Dynasty Trusts: How to Use Them in the Real World
September 24, 2007
“Dynasty trust” is an amorphous term for any trust that lasts for a very long time, often perpetually. Although the idea of creating dynastic wealth through trusts has been around for hundreds of years, and there are many examples in the United States of large family fortunes being preserved in trust, the dynasty trust as it is currently understood began in the last 10 years with legislation eliminating the “Rule Against Perpetuities” in several different states.
The Rule Against Perpetuities is a very old English law that sets forth how long a trust can last before it must terminate. Under the laws of most states that still have this rule, trusts can last about 90 years. However, a trust created in a state that has abolished the rule can theoretically last forever. In addition, many dynasty trusts are created in states that have no state income tax, so that the assets that are held in a perpetual trust are less likely to be depleted by taxes.
Early discussions of dynasty trusts tended to focus on the economic consequences of a trust that would not be subject to state income tax and could last forever. Under such circumstances, enormous amounts of money could be built up inside of a trust within several generations. However, such an analysis, while impressive, did not answer some very basic questions in some clients’ minds, such as “why should I create a trust like this for people I will never meet (and might not even like if I did)” and “what will such large sums of money do to those beneficiaries?” The dynasty trust, in short, seemed like a solution in search of a problem.
However, in truth, dynasty trusts can be used for many different purposes, each with different ramifications, so to discuss them in the abstract is misleading. In addition to the state income tax and federal gift, estate and generation-skipping transfer tax savings, they can be used to provide long-term incentives for certain types of family behavior, leaving a legacy from the grantor of the trust that is more than financial. They can help to create continuity in the operation of a closely-held family business, acting in essence as a voting trust. They can be used for very specific, long-range purposes, such as ensuring that all of the grantor’s descendants are able to afford to go to college or make a down payment on a home.
Planning Issues
The paramount question when creating a dynasty trust is: “Why?” To be effective, a dynasty trust must be created for a particular purpose that cannot be served by other estate planning techniques, and in general, merely saving taxes, while important, is not one of those purposes.
Many affluent parents are asking variations on the same question: “How much money does it take to ruin a child?” This overall concern for beneficiaries can be divided into several subcategories. A client may be primarily concerned that the beneficiary needs to learn more about investing and handling money, needs to have enough money to educate his or her own children, may get divorced, needs to have enough for the down payment on a house, needs to develop a better sense of philanthropy, or address other important considerations. In each of these areas, a dynasty trust can be a useful tool.
The process of planning for and drafting a dynasty trust can be broken into three steps:
1) vision
2) funding
3) drafting
By deciding the overall vision for the dynasty trust first, the client can see the very real need that is being addressed by the trust and can dictate more effectively to the estate planner which assets should be used to fund the trust, and what the terms should be. After the vision has been formulated, the client and the planner can work together to decide how much should be put into the trust in order to accomplish this purpose.
The funding choice is an important one, because the choice of particular assets in the dynasty trust will dictate the exact drafting questions to be addressed (for example, who should be trustee, what powers beneficiaries ought to have to withdraw assets, whether business decisions need to be made by the trustees if a closely-held interest is transferred to the trust). Finally, after the vision and funding decisions have been made, the planner can begin the drafting process.
A Single Vision: The Mission Statement
The process of preparing a dynasty trust is no different than the process of estate planning itself. Done properly, it involves identifying those issues that are most important to the client. Perhaps the best way to determine a family’s values is for the members of that family to prepare a mission statement.
The importance of such a vision is most clear in family businesses, because they usually succeed only when all of the family members have a single vision of where the business should go. The same is generally true for families that have other types of wealth (large securities holdings, for example). Wealthy families still should pass along the family vision for the wealth even when the operation of a business is not an issue. Discussing asset management, financial training, education and philanthropy all can be important aspects of a family’s cohesiveness and healthy functioning.
Once the family has developed its mission statement, the family must next apply that mission statement to estate planning tools. Perhaps the best way to begin the process of crafting the document is for the family to determine the type of “model” that they want the trust to follow. In other words, if the dynasty trust is to be the legal embodiment of the family’s values, the family must first state in the largest sense what the economic results should be. Examples of such “models” are the following:
• The “Leg Up” Model
In this type of plan, the family’s mission statement might specify that all family members need to make their way in the world by having their own careers and that they should not be allowed to rely upon family money to simply drift. However, family money should be available to help with certain key (and expensive) decisions.
The trust might make distributions, for example, for family members’ medical insurance, education (including not only college but also private elementary and secondary schools) and down payments for a house. These benefits might be extended not only to immediate family members but perhaps even to nieces, nephews or cousins, depending upon the nature of the family relationships.
This type of trust is particularly effective for those clients who have decided that the dynasty trust is to be an enhancement of an existing estate plan. It can also be effective for those who have either determined that their direct descendents (children and grandchildren) already have been adequately provided for – and that the family wealth can be better spread among extended family – or for those who have no direct descendents of their own.
• Retirement Plan Model
Under this model, distributions from the trust are available for support, education and medical care, but only in the event that the trustee determines that there has been an emergency that requires such distributions. In this case, obviously, the term “emergency” would have to be carefully defined, and latitude would have to be given to the trustee to decide whether such an emergency has occurred.
Once the beneficiary reaches retirement age, however, the emergency requirement is removed, and the trustee can begin making distributions for health, education and support without regard to the beneficiary’s circumstances. This type of plan is appealing to those clients who want their children and/or grandchildren to have to make their own way in the world and provide their own support, but who don’t want those descendents to have to choose a career based upon financial decisions. In other words, the beneficiary of such a trust can choose to be an artist or a social services worker without fear that, when they retire, they will not have sufficient assets on which to live.
• Encouraging Philanthropy Model
Under the philanthropy model, the dynasty trust distribution provisions can be drafted to incorporate charitable giving by the individual. This can be done by giving to trust beneficiaries a distribution of some percentage of their charitable giving each year (for instance, the trustee will distribute to each beneficiary an amount equal to half of that beneficiary’s contributions made to qualified charities for which the beneficiary can produce adequate documentation). In this way, the trust makes it easier for beneficiaries to pursue philanthropy while not actually doing it for them.
The philanthropy dynasty trust also can be drafted so that each beneficiary has the power to appoint a certain amount of trust assets to charity each year. Such a trust will not meet the qualifications under the Internal Revenue Code to allow the grantor to receive an income tax deduction upon contribution (or an estate tax deduction if the trust is funded at the grantor’s death), unless the trust is somehow divided into separate trusts, one that is purely charitable and one that is not.
However, even if such deductions are not available, allowing (but not requiring) a certain portion of the trust assets to be given to charity will satisfy many clients’ desires to increase their beneficiaries’ spirit of philanthropy.
• Business Control Model
A dynasty trust can operate as a voting or control trust, designed to prevent one person from steering the business away from its original vision. Such a trust would hold a majority of the voting shares of the business. These might be “supervoting” shares representing a relatively small portion of the equity in the company, with family members holding a large portion of the equity, in the form of nonvoting shares, individually.
A special panel of advisors, consisting of certain family members, would have the job of voting the shares of stock in order to appoint directors. The bylaws of the company might provide, in turn, that the directors shall always consist of so many family members and so many “outsiders.” This would give the board a certain level of objectivity.
A different panel of advisors might serve to coordinate activities of the trust, providing advice to the trustees about ways in which to use the dividends paid to the trustee for family business activities (for example, where to hold the family retreat), which charitable contributions might be made from the trust, and so forth.
Trustee selection, as one might imagine, is critical in a long-term trust like a dynasty trust. To be most effective, dynasty trusts should be created in a state that has no Rule Against Perpetuities or state income tax (like Delaware, Alaska or South Dakota). Generally the trustee must be a resident of the state selected by the client creating the trust. Often times, the primary trustee of a dynasty trust is a corporate trustee (a bank or trust company). However, many clients also want family members involved. One way to do this is to allow for a “trust protector,” essentially an advisor to the trustee with limited authority and no fiduciary responsibility. The trust protector might have the job of removing and replacing the trustee, moving the location of the trust property and supervising certain types of investments.
Funding Issues
There are significant limitations on contributions to a dynasty trust. First, the gift tax limitations are twofold: the annual exclusion amount (currently $12,000 per person per year) and a lifetime credit of $1,000,000. For estate tax purposes, the amount a person can leave free of estate tax at death is currently $2,000,000. Finally, the generation-skipping transfer (GST) tax is imposed on gifts to so-called “skip persons” (such as grandchildren) or on distributions to skip persons from trusts, unless the gift qualifies for the annual exclusion or the donor allocates some or all of his or her GST exemption (currently $2,000,000) to the gift.
These limitations interact with each other: a lifetime transfer of $1,000,000 to a dynasty trust that is intended to be GST exempt also will need to have GST exemption allocated to it. The same is true for gifts at death that avoid estate tax through the application of the $2,000,000 estate tax exemption; GST exemption also will have to be allocated to that transfer.
Note that a transfer can avoid one tax but not another. For example, assume a parent makes a $1,000,000 lifetime gift to a child outright. In addition, the parent’s will directs that the maximum amount of GST exempt property available at the parent’s death should pass to a dynasty trust. If the parent has not used any GST exemption, that amount will be $2,000,000. However, only $1,000,000 can pass free of estate tax at the parent’s death (the parent’s $2,000,000 estate tax credit, reduced by the lifetime gift of $1,000,000).
This means that half of the gift to the dynasty trust, though completely exempt from GST tax, will still be subject to estate tax liability. The parent’s will should provide that the estate tax attributable to the dynasty trust gift should be paid from some source other than the gift itself, in order to make the maximum use of the GST exemption.
Drafting Issues
Given the very long life span of dynasty trusts, trust terms must be drafted in as flexible a manner as possible. Such flexibility obviously will create some drafting tensions, because the grantor will have very specific ideas about when and under what circumstances distributions can be made. However, by building in flexibility, the drafter is creating opportunities for the trustee or beneficiary to circumvent those ideas. Therefore, care must be taken to ensure that a balance is maintained between the grantor’s goals in creating the trust and the ability of a trustee or beneficiary to compensate for unanticipated events.
For more information, email Christopher P. Cline at Chris.Cline@hklaw.com or call toll free, 1-888-688-8500.