Protecting Family Wealth for Generations with a Dynasty Trust

The word “dynasty” conveys the image of a powerful and long-ruling family, and the dynasty trust in some ways fits that description. A dynasty trust is an irrevocable trust that provides benefits over multiple generations. Generally speaking, the trust property does not vest in the grantor’s children — although they benefit from it — but is held in further trust for the grantor’s grandchildren and possibly later generations. Dynasty trusts are used to create a financial legacy that can cascade through multiple generations in a tax-efficient manner.

A properly conceived and drafted dynasty trust preserves wealth — and compounds it — by allowing it to endure for many generations and avoid the various layers of taxation that would normally apply during heirs’ lifetimes and at death. Asset protection, whether in the context of a divorce proceeding or in regard to another creditor, is another key attribute of dynasty trusts.

Dynasty Trusts’ Duration and the Rule Against Perpetuities

The recent trend in many jurisdictions to abolish the rule against perpetuities or provide for a very long perpetuities period bolsters the attractiveness of dynasty trusts. A dynasty trust typically provides for transfers of life interests for as long as state law permits. For example, a trust could provide for a transfer “to my daughter, D, for life, then to D’s children for their lives, and then in successive life estates until the perpetuities period expires, at which time the assets are to be distributed to D’s living descendants.” State law determines how long the trust may last.

There is a longstanding public policy created under common law against tying up assets in trust for an indefinite period of time. The rule against perpetuities grew out of this concern about protecting the free alienability of property. Generally speaking, at common law, this meant that a dynasty trust could last for selected lives in being at the creation of the trust plus 21 more years after the expiration of those lives. Thus, if the youngest living grandchild of a settlor was five years old and lived to be 85 years old, the trust could endure for 101 years (80 years for the “life in being” plus 21 additional years) under the common law.

Historically, dynasty trusts were often created in jurisdictions that had repealed the common law rule against perpetuities — which would allow trusts to last forever. In fact, many states have recently repealed the rule (as codified in the Uniform Statutory Rule Against Perpetuities (USRAP)) or have extended the perpetuity period considerably. Other states allow the testator to “opt out” of the rule and create a perpetual trust.

Valuable Despite Possible Tax Law Changes

A permanent repeal of federal estate and generation-skipping transfer (GST) taxes — or a significant increase in the estate-tax exclusion amount and the GST-tax exemption — would not obviate the need for dynasty trusts. In either scenario, it is very possible that gift taxes, in one form or another, would continue to be imposed.

The scheduled increases in the estate-tax applicable exclusion amount and the GST-tax exemption legislated by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) do not carry over to gift taxes. Under EGTRRA, the gift-tax exemption was raised to $1 million beginning in 2002 and has remained at that level. The gift tax is scheduled to continue under EGTRRA phase-in provisions and after the temporary repeal of the estate tax in 2010.

A dynasty trust can avoid issues created by a limited lifetime gift-tax exemption. If a descendant is holding assets outright and wants to distribute a substantial amount to other family members during his or her lifetime, he or she would be limited — short of making taxable gifts — by the available lifetime exemption. If, instead, those assets were held in a dynasty trust, descendants could be given the latitude to direct lifetime distributions through limited powers of appointment without concern over exceeding the gifting limits.

Limited Powers of Appointment

A dynasty trust agreement can grant to children, grandchildren, and other remote heirs broad limited powers of appointment. These powers can provide significant control over the direction of trust property without triggering a gift tax or causing estate inclusion for the heirs. A child may be granted the ability to appoint his or her assets “to such one or more persons or organizations as the child may appoint by will, except that this power shall not be exercisable in favor of the child, the estate of the child, or the creditors of either” (Reg. Sec. 20.2041-1(c)(1)). This is the best of both worlds for a dynasty trust beneficiary: The exercise of a limited power of appointment by a beneficiary allows control over trust asset distribution but will not be treated as a taxable gift — regardless of the identity of the recipient of the distribution.

Asset Protection Alone Is Powerful

A dynasty trust may make sense for even a modest estate, in light of the broad asset protection it provides from potential creditors and divorce settlements. Since trust distributions are typically not required in a dynasty trust, but, rather, are based on what an independent trustee (or trustees) deems appropriate under his or her broad discretion, no property right is created in the beneficiary. This fact, in conjunction with the inclusion of a spendthrift provision in the trust document, minimizes, if not negates, the exposure of trust assets to any potential creditors.

The key distinction in this regard is drafting the trust as a discretionary as opposed to a support trust. The latter defines a support standard for distributions to beneficiaries, such as “health, education, maintenance, and support.” In contrast, a discretionary trust’s distributions lie in the absolute discretion of an independent trustee. It is this difference that generally determines whether a property right has been created that is sufficient to allow a potential creditor to pursue those assets.

Better Than Outright?

Beneficiaries under trust arrangements sometimes have the misconception that trusts are designed to take rights away from them and “control the money from the grave.” However, the argument can also be made that receipt of an inheritance by means of a dynasty trust produces many benefits without causing any harm. A properly constructed dynasty trust can provide virtually all the enjoyment and use of the assets that an outright bequest would provide. In addition, the asset protection benefits outlined above are available.

Consider residential real estate in the context of a dynasty trust. A trust agreement can be drafted in a way that allows the trustee to purchase residential real property and permits a beneficiary to live in the residence rent free. Or, the language of the trust can allow a beneficiary to use any property owned by the trust. The trustee can be given the authority to assist with guaranteeing loans of the beneficiary, invest in the beneficiary’s business ventures, or even loan the beneficiary money to start up a business.

A dynasty trust can be designed so that children (and more remote issue) can (1) control investments; (2) have the power to remove and replace trustees; (3) direct some distributions from the trust, so long as they are not to themselves or in discharge of a support obligation; and (4) act as co-trustees. And all of this can be done without creating any tax impact on the beneficiary. In fact, creating the flexibility to modify a trust, should transfer-tax law change, is one of the compelling reasons to utilize a dynasty trust.

Conclusion

Dynasty trusts offer many benefits to clients who wish to create a legacy by passing assets to future generations. With proper drafting and funding, estate and GST taxes can be avoided, and the preserved wealth can appreciate as it is handed down through the generations. Valuable benefits and added planning flexibility can be provided to trust beneficiaries without any concern that trust assets will become a part of their estates. Lastly, the creditor protections afforded by dynasty trusts will ensure that creditor-type concerns will not deplete descendants’ trust assets. 

If you'd like to learn more about dynasty trusts and other trust services, conatct the First Market Bank's Trust Group at 1-804-347-5749.