A Primer on Dynasty Trusts

By Shaun M. Eddy and Dennis Suckstorf

Do you want to provide for your heirs and for generations to come without paying any estate taxes? A dynasty trust may be the solution.

Is your estate set up to benefit more than one generation at a time? To answer this question, ask yourself: (1) Does your will or trust provide that your assets are distributed outright to your children? (2) Does your will or trust provide that your assets are distributed to your children in trust, but your children get the assets outright at some age or upon the fulfillment of some contingency?

If you answered “yes” to either or both of the above questions, then your estate plan is designed for only one generation. By not protecting subsequent generations, your assets could be lost to your child’s ex-spouse, your child’s creditors or to U.S. and state estate and inheritance taxes. An estate plan can be designed for more than one generation at a time, saving taxes and protecting assets from creditors for generations.

Historical Perspective

Historically, wealthy families transferred their wealth to future generations without paying estate or death taxes through the use of family trusts, which became known as dynasty trusts. The duration of a dynasty trust was limited by the rule against perpetuities which prohibits a trust from continuing beyond 21 years after the death of the last survivor of a class of persons related to the person who initiated the trust. Under that rule, it was difficult to have a trust last for more than 100 to 110 years. It did, however, protect funds from estate taxes for three or four generations.

To eliminate generation-skipping transfers, the 1986 Tax Reform Act added a provision called the federal generation-skipping tax that provides for a flat rate tax of 55 percent on gifts or distribution of property to grandchildren or their descendants. This tax is in addition to any gift or estate tax imposed on a gift or bequest to grandchildren or their descendants, and could impose an effective tax rate in excess of 100 percent on the transfer.

To lessen the full impact of the tax, Congress granted a very important exemption from the generation-skipping tax. Transfers totaling $1,000,000 of assets per taxpayer are exempt. Thus, a married couple has a total generation-skipping tax exemption of transfers of up to $2,000,000. However, it is important to remember that the generation-skipping tax is separate from the estate and gift tax, which only allows an individual to pass $675,000 (2000 exemption) of property, estate or gift tax-free. For example, if a couple were to use the full $2,000,000 exemption from the generation-skipping transfer tax, $675,000 of it would be subject to gift or estate tax because the couple only has a $1,350,000 combined exemption for estate tax purposes.

Non-Tax Reasons for a Dynasty Trust

Non-tax reasons exist for leaving assets in a dynasty trust for a child. First, it protects assets from claims by your child’s creditors. Second, it protects assets from being lost to an ex-spouse of your child in the event of a divorce. With such a high current divorce rate, using a dynasty trust may help keep your estate within bloodlines.

State and federal laws recognize that a trust is a separate legal entity from you or your child. Many states give special protection to trusts that have “spendthrift” clauses in them and federal statutes give special protection to trusts that have “anti-alienation” clauses in them. If the trust provides that the trust assets are protected from the claims of your child’s creditors, they will be protected under federal and/or state law.

The dynasty trust is irrevocable and is created for the benefit of the grantor’s descendants. It’s funded with property to which the grantor allocates all or a portion of his or her generation-skipping transfer tax exemption. If the grantor is married and the spouse participates in making transfers to the trust, a total generation-skipping transfer exemption of $2,000,000 is available (unless you’d want to avoid gift taxes, as mentioned above). Once exempted, property transferred to the trust, including all appreciation in value and all accumulated income, remains free from further federal transfer tax as long as it remains in trust, which can be for many generations. Given compounding possibilities, a successfully invested trust can accumulate substantial funds which can be made available to future generations’ beneficiaries undiminished by estate and generation-skipping taxes.

Saving on Gift Taxes

There are no immediate tax savings when you create a dynasty trust. Dynasty trusts can be funded using your Unified Credit (currently $675,000), which doubles for a married couple. The tax savings occur later, at the deaths of your descendants. Even after the trust’s assets have been accumulating for years, they remain free from federal gift and estate taxes for the life of the dynasty trust. That means no federal gift or estate taxes on: (1) distributions from the trust to the grantor (the founder of the trust) or the grantor’s descendants while the trust is in force; (2) distributions at the descendants’ deaths while the trust is in force; or (3) distributions of trust assets when the dynasty trust ends.

Shaun M. Eddy, CFP, is the vice president and managing partner and Dennis Suckstorf, CFP, ChFC, AFC, is the Financial Planning Department manager at Eichelberger, Griesser, Eddy and Alms, Inc. They may be reached at 410-988-9494.