DYNASTY TRUSTS

By Nathaniel E. Clement, J.D.

A Summary of the Advantages

The dynasty trust offers the following advantages:

It avoids a current U.S. estate tax of up to 46% on the value of the assets transferred to the trust (55% in 2011 under current law).

It allows the transfer of a substantial amount of assets to the maker's family for little or no gift tax.

It leverages and maximizes the generation-skipping transfer tax exemption ($2,000,000 in 2007).

It shelters large amounts of income and principal from the claims of potential creditors.

Using a dynasty trust is appropriate for those people who wish to pass substantial wealth to subsequent generations free from estate and generation-skipping tax.

A Brief Description of the Strategy

A dynasty trust is designed to keep assets that are put into the trust from ever being subject to gift, estate, or generation-skipping tax. Under the laws of the United States and some individual states, all assets are subject to federal estate taxes when they pass from generation to generation. A dynasty trust assures that assets not used by one generation can pass to subsequent generations without being diminished by any federal or state estate or inheritance taxes. To be able to last for as long as the maker has descendants, the trust must be controlled by the laws of a state that allows trusts to continue in perpetuity. Most states have laws which prevent a trust from lasting in perpetuity. These laws are known as the Rule Against Perpetuities. However, several states do allow perpetual trusts - that is, dynasty trusts.

Here is a summary of how the typical dynasty trust operates:

1. The trustmaker gives property to the trustee of the dynasty trust, which is controlled by the laws of a state that does not recognize the Rule Against Perpetuities. There can be one or more trustmakers of a dynasty trust.

2. The trustee generally cannot be the trustmaker or trustmakers. It can be another individual or individuals, a professional advisor or advisors, or it can be a bank trust department or a trust company. At least one trustee must reside in a state that does not have the Rule Against Perpetuities. The trustee administers the trust and invests the trust assets.

3. When the trustmaker gives property to the dynasty trust, the beneficiaries are the maker's descendants.

4. The dynasty trust may have demand right powers. If it does, then the trustee notifies the demand right beneficiaries, who have a limited period of time to withdraw the trustmaker's gift. The demand right means that the gifts to the dynasty trust qualify for the $12,000 annual gift exclusion. If the beneficiaries do not exercise their demand right, then the funds stay in trust and are often used to pay the premiums of life insurance on the trustmaker or on the trustmaker and his or her spouse.

5. At the death of the trustmaker, the trust principal, including any life insurance proceeds, is not subject to gift, estate, or income taxes.

6. The trustee of the dynasty trust administers the trust as provided in the trust agreement. Generally, the trust proceeds are used for the health, education, support, and maintenance of descendants based on needs.

The Rule Against Perpetuities Strategy

The major limitation on the benefits that a dynasty trust presents in most states is the requirement of vesting within the period provided in the Rule Against Perpetuities. Once the trust property vests in a beneficiary, transfer tax will occur at that beneficiary's generation level (at rates as high as 46% as of 2007), which will drastically reduce the amount of property remaining for future generations.

These states currently do not have the Rule Against Perpetuities Law. They are South Dakota, Alaska, Deleware, Wisconsin, Idaho, Illinois, Maryland, Virginia, and Rhode Island. In these states, there is no legal limit on the length of time for which a trust could be established, or vesting postponed, so a dynasty trust established in one of these states could theoretically last forever without creating vested interests. So long as the trust continues, the GST tax exemption should protect it from further transfer taxation over many additional generations.

South Dakota does have a statutory limitation known as the "rule against suspension of the power of alienation." Under that rule, the power to sell assets held in trust may not be suspended for any period longer than the lives of persons living when the trust is created, plus 30 years thereafter. However, the law also provides that if the trustee has a power to sell the trust assets, this rule is not violated. Therefore, if the trustmaker of the dynasty trust is willing to grant the trustee a power of sale over the trust assets (which does not translate into an automatic power to distribute sale proceeds to the beneficiaries), then the rule against suspension of the power of alienation does not apply.

We believe that South Dakota and Alaska are the best jurisdictions for the administration of a dynasty trust. This is because, in addition to the elimination of the Rule Against Perpetuities, South Dakota and Alaska do not impose an income or personal property tax either on trusts or their beneficiaries. As a result, locating the trust in these states will not create the imposition of any additional income tax burdens on the trust. Indeed, in the case of a nonresident trustmaker or nonresident beneficiaries, if income taxation of the domiciliary state can be avoided, locating the trust in South Dakota or Alaska can produce a more favorable income tax result, at least as long as income or gains are accumulated in the trust.

Alaska allows an additional right for the trustmaker that South Dakota does not currently allow. Alaska allows a creditor protection for a "self-settled" trust which no other state effectively allows. Under Alaska law a trustmaker may establish ("settle") an irrevocable trust (whether dynastic or not), transfer assets to that trust, and name the maker as a discretionary beneficiary of that trust and have those assets in the trust protected from the creditors of the maker. In all other states if the maker reserves the right to be a beneficiary of a self-settled trust, the assets of the irrevocable trust are not protected from claims against the maker. There is some question about whether the assets of the self-settled trust in which the maker reserves the right to be a beneficiary will be taxed as part of the estate of the maker. It is believed that the assets of such trust are outside of the maker's estate, but the IRS has refused thus far to issue any rulings in that regard (we suspect this is to deter this planning device). Unless creditor protection is extra important to you, or unless it is quite important for you personally to have access to the funds of the trust, we recommend South Dakota as the jurisdiction of choice.

A Case Study Comparison

To illustrate the superior results that creating a South Dakota dynasty trust can present, it must be compared to the benefits available if the dynasty trust is established in another jurisdiction. For this purpose, we have developed a case study comparing three identical trusts established in South Dakota, Virginia, and New York, respectively. Virginia and New York were selected as the comparative states because they are representative examples of low-income-tax and high-income-tax states. However, any other state could be selected to perform a comparison, and the conclusions reached from our comparative analysis should have general application to most other states. The case study we have developed is based on the following set of facts:

Assume that in 2005, a 70-year-old trustmaker established a dynasty trust by lifetime gift for the benefit of his descendants with $1,000,000 of cash, and exempts the entire trust with his GST tax exemption. It is his intention that the trust last for the longest possible time permitted by law. At the time the trust is created, he has a 45-year-old child and a 20-year old grandchild living. Under mortality tables used by the Internal Revenue Service, the grandchild has a life expectancy of about 62 years. Therefore, in a state where the Rule Against Perpetuities applies to the trust, the longest expected period of time that vesting of the trust can be postponed, assuming the grandchild is the youngest identifiable life when the trust is created and he lives to his life expectancy, is 83 years (62 + 21). Assume further that at the end of the 83 years, there will be a great-grandchild living in whom the trust will vest, and that the great-grandchild will die two years later. (i.e., in the 85th year after creating the trust). Finally, assume that the cash will be invested in marketable assets that will earn a 5% current yield over the trust term, that trust assets will appreciate at the rate of 7% annually over the term, and that the trust portfolio "turns over" (is sold and reinvested) at a rate of 20% annually.

Our comparison determines what the dynasty trust will be worth, and hence what amount of property will be available to the family, following the great-grandchild's death in year 85, if the trust is established in each of the three selected jurisdictions. In South Carolina or New York, the trust must vest in the great-grandchild at the end of the 85-year term, which means that the trust property will be subject to transfer taxation (gift or estate tax) at the generation level of the great-grandchild before it passes to the next generation. We have assumed for purposes of this analysis that the applicable transfer taxes will be imposed at a 55% rate (federal and state estate taxes - the rate that, under current law, will be in effect in 2011). In contrast, because of the continuing ability of the South Dakota trust to postpone vesting indefinitely beyond the 85th year, no vesting in the great-grandchild is required, and therefore no transfer taxation at that generation will occur.

On the basis of the foregoing facts, the performance of the South Dakota trust by the end of the 85-year period, compared to the performance of the other two trusts is as follows:

1. Total After-Tax Income Generated:

South Dakota: $1.4 billion

South Carolina: $1.3 billion

New York: $871 million

2. Total Appreciation in Trust Assets:

South Dakota: $1.0 billion

South Carolina: $934 million

New York: $622 million

3. Total Aggregate Value Available to Family:

South Dakota: $1.5 billion

South Carolina: $777 million

New York: $488 million

As you can see, based on our assumptions, the South Dakota trust will provide over 240 percent more value than is available from the South Carolina trust, or almost 390 percent more value than is available from the New York trust. However, there is much closer similarity in performance of the South Dakota and South Carolina trust with respect to after-tax income and appreciation generated over the 85-year period. This is primarily due to the relatively low level of state income taxation in South Carolina . We also assumed that similar bank fee structures applied for the South Dakota and South Carolina trusts in our computations.

Why does the South Dakota trust produce so much more overall value to the family at the end of the 85-year period? The answer is its avoidance of a devastating transfer tax because the South Dakota trust need not vest or terminate, while the South Carolina and New York trust must create vested interest and become exposed to transfer taxes after 83 years.

This comparison is based on the assumption that all trust income is accumulated and no principal invasions occur over the term. As stated earlier, total accumulation and retention is not required for such a trust, and discretionary invasion provisions for family beneficiaries are commonly used. Thus, while total accumulation is certainly unrealistic to expect for most dynasty trusts, the relative advantages of the South Dakota trust over the same trust created in another state should remain about the same, even if a "normal" pattern of discretionary income and principal distributions is assumed, as long as some degree of accumulation or appreciation occurs.

f course, the benefits of the South Dakota trust will not end after the 85-year period assumed in our factual example. Because the South Dakota trust need never terminate, the benefits will continue to compound over future generations. It is easy to imagine that the relative benefit of the South Dakota dynasty trust over a couple of hundred years could reach into the multiple billions of dollars. This potentially endless availability of transfer-tax-sheltered funds to descendants distinguishes the South Dakota dynasty trust from all others.

Establishing Trust Situs in South Dakota

How does a trustmaker go about ensuring that his or her dynasty trust will have a South Dakota situs, and therefore will be governed by South Dakota law? There is little problem if the trustmaker is a South Dakota resident. Even for a nonresident trustmaker, in most cases this should be no more difficult than naming a South Dakota bank or trust company as trustee or co-trustee, delivering the trust assets to the bank for administration, and designating South Dakota law to govern the trust by including an express provision in the trust instrument. While there is no hard and fast rule that can be cited as to how a trust situs is established, under generally applicable legal principles, the trustmaker of a trust funded with personal (as opposed to real) property may designate the state whose laws he or she desire to govern the validity and construction of the trust, provided that the designated state has a substantial relationship to the trust. Whether a particular state has a "substantial relationship" to the trust is a determination of fact, but it can usually be established if the designated state is the one where the trustee maintains its place of business or where the trust assets will be administered. In most cases, this should be equally true if the trust is established after death or during life. On the other hand, the validity and construction of a trust of real estate is normally determined by the law of the state where the property is located. For this reason, a nonresident trustmaker who wishes to establish a South Dakota dynasty trust should not fund it with out-of-state real estate.

Despite the establishment of a South Dakota situs for a dynasty trust created by a nonresident trustmaker, it is important to note that the trust may still be subject to state income taxation elsewhere. Rules of taxability differ significantly from state to state, and it is possible for a South Dakota trust to be characterized as a "resident trust" for income tax purposes in the state where either the trustmaker or the beneficiaries reside. However, because South Dakota has no income tax of its own, there will be no additional tax burden imposed on the trust from locating it in South Dakota, and the trust should still offer most of the advantages discussed previously.

Finally, one should keep in mind that once distributions are made from the dynasty trust to nonresident beneficiaries, the assets distributed will no longer be governed by South Dakota.

Creditor and Lawsuit Protection

Assets of the dynasty trust is subject to the claims of the maker's creditors or lawsuit judgments unless the transfer into the trust was made to avoid creditors. Since the assets and their income have irrevocably been given away, creditors have no rights to them.

Divorce Protection

Assets of the dynasty trust are secure from the claims of ex-spouses. A trust serves to keep assets segregated and not being "mixed" for divorce-law purposes.

Spendthrift Protection

No all clients have children or grandchildren who are spendthrifts with their own money. Nevertheless, what isn't present today could develop tomorrow, especially when a child or grandchild comes under the influence of a spouse or some other persuasive person. Using a trust as a vehicle for a beneficiary's inheritance allows you, the maker, to insert rules in the trust document dealing with mismanagement of money or with how you desire to have the assets of the trust spent for or applied for the benefit of the recipient.

Planning Risks and Detriments

As with all planning strategies, there are risks and detriments in using a dynasty trust. A dynasty trust is irrevocable. It is important for there to be a substantial amount of thought and understanding by both the maker and his or her advisors before a dynasty trust is used.

The greatest risk in a dynasty trust is the loss of income and net worth that occurs when the trust is funded. Once gifts are made into a dynasty trust by the trustmaker, the assets and the income from them are irrevocably gone.

Finally, the administration of a dynasty trust is vitally important. Choosing the right trustee and insuring that the rules with regard to demand rights are followed is critical. There are certain notices that must be sent to the demand right beneficiaries. In addition, the monitoring of life insurance or other financial products that are owned by the trust is important to insure that the goals of the dynasty trust be met.

Any Trust Can Be a Dynasty Trust

The dynasty trust planning technique can be built into any trust, so long as the trust is presently irrevocable or will become irrevocable at some point in time. This means that a revocable living trust can be made a dynasty trust effective with the death of the trustmaker. We believe that all irrevocable trusts in the estate plan should be dynasty trusts.

===========

1709 Legion Rd., Ste 214 Chapel Hill, NC 27517

Tele: 919-929-9298

THIS ARTICLE MAY BE PHOTOCOPIED AND DISTRIBUTED IF COPIED IN WHOLE WITHOUT ALTERATIONS.