There’s More To Learn About Dynasty Trusts

By James M. Griesser and Dennis Suckstorf

With a dynasty trust, a generation skipping transfer trust, estate tax savings can be enormous. Considering that estate tax rates climb as high as 55 percent, and that estate taxes are applied to each generation, you could save up to 80 percent of your estate through three generations. For instance, suppose you have $1 now and you die. Assuming you have an estate tax rate of 55 percent, that $1 would shrink to 45 cents before it ever got into your children’s hands. Assuming their estate tax rate is 55 percent also, when your children die, that 45 cents will shrink to 21 cents. In other words, to pass on $1 million to grandchildren, you would have to start with close to $5 million.

This is where the dynasty trust becomes most effective. That $1 is not consumed by estate taxes, and is able to keep working for your heirs. In fact, if we assume a modest 6 percent annual rate of return and if your dynasty trust lasts for 100 years (which happens often), that $1 would turn into $339.30. Which scenario would you want to be a part of your grandchildren’s future?

When To Initiate the Trust

The advantage of using the generation skipping tax exemption is greater during the grantor’s lifetime. Once property is transferred to a dynasty trust, all appreciation and accumulated income generated by the property until the grantor’s death will be exempt from estate tax as long as it remains in the trust. In order to avoid gift taxes during their lifetime, many individuals prefer to fund a dynasty trust only to the extent of the exemption transfer ($675,000 for an individual or $1,350,000 for a married couple in 2000), with the remaining available balance of $325,000 for the individual grantor or $650,000 for the married couple funded at death. Lifetime funding of a dynasty trust may have additional benefits as well. Since the trust is irrevocable, future changes in the estate tax law should not affect it, as those benefits cannot be eliminated if the generation skipping tax exemption is reduced in the future.

To provide an example of the power of a dynasty trust, $2 million placed in a dynasty trust today at seven percent creates $64 million in 50 years. Most dynasty trusts are typically structured to continue in existence for the maximum period of time permitted under the applicable state law in which the trust is located.

A very attractive way to take advantage of the generation skipping trust exemption is to fund a dynasty trust and use the contributions to the trust to purchase life insurance within the trust. For instance, a 45-year old person may be able to purchase a $20 million policy by contributing $100,000 per year to the trust with the trust paying a premium over 10 years. Because the rule against perpetuities has been repealed in many states (including Delaware and Maryland), a dynasty trust of this type can truly create an enormous trust exempt from death taxes for the indefinite future.

The Dynasty Keeps Working After You Do

The grantor’s children are usually the preferred beneficiaries of a dynasty trust. After the last child dies, the grandchildren (or even great-grandchildren) become the preferred beneficiaries. The dynasty trust, like any trust, has a trustee who controls it. The trustee can use trust income or principal for the benefit of the beneficiaries. When drafting a dynasty trust, you can determine just how narrow (or broad) the trustee’s discretion is. The dynasty trust can allow responsible beneficiaries to have complete control and access to their trust assets. For beneficiaries who are not as financially responsible, certain provisions restricting their access to trust income or principal can be incorporated into the trust. By limiting beneficiaries’ access, such “spendthrift clauses” can also prevent creditors of a beneficiary from attacking trust assets for indebtedness, or prevent the divorcing spouse of a beneficiary from laying claim to trust assets.

Starting a Dynasty Trust

Spendthrift clauses (as well as any dynasty trust) must be properly drafted by an experienced estate planning attorney. A knowledgeable attorney, who understands the grantor’s situation, can also create discretionary clauses. Discretionary distributions can be conditioned on each beneficiary being able to support himself or herself. The trust itself can be created during a grantor’s lifetime, or a portion of the grantor’s estate can be used to fund the dynasty trust at death. Creating a dynasty trust while alive allows the grantor to leverage his or her $1 million GSTT exemption. The dynasty trust will shelter not only the value of the assets transferred inside it, but also any appreciation of those assets.

Dynasty trusts should only be funded with certain types of assets. The IRS taxes the income from these trusts very heavily (a flat 39.6 percent). As a result, the assets placed inside the dynasty trust must be tax-free, so as not to incur an annual tax bill. Non-dividend growth stocks, tax-free municipal bonds and cash rich life insurance are suitable choices.

Many grantors choose to use their dynasty trust as an irrevocable life insurance trust. The trust is funded with insurance on the life of the grantor. When the grantor passes away, the proceeds of the policy pay any estate taxes on other assets in the grantor’s estate. Cash-rich life insurance also provides an immediate death benefit and is self-completing.

Conclusion

Although the above examples assume that your estate is large, it does not have to be for the dynasty trust to become useful in your estate plan. Many individuals and families with very modest estates have one or more children who already have or will have large estates. If your child’s profession allows the child to earn a great deal of money, your child will have a tax problem even though you may not. The dynasty trust is a solution to this double estate tax problem.

Transferring wealth to future generations without the assets becoming subject to the claims of an ex-spouse, creditor or the Internal Revenue Service is the way that dynasties have traditionally been created in the past and the way in which dynasties can be created in the future.

James M. Griesser, CFP, is vice president of Eichelberger, Griesser, Eddy and Alms, Inc.

Dennis Suckstorf, CFP, ChFC, AFC, is the Financial Planning Department manager at the firm. They can be reached at 410-988-9494.