Dynasty Trusts

A dynasty trust (aka perpetual trust, descendants trust) is a trust lacking  a defined termination date or event, which is only allowable in those states that have eliminated the rule against perpetuities. The main benefit to this type the trust is that it avoids estate taxes on succeeding generations. When the grantor dies, the assets of the trust will be subject to the estate taxes imposed on the grantor, but because the dynasty trust can last virtually forever, those will be the only estate taxes imposed. By contrast, if the grantor simply bequeathed her fortune to her child, who then bequeathed his fortune to his child, etc, then estate taxes will be assessed each time an heir dies. If the grantor tried to skip 1 or more generations by, for instance, bequeathing to grandchildren, then the amount transferred may not only be subject to estate taxes, but also to generation-skipping transfer taxes. Thus, a dynasty trust is only subject to the estate taxes of the grantor, and generation-skipping transfer taxes are avoided entirely.

The trust can also be structured to protect both the income and the property from the creditors or divorced spouses of the beneficiaries, or it can also be used to extend the dead hand control of the grantor over a longer time period, conditioning the gift to beneficiaries by whether they follow the grantor's wishes. Because a dynasty trust will mostly be distributing income and property to beneficiaries more than 1 generation younger than the grantor, dynasty trusts are sometimes called generation-skipping transfer trusts.

Although some states still retain the rule against perpetuities, this is generally no problem to the grantor, since the grantor does not have to live in the state to take advantage of its trust rules. However, these states generally require that the trust employs at least 1 trustee who is a resident or corporation within the state.

States That Have Abolished the Rule Against Perpetuities
  • Alaska
  • Delaware
  • District of Columbia
  • Idaho
  • Illinois
  • Kentucky
  • Maine
  • Maryland
  • Michigan
  • Missouri
  • Nebraska
  • Nevada
  • New Hampshire
  • New Jersey
  • North Carolina
  • Ohio
  • Pennsylvania
  • Rhode Island
  • South Dakota
  • Tennessee
  • Utah
  • Virginia
  • Wisconsin
  • Wyoming

The trust uses its principal of property and money to generate income for the beneficiaries or to allow their use of the property, such as a residence. Since the law provides a unified tax credit that can be applied to gratuitous transfer taxes, each individual can transfer more than $5 million to others before any of it will be subject to tax. Therefore, dynasty trusts are most useful to the very wealthy, especially since it is difficult for a trust to accumulate wealth through investments because of the high marginal tax rates that apply to any retained income.

Taxation of Dynasty Trusts

Dynasty trusts usually begin as grantor's trusts so that income is taxed at the grantor's tax rate rather than at the higher trust rate. When the grantor dies, the trust becomes irrevocable, becoming a separate taxable entity that must file its own tax return — Form 1041, U.S. Income Tax Return for Estates and Trusts.

Trusts are subject to most of the same tax rules that apply to individuals. They even have the same percentage tax brackets, but the boundaries of the tax brackets occur at much lower income levels. For instance, for 2013, the top rate for trusts is 39.6% on income above $11,950. Trusts may also be subject to the alternative minimum tax, but this is usually easy to avoid. (More info: Taxation of Trusts and their Beneficiaries)

For 2011-2012, there is a $5 million exemption for gift, estate, and GST taxes — this exemption is doubled to $10 million for a married couple. The $5 million exemption has been extended to 2013, and will be adjusted for inflation thereafter. If the grantor did not use any of his exemptions in prior gifts, he can fund a dynasty trust with $5 million that will be free of gift or estate taxes and GST taxes for as long as it exists, regardless of how much the trust property appreciates. If the spouse also contributes to the trust, then at least $10 million will be exempt from all taxes. This amount can be increased by using legal maneuvers such as funding the trust with discounted property or with the proceeds of a life insurance policy where the grantor had no incidents of ownership within 3 years of his death.

Generally, taxes must be paid on trust income in the year that is earned. If the trust retains income at the end of the tax year, then it must pay taxes according to the graduated scale for trust income. If the income is distributed to beneficiaries before the end of the tax year, then the income is taxed at the beneficiary's rate. The high marginal tax rates is the major reason why trusts tend to retain long-term capital gains that are taxed at flat statutory rates, while distributing most of its income to beneficiaries, since the tax brackets that apply to beneficiaries are at much higher incomes. For instance, in 2013, the 39.6% marginal tax rate will only apply to those single beneficiaries whose income exceeds $400,000.

Besides the savings of transference taxes, the dynasty trust can be structured as a sprinkling trust, giving the trustee discretion to sprinkle more of its income to beneficiaries in lower tax brackets.

If any of the original trust property is ultimately distributed to beneficiaries who were 2 or more generations younger than the grantor of the trust, and the property is not covered by the grantor's exemption, then GST taxes must be paid on the property value, but will not be subject to income taxes since it was a distribution of principal.

Disadvantages of Dynasty Trusts

There are several disadvantages to dynasty trusts. After several generations, the beneficiaries will no longer be closely related to the grantor. A child of the grantor will be related 50%, a grandchild, 25%, a great-grandchild, 12.5%, so that by the 6th generation, the beneficiary only has a 1.6% relationship with the grantor, and that relationship continues to halve with each successive generation.

By the same reasoning, the trust income or property will have to be divided among more and more beneficiaries. If the grantor and each beneficiary has 2 children, then there will be 64 beneficiaries in the 6th generation.

Moreover, because the dynasty trust usually lasts longer than people's lifetime, the trustee must be a corporation, which often charges hefty fees for trust administration. Furthermore, a committee is often used to decide on distributions when the trust document gives the trustee discretion to pay beneficiaries income or principal.

Another drawback of any trust is that it must pay taxes on income using a graduated scale that is steeper than it is for individuals with the top marginal tax rate, starting in 2013, of 39.5% for any income greater than $11,950.

Some critics of dynasty trusts argue that dynasty trusts should be against public policy since they may create an aristocracy whose wealth can be transmitted without being subject to transference taxes and that may also not be subject to claims of creditors or divorced spouses. However, since tax policy has always favored the wealthy, dynasty trusts are unlikely to disappear.

Taxing Dynastic Wealth

Dynastic trusts are often used to exert dead hand control, but they are also used to reduce estate taxes, because the wealth no longer passes from generation to generation directly. Dynastic trusts are simply 1 of the many ways that the wealthy can greatly reduce their taxes, paying even less than people who work for their income. An effective means of taxing the wealthy that could not easily be evaded is by assessing a wealth tax, a small tax rate that is assessed on people's net worth, or the net worth of all their assets, or on trusts. This can easily be computed for trusts, so by assessing a wealth tax on noncharitable trusts that do not have a specific socially desirable goal, such as the trusts for retirement accounts, then an annual wealth tax will go a long way to compensate the government for the loss of tax revenues through tax loopholes. This would motivate trustees to distribute more of the trust wealth to individuals more likely to spend it, thus stimulating the economy.