The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.