Dynasty Trusts: Long-Term Tax Savings
and Protection of Family Assets

This article discusses the availability and use of a tax-planning device known as the "dynasty trust."

The basic premise underlying the federal gift and estate tax system is that assets are subject to taxation each time they pass from one generation to another. Nonetheless, prior to 1986, these taxes were successfully avoided by many families through the use of "dynasty trusts" created for the benefit of successive generations of the descendants of the original donor or donors.

In 1986, in order to limit the tax-free or tax-advantageous transfer of wealth through dynasty trusts, Congress enacted the federal generation-skipping transfer tax. The new tax attempts to level the playing field between families that use dynasty trusts and those that do not: in its simplest application, the 1986 law taxes the assets held in a dynasty trust at the death of a trust beneficiary essentially as though the beneficiary owned the assets outright and as though the assets were included in the beneficiary's estate for purposes of the federal estate tax.

However, Congress included a significant exemption in the generation-skipping transfer tax law -- every person has a "GST exemption" that enables him or her to create and fund a dynasty trust with property having a value of up to $1,000,000 (a married couple's combined exemption is $2,000,000). Within these limits, a dynasty trust can be created that has all the gift and estate tax advantages of similar trusts created before 1986.

A dynasty trust is a long-term trust created for the benefit of a person's (or a married couple's) descendants of all generations. A dynasty trust typically lasts for the entire "rule against perpetuities" period (the maximum trust term allowable under state law), which extends 21 years beyond the death of the last to die of all of the trust beneficiaries who are living when the trust is created. A dynasty trust may be created for a shorter term, but the trust's tax-saving impact is greatest if it lasts for the entire perpetuities period.

For example, if a person who creates a dynasty trust (the "settlor") has one or more now living grandchildren, the term of the trust may extend 21 years beyond the death of the last of the now living grandchildren to die. If the youngest now living grandchild is a newborn infant and if he or she lives to age 89 and then dies, surviving all of the other children and grandchildren of the settlor who were living when the trust was created, the trust will not terminate until 110 years after it is created (the 89-year life of the surviving grandchild + 21 years).

The tax savings associated with a dynasty trust do not occur when it is first funded: gift or estate taxes are generated if the value of the property placed into the trust exceeds the settlor's $600,000 federal gift and estate tax unified credit equivalent (or the combined $1,200,000 credit equivalent of a married couple who create such a trust).

The tax savings occur later as the dynasty trust is administered for the benefit of the settlor's or settlors' descendants and at the successive deaths of those descendants. Once the original transfer of assets into the dynasty trust has occurred, the trust assets, as well as their appreciation and accumulated income, remain free from federal gift and estate taxes for the entire term of the dynasty trust:

the federal gift tax does not apply to distributions from the trust to or for the benefit of the settlor's or settlors' descendants during the trust term; and

the federal estate tax does not apply to the trust assets at the descendants' respective deaths during the trust term; and

the federal estate tax does not apply to the trust assets when the trust terminates at the end of the perpetuities period.

The cumulative impact of the gift and estate tax savings can be enormous. For example, assume that the settlor of the hypothetical 110-year dynasty trust discussed above funds the trust with assets then worth $100,000 (using only 10% of his or her available $1,000,000 GST exemption). Assume also that the trust assets appreciate at 6.00% annually (after income taxes) and that all appreciation and after-tax income are accumulated within the trust during its 110-year term. The value of the trust assets at the expiration of that term would be $60,764,000.

Next, assume that the original $100,000 is not held in the dynasty trust but is instead transferred outright from generation to generation, subject to the 55% federal estate tax at the death of the last to die of the settlor's children (assumed to occur in year 55) and again at the death of the last to die of the settlor's grandchildren (assumed to occur in year 110). The after-tax value of the assets remaining in year 110 would be $12,305,000, only 20.25% of the value of the assets that would then remain in the dynasty trust.

Usually, the settlor's children are the preferred beneficiaries of a dynasty trust during their lifetimes, and, after the death of the last of the children to die, the settlor's grandchildren (and sometimes great-grandchildren) become the preferred beneficiaries.

The trustee or trustees of a dynasty trust are typically given broad discretion to use trust income or principal for the benefit of the trust beneficiaries. That discretion can be as broad or as narrow as the settlor wishes it to be:

responsible beneficiaries can be given control over and access to the trust assets that are the near equivalents of outright ownership; or

so-called "spendthrift" provisions can be applied to beneficiaries who are not financially responsible or whose family situations are not stable.

In fact, the possibility of including a "spendthrift clause" in a dynasty trust may be even more appealing to the settlor than the gift or estate tax savings available through the trust. If properly drafted: (1) a spendthrift clause can insulate the assets of the trust from the reach of the creditors of a beneficiary until, or unless, distributions are in fact made to him or her; and (2) a spendthrift clause can prevent a beneficiary's spouse from reaching any of the assets of the trust on divorce for purposes of alimony or division of property.

The critical point from a tax-planning perspective is that no trust beneficiary be given an interest in or power over the trust that is so broad as to subject the trust assets to gift taxes when distributions are made from the trust or to estate taxes on the beneficiary's death.

A dynasty trust can be set up on an "incentive" basis: discretionary distributions can be conditioned on a beneficiary's putting forth reasonable efforts to support himself or herself and his or her family. The "incentive" trust encourages a beneficiary to become a productive member of society and not to become overly dependent on the trust for his or her support.

A dynasty trust can be created by the settlor during his or her lifetime, or a portion of the settlor's estate can be carved out under the settlor's will (or living trust) to fund the dynasty trust at the settlor's death.

The advantage of creating the dynasty trust during the settlor's lifetime is the "leveraging" of the $1,000,000 GST exemption -- the dynasty trust shelters not only the value of the assets transferred into the trust when it is first funded during the settlor's lifetime but also post-funding appreciation of those assets.

A dynasty trust can also be made to do double duty as an irrevocable life insurance trust (an irrevocable trust funded with insurance on the life of the settlor, the proceeds of which are available on a tax-free basis to pay estate taxes on other assets passing at the settlor's death) or as a qualified personal residence trust.

The dynasty trust illustrates a fundamental truth about estate planning: it is generally more beneficial for family wealth to be held in trust than to be owned outright by successive generations of family members. A consultation with an attorney can help determine whether a dynasty trust could be an effective part of an estate plan.

Copyright © 1994, Fairfield and Woods, P.C.,
ALL RIGHTS RESERVED.

Comments or inquiries may be directed to:
Michael H. Smith or Robert L. Loeb.