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Dynasty trusts are not new. They have been in existence for 600-700 years. Although popular in the past, they have declined in use due to the federal estate tax and the generation-skipping transfer tax. With the recent changes in the estate and generation-skipping tax laws, with the new increased exemptions, and with changes in the rules as to how long a trust may last, they are coming back into favor.
For couples with assets of over $3,000,000, they should be considered. Dynasty trusts do not initially save any taxes. They are designed to provide a continuing, variable annuity for children, grandchildren, great grandchildren, and later generations without any subsequent taxes after husband and wife both die.
A Dynasty Trust is a trust that continues for approximately 100 years or longer and provides payments to future generations, without any additional estate or generation-skipping transfer taxes.
This is different from the standard estate plan whereby husband and wife usually leave all of their assets outright to their children equally when the surviving parent dies.
This type of trust continues for the couple's children for their lifetimes, with the children receiving payments from the trust. As each child dies, the trust then continues for the deceased child's children (the couple's grandchildren) with payments for the grandchildren during their lifetimes. Depending on a number of factors, the trust may continue for great grandchildren and even future generations beyond great grandchildren.
A Dynasty Trust provides for a number of things. Since the beneficiary does not own the trust assets and the assets are controlled by a trustee, the assets are not subject to claims of creditors, not subject to division upon divorce, not subject to a child leaving the assets to a second or third spouse, with the assets never passing on to the grandchildren.
The trust beneficiary cannot spend the principal but is limited to the fixed payments and discretionary payments (made only in the trustee's discretion).
There is not a concern that a 50 year old son will leave the assets to his 26 year old fourth wife, that a grandchild will use the money to drink, spend and have a good time (spending $500,000 in six months), or that a daughter will convert her inheritance to community property and lose half of it when her husband divorces her.
The beneficiary receives a fixed annual sum, like a variable annuity, from the trust monthly. If the beneficiary needs more money for his "health, support, maintenance, and education" and does not have funds available for these purposes, the trustee can make additional payments to the beneficiary from principal, in the trustee's sole discretion.
If a person sets up such a trust and then dies, changes in tax laws will not affect the trust and make it taxable.
For example, Mary Smith died in 1963 with an estate of $1,000,000, after estate taxes were paid. In those days it was a lot of money. The trust continued for her daughter and then for the daughter's son, after the daughter died. The grandson died in 2001 and the trust had a value of $30,000,000, with annual payments to the grandson of $1,000,000. Since the trust is exempt from both estate taxes and generation-skipping transfer taxes, and the son has a limited power to dispose of the trust assets (which are not taxable), the son left the assets in trust for his wife and children, ultimately going to his grandchildren after his wife and children die. Although there were substantial estate taxes in 1963 the trust has not been and will not be subject to any additional taxes though its termination is probably some 60-80 years in the future.
The United States has two tax systems that may affect an individual's assets at death.
The Federal Estate Tax is a tax established in 1917 designed to tax assets owned by the decedent at death. Any assets left to a surviving spouse, if the spouse is a United States citizen, are exempt, as are any bequests at death to a qualified charity. Other assets are subject to this estate or death tax.
The exemption from the tax is $1,500,000 in 2004, increasing to $2,000,000 in 2006, to $3,500,000 in 2009, and the estate tax is due to be abolished in 2010. The estate tax rates start at 45% in 2004 with a maximum rate of 48%, with the maximum rate due to decline to 45% in 2007.
The tax is charged on all of the assets of the decedent located anywhere in the world. If the deceased was a United States citizen or resident of the United States this tax is imposed even though another country may tax part of the assets if the person who died was a citizen of another country or owned property in another country.
For an individual with a $3,000,000 of net worth, with no spouse, dying in 2004, the estate tax would be $705,000 declining to $460,000 in 2006, and disappearing in 2009.
The second tax system is the generation-skipping transfer tax, which was introduced in 1986. This was designed to prevent wealthy individuals and couples from setting up an irrevocable trust, after paying estate tax, to avoid having the assets in the trust taxed when the children and grandchildren died.
Under this tax structure, there is a separate exemption ($1,500,000 for someone dying in 2005 and larger amounts in later years) which is set up at the creation of the irrevocable trust. When the assets pass to the second generation, such as the grandchildren, the amount over the exemption is then taxed at the highest estate tax rate then in effect. There are no estate taxes payable.
However, John Doe can set up a trust or trusts containing $1,500,000 when he dies. The trust continues for his wife and his children. When it goes to his grandchildren it is worth $8,000,000. All of this amount is exempt since if it was exempt when the decedent died, all future earnings and appreciation are also exempt.
People sometimes ask what the Kennedys and Rockefellers did to avoid these taxes. They paid the large federal estate tax when the family patriarch died, but then left the remaining assets in trusts for several generations, with the children, grandchildren, and great grandchildren receiving the earnings from the trust assets and payments of principal from the trust, if needed. Since the patriarchs died before the generation-skipping transfer tax was introduced and their trusts were irrevocable, these trusts were exempt from this tax. The next best thing to having $300,000,000 of assets is having the earnings on $300,000,000.
There has recently been a very strong movement in the United States to abolish the federal estate tax, gift tax, and generation-skipping transfer tax. People pay taxes all of their lives, so why should their children pay additional taxes on their wealth when they die?
Congress has wrestled with this for several years and the legislation passed in 2001 was a compromise with the immediate abolition of these taxes. The 2001 raised all of the exemptions, reduced the maximum tax rates by 10%, and abolished all of these taxes (except the gift tax) in 2010. However, because of uncertainties, Congress put a strange provision in the law. If subsequent legislation is not passed, the tax rates and exemptions in existence on January 1, 2001, would return on January 1, 2011. Thus, the taxes could only disappear for one year-2010, and then return at a much higher rate the next year.
At the time this legislation was passed the federal government was awash in money. This was before the economy took a large downturn, and before the extraordinary events of September 11, 2001.
With the government estimated surpluses in the future quickly turning into apparent deficits, the question arises as to where the federal government will get additional revenue. One simple alternative is to freeze the increased estate and other tax exemptions, extending the $1,500,000 exemption by five or ten years. Since the federal estate tax produces approximately $30 billion of revenue each year, it presents an easy target for additional revenue, especially since 95% of the individuals who die do not have sufficient assets to pay the tax.
In 1981 when Ronald Reagan became president he lobbied and got the federal estate tax changed. The exemptions from tax increased over a number of years, assets left to one's spouse were totally exempt from tax, and the maximum federal estate tax rate was cut from 70% to 50% over a period of years. It was due to drop from 55% to 50% in 1986. In 1986, federal revenue was not sufficient so Congress extended this reduction for several years, and continued to extend it. In 2002, 16 years after it was due to go into effect, the maximum estate tax rate finally went from 55% to 50%.
It is therefore quite likely that Congress will either extend the phaseout of these taxes or freeze the exemption and rates for a number of years so that the abolition in 2010 may become 2020, or 2030.
When trusts were established in England in the 12th and 13th centuries they were used to avoid losing property if the individual took the wrong side. With frequent conflicts over the English Crown, a noble who took the wrong side would not only lose his life, but would forfeit all his lands and assets. To avoid this, lands and assets were put into a trust with the trustee being someone who did not take one side or the other in the fight for the Crown. The trusts were originally designed to last for several hundred years. Because property was being tied up for this lengthy period, England created a law referred to as "The Rule Against Perpetuities," to prevent a trust from lasting forever.
Under this law or rule, a trust could not last longer than the lifetime of the various beneficiaries alive when the trust was created, plus an additional 21 years after the last person died. This rule has been extended to the United States and the various states.
Under this rule or law, if John Doe died and had children and grandchildren, the trust could last until the last of them died, plus an additional 21 years. If the youngest grandchild who was alive when John Doe died was 3, and she lived until age 85, the trust could continue until she died, 82 years in the future, plus another 21 years, or a maximum of 103 years.
Most states, including California, have passed legislation allowing a trust to last at least 90 years from its creation. It can therefore run until the end of the period of the Rule Against Perpetuities, or 90 years, whichever is the longer of those two periods. Many states have completely abolished the Rule against Perpetuities, and a trust under those state laws can last forever. States such as New Jersey, Delaware, Alaska, South Dakota, Wisconsin, and Idaho have abolished this rule and many other states will probably do so within the next 10-15 years.
The typical living trust established jointly by husband and wife is designed to be divided into two subtrusts at the death of the first spouse, to take advantage of the estate tax exemption for each spouse. The Dynasty Trust is very similar. Here, it is divided into two trusts at the death of the first spouse, with Trust A being the surviving spouse's trust, Trust B being the amount of the federal estate tax exemption for the decedent and containing the balance of the generation-skipping transfer tax exemption.
The surviving spouse receives the income from all of the trusts (interest, dividends, and net rents) and can use principal, if needed, for the survivor's health, support, and maintenance. The surviving spouse can buy and sell assets in any of the trusts. There is no estate tax or generation-skipping transfer tax at the first death.
The trusts are set up as follows:
| Trust A | Trust B |
|---|---|
| Surviving spouse's trust | Exemption trust |
| Fully revocable & amendable | Irrevocable Trust |
| Value-$1,500,000 | Value-$1,500,000 |
Surviving spouse receives all of the income from all trusts and can use principal from Trust B if needed for health, support, and maintenance.
When the survivor dies, Trust B is totally exempt from estate tax and generation-skipping transfer tax.
The maximum exemption for Trust A is added to Trust B. Since all estate taxes have been paid and the full generation-skipping transfer tax exemption is used, all of Trust B is now exempt from future estate and generation-skipping transfer taxes.
| Trust A | Trust B | |
|---|---|---|
| Taxable for estate tax | Not taxable for estate tax | |
| Taxable for GSTT | Not taxable for GSTT | |
| No taxes due since value $1,500,000 | ||
| Trust continues | ||
| Trust ends |
Trust B is now divided into equal shares, one equal share for each of the couple's children. Each child receives a fixed annual payment from the trust, instead of just the income. This amount is a percentage of the value of the trust, determined every year. If the child needs additional funds, in the discretion of the trustee, payments can be made from the principal of the trust for the child's health, support, maintenance, and education.
| C | C | C |
|---|
$1,000,000 in each trust
Additional payments can also be made for health, support, maintenance, and education; each child receives 6% of trust value per year or $60,000 the first year.
As each child dies, the child's trust continues in separate, equal subtrusts for each child of deceased child (grandchild) with grandchildren receiving 6% of trust value per year.
Additional payments can also be made for health, support, maintenance, and education.
Trust may continue after death of grandchildren, for great grandchildren, or terminate and go to grandchildren at certain ages.
If the person setting up the trust is not married, then the exemption is that of one person as opposed to two persons for husband and wife.
The discussion under husband and wife, above, would apply but there would only be one trust, which would contain the full generation-skipping transfer tax exemption. This would obviously lead to a smaller amount being segregated tax-free then if the exemption is doubled for a couple.
The concern is the amount of payments from the trust to future generations after either husband and wife for a joint trust, or a single person for one trust, dies. Traditionally, the "income" from the trust has been paid to a beneficiary. The term "income" relates to what the trust earns in terms of interest, dividends, and net rental income, if any. Any capital gains from sale of estate assets are principal and are not allocated to the income.
In the 1960s and 1970s the annual income in terms of dividends from stock and interest frequently ran 4% or greater of the principal of the trust. However, in the late 1990s and at the beginning of the 21st century, this has turned down significantly, when dividend rates decreased and interest rates fell significantly. Now the returns are in the range of 3%. If there is a trustee who takes a fee, under California law, one-half of the trustee's fee comes from income, reducing the distribution further.
With a Dynasty Trust it is suggested that the trust convert upon the death of the creator, or upon death of both husband and wife, into what is called a "unitrust." This is a trust which is valued annually and the payments made to the beneficiary are a percentage of the value of the trust assets for the following year. Such payments increase or decrease depending on whether the trust assets increase or decrease annually.
If there is $1,500,000 in trust at the end of the calendar year, and the trust provides for a payment of 6% of the value, the beneficiary would then receive $90,000 during the following year, payable monthly, or at the rate of $7,500 per month.
The value of this arrangement is that a beneficiary can determine how much he or she receives during the following 12 months instead of getting varying payments which go up or down monthly depending on the monthly dividends and interest. If the trust increases in value, then the annual payments increase in future years.
In addition, the trust can be written so that principal can be used if necessary for a beneficiary if he or she needs, in the trustee's discretion, additional funds for health, support, maintenance, or education, and there are no other assets or income of the beneficiary available for these purposes.
The concern is the amount or percentage payment made to a beneficiary each year. Presupposing that the trust earns an average of 10% growth per year over a long term, if the payment of 6% is made to a beneficiary, and another 1% to the trustee and for costs, this leaves an annual growth rate of 3% per annum, which would allow the trust to keep up with inflation.
After the death of husband and wife, in connection with a joint living trust, or the death of a single trustor in the case of a single person living trust, the question arises as to who is to be the successor trustee or trustees.
The general thought is to name a child or children as the trustee. This can create problems. The trustee must keep detailed records, invest the assets in a prudent manner, file annual federal and state income tax returns, and determine any discretionary payments from principal for a trust beneficiary, if required. A child may not have sufficient time or expertise to do this. Several children as co-trustees may disagree on what should be done. Investments may not be done in a prudent manner. A child who is the sole trustee may decide that he or she needs another $50,000 from the principal of the trust to buy a new BMW or add improvements to his or her home.
Also if a trust continues for the lifetime of a child, the question arises about who will be the trustee upon the child's death or incapacity. Consideration should be given to having a bank which professionally handles these types of trusts as the successor trustee. A bank will not go on vacation, run off with all of the assets, or dissipate the funds held in the trust.
These types of trust need professional management after the trustors are deceased. To turn the management over to a child or children may lead to future potential problems. It can occasionally lead to litigation between relatives, the costs of which will exceed the fee paid a professional trustee.
Trustors who are considering a dynasty trust need to answer several questions when setting up the trust, since when the trust becomes irrevocable at death it cannot be amended or changed.
What percentage payout will be made annually to the beneficiaries? This can range from 4-7%. A payout of 5-6% seems reasonable to give the beneficiary a return on the funds and allow limited growth. A lower percentage causes the trust to grow faster but penalizes the beneficiary. A larger payout reduces the growth and limits payments in future years.
Should each beneficiary have a limited right to determine who receives his or her assets at death? It is possible to give each trust beneficiary a "limited power of appointment" for the assets in his or her trust at death. The beneficiary can be given the right to leave assets to his or her spouse or children and grandchildren in any proportion or way. However, the beneficiary cannot give assets to anyone else. This limited power of appointment is not taxable for estate tax or generation-skipping transfer tax purposes. The beneficiary could leave assets all to his or her spouse, or favor one child over others.
What happens if everyone dies before the trust ends? If a couple has two children, only one of whom marries and has one child, who then dies before having any children who receive the trust assets, to whom do they go? If you run out of "issue" you need to put in a provisions as to who inherits, or it goes to your nearest relatives, which could be someone you don't know, since this could occur some 25-75 years in the future. Many people put in a charitable institution or institutions as the final beneficiary if everyone dies.
A dynasty trust is not for everyone, but it is useful for a couple who have a net worth of over $3,000,000 and who want to provide for children and grandchildren. Normally, on the surviving spouse's death, everything over the generation-skipping transfer tax and estate tax exemption is distributed outright to the children and the Dynasty Trust contains only the maximum amount which is exempt from future taxes.
This type of trust protects future generations against uncertainties and provides a variable income for them, stretching out such payments as long as legally possible.
© Milton Berry Scott, 2001, 2005Revised 6/21/05