For those who want to arrange for a long-lasting transfer of wealth through multiple generations, consider a dynasty trust. The roots of dynasty trusts can be traced back to the common law principle known as the “rule against perpetuities.” This rule prohibited trusts from lasting indefinitely and was incorporated into law in most states. Typically, state law would require a trust to end within 21 years of the death of the last potential beneficiary at the trust’s creation.
However, some states, such as California, have adopted a simplified version that limits the trust’s duration to 90 years. And even better, more than half the states have lifted restraints on the duration of trusts, paving the way for the increased use of dynasty trusts. A handful of states—including Delaware, Alaska, and Florida—encourage outsiders to set up dynasty trusts in their jurisdictions.
Dynasty trust in a nutshell
A dynasty trust can be established during your lifetime, as an inter vivos trust, or as part of your will as a testamentary trust. With an inter vivos transfer, you’ll avoid estate tax on any appreciation in value from the time of the transfer until your death. Generally, though, with an inter vivos transfer, the assets won’t be eligible for a step-up in basis at your death.
When using a dynasty trust, the emphasis should be on protecting appreciated property. Thus, consider funding the trust with assets such as securities, real estate, life insurance policies, and business interests.
And while it may seem natural to choose a succession of family members to function as trustee, that may not be your best route. Instead, consider a professional trustee, often referred to as a fiduciary.
Tax implications
Previously, dynasty trusts were primarily used to minimize transfer tax between generations. Without one, if a family patriarch or matriarch leaves assets to adult children, the bequest is subject to federal estate tax at the time of the initial transfer to the second generation. It’s then taxed again when the assets pass from the children to the grandchildren, and so on. Although the federal gift and estate tax exemption can shield the bulk of assets from tax for most families, the top federal estate tax rate on the excess is 40%—a hefty amount.
Furthermore, the generation-skipping transfer (GST) tax applies to certain transfers made to grandchildren, thereby discouraging transfers that skip a generation. The GST tax exemption and 40% GST tax rate are the same as they are for regular gift and estate taxes.
With a dynasty trust, assets are taxed just once when they’re initially transferred to the trust. There’s no estate or GST tax due on any subsequent appreciation in value. When the assets are subsequently sold, any gain will be taxable. Note that the basis of the assets will be determined at the time of the initial transfer, although depending on the circumstances, the “step-up in basis” rules may help to reduce the taxable amount.
Nontax benefits
Regardless of the tax implications, there are many nontax reasons to create a dynasty trust. For example, you can designate the trust’s beneficiaries spanning multiple generations. Typically, you might provide for the assets to follow a line of descendants, such as your children, grandchildren, great-grandchildren, and so on. You can also impose certain restrictions, for example, limiting access to funds until a beneficiary graduates from college.
A drawback
One significant drawback to a dynasty trust is that it’s irrevocable. This means that the trust generally cannot be revised in the future. If you’re going to chart the course for future generations, you must have the courage of your convictions. Talk to your estate planning advisor for additional information.
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