-skipping transfer tax.
The state of the States
Most states have long had a "rule against perpetuities," typically limiting trust duration to the lives of beneficiaries living at the time of the trust's creation plus 21 years. Name a 10-year-old grandchild as a trust beneficiary under these rules and, if she lives to age 75, the trust will end in 96 years.
The rule against perpetuities is rapidly going the way of the dodo bird. At least 17 states and the District of Columbia have discarded it completely, while others have passed laws retaining the concept of a time limit but extending the period. Florida now limits trusts to 360 years, according to Oshins, while Wyoming and Utah have 1,000-year rules.
Of these states, estate attorneys prefer the ones with the golden combination of no state income tax on trusts and strong asset protection laws. Among them: Alaska, Delaware, Florida, and South Dakota. Delaware, a very popular state for dynasty trusts, does levy income tax on trusts—but not on trusts established by nonresident grantors. Delaware does have "one problem," Oshins says. "It has a rule against perpetuities of 110 years for real estate." This does not preclude establishing a dynasty trust in Delaware with other assets.
Clients need not live in one of these states to take advantage of dynasty trusts. But they do need to designate trustees who are residents of that state. For this reason—and because dynasty trusts are designed to last for generations—the trustee is most often a corporate trustee, although a family member may be named as co-trustee.
Before establishing a dynasty trust—or any trust—and before naming trustees, clients should seek the advice of a knowledgeable estate planning attorney. State laws differ. Without good advice, it's easy to make a mistake that will invalidate the trust or subject it to unnecessary tax.
Tax exclusions
For years, contributions to generation-skipping trusts had to be limited to $1 million to prevent a brutal generation-skipping transfer tax from kicking in, a tax imposed on top of—not instead of—the federal estate tax. Today the generation-skipping tax is linked to the federal estate tax. Both have exemptions of $1.5 million in 2004 and 2005. By 2009, that exemption will be $3.5 million.
But clients need to be careful. The generation-skipping exemption may be $1.5 million and rising, but the gift tax exclusion is frozen at $1 million. Anita Rosenbloom, an attorney with Stroock and Stroock and Lavan in New York, points out that if more than $1 million is placed in the trust, "gift tax must be paid on the difference, a spread that will increase over time." To avoid gift tax, lifetime gifts to a generation- skipping trust should total no more than $1 million, or $2 million for a married couple.
In a solution to the exclusion limitation, clients can fund a generation-skipping or dynasty trust during life, then fund additional a mounts at death. At the death of the survivor, given the right year, up to an additional $5 million can pour into the dynasty trust. By coordinating lifetime and testamentary gifts to dynasty trusts, maximum advantage can be taken of tax exemptions.
Why not wait until death to fund the entire amount? Because removing $2 million from a married couple's assets during life also removes appreciation on those assets from their potentially taxable estates and from the generation-skipping transfer tax as well.
Flexibility
The downside of trusts that can last forever is that they can last forever. "Because these trusts can have such a long time horizon," Rosenbloom says, "the only thing we can be certain about is that everything will change—family circumstances, tax laws, even the markets."
Given this uncertainty, dynasty trusts should be drafted to be as flexible as possible so as not to lock future beneficiaries into out-of-date provisions. A power of appointment can permit beneficiaries to change the trust provisions, shift the trust to another location, or even terminate the trust to meet changing family circumstances and tax laws. "Powers of appointment are vital," Rosenbloom insists, "and they are under-utilized."
Flexibility should also be built into administrative provisions, particularly the power to invest, so trustees can meet changing market conditions. Provision should be made for successor trustees to ensure an orderly transition over the long term.
Another strategy, Langa suggests, is naming a "trust protector," an independent person who can oversee the trustees. A trust protector, common in offshore trusts and now starting to be seen more often in domestic trusts, can be given the power to remove and appoint trustees and to add or remove beneficiaries.
Families can multiply over the generations, to the point where trusts need to be split to be manageable and to avoid family strife. If drafted as "one big pot," Oshins notes, "after a number of generations the trust starts to look more like a publicly traded stock because there are so many beneficiaries." To solve this problem, dynasty trusts can be drafted so that a "per stirpes" split takes place at each generation. Under a "per stirpes" arrangement, lineal descendants are each entitled to a share of the original beneficiary's share. Even then, a power of appointment could allow trustees to change the arrangement if necessary.
Conversely, families can die out over time. To cope with the latter possibility, Langa suggests building in a "fallback provision, such as giving trustees the power to name charities as beneficiaries."
The long time horizon of dynasty trusts poses other potential problems. In addition to paying trust maintenance and administrative fees over several lifetimes, perhaps the key impediment is, as Langa says, "it's hard for clients to wrap their minds around something going on forever." Clients often know their grandchildren. They may know their great-grandchildren. But they are uncertain about wanting their money to flow four or five or six generations down the road to people they've never known.
This long-term uncertainty may be one reason dynasty trusts are best suited to people with considerable fortunes, people whose children have independent means and do not need the inheritance. Even so, professional advice is absolutely critical before clients move into dynasty trusts. Family resentment can brew if so much is put into trust that heirs receive little outright. Perhaps more to the point, as Alexander A. Bove, Jr., writes in The Complete Book of Wills, Estates & Trusts, "the GST rules and regulations are among the most complex and intricate areas of the tax code."
