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.

Federal Estate and Gift Taxes -- the Generation Skipping Transfers Tax

The generation-skipping transfers tax, or "GST" for short, is perhaps the hardest-hitting element of the federal wealth transfer tax system. For purposes of illustration, let's use a very simple family tree:

Grandma

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Junior

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Skippy

To begin, imagine that it's before 1976, when the first version of the GST was enacted.  (It was replaced in 1986 with the arrangement we have today.)  By virtue of his place in the family business and/or earlier gifts from Grandma, Junior is independently wealthy.  Anything that Grandma leaves to him at death will simply get added to Junior's gross estate and taxed again at Junior's passing.  What people in Grandma's position often did was to create a trust for Skippy and the other grandkids, and perhaps also later generations, and thus "skip" taxation in Junior's generation.  The trust usually could reach no farther than the grandchildren's generation because of something called the Rule Against Perpetuities, which we'll discuss another time.

As we've noted in earlier posts, one of the baseline policies of the gift and estate tax system is to tax accumulated wealth once per generation, and generation skipping transfers like these cut that down to once every other generation.  Because most people would only do this if Junior was well provided-for, these "generation-skipping trusts" were a strategy only a very very high net worth family could make use of--so that the estate and gift taxes actually fell harder on those who were wealthy enough to pay estate taxes, but not wealthy enough to play at generation skipping.

To redress this flaw and discourage generation skipping transfers, Congress enacted the GST.  The GST is imposed, in addition to the estate or gift tax, on any transfer to a "skip person."  There's a complex definition of a "skip person" in the tax code, but what it boils down to is that, in the example above, Skippy is a "skip person" if Junior is living on the date of the transfer.  If Junior dies, and then Grandma makes the transfer to Skippy, it's not a generation skipping transfer and the GST does not apply.

What makes the GST hit so hard is the rate of tax: it's equal to the highest estate tax rate then in effect.  In 1986, when the modern version of the GST entered the tax code, that top rate was 55%--so it was possible for a generation-skipping transfer to be taxed at a combined 110% (up to 55% estate/gift tax + 55% GST).  The purpose of this was not to collect a 110% tax so much as it was to make large generation-skipping transfers so uneconomical that no one would want to do them.

Well, maybe not all generation-skipping transfers.  Not wanting tax policy to interfere too much with the time-honored tradition of doting on grandchildren, Congress also provided that the GST does not apply to most annual exclusion gifts, and gave every person a $1 million GST exemption.  The exemption let each person transfer a total of $1 million to the grandkids (and other skip persons) before the GST kicked in.  (There was also a $2 million-per-grandchild temporary exemption which expired in 1989--named the "Gallo provision" in honor of the high net-worth family which "suggested" it to their Congressional representatives.)

Under the 2001 tax act ("the Bush tax cuts"), the GST exemption increased in parallel with the exemption equivalent provided by the estate and gift tax unified credit, so that it reached $3.5 million in 2009.  During the "estate tax holiday" in 2010, there was (so we thought) no GST at all.  The 2010 tax act reinstated the GST retroactive to January 1, 2010, but at a 0% rate--so if you made a generation-skipping transfer before the tax was retroactively re-imposed, you didn't get hit with a surprise tax assessment.  For 2011 and 2012, the GST exemption is $5 million.  Unless Congress acts before the end of next year, the GST exemption will "snap back" to $1 million on January 1, 2013, as part of what the media calls the "expiration" of the "Bush tax cuts."

You may think that the GST is a problem only for the super wealthy, but it can affect people of relatively modest means.  A trust for your "gray sheep" child which holds the assets for the child's life, then distributes to that child's offspring afterward, is a generation-skipping transfer that is subject to the tax unless there is sufficient GST exemption to cover it.  We'll talk about how the GST affects trust design, and some of the "work-arounds" that have been developed to counter it, in future postings.

Federal Estate and Gift Taxes - an Introduction

The federal estate and gift taxes--we sometimes call them "wealth transfer taxes"--are the reason for much of what I do for my higher net-worth clients.  These taxes have gotten a lot of attention and debate time among pundits and politicians recently, and we're going to be talking about them a lot on this blog.  This post is the first in a series on how these taxes work, and what you can do to minimize their impact on your family.

The stated policy purpose of the wealth transfer taxes is to prevent the creation of large concentrations of inherited private wealth.  The tax is therefore supposed to be paid only by "the wealthy."  There's a never-ending debate over whether this is a proper thing for the government to be taxing in the first place, and whether it's not so much a tax on dynastic wealth as it is a tax on upward mobility--but all I want to talk about on this blog is how the taxes work, and how good estate planning responds to them.

While the estate tax is imposed on any transfer at death, and the gift tax on any transfer during lifetime, the Internal Revenue Code gives you a "unified credit" which cancels out the tax on a certain amount of wealth being transferred. We usually talk about the "exemption equivalent" amount that is protected from the credit, rather than the amount of the credit, because it's easier for clients to understand.  However you want to think of it, if the wealth that you have to pass on to the next generation is less than the exemption equivalent, the federal wealth transfer taxes aren't an issue you need to worry about.  (The Ohio estate tax might be, but that's another topic for another time only if you die before January 1, 2013.)


Right now, the exemption equivalent is $5 million, but that could change in a very taxpayer-unfavorable way at the end of next year.  We'll go into why that is in a future installment.

There are a couple of other mechanisms that provide relief from the estate and gift taxes.  The policy of the current estate tax is to tax accumulated wealth once per generation, so transfers between spouses are accorded a "marital deduction" and are thereby not taxed.  Also, mostly for administrative convenience, you are allowed a certain amount of gifts each year, the "annual exclusion," which are not counted for tax purposes.  The annual exclusion is $13,000 per recipient per year, and that number is adjusted for inflation from time to time.

In our next installment, we'll talk about what gets included in an estate for estate tax purposes.

(Updated in response to the repeal of the Ohio estate tax effective 1/1/13.)