Dynasty Trust

I have been reading about maximizing the Generation-Skipping Tax (GST) exemption. We want to set up a trust that will benefit more than one generation beyond our two children. We have $750,000 we want to invest in a trust. This is money that we do not need to live comfortably. We are also concerned about keeping the assets from being included in our estate or our children’s estate so they can pass tax-free to each subsequent generation. We especially want to be certain that creditors or ex-spouses are unable to make claims against the estate so it is preserved for our grandchildren and (hopefully) their grandchildren. We also want to set some stipulations so our heirs don’t become "trust fund babies". We were considering requiring they maintain employment in order to receive funds from the trust.

Because you want to provide security for future generations AND utilize the tax benefits of the GST exemption, you might want to investigate a Dynasty Trust.

What it is…

Dynasty Trusts are very similar to legacy trusts. The difference is more semantics than anything. However, generally speaking, people will call a trust intended to benefit multiple generations a dynasty trust; whereas a legacy trust would more often be aimed at a particular future generation or beneficiary.

Dynasty trusts, like legacy trusts, are designed to maintain assets in a trust with the beneficiaries having no direct ownership. This protects the assets in the trust from creditors, divorces, or lawsuits that could compromise those assets if the beneficiary had direct ownership of their portion of the trust. In addition, assets in a Dynasty Trust can be protected from estate taxes for generations. For tax purposes, the assets in the trust are valued at the amount they were worth when the trust was created as long as they stay in the trust.

How it works…

When Congress enacted the Generation-Skipping Transfer (GST) tax in 1976, and then updated in 1986, its purpose was to recapture federal estate revenue that had been lost through wealthy families using trusts to place their assets in and use income from those trusts to benefit multiple generations -- all the while avoiding paying transfer (estate or gift) taxes. They did this by putting the assets into a trust and attaching sufficient "strings" so that future generations were not deemed to "own" the assets -- thereby avoiding transfer taxes. They also could simply leave assets directly to a grandchild or great-grandchild -- thereby avoiding the normal transfer taxes that would occur as the assets passed through the older generations.

So, the GST will impose a tax when assets are transferred, skipping a generation (i.e. grandparent leaves asset to grandchildren, skipping children who are still alive; if the beneficiary is not related to the transferor, then there are rules to determine whether the age difference is enough to deem them a "skipped" generation). The GST tax rate is now equivalent to the highest marginal estate tax rate.

However, the GST tax can be avoided by using the Generation-Skipping Tax Exemption. The GST exemption is equivalent to the estate tax exemption ($3.5 million in 2009; unlimited in 2010; $1,000,000 in 2011) and only assets in excess of the exemption (that "skip" a generation) are subject to the Generation Skipping Tax.

So, if you use the GST exemption to create what is often referred to as a "Dynasty Trust" or Legacy Trust, then trust income and principal is exempted from the GST for the life of the trust.

However, please remember that assets subject to the GST tax are also subject to the estate tax. So, to pass the assets tax free, skipping a generation, they will have to be within the estate tax exemption and also within the GST exemption. So, you effectively use up both exemptions at once. Still, you are able to get those assets to a second generation without any transfer taxes -- so, if you are able to do this (first generation not need inheritance or able to pay estate taxes on their estate) then, this can be a great long-term dynasty/legacy tax savings strategy.

In some states the Dynasty Trust can last indefinitely. Other states limit the trusts to between about 80 years and 100 years after they are created as defined in the Rule Against Perpetuities (RAP) (you can read more about the RAP at legacy trust).

Just to make it a little more confusing, over 20 states have revoked the RAP. You can establish and maintain a trust in one of these states. You don’t have to be a resident of the state to benefit as long as the trust has some connection with the state…such as the trustee living there. You can establish and maintain trusts in these states until all of the trust’s funds have been distributed or until the last living descendant of the trust’s creator dies. Other states do limit the duration of Dynasty Trusts with limits ranging from 150 to 1000 years.

You can place stipulations on a Dynasty Trust that prevents your children and grandchildren from becoming "trust fund babies". You could, for example, require they obtain a college education, maintain a job or match a percentage of their earnings with income from the trust.

Special Considerations…

A Dynasty Trust is a complicated planning tool that provides a highly effective way to pass wealth on to future generations. It requires careful planning. Remember – you are leaving a legacy that could be impacted by unforeseen changes in tax codes, laws and regulations.

Your first consideration should be whether to fund the Dynasty Trust during your lifetime or upon your death. Lifetime funding allows for more asset growth with less tax impact.

You also need to decide how much you can afford in funding the trust. The general rule is that -- before even considering a dynasty trust -- you need to have about $500,000 in reserve for yourself, above what you need to live comfortably, to be sure you can cover your own living expenses.

Be certain you are clear about the intended outcome and stipulations of the trust. No changes can be made by the beneficiaries or trustee to the Dynasty Trust as it becomes irrevocable upon the death of the creator of the trust.

Select the trustee for the Dynasty Trust carefully. It could be one of your adult children who can pass the responsibility to the next generation upon their death. Or, you may decide to use a financial institution for ongoing management of the trust. You may find that an independent corporate trustee is well worth the annual fee. They can help prevent tax liability (a beneficiary who is also a trustee could have adverse tax implications depending on the control and discretion the trustee has to use the assets for personal benefit). You may decide a combination of family member(s) as part of an advisory committee with professional management will insure family involvement and avoid the trustee/beneficiary implications which could lead to unfavorable tax consequences.

The dynasty trust is a sophisticated tax planning strategy so it is highly recommended that you utilize the services of an experienced living trust or estate planning attorney. If not done properly, you could end having your assets subject to two estate taxes within two generations, virtually wiping them out.

Your living trust attorney needs to be someone familiar with your goals, your assets and the beneficiaries. The attorney can draft a dynasty trust document that is tailored to the needs of each beneficiary. For example, you might decide to withhold funds from a beneficiary with marital problems or increase distributions to an heir who needs additional help to supplement their income. The attorney can also set up irrevocable life insurance trust to cover any estate taxes.

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