One of the most popular "buzzwords" that has recently surfaced in the area of estate planning is the "Dynasty" Trust. Ironically enough, the word "Dynasty" never appears in the Internal Revenue Code ("IRC"). What does appear in the IRC, of course, is Chapter 13, which provides a complete and largely effective system of taxation of generation-skipping transfers. The "Dynasty" Trust does sound quite impressive to clients, and certainly does add that creative marketing appeal that many of us estate planning attorneys are trying to inject into what may be our otherwise uninspiring practices. Whether you call them "Dynasty" Trusts or "Generation-Skipping Transfer Tax" ("GSTT") Trusts, as Chapter 13 of the IRC prescribes, Dynasty Trusts offer tremendous estate tax advantages as well as significant asset protection for their beneficiaries for countless generations. Dynasty Trusts give their makers ("grantors") the opportunity to provide for their children, grandchildren, great-grandchildren and so on through the generations with wealth that is both estate tax-protected and creditor-protected.
Dynasty Trust planning is complicated and does involve a thorough understanding of Chapter 13 of the IRC and the related regulations and cases. This Article will not address the more technical aspects of Dynasty Trust planning, but will simply provide an overview of the general structure of the Dynasty Trust as well as the unique benefits that it possesses.
At one time, not that long ago, it was possible for individuals to avoid federal estate taxation by creating trusts at death that provided successive life estates for each succeeding generation. Federal estate taxes are not imposed on property in which a descendent only has a life estate. However, in 1976, Congress decided to close this incredible loophole by enacting a law that taxed generation skipping transfers (GST). The first of these GST laws was scrapped and recreated in its current form in 1986. By assessing a GST tax, the government is attempting to carry out a policy of imposing an estate tax at least once as wealth passes from one generation to the next. When a generation has been skipped, an opportunity for taxation is lost. For example, the kind of generation skip with which the GST tax is concerned would occur when wealth passes directly from grandparent to grandchild because the wealth bypasses the grandparent’s child.
What Are the Limits?
Congress is willing to allow a generation skipping transfer to go untaxed but only to a limited extent. Each of us has a $1 million dollar generation skipping tax exemption to go with our estate tax applicable exclusion amount (as of 1999, $650,000). As a result of the Taxpayer Relief Act of 1997, the $1 million GST exemption is now indexed for inflation by applying the "cost of living" adjustment of Section 1 (f)(3). This was effective for gifts made or decedents who died after December 31, 1997. Thus, the GST exemption amount for 1999 is actually $1,010,000. For the sake of simplicity, we have used the $1,000,000 figure in this Article.
It is important to remember that the generation skipping tax is a tax imposed in addition to the estate tax. So, if grandfather attempts to transfer more than $1 million dollars to his grandchildren, there will be an estate tax imposed on the transfer, and in addition, to the extent that more than $1 million dollars is transferred to grandchildren, a GST tax as well. The GST tax is currently set at the highest rate of 55%. However, the $1 million dollar GST exemption amount each of us has provides a wonderful planning opportunity when used in combination with other estate tax planning techniques.
There is no reason that Dynasty Trust planning cannot be incorporated as a part of a revocable living trust-centered plan. It is important, though, to make sure that the grantor makes full use of his or her $1 million dollar GST exemption. For married couples, this means making use of both spouses’ GST exemptions. When done properly, married couples with an estate worth $2 million dollars or more should be able to shelter the full $2 million dollars from GST tax. They can leave that $2 million dollars in trust for the benefit of succeeding generations in a way that the assets left in trust will never be subject to estate tax again. The wealth in a Dynasty Trust then passes from generation to generation allowing the beneficiaries to have access to funds to provide many comforts in life, to provide for support and health needs and to provide each generation with an opportunity for a college education if desired.
How Does It Work?
Dynasty Trust planning set up in a revocable living trust could first provide for the care of the grantor’s children, specifically for their health, education, maintenance and support. While the child is alive, he or she can also use this money to provide for his or her children for their health, education, maintenance and support. The value of the Dynasty Trust is that it is available to provide for the health, education maintenance and support of each and every one of the grantor’s descendants. This can insure for example that every one of the grantor’s children and grandchildren and so on has enough money to pay for a college education at his or her college of choice. Then, when each child dies, the remaining trust assets would pass to individual trusts for each of that child’s children. This pattern could go on repeatedly through the generations, subject only to the limits of state law on the duration of the trust. Provisions can even be made to permit a beneficiary to become Co-Trustee of his own trust upon attaining a minimum age such as 30.
Apart from providing for children and grandchildren, Dynasty Trusts also provide protection from each child’s creditors and from failed marriages since the assets generally cannot be reached in divorce proceedings because they are owned by a trust and not by the child or grandchild. As long as the Dynasty Trust does not allow too much access (remember, health, education, maintenance and support are acceptable reasons for trust expenditures for your beneficiaries), the assets are never regarded by the IRS as being "owned" by the beneficiaries and therefore are not taxed in their estates when they die. This allows a terrific opportunity for the growth of these funds to the extent that they are not used to take care of the needs of the beneficiaries.
The key to insuring that the Dynasty Trust continues to provide these wonderful benefits throughout successive generations is keeping the assets originally funded into the Dynasty Trust as Dynasty Trust assets. For example, if a beneficiary wanted to use assets from the Dynasty Trust to purchase a home, he or she could use the Dynasty Trust assets but would simply purchase the home in the name of the Dynasty Trust. If that same beneficiary later wanted to sell the home and invest in stocks, he or she would want to purchase the stocks in the name of the Dynasty Trust, or in the name of an investment account that was titled in the name of the Dynasty Trust. This pattern of buying and selling assets in the name of the Dynasty Trust insures that they will remain protected from creditors, divorces and future estate taxes. Once the assets in a Dynasty Trust are taken out of the Trust and titled in a different name, then those assets will no longer enjoy all of the benefits and protections that the Dynasty Trust assets enjoy.
To see just how powerful this can be over a long period of time, consider the following example: Based on a 6% growth rate, $1 million would grow to be almost $80 million in the 75 years it would take for it to pass through three generations (assuming a 25 year age difference between generations). All the while the beneficiaries would have very comfortable access to money and could spend it all if they needed to (for a health crisis for example). Further, if they did buy and retain assets in the name of the trust they would always have the asset protection of the trust and allow the trust to grow federal estate tax free over time. Using this example to see what would happen by not using a Dynasty Trust, consider the following: If a family does not create a Dynasty Trust and that $1 million also grows at 6% over 75 years but at each generation is taxed at the 55% estate tax level, then at the end of the 75 years the money would have grown to $7.2 million. Therefore over a 75-year period using conservative growth numbers, the difference between using a Dynasty Trust and not using a Dynasty Trust would be about $73 million.
A revocable trust is not the only place Dynasty Trust planning can occur. For example, an irrevocable trust which holds life insurance on an individual’s life can be set up for the benefit of his or her children, grandchildren, or both. If done correctly, the generation skipping tax exemption would be applied to the money gifted to the trust and used to pay the insurance premiums. The amount of the GST exemption used up would be the amount of those gifts and not the death benefit of the insurance. For example, if $100,000 in gifts were made to an irrevocable life insurance trust for the benefit of grandchildren and that trust used the $100,000 to pay premiums on a life insurance policy payable to the trust for the benefit of the grandchildren, the policy, depending on the lives of the grandparents at the time the policy is obtained could be worth several times the $100,000 premium paid. The GST exemption used would be the gifted amount of the premiums rather than the higher death benefit. This is only the second of a number of other opportunities that are available to combine Dynasty Trust planning with other estate planning techniques.
How Long Can They Last?
A Dynasty Trust can last as long as local law allows. Each state falls within one of three categories regarding the duration of a Dynasty Trust: (1) States that adhere to the common law perpetuities period which is that the trust must end 21 years after the expiration of the named lives in being in the trust; (2) States that have adopted the Uniform Statutory Rule Against Perpetuities (USRAP), which states that a Dynasty Trust can endure for the common law perpetuity period discussed above or, alternatively, for 90 years; or (3) States with no Rule Against Perpetuities which permit a trust to last perpetually. Jurisdictions that have changed their laws to fall into the third category of permitting trusts to last perpetually include Illinois, Alaska, South Dakota, Wisconsin, Idaho and Delaware.
Whether large or small, estate size really is not critical when deciding whether to implement a Dynasty Trust. The key questions to ask are 1) Does the grantor want his or her assets, no matter what the size, to be protected from future divorces and lawsuits his or her children may face? 2) Does the grantor want his or her assets to grow and pass federal estate tax free through generations? If the answer to either one or both of these questions is "yes", then you should seriously consider Dynasty Trust planning for all such clients.
Mark Perkins is a Principal of Perkins & Zayed, P.C., Downers Grove. His practice is concentrated in Estate and Business Succession Planning. He is a former Chair of the DCBA’s Tax Committee. He may be reached at firstname.lastname@example.org.
Dean Zayed is a Principal of Perkins & Zayed, P.C., Downers Grove. His practice is concentrated in Estate and Asset Protection Planning. He is the Chair of the DCBA’s Tax Committee. He may be reached at email@example.com.