For anyone seeking to preserve family wealth, developing a strategy to minimize estate transfer taxes is critical. Without a well-crafted mechanism to pass assets down to children, grandchildren and future heirs, recurrent taxation can erode the value of an estate with each successive generation.
By protecting your clients' wealth from repeated exposure to transfer taxes—as well as from other threats like future divorces—a dynasty trust can serve as one of the most powerful weapons in your financial planning arsenal. Furthermore, thanks to a provision of the Tax Cuts and Jobs Act (TCJA) of 2017, the present day may well be the best time to create a dynasty trust since federal estate taxes were first created over a century ago.
ABCs of Dynasty Trusts
Like all trusts, a dynasty trust begins when a person with assets (the grantor) executes a declaration of trust and then transfers possessions into the trust. If the trust is created while the grantor is still alive (inter vivo in legalese), then any property transferred into the trust becomes excluded from the grantor’s taxable estate—it belongs to the trust, not the grantor. In order to gain this tax advantage, the trust must be irrevocable, meaning that the grantor cannot later take property back from the trust or dissolve the trust altogether. The grantor names the beneficiaries of the trust (the heirs or other individuals who can receive funds from it) and also designates one or more trustees to manage it.
A major problem with ordinary trusts is that they have an expiration date; most of them endure only for perhaps two or three generations. When the trust’s lifespan ends, the property is distributed among heirs and becomes part of their taxable estates, thus becoming exposed to transfer taxes for a second time. Dynasty trusts, however, last for centuries, or even (at least in theory) forever. As each generation of beneficiaries passes on, the trust splits into subtrusts—one for each living heir.
Bear in mind that a number of states have laws called “Rules Against Perpetuities” that effectively outlaw dynasty trusts, while others are far more favorable for long-term wealth preservation. Importantly, there is no law requiring that a dynasty trust be established in one’s own state of residence. Five states—South Dakota, Rhode Island, Missouri, Illinois and New Hampshire—allow perpetual dynasty trusts; Wyoming, Ohio and Alaska assign such trusts a lifespan of 1,000 years in most cases; and Nevada, Tennessee and Florida allow trust durations of at least 360 years. Competent legal counsel should be retained to draft the trust documents to ensure compliance with the most up-to-date state laws.
Options for the Grantor’s Level of Control of the Trust
The grantor of a dynasty trust can exercise as much oversight over the trust’s future as he or she wishes. For example, if trust beneficiaries are also designated as trustees, they can essentially manage and use the trust however they see fit—which means that the wealth may not survive beyond their generation. More commonly, the trustee is a bank or other financial management agency (and oftentimes includes “trusted advisors” like CPAs or attorneys who are very close with the grantor), which controls the distribution of trust funds to beneficiaries. By specifying the conditions for such distributions, a grantor can shape the future of a dynasty trust for generations to come.
As an example, suppose James and Catherine have an estate valued at $18 million. They want to leave the estate to their two children, Ryan and Margaret, but they also want to make sure that their grandchildren and great-grandchildren enjoy the financial security that a trust provides. They, therefore, set up two irrevocable $9 million dynasty trusts—one for each of their children. To ensure minimal tax liability and the smoothest possible transfer of wealth, they execute the trust declarations and transfer assets into the trust while they are both still alive. They appoint Lionel Williamson, a wealth management expert at First Moneytown National Bank, as the trustee. Importantly, James and Catherine also provide clear instructions regarding how successor trustees will be appointed upon Lionel’s retirement or death.
After James and Catherine have passed on, Lionel follows their instructions to manage the trust. These include making distributions from the trust to Ryan and Margaret for events like home and automobile purchases, job transitions and the marriages of their children, while preserving the trust’s principal for future generations. After Ryan and Margaret pass away, successor trustees manage the resulting subtrusts for the next generation of beneficiaries.
TCJA Creates Temporary Tax Break for Large Trusts
As a general rule, assets bequeathed to heirs or given away as gifts are subject to federal estate transfer and/or gift taxes. However, the federal tax code provides an exemption—an amount of property that can be transferred before tax liability arises. The exemption is a lifetime limit, meaning that transfer taxes kick in whenever the total amount that an individual or couple has bequeathed or gifted exceeds the exemption.
For tax year 2017, the exemption was $5.49 million for an individual, or $10.98 million for a married couple. However, the TCJA more than doubled the exemption for 2018 to $11.18 million per individual and $22.36 million for married couples. Since the amount is adjusted annually for inflation, the 2019 exemption is higher still, at $11.4 million for an individual benefactor and $22.8 million for assets bequeathed by a married couple. This change makes a huge difference for our hypothetical couple. If they had established their two dynasty trusts in 2017, only $10.98 million of their $18 million estate (or $5.49 million out of each $9 million trust) would have been protected from estate tax. In other words, $3.51 million designated for each trust would have been exposed to transfer taxes. Since the maximum estate tax rate is 40%, as much as $1.4 million would have been lost from each trust.
By contrast, if James and Catherine had set up their dynasty trusts in 2018 or later, their combined exemption of over $22 million would have shielded every dollar from estate taxes. The TCJA has thus created a remarkable window of opportunity for family wealth preservation. However, it is important to act on that opportunity sooner rather than later, since the TCJA will expire in 2025 and no one knows what the estate tax rules will be thereafter.
How Dynasty Trusts Avoid Future Estate Taxes and the GSTT
The TCJA rules are favorable to all trusts and wealthy families, but dynasty trusts offer unique tax advantages that short-lived trusts cannot match. Because assets in a dynasty trust legally belong to the trust, not the beneficiaries, only one estate transfer ever occurs for tax purposes—the original transfer of property from the grantor to the trust. Even if the trust benefits many future generations and grows in value far beyond the current estate tax exemption, it will never again be subject to estate transfer taxes.
To demonstrate the magnitude of this benefit, imagine that instead of setting up dynasty trusts, James and Catherine bequeath their estate directly to their children, Ryan and Margaret, either through instructions in their wills or via 25-year trusts. All the assets will thus become part of Ryan’s and Margaret’s taxable estates. If the inherited assets then grow in value beyond the lifetime exemption (or if the lifetime exemption decreases after the TCJA expires), those assets will be exposed to estate tax when passed down to their children.
For example, suppose that because of Margaret’s excellent money management, her $9 million dollar inheritance grows in value over her lifetime to $17 million, which she passes on to her only child, Allen. Even if the higher lifetime exemption established under the TCJA were to be extended beyond 2025 and continually adjusted for inflation, Margaret’s $17 million bequeathal to Allen would surely exceed the exemption. Under current estate tax rates, up to 40% of the excess amount would be lost to transfer taxes.
Historically, estate owners sometimes sought to avoid this problem by passing assets over their children’s heads and directly to later generations, a process known as “generation skipping.” The most common device used for the purpose was a generation-skipping trust. Typically, a generation-skipping trust has a grandchild as the named beneficiary and is set up to terminate when the grandchild reaches a specified age. Hence, the trust ultimately transfers assets directly into the grandchild’s hands. Note, however, that the beneficiary need not be a grandchild in order for the IRS to classify a trust as generation skipping. Under IRS rules, a trust skips a generation anytime the beneficiary is at least 37 ½ years younger than the grantor and not the grantor’s spouse or ex-spouse.
Recognizing that estate owners could use generation-skipping trusts to avoid estate taxes, the IRS created the generation-skipping transfer tax (GSTT) in 1976. Later, the 1986 Tax Reform Act set the GSTT at a flat rate equal to the highest existing estate tax rate—currently 40%, or well over one-third of the bequeathed value above the exemption.
It is this flat-rate rule that makes the GSTT so dreaded by estate planners. Depending on a variety of factors, a direct (parent-to-child) transfer might be taxed at a rate well below the 40% estate tax maximum. Meanwhile, every generation-skipping transfer is subject to 40% GSTT. Hence, although generation-skipping transfers are covered by the same lifetime exemption as other gifts and bequeathals, such transfers are particularly costly for those with large estates.
By its very nature, a dynasty trust is passed directly from each generation to the next, meaning generation skipping never occurs. Once assets go into the trust, they are protected from transfer taxes for many generations—possibly forever. Since our hypothetical couple passed along their wealth via a dynasty trust, the transfer from James and Catherine to Margaret, then to Allen and on to Allen’s children and grandchildren occurs with no estate tax or GSTT implications at all.
Caution: Tax-Protected Is Not Necessarily Tax-Free
Because dynasty trusts so effectively shield a family fortune from transfer taxes, many people described these trusts as “tax-free wealth protection.” However, that designation carries three very important caveats. First, if the value of assets initially transferred into the trust exceeds the lifetime exemption, estate taxes will apply. For example, if James and Catherine’s estate was worth $30 million when they divided their assets between the two dynasty trusts in 2019, estate tax would be assessed on $7.2 million ($30 million less the $22.8 million married couple exemption) of the estate, or $3.6 million of the assets designated for each trust. Even if their estate has only the $18 million value used in our previous example, the estate tax could still be triggered if they have previously given gifts totaling more than $4.8 million in value (thus putting them over the $22.8 million lifetime exemption).
Second, income generated by the trust will generally be taxable as ordinary income. The good news here is that under the TCJA, all income tax rates are below the 40% GSTT level. More importantly, beneficiaries can usually offset trust income (and hence, neutralize its tax impact) by investing trust funds in non-income-generating assets, such as growth stocks that pay no dividends or tax-free municipal bonds.
Third, U.S. tax law is ever-changing, as the TCJA proves. The advantages of a dynasty trust under current tax law are clear, but whether those advantages will still exist three generations from now is anybody’s guess. Therefore, although it is appealing to have complete control over the future of one’s estate, it might be wiser to write some flexibility into a dynasty trust, so that both trustees and beneficiaries can adapt to future law and economic changes.
One of the most important advantages of a dynasty trust applies to everyone with assets, even those with estates too small to ever bring estate, gift and GSTT taxes into play. It is well known that a single bad business deal, catastrophic injury or divorce can be devastating to a family fortune. However, a dynasty trust keeps a family’s core wealth out of the reach of creditors, including ex-spouses.
Once again, the key legal point here is that heirs do not own the assets held in a dynasty trust. As long as the trust exists, those assets are not part of any individual’s personal wealth or estate. Therefore, a dynasty trust cannot be broken up in divorce proceedings. Nor can it be pursued by a beneficiary’s creditors, even if that beneficiary has racked up huge debts through reckless living.
Just as laws governing (or banning) the existence of dynasty trusts vary from state to state, so do laws determining the level of asset protection such trusts provide. Tennessee, South Dakota and Nevada get the highest marks for locking down assets in a dynasty trust. Once again, legal counsel should be retained to ensure accomplishment of asset protection goals.
Death is inevitable, but worrying about the financial futures of one’s heirs is avoidable with sound planning. Whether it is minimizing tax liability, enforcing financial discipline on immediate heirs so that future generations are well provided for or protecting family assets in the event of a tragedy, people in all income and wealth ranges have a lot to gain by establishing dynasty trusts.
This article is not tax, legal or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
Harvey Bezozi is a CPA and CFP ®. More information can be found at YourFinancialWizard.com