Summit Trust Company - Dynasty Trusts

DynastyTrusts

In the early 1900's, a handful of industrialists and entrepreneurs had amassed tremendous fortunes. John D. Rockefeller had made his name in oil, Henry Ford in automobiles, Carnegie in steel. Their estates, in today's dollars, would rival those of Bill Gates and Warren Buffett.

As these visionaries aged, most of them asked a handful of lawyers the same question: "What can I do to preserve my estate?" They knew that when they died, their estates would be heavily taxed when passing to children, and would shrink even more when going to grandchildren.

Using some of the most tax-savvy minds in the country, some of the most successful families created a separate trust . . . a legal entity designed to provide substantial assets to future generations, with little or no estate taxes. What they did, in the process, was create the "Dynasty Trust."

Introduction

In today's tax system, estate and gift taxes are levied every time assets change hands from one generation to the next. These dynasty trusts avoided those taxes by creating a second estate that could outlive most of the family members, and continue providing for future generations.

Dynasty trusts are long-term trusts created specifically for descendants of all generations. In most States in the United States, there is a rule against perpetuities. This means that dynasty trusts can survive 21 years beyond the death of the last beneficiary alive when the trust was written.

If you were setting one up today in one of the States that has the “rule against perpetuities”, and you had a 2 year-old grandchild, your dynasty trust could last well over 100 years. Long after you're gone, a dynasty trust can distribute income and principal exactly the way you would have wanted.

New Nevada Law extends term to 365 Years

As of October 1, 2005, if you set up a dynasty trust in the State of Nevada, with a Nevada Trust Company, the newly passed law of Nevada says that your trust can last as long as 365 years. That can allow you to pass your estate for up to a dozen generations, or more. This is a major step in estate planning, and will usually accommodate most people’s concerns about creating a legacy for their heirs. To learn more, click here.

Saving on Gift Estate Taxes

There are no tax savings when you create a dynasty trust. Dynasty trusts are often funded using your Estate Tax Credit (currently $1.5 million per individual, $3 million per couple).

The tax savings occur later at the deaths of your descendants. Even after the trust's assets have been accumulating for years, they remain free from federal gift and estate taxes for the life of the dynasty trust. That means no federal taxes on:

Distributions from the trust to the grantor (the founder of the trust) or the grantor's descendants while the trust is in force;
Distributions at the descendants' death while the trust is in force;
Distributions of trust assets when the dynasty trust ends.

The estate tax savings can be enormous. Considering estate tax rates climb as high as 48%, and that tax is applied to each generation, you could end up saving up to 73% of your estate through just the first three generations. Imagine how much of your estate would be taken through another ten generations.

For instance, suppose you have $1.00 now. Assuming an estate tax rate of 48%, that $1.00 would shrink to 52 cents before it ever got into your children's hands. Many heirs will spend the income, and sometimes the growth in value of an estate, and many more will exhaust the principal altogether. But if it just stays the same value, now assume that your children’s estate tax rate is 48% also. When your children die, that 52 cents will shrink to 27 cents! By the time your grandchildren see the benefits of your lifetime of hard work, $1.00 will only be worth $0.27. To pass $1 million on to your grandchildren, you would have to start with close to $5 million.

And that is just Three Generations. As you can see, if you carry out the numbers, there will be nothing left to speak of after the seventh generation. In fact, if you wanted to leave just $5,000 to the twelfth generation, you would to have $10 million in your estate.

That's where the dynasty trust comes in. That $1.00 is not consumed by estate taxes, and is able to keep working for your heirs. In fact, let's assume a modest 6% annual rate of return. If your dynasty trust lasts for 100 years (which happens often), that $1.00 would turn into $339.30. If you had a dynasty trust in Nevada, it could turn into $5,000.

Which scenario would you want your grandchildren to have?

The savings potential is often greater than illustrated since the example ignores the fact that property received outright will probably be reduced further due to (1) divorce settlements, (2) creditor problems, and (3) the fact that assets are less likely to be dissipated in a trust than if held outright even if the invasion rights in a trust are extremely broad and generous. In addition, the leverage feature increases the longer the trust continues.

Limits on the Dynasty

In 1986, Congress (recognizing Uncle Sam was losing billions in estate taxes) attempted to thwart these transfers by creating the "generation-skipping transfer tax" (GSTT). The GSTT is applied to dynasty trust by assuming that the trust's beneficiaries own the assets in the dynasty trust outright.

However, Congress did include a significant exemption in the law. Every person has a GSTT exemption of $1 million ($2 million if married). That means each person can transfer up to $1 million inside a dynasty trust, without any GSTT. Dynasty trusts of $1 million or less offer the same gift and estate tax advantages of similar trusts created before 1986.

Dynasty Continues On

The grantor's children are usually the preferred beneficiaries of a dynasty trust. After the last child dies, the grandchildren (or great-grandchildren) become the preferred beneficiaries.

The dynasty trust, like any trust, has a trustee that controls it. The trustee can use trust income or principal for the benefit of the beneficiaries. When drafting a dynasty trust, you can determine just how narrow (or broad) the trustee's discretion is.

The dynasty trust can allow responsible beneficiaries to have complete control and access to their trust assets. For beneficiaries that are not as financially responsible, certain provisions restricting their access to trust income or principal can be incorporated into the trust.

By limiting beneficiaries' access, such "spendthrift clauses" can also prevent creditors of a beneficiary from attacking trust assets for indebtedness, or prevent the divorcing spouse of a beneficiary from laying claim to trust assets.

Starting a Dynasty Trust

Spendthrift clauses (as well as any dynasty trust) must be properly drafted by an experienced estate planning attorney. A knowledgeable attorney, who understands the grantor's situation, can also create discretionary clauses. Discretionary distributions can be conditioned on each beneficiary being able to support himself or herself on their own. With so many options, dynasty trusts can be tailored any way you choose.

The trust itself can be created during a grantor's lifetime, or a portion of the grantor's estate can be used to fund the dynasty trust at death. Creating a dynasty trust while alive allows the grantor to leverage his or her $1 million GSTT exemption. The dynasty trust will shelter not only the value of the assets transferred inside it, but also any appreciation of those assets.

Funding The Trust

Dynasty trusts should only be funded with certain types of assets. The IRS taxes the income from these trusts very heavily, sometimes close to 40%. As a result, the assets placed inside the dynasty trust should be tax-free, so as not to incur an annual tax bill. Non-dividend growth stocks, tax-free municipal bonds, and cash rich life insurance are suitable choices. As an alternative, some attorneys will draft the trust so that the grantor pays the tax on the trust income, which can be an advantage under some circumstances.

Many grantors choose to use their dynasty trust as an irrevocable life insurance trust. The trust is funded with insurance on the life of the grantor. When the grantor passes away, the proceeds of the policy pay any estate taxes on other assets in the grantor's estate. The cash-rich life insurance also provides an immediate death benefit and is self-completing. Using the dynasty trust as an irrevocable life insurance trust can provide excellent peace of mind.

Dyanasty Trusts generally create Family Limited Partnerships (FLPs) or Limited Liability Companies (LLCs) to own the assets to be protected. For further information, click here.