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Dynasty Trusts Planning Tool: Estate Vs. Income Tax

When it comes to estate tax planning, one of the most common questions Tax Lawyers receive is whether or not a Dynasty Trust is the proper tool for tax planning purposes. Presuming the State allows for Dynasty Trusts — the Dynasty Trust can be a great and effective tool for estate tax planning. But it is very important to note that estate tax planning vs. income tax benefits are the two different things. Since the income within the Dynasty Trust is still taxable — it is important to evaluate the assets before they are placed into the dynasty trusts, in order to try to facilitate growth investments that do not generate any (or minimal) income vs. income generating assets that will result in immediate tax liability.

With the Dynasty Trust, it is a trust designed to eliminate future estate tax implications for generations to come by requiring the estate tax to be paid when the contribution to the Dynasty Trust is made (subject to exemption/exclusion amounts). Therefore, when a Taxpayer creates a dynasty trust, they are required to pay estate tax at the time they fund the trust. But, just because estate taxes are being paid at the time the trust is being funded (now) does not stave off all taxes associated with the Dynasty Trust – namely, those pesky income taxes.

Income Tax & Dynasty Trusts

The income that is generated within the Dynasty Trust is still taxable. Therefore, it is important to carefully evaluate each asset before it is placed into the Dynasty Trust — because since it is an irrevocable trust, which means short of decanting the trust – a hit or miss exercise that depends on the state laws, revised rules, grandfather clauses, etc.– the assets within the trust are still taxable as income tax. This is why it is very important to choose assets that have the least amount of taxable income and most potential for value increase. That way, there will be no (or minimal) income tax implications when forming the Dynasty Trust.

International Dynasty Trust

Taxpayers with international/offshore tax issues should carefully evaluate the pros and cons of using a Dynasty trust – including the onerous foreign trust reporting requirements (FBAR; Form 8938; Form 3520 and 3520-A for example). Before any Taxpayer considers a Dynasty Trust, they should speak with a Board-Certified Estate Planning Lawyer in their state.

New Laws That Allow and Encourage Dynasty Trusts

An old legal principle, called the “rule against perpetuities,” used to prohibit trusts that could potentially last forever. Still, even with this rule, trusts could last a long time. To oversimplify, the rule stated that a trust couldn’t last more than 21 years after the death of a potential beneficiary who was alive when the trust was created. Some states (Utah, for example) have adopted a different, simpler version of the rule, which allows a trust to last about 90 years. (This is called the Uniform Statutory Rule against Perpetuities.)

About half the states have done away with the rule against perpetuities altogether, clearing the way for dynasty trusts. Some states go further, luring trust-makers with tax breaks and flexibility, including strong protection if beneficiaries divorce or get into debt. Financial institutions in these states benefit handsomely from the sizeable fees they charge to manage dynasty trust assets.

How Trusts Avoid Estate Tax and Generation-Skipping Transfer Tax

The biggest advantage of a dynasty trust is that it can save your descendants a significant amount of money in estate taxes. The assets you put in the trust (plus any increase in their value over the years) are subject to the federal gift/estate tax just once, when you transfer them to the trust. They are not taxed again, even though multiple generations benefit from them.

By contrast, if you simply left a very large amount of money to your children (without a trust), it would be subject to the estate tax. And whatever they left to their children would be taxed again. If you tried to avoid one of those “tax events” by leaving assets directly to your grandchildren, the federal generation-skipping transfer tax could apply. (Though keep in mind that only very large estates, worth more than $12.06 million dollars, are subject to federal estate or generation-skipping transfer tax.)

For example, say you and your spouse leave $10 million to your daughter. If her inheritance grew, over 30 years, to $30 million, it would be subject to estate tax at her death—and if federal estate tax rates and exemptions in effect then were about what they are in 2022 ($12.06 million exemption, 40% top rate), more than $7 million would go to pay estate tax. That amount wouldn’t be owed if the money were in a carefully drafted dynasty trust—it would stay in the trust, where it could be invested and keep growing.

Taxation of Trust Income

Income taxes are still due on income generated by trust assets. For this reason, people generally prefer to put non-income-producing assets into dynasty trusts—assets such as growth stocks that don’t pay dividends, or tax-free municipal bonds. It’s also common to transfer life insurance policies to a dynasty trust. After the policyholder’s death, the policy proceeds can be used to pay estate tax that’s owed on other assets in the estate.

Control and Lack of Flexibility

You have a lot of control over a dynasty trust—your descendants have little. This offers both benefits and disadvantages. You get to decide who your beneficiaries are and what rights they have. Typically, children are the first beneficiaries; after their deaths, the grandchildren are next in line. You appoint a trustee—usually a bank or trust company—to manage the money and spend it on beneficiaries’ needs according to the terms you set out in the trust. Those rules can be as vague or as detailed as you wish. You can also give the beneficiaries power to give away some of the trust assets or leave them to others at their own deaths. But because dynasty trusts are irrevocable, you can’t change your mind later, and your descendants can’t alter the terms of the trust when family or financial circumstances change. You’re guessing about what will be good for your distant relatives, decades in the future.

Are Dynasty Trusts Bad Public Policy?

The rule against perpetuities was based on the idea that it’s bad for society—and especially a society that prides itself on social and economic mobility, like the United States—to reward strategies that concentrate wealth in families over many generations. Why give tax breaks to dynasty trusts, which give descendants of wealthy families access to wealth that can’t be touched by taxes or creditors?

Many people don’t really want to control events so long after their deaths, in any case. After all, you will never know your distant descendants—and genetically, you won’t share that much with them. In 150 years, the average person can expect to have 450 descendants. And while you share half of your DNA with your children, a descendant six generations has no more than 1.6% of it.

Creating a Dynasty Trust

Needless to say, these trusts are complex and must be carefully prepared by a lawyer who has experience with trusts, taxes, and investments. No one knows what the future may bring, so flexibility is important. For example, you don’t want to tie beneficiaries to a trustee (a bank or trust company) that may not manage trust assets well. And as anyone who has been paying attention knows, federal gift and estate tax rules—which have a big effect on a trust that’s designed to avoid these taxes—have changed significantly in the last few years and are likely to be amended again soon.

What is Involved in Setting Up a Dynasty Trust?

Dynasty trusts are irrevocable; at a base level, setting up a dynasty trust is similar to setting up any other form of irrevocable trust. The settlor (the person establishing the trust) must choose a trustee and beneficiaries, and then once the paperwork has been drafted the settlor must fund the trust with sufficient assets to achieve its long-term gift and wealth-preservation goals. However, there are several unique considerations with dynasty trusts, as well. Among them, it is not possible to establish a dynasty trust in all states. This is because the majority of Utah resident have laws that prohibit trusts from living on indefinitely after the settlor’s death. As a result, when establishing a dynasty trust, it is necessary to ensure that the trust will be governed by the laws of one of the limited number of states that allow trusts to survive in perpetuity.

Generally speaking, the law governing a trust is the law of the state in which the trust is administered. So, to avoid questions of long-term enforceability, establishing a dynasty trust usually involves choosing a trust company located in one of the non-duration-limited states to serve as trustee.

Tax Benefits to Establishing a Dynasty Trust

When structured and funded appropriately, dynasty trusts can have estate tax, gift tax, and income tax benefits. While the settlor may incur certain transfer-related taxes when funding the trust (although careful tax planning can avoid or mitigate this tax liability, as well), dynasty trusts are specifically designed to avoid estate and gift tax liabilities for future generations. This, of course, assumes that these future generations will have sufficient wealth to be subject to estate taxes in the first place and that estate taxes will continue to exist at all under then-current political circumstances. If beneficiaries (i.e., the settlor’s children, grandchildren, and great grandchildren) reside in states that have personal income taxes, then distributions they receive from the trust may trigger income tax liability. However, any trust income that is not distributed will generally be subject to the income tax regime of the jurisdiction where the trust is being administered. As a result, by establishing a dynasty trust in a state without income tax, the settlor can preserve income tax benefits for future generations as well.

Can I Provide for Charitable Giving with a Dynasty Trust?

Yes. There are two primary ways of doing so. The first option is to include a charity as a beneficiary of the trust, but structure the trust so that the charity is only entitled to receive any trust assets not used by descendant beneficiaries. Essentially, family comes first, and whatever is left over when the dynasty trust has served its purpose then goes to charity.

A second option is to use a dynasty trust in conjunction with what is known as a “charitable lead trust.” This option allows for posthumously making charitable donations while your descendant beneficiaries also receive ongoing distributions from the dynasty trust. You can also allow your descendant beneficiaries to select charitable recipients, and can even place conditions on their selections (e.g., they must play an active role in their chosen charity).

Do I Need to Be Concerned About the Generation-Skipping Transfer Tax with a Dynasty Trust?

Potentially. If the value of your estate exceeds the amount of your generation-skipping transfer (GST) tax exemption, the amount you can transfer to your dynasty trust will be limited to the amount of the exemption. Here, too, careful tax planning (including with respect to lifetime gift-giving) can help maximize the benefits of establishing a dynasty trust. Along with tax savings and long-term wealth preservation for multiple generations, another benefit of using a dynasty trust is that it can shield trust assets from liabilities that may arise during your beneficiaries’ lifetimes. For example, suppose your grandchild gets divorced. If he or she receives trust assets outright, those assets could become subject to division during the divorce process. However, by keeping assets within the dynasty trust, they avoid any chance of becoming part of your grandchild’s marital estate. The same principle applies to creditor claims and civil judgments. As a result, using a dynasty trust can effectively serve as an asset protection plan for your immediate beneficiaries, as well as generations down the line.

Should I Consider a Dynasty Trust?

Maybe. As with all types of estate planning tools, deciding whether to incorporate a dynasty trust into your estate plan requires a careful assessment of the value of your estate (currently and as anticipated in the future), your estate planning goals, and your financial and family circumstances. To summarize, some of the key considerations include:

Advantages of Using a Dynasty Trust:

  • Ability to preserve your wealth for future generations
  • Ability to including charitable giving in your estate plan
  • Asset protection for future generations
  • Potential estate tax and income tax savings

Disadvantages of Using a Dynasty Trust:

  • Limited flexibility during your lifetime due to dynasty trusts being irrevocable
  • Limited flexibility for beneficiaries with respect to making use of trust assets

Speak with an Estate Planning Attorney at Parklin Law

If you would like to speak with an attorney about incorporating a dynasty trust into your estate plan, we invite you to schedule an initial consultation. Contact Parklin Law now!!!

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