The Dynasty Trust

By Ralph M. Engel and Al W. King III

Trusts can be used to defer the payment of estate taxes. Most states provide limits on how long such trusts may exist so that such taxes eventually become payable. Certain states, however, do not require properly drafted and funded trusts to end at any particular time. Here's how these "dynasty trusts" work.

Over the last century or so, most of the really wealthy families in this country utilized trusts to pass assets from generation to generation for as long as the law would allow. In most states the longest period such a trust could run was until the death of the last to die of the members of a specified group of individuals living when the trust was created, plus twenty-one years (and possibly an additional nine months). Thus, the trusts created by the well-known industrialists of the late 19th and early 20th centuries have ended, or will soon end.

In the "good old days," there was no limit as to the amount that could be left in trust for descendants. Yes, estate taxes had to be paid (once there were estate taxes) upon the patriarch's death, but no additional death taxes were payable until the deaths of the persons who received the assets when the trusts into which the assets were placed finally terminated. Thus, many of the great fortunes were able to survive and, in some cases, grow tremendously, because death taxes did not reduce them by as much as 60% every single generation.

Congress changed the rules as to such trusts years ago, and created what is known as the generation-skipping tax (GST). That tax is not merely on transfers that skip a generation--as the name of the tax implies--but in effect applies to any non-exempt assets that wind up with an individual who is, or who under applicable law is deemed to be, more than one generation younger than the person from whom the assets were derived. Thus, a transfer, whether during lifetime or at death, from a grandparent to a grandchild may be subject to the generation-skipping tax.

A few states, including New York, jumped on the bandwagon and enacted their own generation-skipping taxes, as a way to raise a few dollars (and, perhaps, to make sure that more of their wealthy residents flee to lower-tax jurisdictions).

There are certain exemptions from the tax on generation-skipping transfers. The principal exemptions relate to the usual $10,000/$20,000 annual gifts (but not through the use of "Crummy powers," such as in insurance trusts) and to an aggregate of $1 million (per donor, not per donee). The $1 million aggregate can be used for lifetime or at-death transfers, and the portion of the GST exemption not utilized during lifetime may be utilized at death. Whatever portion is not utilized is lost.

Gift and estate taxes are payable utilizing a sliding scale, with the lowest effective Federal tax bracket being 37% and the highest (excluding the phase-out of the unified credit) being 55%. In an effort to break up family fortunes, however, Congress did not adopt the same sliding scale with respect to the generation-skipping tax but set it at a flat 55%. State gift, estate, and generation-skipping taxes are additional, subject to certain credits.

What Does This Mean?

It means that a bequest from a grandparent to a grandchild of non-exempt assets may be subject to a 55% federal estate tax, assuming the grandparent is in the maximum Federal estate tax bracket, plus a 55% Federal generation-skipping tax on whatever remains after the first tax, plus state taxes. Even if we ignore the state taxes, a $10 million bequest subject to the payment of such taxes is first reduced to $4,500,000 by the $5,500,000 (55%) Federal estate tax and then further reduced to $2,025,000 by the $2,475,000 (55% of $4,500,000) generation-skipping tax. Thus, within only two generations federal tax alone can consume almost 80% of the grandparent's assets! Accordingly, effective planning for a person's descendants using assets subject to death and GST taxes is extremely difficult but an absolute necessity for those who want to take care of those who come after them.

What About the $1 Million
Exemption From GST?

Since the advent of the tax on generation-skipping transfers, those who can and want to take care of their grandchildren, or their more distant descendants, have been using inter vivos (created during lifetime) or testamentary (created by will) trusts that utilize the GST exemption. Such trusts may well leverage the contributions made to them by investing their assets in life insurance (particularly second-to-die life insurance, when possible), or by utilizing various valuation-reduction techniques. The amount that can be put into such trusts, however, is limited.

The duration of such trusts is also limited. In New York and most other states (e.g., New Jersey, Connecticut, and Florida) such trusts usually must terminate no later than 21 years after the death of the last to die of the members of a defined group of people all of whom were living when the trust became irrevocable.

What Does This Really Mean?

Suppose a person has grandchildren but no great-grandchildren. That person can create a trust that will continue until 21 years after the death of the last of his or her living grandchildren to die, but that is as far as the trust can go. Thus its assets will probably one day pass, outright, to his or her great-grandchildren. When the great-grandchildren die those assets will be subjected to death tax at whatever brackets are then in effect.

Unlike New York, New Jersey, Connecticut, Florida and most other states, four states, South Dakota, Delaware, Idaho and Wisconsin, do not require certain properly drafted and funded trusts to end at any predetermined time. Thus a person can create a trust that can continue almost forever (often called a "dynasty trust").

Idaho and Wisconsin, however, unlike South Dakota and Delaware, have state income taxes on trusts created by non-residents for non-residents. Delaware presently has no state income tax on such trusts but, for whatever reason, requires the filing by such trusts of informational returns. It is thus possible that Delaware is considering such a tax. No such filings are required in
South Dakota.

If a New Yorker properly creates a dynasty trust for others (such as descendants), whether during life or via a will; if such trust is governed by South Dakota or Delaware law and properly located in either of those states; and if none of the trustees of the trust are in New York and none of the trust's assets are in New York either, the trust itself can avoid all New York income taxes on its taxable income (including capital gains). Thus, with proper planning, what would have been a typical generation-skipping-tax-free trust can be structured as a dynasty trust and run for far longer than is otherwise possible. In addition, it can avoid New York's substantial income tax (and, for New York City residents, New York City's income tax). Florida residents may also use such trusts to avoid Florida's intangible property tax.

What is the Best Way to Structure Such a Trust?

No one can predict what the future will bring. Accordingly, it is strongly recommended that dynasty trusts be structured to incorporate substantial flexibility. Thus, the "sprinkling" or "spray" trust is frequently utilized, with the independent trustee or trustees having the right to distribute income and/or principal among the donor's descendants, as appropriate. For those who do not want to put this much discretion in anyone's hands, however, it is possible to structure such trusts with a family line (per stirpital) distribution or in almost any other manner.

Who Gets to Decide About the
Distributions?

To avoid the IRS determining that someone has a general power of appointment (which would lead to estate and/or gift tax liability and to the constructive receipt of income and capital gains), the discretion as to who gets what should be with a truly independent trustee. Nevertheless, the dynasty trust may provide for an advisory committee of one or more family members (other than its creators), or of other designated individuals. Although they should not be legally required to do so, most corporate trustees will give great credence to the non-binding advice given to them by such individuals, particularly if the document requests them to do so.

Why Do We Refer to a Corporate Trustee?

Due to the duration of a dynasty trust, a corporate trustee is almost a necessity, since no one else will live long enough to carry out the provisions of such a trust. A trust could potentially have a series of individual trustees who appoint their own successors, but then the creator of the trust will have absolutely no idea of who will be running the trust years or decades in the future. If he or she desires one or more specific individuals to serve as trustees, he or she may name them to serve as co-trustees with a bank.

There should be no New York-resident trustees whatsoever if the trust is created by a New Yorker. Additionally, to create a trust governed by South Dakota or Delaware law and subject to the tax law of the applicable state, at least one trustee should be located there and the assets of the dynasty trust should be kept there.

People who live (whether or not they profess to live elsewhere, such as in Florida) in the New York metropolitan area generally want New York banks to handle their affairs, assuming they are willing to utilize banks at all (as noted above, for dynasty trusts a bank is almost a necessity). Accordingly, a few major New York banks, principally Citibank and Morgan Guaranty, have established affiliates in the two states that allow dynasty trusts and have no state income taxes. Morgan set up its affiliate in Delaware; Citibank set up its affiliate in South Dakota. In neither case, however, does the creator of the trust physically have to go to either state to create or to otherwise deal with the dynasty trust or the trustees thereof.

The New York banks cannot be trustees of such trusts themselves, since, if a New York trustee is used (be it a bank or an individual), the income of the trust, including capital gains, will be subject to New York State and, if appropriate, New York City income taxes, if the trust was created by a New Yorker. The banks' Delaware or South Dakota affiliates, however, can utilize the investment expertise of their New York affiliates.

How Do the Benefits of a Dynasty Trust Compare?

The Exhibit illustrates the difference between such a trust created in New York (or an equivalent trust created in Florida) and one created in South Dakota or Delaware. As the chart graphically illustrates, the difference, as far as the creator's descendants are concerned, is
astronomical.

Is It Possible to Create a Dynasty Trust by a Will as Opposed to
During Life?

The answer is yes. The fairly common (for rather wealthy people) three-trust will, with a unified credit (by-pass) trust, a generation-skipping-tax-free trust, and a marital deduction (QTIP) trust, may be structured to include a dynasty trust in lieu of one or both of the first two trusts. As discussed below, however, there may be problems with such a trust.

What Is the Difference Between a Testamentary and Inter Vivos Dynasty Trust?

A testamentary trust, being included in the client's will (unless a pour-over trust is utilized), will be subject to control by the applicable surrogate's court. Furthermore, it will be subject to the law applicable to the decedent, which is normally the law of the state in which the decedent resides at death. Assuming there will not be a major exodus to Delaware or South Dakota, a testamentary dynasty trust cannot be effectively created unless the person first creates an unfunded (or partially funded) dynasty trust in a separate document and then, at death, pours over assets from the estate (pursuant to a provision of his or her will) to the dynasty trust. Even then there is the possible reluctance of a surrogate to give up all control over funds passing under the will of a resident to a trust governed by the law of a different state, run by trustees none of whom are in the resident's state, and requiring the removal of all of the assets of the trust from that state. Why take the risk, unless the would-be creator of the trust cannot afford to fund the dynasty trust now or is unwilling to do so?

In addition, who knows what the law will be in the future, both as to the creation of trusts not limited as to duration and as to the tax on generation-skipping transfers and the exemptions therefrom. Creating such a trust now, as opposed to by will, provides the ability to utilize the protections afforded by existing law. Also, future income from the property put in the dynasty trust and future appreciation in the value of that property will also escape transfer taxation if the property is already in the trust when the income is earned or the appreciation occurs.

It is possible to create a "defective" dynasty trust, the income of which is taxable to the creator of the trust during his or her lifetime. Such a trust would, in effect, permit the creator of the trust to add the income tax payments to the trust gift tax free. Note, however, that at the time this article is being written, the IRS is considering how to change this result.

If life insurance is to be utilized to fund the trust, whether on one life or second-to-die, a testamentary trust will clearly not suffice. Accordingly, the person who contemplates using a dynasty trust usually will be better off creating one during his or her lifetime and appropriately funding it as soon as economically possible, as compared to trying to do the same thing at death.

Why Fund a Dynasty Trust Now?

* If the amount placed in the dynasty trust is not more than the amount protected by the available Federal unified credit, there will be no Federal gift tax, although there may be a state gift tax. If a larger gift is made, such as $1 million or $2 million (by a couple), the gift will result in the payment of an out-of-pocket Federal gift tax, but that is not necessarily so bad (see Exhibit).

* The income earned by assets placed in a properly structured dynasty trust will not belong to the creator of the trust and therefore not be subject to estate taxes on his or her death;

* The post-contribution capital appreciation of the asset of the dynasty trust will also inure to the beneficiaries of the trust. Because a dynasty trust has been utilized, that appreciation should not be subject to future estate or generation-skipping tax for as long as the trust continues, which may be for centuries. If the gift had not been made, the same appreciation would only have served to increase the donor's estate and, accordingly, any estate taxes payable. (Note that the capital gains step-up at death is usually forfeited if the trust is funded during life, so that it is best to fund a dynasty trust with cash or with assets that have not yet appreciated substantially); and

* If the donor lives for more than three years after the gift is made, the gift tax on the gift itself is not includable in the donor's estate for estate tax purposes. This means that the donor's potential taxable estate has been decreased by the amount of the gift tax. If the donor is in the 60% aggregate death tax bracket, as is frequently the case with "heavy-hitters," the fact the gift tax is out of his or her estate effectively saves 60% of the gift tax.

How Are the Assets of Such a Trust Invested?

Many individuals create insurance trusts, often funded with second-to-die insurance, for the purpose of avoiding death taxes and providing liquidity for the payment of the taxes on the portion of the estate that cannot be made estate tax free. That insurance is frequently held in a trust that will be distributed to the client's children or, at most, grandchildren after the death of the client (or the client and his or her spouse and/or children).

The same insurance can instead be held in a dynasty trust, and its proceeds can still be utilized for the same purposes. The proceeds of the insurance (or the assets of the decedent's estate purchased with such proceeds) remain in the dynasty trust, simply growing and growing, for the benefit of the client's descendants forevermore. Insurance on the decedent's children, or even grandchildren, should be considered as one of the ways to fund a dynasty trust.

Another way to maximize the utilization of the dynasty trust is to fund it, at least in part, with interests in start-up companies or other new ventures.

Many of today's highly successful entrepreneurs, especially younger ones who are making scads of money in computers, technology, biotech and other hot fields, create new enterprises they believe will be highly successful but which, at inception, have minimal value. Putting a portion of the stock of a newly formed corporation, or an interest in a new partnership or limited liability company, into a dynasty trust can mean that future growth in value may escape estate and gift taxes essentially forever. That requires advance planning, plus astute selection of assets to place in the trust, but planning is what sophisticated professionals, be they accountants, attorneys or whatever, do.

Other assets can also be included in a dynasty trust, such as works of art, jewelry, real estate, or family heirlooms--items that are to be kept in the family. The trust must be appropriately drafted to deal with such items; but the sophisticated draftsman, presumably an attorney, working with the client's other principal advisors, such as his or her accountant, should be able to do so.

What About Descendants that Become "Lazy Bums"?

Some wealthy individuals worry that their descendants, if they have large trusts for their benefit, may become "lazy bums." Such concerns may be dealt with by including, for example, provisions requiring that, for an adult descendant to share in the income of the trust (except due to illness, etc.), he or she must first accomplish certain goals, such as graduating from college or obtaining full-time employment. Some dynasty trusts provide that distributions are to be based upon the amount an adult descendant earns, such as $1 or $2, or even $5 to $10, from the trust for every dollar earned. Variations on the above include provisions to deal with descendants who are productive but may not earn much, such as due to artistic or other less-than-remunerative, but potentially worthwhile activities. Minimum and maximum distributions can also be dealt with.

South Dakota or Delaware?

The answer to this question revolves around the selection of the corporate trustee, since the principal player in Delaware with a New York connection is Morgan Guaranty (or its Delaware affiliate), whereas the principal such player in South Dakota is Citibank (or its South Dakota affiliate).

Both states do not tax capital gains retained in trusts located in those states. Neither state taxes accumulated income within a trust (as to Delaware, there may be a question as to income accumulated for the future benefit of a resident of Delaware). Unlike Florida, neither state taxes intangible personal property (such as stocks and bonds) or personal property.

Delaware has had restrictions with respect to the duration of a trust that owns real estate; whereas South Dakota has no such limitations on its trusts. Unless Delaware's restrictions are repealed--since it is always possible that the trustees of such a trust, at some point, will determine that real estate is an appropriate trust investment--for that reason alone South Dakota merits prime consideration as the "home" of a newly created dynasty trust.

Since there is no need for any family member to travel to Delaware or to South Dakota at any time in connection with the preparation, execution, or carrying out of the trust, the physical location of the state is truly irrelevant.

What Else Should I Know?

Many clients are reluctant to give up total control of assets placed in trusts. For this reason, various provisions have been devised that may be included in a dynasty trust. These include the following:

A "Trust Protector." A trust protector is an individual, or group of individuals, generally not beneficiaries of the trust and certainly not the creator of the trust, who are often given the authority to change trustees, or to change the corporate trustee. With respect to investment performance, however, the same result may be achieved by having, for example, two individual trustees in addition to the corporate trustee, with the individual trustees being given authority as to investments but not as to distributions. This permits the use of family members or professionals as some of the trustees.

Uses for Trustees. Provisions may be included in the document creating the dynasty trust dealing with the selection of successors to the original non-corporate trustees (such as, for example, the eldest member of each family line, although this may eventually result in there being quite a number of trustees).

The Use of Special (Limited) Powers of Appointment. A dynasty trust may be structured so that it splits into family lines every time the eldest member of a family line dies (e.g., when a child dies survived by two children, that child's portion of the trust is divided into two). If the client so desires, to the extent permitted by the IRC and regulations, the eldest member of a family line (who is the closest relative of the creator of the dynasty trust in that family line) may be given a special or limited power of appointment, being the right, in his or her own will, to vary what happens to that family line's portion of the trust and to direct that that line's portion be given, for example, to any one or more of the then living descendants of the creator of the trust. Thus, if a great-great-grandchild determines his or her own children should receive the family line's share of the trust outright when he or she dies, the trust can be adjusted to produce that outcome. If, on the other hand, a descendant is a drug addict, he or she can be excluded from future benefits from the trust, or it can be adjusted to provide that that descendant receive benefits only if he or she is "clean." Whereas such a power of appointment could interfere with the concept of a "perpetual" trust for all of a client's descendants, it does permit the creator of the trust, if desired, to give descendants a considerable amount of discretion as to what happens to the trust in the future, discretion that may be very useful.

Changing of Trustees Based on Performance. A provision may be included providing a way to change trustees in the event they do not invest in a manner that complies with an appropriate standard. For example, the trust document might provide that the then living adult, competent beneficiaries of the trust have the right to change from one corporate trustee to another if the performance of the securities investments made by the corporate trustee then in office does not at least match the Lipper Index for balanced mutual funds over a period of two or three consecutive years.

Investment Advisor. Some clients want their assets managed by a particular investment advisory firm, by one or more professionals, or by other individuals. It is thus possible to provide in the dynasty trust itself that the trust's investments are to be handled by a particular investment advisory firm, investment advisor or other professional or, if desired, by an investment committee. Some corporate trustees find such arrangements acceptable, whereas others do not. Note, however, that the language used for the applicable provisions of the trust document should be approved, in advance, by all concerned.

Amending the Trust. An independent trustee (or a trust protector, if independent) may be given the power to amend the trust itself to take advantage of future changes in tax laws, be they beneficial or adverse, so long as the changes made do not interfere with the exemption of the trust from the tax on generation-skipping transfers. Thus, through careful drafting, a dynasty trust may be constructed in a manner that will protect a client's assets, and descendants, while dealing with his or her concerns. *

Ralph M. Engel, JD, heads the trusts and estates department of the law firm of Rosen and Reade, LLP, with offices in Manhattan and Larchmont. Al W. King III, JD, is national director of estate planning of the Citibank Private Bank.

EXHIBIT

DYNASTY TRUST COMPANY

(Trust Created by New York or Florida Resident)

(In millions of Dollars)