Dynasty Trusts- the Most Powerful Planning Available to Combat the Estate, Gift, and the Generation Skipping Tax

By Anthony Diosdi

Introduction

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act of 2017. The 2017 Tax Cuts and Jobs Act increased the exemptions for federal estate tax, gift tax, and generation-skipping tax (“GST”) to $11,180,000 per person for 2018. The exemptions are indexed for inflation. In 2023, the exemption was increased to $12.92 million. The tax rates on estates, gifts, and GST transfers is forty percent. The 2017 Tax Cuts and Jobs Act contains a sunset provision. The exemption for federal estate tax, gift tax, and GST are scheduled to revert back to $5.5 million effective January 1, 2026. As a result of the 2017 Tax Cuts and Jobs Act, individuals are presented with a number of estate planning opportunities to transfer significant amounts of wealth out of their estate without the imposition of transfer taxes. Dynasty trusts have become a popular tool to transfer taxable assets out of an individual’s estate.

What is a Dynasty Trust

A dynasty trust is a trust that perpetuates from one generation to the next without the requirement of terminating on a set date. For example, a mother may create a dynasty trust for the benefit of her son and his descendants. Upon the death of the son, the remaining assets in the dynasty trust would be divided into shares, per stirpes, for the son’s descendants and continue in further trust for their lifetime benefit. Upon the death of a descendant of a son such descendant’s trust would divide, per stirpes, for the descendant’s descendants and continue in further trust. If drafted properly, a dynasty trust, in general, can transfer wealth from generation to generation, with minimal exposure to the federal estate tax, federal gift tax, or the GST (hereinafter the federal transfer tax system).

Thus, dynasty trusts are probably one of the most effective tools of preserving family wealth. Such a trust permits discretionary distributions of income and principal for as many generations as state law allows. States such as Alaska, Arizona, Delaware, Idaho, Illinois, Maryland, Ohio, South Dakota, and Wisconsin have abolished, or provided individuals funding a dynasty trust with the ability to opt out of their respective rules against perpetuities. This means that a trust established in one of these jurisdictions could last forever. The essence of such a trust is that, if properly drafted and funded, to be exempt from the federal generation skipping transfer tax, it will avoid transfer taxes after creation of the trust until the last beneficiary dies. Because of the transfer tax-free compounding, the trust should recognize significant wealth accumulation without being subject to significant federal transfer tax.

Rule Against Perpetuities

Anyone considering establishing a dynasty trust must understand that it is subject to the rule against perpetuities. This rule has frustrated lawyers and law students for generations.  The common law rule against perpetuities is designed to prevent the perpetuation of wealth disparities, promote alienability of property, and make property productive. However, these rules have been criticized as no longer applying in today’s capital market system. The rule’s application has baffled practitioners who have failed to master the rule. The common law rule against perpetuities has inhibited the use of dynasty trusts (trusts which last forever) because such a trust would violate the rule.

Uniform Statutory Rule Against Perpetuities

To alleviate some of the perpetuities problems, “[i]n 1986 the national Conference of Commissioners on Uniform State Laws promulgated the Uniform Statutory Rules Against Perpetuities (“USRAP”). USRAP gives the drafter the opportunity to comply with the common law rule against perpetuities with an alternative ninety-year wait and see period applies.

According to the alternative rule, an interest will be valid if the interest vests within ninety years. After the ninety years expires if the instrument fails, a court may reform the trust to company with the common law rule against perpetuities and still carry out the settlor’s intentions.

It was believed that USRAP had given estate planners a valuable tool: the ability to create a dynasty trust for ninety years or for the common law perpetuities period. A ninety-year dynasty trust may be more appropriate for a settlor who wants control of the trust as long as possible because the trust is guaranteed to last for ninety years. Conversely, if the settlor chose a dynasty trust to last for lives in being at the creation of the interest plus twenty-one years, the trust may not last ninety years. Consequently, the USRAP does little to assist in dynasty trust planning. 

Generation Skipping Transfer Tax

The United States wealth transfer tax system is “designed to erode the concentration of multigenerational wealth” to reduce economic disparities with society. The government’s goal is to tax the transmission of assets at each generation. Before 1986, dynasty trusts were free from any transfer tax after the time of creation, when they would have been subject to an estate or gift tax, until either the last beneficiary died with assets in her asset or gave the assets away.

However, in 1986, Congress felt that it was necessary to close a loophole in the transfer tax system and enacted the GST. The GST applies when a person passes property to another person two or more generations below the transferor. The GST is calculated by applying the highest rate of estate tax (currently 40 percent) to the fair market value of the transferred assets at the time of transfer. See IRC Section 2641(b).

Below, please see Illustration 1 and Illustration 2 which provides examples of a “parent” that does not utilize estate planning when making a gift to a “child” and a “parent that utilizes a dynasty trust to make gifts to future generations.

Illustration 1.

A parent has worked extremely hard and accumulated $10 million over her lifetime. Over the years, the parent invest the $10 million and are able to grow the $10 million to $30 million by the time of her death. Let’s assume that the parent died in 2018. At death, the parent leaves all of her assets to child. Under  provisions of the Internal Revenue Code, the parent currently has $11.4 million of exemption to shelter $11.4 million of the $30 million of assets from the estate tax, leaving $28.6 million subject to tax ($30 million – $11.4 million exemption from estate tax = $28.6 million). Accordingly, the IRS effectively becomes a beneficiary of $11.44 million ($28.6 x 40 percent = $11.44) of the parent’s estate which leaves the child with only $18.44 million for the estate.

Carrying Illustration 1 a step further, assume the child from the above example passes wealth on to his child or the parent’s grandchild. Let’s assume that the parent’s child is not as successful with investments as the parent but is able to preserve the $18.44 million inherited from the parent until his death. At death, the child leaves all of his assets to grandchild. Under current law, child also has $11.4 million of exemption (in 2018) to shelter $18.44 million of the of assets from the federal estate tax, leaving $7.04 million ($18.44 million – $11.4 million = $7.04 million) subject to a 40 percent estate tax.

Illustration 2.

Let us consider the same facts as above, except that the parent creates a dynasty trust during her lifetime. The trust provides for child during child’s lifetime, and upon the child’s death, the assets remain in trust for the benefit of the grandchild and future generations. Parent contribute $10 million to the trust for the benefit of grandchild and future generations. Parent contributes the $10 million to the trust and allocates $10 million of parent’s gift tax exemption and $10 million of parent’s GST tax-exemption to the trust. Assuming that on the parent’s death, the trust is worth $25 million, because the parent did not retain any interest in the dynasty trust, the trust is not included in the parent’s gross estate and is not subject to the federal estate tax. Accordingly, the parent is able to transfer the entire $25 million for the benefit of child, grandchild, and future generations for the lifetime of the trust without any federal transfer tax.

Current Status of Dynasty Trusts

Jurisdictions Which Have Repealed the Rule Against Perpetuities

Anyone considering establishing a dynasty trust must decide where the trust will be domiciled. As we stated above, one of the fundamental characteristics of a dynasty trust (other than its ability to minimize the effects of the federal transfer tax system) is its duration. The duration of a dynasty trust is governed by the state’s rule against perpetuities. The rule against perpetuities is derived from common law and, in general, controls how long after the transfer of the property that the property can be held in trust. Because the Internal Revenue Code permits trusts to last as long as permitted by state law for GST purposes, a number of states have repealed their rules against perpetuities to compete for trust business. The states that have elected to abolish the rules against perpetuities are Alaska, Arizona, Delaware, Idaho, Illinois, Maryland, Ohio, South Dakota, and Wisconsin. Other states have significantly abrogated the rule. For example, under Florida law, a dynasty trust must terminate 360 years after its creation. Because of the growing number of states that allow dynasty trusts not to be governed by the rule against perpetuities, many estate planning attorneys and settlors of trusts have decided to ignore the rule against perpetuities altogether, common law and USRAP alike.

Instead, states which have abolished the rule against perpetuities have become the choice of establishing a dynasty trust. It is important to note that a trust’s situs and governing law is not limited by the residence of the settlor of the trust (A settlor is a person who settles property on trust law for the benefit of beneficiaries) or its beneficiaries. In other words, a dynasty trust can be established in a state which has set aside the rules against perpetuities regardless of where the trust’s property is located, the state residence of the settlor, or where the beneficiaries reside.

The rule against perpetuities isn’t the only consideration a settlor should have when choosing the trust situs. Settlors and estate planners should consider to what extent the trust will be subject to the state’s income tax. Currently, only seven states do not have a state income tax for trusts. They are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Of these seven “no tax states,” Alaska, Florida, Nevada, South Dakota, and Wyoming have modified the default rule against the rule against perpetuities.

The Dynasty Trust and Taxes

As discussed above, U.S. persons can be subject to an estate tax on the date of their death. The use of dynasty trusts has permitted individuals to avoid the estate and gift tax at each generation level. To illustrate, suppose Andrew bequests his personal estate of $5,000,000 to his daughter Beth who, in turn, bequests her entire estate that she inherited from Andrew to her son Carl. Assume that both Andrew and Beth have used up their respective cumulative lifetime exclusions. Upon Andrew’s death, $2,083,000 of estate taxes would be paid by his estate and Beth would receive $2,917,000. Upon Beth’s death, an additional $1,041,500 of estate taxes would be paid by her estate and Carl would receive $1,875,500. Thus, a total of $3,124,500 of estate taxes would have been paid, as Andrew’s property wound its way down to Carl, and he would receive only $1,875,500. On the other hand, if Andrew had created a dynasty trust to pay the income to Beth for her life, with the remainder to Carl, only $2,083,000 of estate taxes would have been paid and Carl would ultimately receive $2,917,000. 

Although dynasty trusts are powerful tools to avoid the estate and gift tax, the generation-skipping tax is more difficult to avoid. Careful planning is often required to avoid the generation-skipping tax with a dynasty trust. The generation-skipping tax was enacted in 1986 in response to this perceived loophole illustrated in the above example. The generation-skipping tax applies to certain transfers by persons in higher generations to or for the benefit of persons in lower generations (i.e., the remainder that Andrew grants Carl in the above example). The generation-skipping tax is imposed at a rate equal to the estate tax and is imposed in addition to the estate and gift tax. We will now discuss the generation-skipping tax in connection with planning a dynasty trust. In order to understand the generation-skipping tax, the reader must first become familiar with the terms discussed below.

Transferor

The person who makes the transfer that is immediately or ultimately subject to the generation-skipping tax is the “transferor.”

Present Interest

A person has a present interest in a trust if the person has a present right to receive the income or corpus of the trust or is a permissible current recipient of either the income or corpus of the trust. While a remainder is also an interest in a trust, it is a right that does not entitle its holder to receive the corpus of the trust until some time in the future. As such, a remainder is a future interest and is not a present interest.

Skip Person and Non-Skip Person

A “skip person” is a person who is assigned to a generation that is at least two generations below the transferor’s generation. A trust can itself be a skip person if 1) all present interests in the trusts are held by skip persons or 2) no person holds a present interest in the trust and, after the transfer of property to the trust by the transferor, no distributions from the trust (including terminating distributions) can be made to a non-skip person from the trust. A “non-skip person” is a person who is not a skip person.

To illustrate, suppose Amy creates a trust to pay the income to her son, Bernie for his life, with the remainder to Bernie’s children (grandchildren of Amy). This trust is not a skip person because Bernie, who is the sole holder of the present interest in the trust, is a non-skip person because he is in the first generation below Amy. While Bernie’s children are skip persons (relative to Amy, as transferor), they do not hold any present interests in the trust. (The fact that a trust is not a skip person does not mean it or its beneficiaries are not subject to the generation-skipping tax). However, if Amy transfers property in trust to pay the income to her grandchildren for their lives, with the remainder to her great-grandchildren, then this trust would be a skip person because all the present interests in the trust are held by Amy’s grandchildren who are skip persons. See IRC Section 2613(a)(2). Suppose this trust included a provision that the trust corpus would be distributed to Amy’s nieces and nephews if it turns out that none of Amy’s great-grandchildren survived Amy’s grandchildren. Although Amy’s nieces and nephews are not skip persons because they are in the first generation below Amy, this fact does not alter the trust’s status as a skip person itself. This is because, at the time of Amy’s transfer of property to the trust, all of the trust’s present interest holders were Amy’s grandchildren who are skip persons.

The Internal Revenue Code sets forth detailed rules to determine a person’s generation assignments based on whether the person in question is a lineal descendant of the transferor, related to the transferor by marriage, or not related to the transferor. The rules include the following:

1. The transferor’s children are assigned to the first generation below the transferor, the transferor’s grandchildren are assigned to the second generation below the transferor, the transferor’s great-grandchildren are assigned to the third generation below the transferor and so forth. The transferor’s siblings are assigned to the transferor’s generation; nieces and nephews are assigned to the first generation below the transferor, grandnieces and grandnephews are assigned to the second generation below the transferor and so forth. 
2. A lineal descendant of the grandparents of the transferor’s spouse (other than the transferor’s spouse who is always assigned to the same generation as the transferor) is assigned to the generation resulting from comparing the number of generations between the lineal descendant and the grandparent and the number of generations between the grandparent and the transferor’s spouse. See IRC Section 2651(b)(2).
3. In determining the generation assignments of lineal descendants of the grandparents of the transferor or the transferor’s spouse, relationships created by adoption are treated as relationships by blood and relationships by half-blood are treated as relations by whole blood. See IRC Section 2651(b)(3).
4. A person who at any time was married to the transferor is assigned to the transferor’s generation. See IRC Section 2651(c)(1). A person who at any time was married to a lineal descendant of the grandparents of either the transferor or the transferor’s spouse is assigned to the same generation as that lineal descendant. See IRC Section 2651(c)(2).
5. If none of the foregoing rules apply, a person born no more than 12 1/2 years after the birth of the transferor is assigned to the transferor’s generation, a person born more than 12 1/2 years but not more than 37 1/2 years after the birth of the transferor is assigned to the first generation below the transferor, and every person born in the next successive 25 year period is assigned to the next lower generation. See IRC Section 2651(d).

Generation Skipping Transfers and Multiple Skips

There are three types of generation skipping transfers. They are taxable terminations, taxable distributions, and direct skips.

Taxable Termination

A taxable termination means the “termination (by death, lapse of time, release of power, or otherwise) of an interest in property held in a trust” unless—

1. Immediately after such termination, a non-skip person has an interest in such property, or
2. At no time after such termination may a distribution (including terminating distributions) be made from such trust to a skip person.

The amount taxed generally equals the value of property with respect to which the taxable termination has occurred. 

For example, suppose Bess creates a trust to pay the income to her husband, Harry for his life, with the remainder to their surviving children for their lives and, upon the death of the last surviving child, to distribute the corpus equally to their surviving grandchildren. Harry is assigned to the same generation as Bess. Their children are assigned to the first generation below Bess. Harry and the children are non-skip persons. The grandchildren are assigned to the second generation below Bess and are skip persons. Harry dies, survived by two children, Ann and Billy. Harry’s death terminates his present interest in the trust, but this termination is not a taxable termination because, immediately afterward, Ann and Billy, two non-skip persons, have interests in the trust. Likewise, if Ann subsequently dies and is survived by Billy, no taxable termination then occurs either because Billy is a non-skip person. However, when Billy dies and is survived by Bess’s grandchildren, a taxable termination occurs upon Billy’s death.

Direct Skip

A “direct skip” is generally a transfer to a skip person that is subject to the estate or gift tax. In the case of a direct skip, the taxable amount is the value of the property received by the transferee. In the case of a direct skip, other than a direct skip from a trust, the generation skipping tax is paid by the transferor.

The Generation-Skipping Tax Exemption

Currently, every person is allowed an aggregate $12.92 million generation-skipping tax exemption. It should be noted that the aggregate $12.92 million generation-skipping tax exemption may significantly decrease at the end of 2025 as the 2018 Tax Cuts and Jobs Act is set to expire. 

A dynasty trust is a trust that is designed to last for the longest period allowable under the rules against perpetuities. The “rule against perpetuities” is a law prohibiting trusts from lasting forever. The rule does not require the trust to last for its maximum legal duration; it permits the trust to last for that period. This common law rule, coming down from centuries ago in England, provides that no beneficiary’s interest in property is valid unless beneficiary’s interest must vest, if at all, no later than 21 years after the death of identified persons, all of whom must be alive at the time the interest is created. “Vest” means that the beneficiaries have an immediate fixed right to enjoy the trust property either low or in the future. That is, a vested beneficiary’s interests are not subject to any contingencies. A condition that a beneficiary must survive the holder of the predecessor interest is not a contingency for these purposes. 

For example, under this common law rule, a trust can be drafted to last for 21 years after the death of all of the donor’s descendants who are living at the time the trust is created. The specified people whose lives will determine the maximum period of the trust are the “measuring lives.” The measuring lives have to be ascertainable with relative ease. Therefore, one cannot, for example, use all persons living in San Francisco on the date of creation of the trust as measuring lives. 

Transfers to a dynasty trust will be subject to the generation-skipping tax, unless a generation-skipping tax is allocated to the trust and the trust is wholly exempt. A trust is wholly exempt if it is established in a state without a rule against perpetuities. California law follows the rule against perpetuities. Thus, a dynasty trust cannot be established in California. As discussed above, a number of states do not follow the common law of perpetuities. A dynasty trust can be established in one of these jurisdictions. Although a dynasty trust can be established in a that does not follow the rules against perpetuities, the generation-skipping tax can still be imposed if a beneficiary of the trust exercises a power of appointment that may, under local law, postpone vesting for a period determined without reference to the date of creation of the trust. See IRC Sections 2041(a)(3) and 2514(d).

A power of appointment is one that allows the holder the power to appoint to himself, his estate, his creditors, or creditors of his or her estate the right to have the beneficial use and enjoyment of certain property covered by the power of appointment. The holder of a power of appointment is treated as if he or she is the owner of the property subject to the power, regardless of whether or not the power is exercised.

For example, Mom creates Trust X, which is governed by South Dakota law and is not subject to the rule against perpetuities. Child, a beneficiary of Trust X, exercises a power of appointment by appointing assets to New Trust for the benefit of Grandchild. If the provisions of New Trust give Grandchild a power to postpone vesting or suspend the absolute ownership or power of alienation of property for a period without reference to the creation of the original trust, Child would be considered to have made a taxable gift or estate transfer, as the case may be. See IRC Sections 2041(a)(3) and 2514(d). 

Unlike the unified credit for estate and gift taxes which must be allocated to gifts in the order in which they are made, the generation-skipping tax exemption can be allocated as the transferor chooses. The exemption can be allocated to the property actually transferred, in the case of a direct skip. In any other case, the exemption must be allocated to a trust.

For example, Mom makes a gift of $50,000 to Grandchild. She can apply $50,000 of her exemption to the transfer. However, if Mom makes a transfer of $100,000 to a trust for the benefit of Child and Grandchild, and the trust distributes $50,000 to Grandchild (a taxable distribution), Mom cannot apply $50,000 of exemption to the taxable distribution and render it exempt. If, on the other hand, $50,000 of Mom’s exemption is allocated to the trust, the taxable distribution will be one-half exempt (assuming the value of the trust is still $100,000 just before the distribution). To render the taxable distribution wholly exempt, either 1) $100,000 of exemption would have to be allocated to the trust, or 2) the trust would have to be severed into exempt and non-exempt trusts and $50,000 of exemption applied to the exempt trust. 

The exempt portion of a partially exempt trust is a fraction. The numerator is the amount of exemption allocated, and the denominator is the value of the trust property or direct skip. The “applicable fraction” and the “inclusion ratio” of a trust are fancy phrases for the “exempt portion” and the “nonexempt portion,” respectively. An agreement for the allocation of the “exempt portion” and “nonexempt portion” must be created prior to the establishment of the dynasty trust which makes an allocation of the generation-skipping tax and the trust language must reflect that such an agreement was created. Below, please find sample trust language discussing the allocation of the generation-skipping tax exemption.

Trust Language

Prior to the funding of any trust to be created under this Agreement to which property that is exempt or excluded from generation-skipping transfer tax and property that is not exempt or excluded from such tax is to be allocated, settlor hereby directs that the trustee of such trust to divide (on a fractional share basis) the property that would otherwise pass to such trust and to establish separate trusts with identical terms to hold such property, so that property which is exempt or excluded from generation-skipping transfer tax shall be held in a separate trust from property which is not exempt or excluded from such tax. Trustee also has discretion to divide (on a fractional share basis) any trust created under this Agreement after it has been funded, and to establish separate trusts to hold such property, so that property which is exempt or excluded from generation-skipping transfer tax is held in a separate trust from property which is not exempt or excluded from such tax. Any such divisions shall be in accordance with the regulations issued pursuant to Chapter 13 of the Internal Revenue Code. With respect to any trust which has been divided into separate trusts as described in the preceding sentence, the trustee of such trusts, in making a discretionary distribution to the beneficiary of such trusts in accordance with the terms of such trusts, may make such distributions either all from one trust, all from the other trust, or part from one trust and part from the other trust, in trustee’s sole discretion; provided, however, that settlor hereby recommends, but does not require, that trustee make discretionary distributions in accordance with the terms of such trusts 1) from the trust which is exempt or excluded from generation-skipping transfer tax, to the extent possible, if the beneficiary to whom such distribution is to be made is a skip person (as defined in Section 2613 of the Internal Revenue Code); and 2) from the trust which is not exempt or excluded from generation-skipping transfer tax, to the extent possible, if the beneficiary to whom such distribution is to be made is a non-skip person (as defined in Section 2613 of the Internal Revenue Code); and provided, further, that settlor hereby directs that any death tax or administrative expense. 

Conclusion

The foregoing is intended to provide the reader with a basic understanding of the basic tax considerations involving dynasty trusts. It should be evident from this article that this is a relatively complex subject. It is important to note that this area is constantly subject to new development and changes. As a result, it is crucial that anyone considering establishing a dynasty trust consult with a qualified tax attorney to review his or her particular circumstances. 

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.