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 reduces or avoids gratuitous transfer taxes (gift taxes, estate taxes, generation-skipping transfer 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 (GST taxes). The GST tax = the highest rate of estate tax at the time of transfer times the fair market value of the transferred assets. (IRC Section 2641(b).) Thus, a dynasty trust is only subject to the estate taxes of the grantor, and generation-skipping transfer taxes are avoided until the trust terminates and the trust property goes to final beneficiaries. A dynasty trust could easily save tens of millions, hundreds of millions, or, for the wealthiest trusts, even billions of dollars of gratuitous transfer taxes during the term of the trust. For instance, the richest people in the world have more than $100 billion of wealth, so gratuitous transfer taxes would equal 40% of that, at least $40 billion.
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.
Historically, the rule against perpetuities restricted the terms of trusts to 21 years after the death of a potential beneficiary who was alive when the trust was created. Although this term could easily exceed 100 years, these laws were vague enough to allow court challenges to their interpretation. However, some states, such as California, have adopted the Uniform Statutory Rule Against Perpetuities, which permits a trust to last about 90 years. The trust can still persist after 90 years but if the continued persistence of the trust is challenged in court, then the court can reform the trust to comply with the governing state law.
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.
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Some states, such as Ohio, require that the grantor opt out of the Rule against Perpetuities.
Federal law allows dynasty trusts to reduce gratuitous transfer taxes, but asset protection against creditors and former spouses and the permitted lifetimes of the trusts as well as many other aspects of trust operation depend on state law of the state of the domicile, or situs, of the trust. Note, however, that both federal and state laws may change that would reduce or eliminate the advantages of dynasty trusts. For instance, the federal government could pass a wealth tax on irrevocable trusts, a tax the trust must pay annually based on the value of its holdings.
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 $11 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 trust is created, the grantor must apply any gift tax exemption or GST exemption to the property in the trust for those exemptions to have an effect. If the value of the property exceeds the GST exemption, then the trust property will only be partially exempt, meaning that some GST tax will have to be paid for any property transferred to final beneficiaries. Some attorneys recommend creating separate trusts, a trust fully exempt from GST taxes and the other trust fully subject to GST taxes. 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.
Irrevocable trusts are governed by the trust document, which should be carefully crafted to best carry out the grantor’s wishes while complying with applicable federal and state laws. The trust document should specify the situs state and name the trustees, with at least one trustee residing in the selected state, though state law may specify more or all the trustees to reside in that state. A forum selection provision should also be specified, requiring that any disputes be resolved in the selected state. The trust document should also specify what happens when state or federal law changes, especially if the changes reduce or eliminate the benefit of the trust. If state law changes, then the trust document should allow changing the trust situs to a more favorable state. The forum selection provision should also probably be changed.
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, until at least 2025, the top rate for trusts is 37% on income above about $12,000, which is adjusted annually for inflation. 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 2021, there is a $11.7 million exemption for gift, estate, and GST taxes — this exemption is doubled to $23.4 million for a married couple. If the grantor did not use any of his exemptions in prior gifts, he can fund a dynasty trust with $11.7 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 $23.4 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 death.
More property can be transferred using the unified tax credit if the value of the property can be discounted in some way, such as shares of a family business where the disposition of the shares is restricted. The grantor can also increase the value of the trust by paying income taxes incurred by the trust instead of having the trust pay the taxes. This would allow faster growth of the trust assets.
Taxes must be paid on trust income in the year 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 2021, the 37% marginal tax rate only applies to beneficiaries whose income exceeds $523,600 ($628,300 for married filing jointly).
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. The heirs will not have full access to the trust property since the trust owns the property. The trust document may not account adequately for future changes in law or with the family, which would lower the benefit of the trust. 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 much steeper than it is for individuals with the top marginal tax rate of 37% for any income exceeding $13,050 in 2021.
|Taxable Income (TI)||Tax Liability|
|Base Tax||Additional Tax|
|2021: Revenue Procedure 2020-45|
|$0||< TI ≤||$2,650||$0||+||10%||×||TI|
|$2,650||< TI ≤||$9,550||$265||+||24%||×||(TI – $2,650)|
|$9,550||< TI ≤||$13,050||$1,921||+||35%||×||(TI – $9,550)|
|$13,050||<||TI||$3,146||+||37%||×||(TI – $13,050)|
- Source: Instructions for Form 1041, U.S. Income Tax Return for Estates and Trusts
- Note that the 3.8% Medicare surcharge also applies to undistributed investment income in the highest bracket. So, for instance, capital gains for the top tax bracket will be taxed at 23.8% on undistributed capital gains.
- This tax table does not apply to grantor trusts, since the trust income is included in the income of the grantor and taxed accordingly.
Some critics 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 with Wealth Taxes
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 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 on trusts, a tax assessed annually on the total value of the trust assets, a property tax for trusts. A wealth tax 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 who are more likely to spend it, thus stimulating the economy.