By Anthony Diosdi
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. 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 has 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 jurisdiction 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.
Background of Dynasty Trusts
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.
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 of her death. At death, the parent leaves all of her assets to child. Under current 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 parent’s child is not as successful with investments as parent but is able to preserve the $18.44 million inherited from parent until his death. At death, child leaves all of his assets to grandchild. Under current law, child also has $11.4 million of exemption 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.
Let us consider the same facts as above, except that 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 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 parent’s death, the trust is worth $25 million, because parent did not retained any interest in the dynasty trust, the trust is not included in parent’s gross estate and is not subject to the federal estate tax. Accordingly, 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 of 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 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.
Finally, a dynasty trust should only be established in a jurisdiction with strong asset protection laws. While the effectiveness will largely depend on the terms of the trust, adding a spendthrift clause and a trustee’s withholding clause can work to limit or completely prevent a beneficiary’s creditors from dwindling the trust assets, as long as the assets remain in trust. Several states have enacted powerful asset protection laws for purposes of dynasty trusts.
In general, anyone planning should have a thorough understanding of the settlor’s situation. Although in most circumstances a lawyer’s imagination is the only limit to the substantive terms of a trust, there are many choices the drafter and settlor must make when creating a perpetual dynasty trust because of its extended duration.
Because only a few states have abrogated or repealed their common law rule against
perpetuities, the “selected state” will likely be a foreign state. An estate planner must be familiar with the laws of the “selected” state because each state has its own rules as to what is necessary to have its laws govern the trust. The estate planner must do more than simply include a clause selecting a state to govern the trust. The trust instrument should name at least one trustee who is a resident of the “selected state.” The trust instrument should contain a forum selection provision requiring that any disputes under the instruments be submitted to a court in the “selected” state. In addition, the trust instrument should specify that the “selected” state if arbitration is the method by which the settlor chooses to resolve disputes.
Because this area of law is evolving so quickly, a prudent planner should include a provision allowing the trust to be shifted to another state which may be more beneficial in the future. Such a provision should include a clause that allows for a change of the situs of the trust assets, administration and governing law. The trust instrument should unequivocally address whether, in the event of a change of situs of trust assets or administration, the applicable governing law is to remain the same or whether the trust is to be governed by the law of the new situs jurisdiction. To assure that the settlor’s objectives are upheld, the drafter should include factors and standards which the trustees should consider when deciding whether to change the situs of the trust.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.