A dynasty trust is a long-term trust created specifically to benefit descendents of multiple generations. It offers both tax and nontax advantages because it makes the most of the generation-skipping transfer (GST) tax exemption. This article explains why this may be a good year to include a dynasty trust in a wealth transfer plan because the GST tax exemption is equal to the estate tax exemption.
It’s been said that all good things must come to an end, but a dynasty trust may be an exception. This type of trust allows substantial amounts of wealth to grow free of federal gift, estate and generation-skipping transfer (GST) taxes for many generations — even forever.
10 THINGS YOU SHOULD KNOW ABOUT A DYNASTY TRUST
Strengthen family ties with a dynasty trust
A dynasty trust is a long-term trust created specifically to benefit descendants of multiple generations. It offers both tax and nontax advantages because it makes the most of the generation-skipping transfer (GST) tax exemption. This exemption increased from $1.12 million in 2003 to $1.5 million in 2004, was $3.5 million in 2009 (and effectively unlimited in 2010), rose to $5 million for 2011 and $5 million adjusted for inflation for 2012. If the government does nothing to extend the current maximums, the exemptions will return to the old, lower amounts — $1 million for gifts and about $1.4 million for GST — in 2013.
Because a dynasty trust is irrevocable, the assets you contribute are removed from your estate. You can avoid gift tax on your contributions by taking advantage of your currently $5,120,000 million lifetime gift tax exemption and, if the trust is properly structured, your $13,000 annual exclusion.
Your children, grandchildren and future generations can receive distributions from the trust at the trustee’s discretion, but so long as they lack control over the trust, the assets will not be included in their estates.
Gain tax and nontax advantages
Assuming Congress won’t permanently repeal the federal estate tax in 2013 — or any other year — a dynasty trust can be an effective tool to transfer wealth, allowing multiple generations to use it transfer-tax free. Assets in a long-term trust remain exempt from estate taxes for the duration of the trust — which could be multiple generations. While these trusts are free of estate taxes, there is still federal income tax to be paid on earnings. If the trust is structured appropriately, that tax can be paid by the trust creator, rather than by the trust itself.
By structuring a dynasty trust as a grantor trust, you can leverage your gift even more. A grantor trust requires you to pay the taxes on the trust’s income. At first glance, that may seem like a drawback. But by paying the income taxes yourself, the trust essentially grows income-tax free, preserving even more wealth for your beneficiaries while removing additional assets from your estate. In effect, your income tax payments become additional tax-free gifts.
If you allocate part of your GST tax exemption as a lifetime gift to your dynasty trust, all future appreciation and all accumulated income attributed to that allocations are free from GST tax. (If a beneficiary withdraws assets from the trust and then transfers them to a grandchild, that transfer may be subject to GST tax.) The trust will pay no or little federal income tax if you fund it with non-dividend growth stocks, tax-free municipal bonds or cash-rich life insurance policies.
A dynasty trust’s benefits go beyond tax savings. Even if Congress repeals the estate tax, you can still use a dynasty trust to provide financial incentives for future generations and to protect assets against the claims of your beneficiaries’ creditors or former spouses.
The GST tax exemption
An important consideration when designing a dynasty trust is avoiding the GST tax. The tax is the federal government’s way of recovering transfer tax revenues lost when property skips a generation. This flat tax is imposed — at the highest estate tax rate of 35% in 2012 (in 2013 55% if Congress does nothing) — on transfers to a grandchild or other “skip person” more than a generation below you. For nonrelatives, a skip person is someone more than 37 years younger than you.
GST tax is in addition to regular estate tax, so it can quickly devour a substantial portion of your estate. The tax can be triggered by a “direct skip” — that is, an outright gift to a skip person.
Long-term trusts have been used for ages, but until relatively recently they couldn’t last forever. The longer your dynasty trust lasts, the more your family will potentially save in transfer taxes. If your jurisdiction still adheres to the common-law rule against perpetuities (Texas still follows this rule), your dynasty trust can last 21 years beyond the death of the last beneficiary alive when the trust was created. Those states — including Alaska, Delaware, Maryland, South Dakota, Idaho and Wisconsin — that have abolished the rule against perpetuities allow dynasty trusts to continue indefinitely. Other states allow you to opt out of the rule against perpetuities. Still other states have extended the maximum duration a trust may exist. For example, Wyoming and Utah allow a trust to last for up to 1,000 years, while Florida permits a trust to last for up to 360 years. So, while a trust may last a very long time, it can be truly perpetual only when organized in a state that sets no limit on duration. Fortunately, no matter where you live, you can create a trust under another state’s law and not be restricted to the duration your home state imposes.
Another advantage of a dynasty trust is that it can provide a trust beneficiary with creditor protection — including claims from a divorcing spouse. How? By limiting the beneficiary’s direct access to income or principal (or both) over his or her lifetime. Generally, creditors can’t access funds the debtor can’t access directly.
Plan within your gift tax exemption
The key to maximizing the value of a dynasty trust is to leverage your GST tax exemption. If you haven’t already used up any of your gift or GST tax exemption and you and your beneficiaries want to benefit from a dynasty trust, consider creating one now and allocating to it up to $5 million of your GST tax exemption (up to $10 million for a married couple in 2012). That transfer will consume your entire gift tax exemption. But by creating the dynasty trust now, you can greatly leverage the amount available to successive generations free of gift, estate and GST tax.
If you created a dynasty trust before 2002, you likely funded it with your then-available gift tax exemption (which would not have exceeded $675,000) and allocated that entire amount to your then-available GST tax exemption (which wouldn’t have exceeded $1.06 million). Thanks to the 2001 tax act, you now have more gift and GST tax exemption available, assuming your other taxable gifts never exceeded your gift tax exemption.
For example, suppose you created a dynasty trust in 2000. You funded it with $675,000 of assets and allocated $675,000 of your gift and GST tax exemptions to the transfer. Today you can allocate your additional $325,000 of available gift tax exemption and an additional $325,000 of GST tax exemption to your trust, thus increasing the ultimate amount available to pass transfer-tax free to successive generations. During the course of two generations (44 years), that additional $325,000 of assets may grow to slightly more than $4.2 million (assuming an after-tax annual growth rate of 6%*), and all of it could pass to your grandchildren transfer-tax free.
Trusts can be funded initially with a lump sum or periodi- cally through annual tax-free contributions of up to $13,000 per beneficiary.
Preserve your wealth for others down the line
A dynasty trust is a powerful tool to keep wealth in the family. Proper use of your GST tax exemption and a dynasty trust may enable you to transfer tax-advantaged assets to multiple generations. If you wish to explore this planning technique in greater detail, please call us.
Consider this example*: A dynasty trust funded with $5 million today will be worth about $1.7 billion 100 years from now — assuming a 6% growth rate and not taking into account income taxes or inflation. In addition, a dynasty trust’s benefits go beyond tax savings. Even if Congress repeals the estate tax, you can still use a dynasty trust to provide financial incentives for future generations and to protect assets against the claims of your beneficiaries’ creditors or former spouses.
* This rate is hypothetical and used for example only.
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