Dynasty Trusts

As I'd mentioned in the discussion of the Rule Against Perpetuities, quite a few states have replaced or supplemented the Rule's complicated and counter-intuitive limit on the duration of a private trust with a fixed term of years. In Florida, for example, a contingent interest is valid if it vests (becomes certain) within 90 years, or within the traditional "life plus 21 years" period of the Rule. In Wyoming, they've replaced the Rule with a rather impressive fixed time limit.  Regardless of when its contingent interests vest, a private trust governed by Wyoming law cannot last more than 1,000 years!

In some other states, of which Ohio is one, a trust can "opt out" of the Rule so long as the trustee has an unrestricted power to sell trust assets.  (The power of sale means you don't have to worry about the problem that inspired the Rule in the first place: unresolved contingent interests interfering with the free transferability of property.)   In other words, an Ohio trust can last, if you so desire, until the Second Coming, or until the sun swells up into a red giant, or until whatever other future event constitutes "the end of the world" in your personal belief system..

This has led to the development of what is commonly called a "dynasty trust."  A dynasty trust is a trust for the benefit of one's descendants which has either a very long period (200 years or more) or no fixed termination date at all.  The trustee has discretion to make distributions to any of the grantor's descendants from time to time in whatever amounts the trustee finds to be appropriate, and the trust may contain language further directing or restricting the trustee's exercise of discretion.

The trust is funded with an amount equal to what can be protected from the federal generation-skipping transfers tax by the use of the grantor's available GST exemption.  It's possible for multiple grantors, such as a husband and wife or a group of siblings, to make contributions to the same trust and thus "pool" their GST exemptions.  The grantor either uses up part of her unified credit, or pays the necessary gift or estate tax.  The effect of the dynasty trust is to place the trust property beyond the reach of the federal wealth transfer tax system for as long as the trust lasts--the transfer subject to gift or estate tax occurs when the trust is created.  Because we've used GST exemption to protect the assets of the trust from GST upon funding, it doesn't matter whether it's a "direct skip" right now or whether there are going to be "taxable distributions" and a "taxable termination" somewhere down the road. 

This makes the dynasty trust a particularly good vehicle for protecting family business assets from future transfer taxes.  Through the end of 2012, every individual has a $5 million GST exemption and a unified credit equal to the tax on $5 million, allowing for some spectacularly large dynasty trusts to be created--provided that you have assets in those amounts and can afford to give away that much.

Drafting a trust like this is an interesting exercise.  The client will often want to give the trustee some guidance on what distributions would or would not be appropriate; my job is to put this down on paper in a way that accurately captures the client's intent while (we hope!) still being understandable to some future bank trust officer 500 years from now and being sufficiently flexible to allow that future trust officer to adapt to several centuries' worth of cultural and tax law changes.

The Rule Against Perpetuities

The Rule Against Perpetuities is an old doctrine from the English common law which limits the duration of a private (noncharitable) trust.  The most widely accepted statement of the Rule comes from Professor John Chipman Gray's classic 1886 treatise on the subject:

No interest is good unless it must vest, if at all, not later than twenty-one years after the death of some life in being at the creation of the interest.

If you're not quite sure what that means, don't feel bad.  It took Professor Gray 496 pages to explain the Rule and its application to lawyers who were already familiar with the subtleties of property law.  The complexities were such that the Supreme Court of California, in a 1961 case, ruled that it was not malpractice if a lawyer drafted a will that violated the Rule because the Rule Against Perpetuities was too difficult to master!

The Rule applies to contingent interests--that is, where the question of whether you get anything from the will or trust depends on some future event. An example would be a trust distribution where Alice receives the trust income for life, and when Alice dies, it goes to the children of Alice who are then living.  We don't know if any particular one of Alice's children will get anything from the trust until either Alice or that child dies.  Alice's children are therefore what we call "contingent beneficiaries."  (Alice is a "vested beneficiary.")

To really, really, really (over)simplify it, the Rule requires that the interests of all contingent beneficiaries be resolved--that is, we know for sure if they'll get anything or not--before the end of a "measuring life"--the life of some person who was living when the trust was created--plus 21 years.  In the example I gave in the previous paragraph, we have no problem.  Alice could be our "measuring life," and when Alice dies we will know which of her children outlived her, and therefore who gets the trust property, well within the Rule's time limit.  A trust with a more complex future distribution involving generations yet unborn could, however, very easily crash into the Rule.  In order to avoid violating the Rule, a trust couldn't attempt to reach too far into the future.

The original purpose of the Rule was to allow for the free transfer of property.  If a piece of land--which was the primary source of wealth back in the 1600s when the Rule got started--had too many contingent interests, it became impossible to transfer it because either you couldn't identify all the dozens of people who might have an interest in the land, or you couldn't find all of them, or you couldn't get them all to agree to sell the land, or you couldn't figure out how to split up the proceeds afterward, or some combination of all that.

In a modern trust with contingent interests, this is not an issue because the trustee, the sole owner of all the trust's assets, will have the power to sell those assets at any time.  Even though the problem the Rule was attempting to solve wasn't a problem any more, the Rule still applied to modern day trusts.  In recent years, however, most state legislatures have overridden the Rule with a statute that either replaces the "life in being plus 21" period with a fixed time limit, or allows a trust to ignore the Rule completely.  We'll talk about some planning arrangements that take advantage of that change in the next post.

If you'd like to learn more about the Rule Against Perpetuities and want to have some fun doing it, I recommend you read three delightful law review articles written by Professor W. Barton Leach (1900-1971): "Perpetuities in a Nutshell" (1938), "Perpetuities in the Atomic Age: The Sperm Bank and the Fertile Decedent" (1962), and "Perpetuities: the Nutshell Revisited" (1965).