Dynasty trust are back in the news. Dynasty trusts are the
province of the ultrawealthy, and are not likely to impact you or me much.
However, allow one or two favorable turns of fate and you or
I might find ourselves interested in such things. Let’s hope for the best.
What sets up the discussion is three main issues:
(1) Estate
taxes
(2) Generation-skipping
taxes
(3) The
rule against perpetuities
Estate taxes are also called death taxes and apply to your
net worth (everything you own less everything you owe) at death. If you own too
much, you owe estate tax – short and sweet. Granted, it is getting harder and
harder too own too much. The threshold for 2017 is $5.49 million per person, or
almost $11 million per married couple.
I would say that – if you have accumulated $11 million – you
have done well.
The estate tax intends for every generation to pay tax.
Let’s say that you are worth $15 million. The estate tax
will apply. Your assets go to your child. Let’s presume that the assets
inherited bounce back to $15 million (remember: there were taxes at your death)
and the exemption remains at $5.49 million. The estate tax presumes that your
child will pay tax again, repeating a virtuous cycle.
Well, an advisor can break that cycle pretty quickly: have
some of the assets go to the grandkids. That skips the estate tax on (at least some
of) the assets upon your child’s death.
Congress figured this out too and introduced the
generation-skipping tax (GST). Its purpose was straightforward: to tax the
assets that skipped tax when your child died. Those assets would otherwise have
“skipped” a generation of estate tax.
A favored and common way to transfer assets across multiple
generations is through use of a trust. There are more varieties of trusts than
there are flavors of Baskin Robbins ice
cream. We however are looking at one trust and one only: the shy and elusive
dynasty trust, which has rarely been captured on camera.
Tax archeologists believe that the dynasty trust evolved in
response to state liberalization of the rule against perpetuities. Trusts
themselves are created under state law, and all 50 states used to prohibit a
trust from existing more than 21 years after the death of the last beneficiary
who was alive when the trust was created.
To rephrase: the law (1) looked at the beneficiaries born
when the trust was created; (2) took the youngest beneficiary; (3) waited until
his/her death; and (4) said “All right, boys and girls, you have 21 years to finish
this”
The point is that the trust had to eventually wrap up its
affairs. It could not be “perpetual.”
In that context, the estate tax – GST tax value meal worked
relatively well in identifying and taxing transfers of intergeneration wealth. No
matter how complex, trusts simply had to give up the ghost eventually.
However, several states have since either modified or
abolished their rule against perpetuities (Alaska and Nevada come to mind). A
trust created in one of these jurisdictions can last for … who knows how long.
This has tax implications.
Because the trust is not required to terminate, tax planners
can more easily get around the estate and GST combo that worked well enough in
an earlier, simpler era.
It is relatively easy to avoid the estate tax issue: the
planner simply does not give the beneficiary so much authority that the trust would
be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively
well-trod minefield.
The GST is a bit more complicated.
I now go where many tax nerds would refuse to go: to give a
quick overview of how a dynasty trust and the GST interact. We are venturing to
the Mordor of tax practice.
Here goes:
(1) You
have a GST exemption equal to your estate tax exemption. Therefore, if the
estate exemption is $5.49 million, your GST exemption is the same amount.
(2) Meaning
you can transfer $5.49 million across as many generations as you like without
triggering the GST.
(3) Rule
(2) is not interpreted the way you expect when using a trust.
a.
One would think that trust distributions over
$5.49 million to a skip beneficiary would trigger the GST tax.
b.
But not necessarily. The planner instead applies
the $5.49 million test at a different point in time. Instead of waiting until
the trust actually writes checks to a grandkid or great-grandkid decades from
now (that is, the distribution date), the planner measures at the moment the
settlor puts money into the trust.
c.
Here is an example. Say your great-grandkid is
15 months old, and you put $5.49 million into a dynasty trust. You next burn your
$5.49 million GST exemption on the trust.
d.
We calculate a ratio: GST Exemption Used/Total
Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example,
Jackson is $5.49 million/$5.49 million or “1.0.”
e.
We next calculate a second ratio: 1.0 – Jackson.
We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or
zero (-0-).
f.
Tax nirvana is an inclusion ratio of zero (-0-).
i. The
magic to an inclusion ration of zero (-0-) is that future distributions from
this trust are exempt from any more GST. That happens because you are
multiplying [it doesn’t matter the number] by zero.
ii. If
the inclusion ratio was 45%, then 45% of future distributions from the trust
would be subject to GST.
g.
To press the point, if the trust is worth a
quantazillion dollars decades from now but has an inclusion ratio of zero
(-0-), it is still exempt from GST.
i. There
are of course ways to ruin this outcome. One way is to put more money into the
trust. The result would be to increase the denominator with no increase in the
numerator. The resulting inclusion ratio would not be zero. A tax planner would
tell you to NOT DO THAT.
To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.
And the estate, gift and GST exemptions have been increasing
every year and are now at $5.49 million per person. A married couple can of
course double that.
Take the near-immortal trusts, stir in the big-bucks exemption,
add a few spices (like family limited partnerships or remainder annuities) and
you have a very nice tax tool for keeping wealth within the family across
generations.
