Leaving a Lasting Legacy with a Dynasty Trust 

By Brent Ritchey, J.D., CLU®, CFP®, Director, Advanced Planning

There’s a lot of talk these days about giving assets before the end of calendar 2012, and for good reason. Currently, the lifetime gift tax exemption is $5.12 million ($10.24 million if you’re married) and the federal lifetime exemption for the generation-skipping (GST) tax is also $5.12 million in 2012.1

On January 1, 2013, these exemptions are scheduled to return to $1 million and the maximum gift and estate tax rate will increase from 35 percent to 55 percent unless there is a change in the federal tax law. As a result, this year may be the last opportunity to shelter substantial amounts of wealth from federal gift taxes and to ensure that future generations of trust beneficiaries receive benefits free of GST taxes through an irrevocable dynasty trust.

ILITs Can Be Dynasty Trusts

A dynasty trust isn’t that different from a regular trust so everything you already know about giving assets to an irrevocable trust applies here. However, dynasty trusts are long-term trusts created specifically to provide for descendants over multiple generations. If properly structured, they can offer substantial tax advantages as well as asset protection for 100 years or longer.

Can this trust own life insurance? Sure.

In fact, you can potentially leverage the amount of wealth you transfer to beneficiaries by funding a dynasty trust with life insurance. As long as your exemption covers the value of your premiums, any future growth will be sheltered from GST tax.

What makes a dynasty trust special?

During the insured’s life, a dynasty trust is largely treated like any other irrevocable life insurance trust (ILIT). Just as with an ILIT, the insured’s death causes income tax-free death benefit to flow into the trust. The difference is that a good portion of the death benefit can stay in the trust forever, and be reinvested for the benefit of the trust beneficiaries. In fact, the trustee can use the death benefit from one policy to purchase more life insurance on the lives’ of the trust beneficiaries.2

Ultimately, you can set in motion a multi-generation cascade of death benefits, where much of the trust assets can be distributed as they normally would be – to help beneficiaries pay tuition or buy first homes as needed – but funds that stay in trust can buy policies on children, grandchildren, great grandchildren and so on.3 This means that long after you’re gone, a dynasty trust can distribute income and principal according to the criteria you establish.

Rule Against Perpetuities

The concept of a trust that can last "forever" is a relatively recent one. Historically, trusts had to end after a couple generations due to something called the "rule against perpetuities" (RAP).4 In the 1990s, however, many states repealed or relaxed the perpetuities rule, making it easier for trusts to continue forever (or at least for a very long time).5

You don’t have to live in a perpetual trust state to take advantage of a dynasty trust, however. Generally, you can still set up a dynasty trust; it’s just a matter of specifying the applicable state law in the trust agreement. There may be other requirements, such as appointing a trustee located in a state whose laws govern the trust (e.g., the Northwestern Mutual Wealth Management Company, located in Wisconsin) and locating at least some of the trust assets in that state.6

GST Tax

In 1986, Congress instituted the generation-skipping transfer tax. This closed a loophole in the estate tax by ensuring that property would be subject to tax as it passed through each generation, even if it would otherwise have avoided estate taxes because it was held in trust. (It prevented "generation skipping.")

Fortunately, everyone has an exemption from this tax, and this year it’s $5.12 million. For married donors, that’s $10.24 million. The key to preventing the tax is to apply GST tax exemption to all transfers to the trust. Thereafter, it doesn’t matter how much the trust assets grow. As long as all assets were covered by the exemption when given to the trust, the GST tax will not apply when the second generation’s interest terminates in favor of, or distributions are made to, the later generations.7

The tax advantage of a dynasty trust is that it never makes a final distribution to a beneficiary to be taxed at a death. Instead, the assets can stay in trust forever.8

GST Tax Exemption – Potential Sunset Ambiguity

Some planners might question whether a $5.12 million gift into a generation skipping trust in 2012 – sheltered by the current $5.12 million generation skipping transfer (GST) tax exemption9 – will still provide for GST tax-free distributions from the trust to grandchildren after sunset.10

As stated above, the GST exemption normally helps eliminate all of the GST tax. The formula for getting this result is multilayered, but the short version is this:

  • The GST tax is generally determined when a distribution is made from the trust to a grandchild or later generation, or when the interest of the first generation after the donor terminates. This almost certainly would be after the current 2010 Tax Relief Act sunsets.

  • The GST tax will be zero at that future date (our desired result) assuming the trust’s "inclusion ratio" is zero at that time.

  • If a $5.12 million gift is made to the trust in 2012, a key to having an inclusion ratio of zero depends on the interpretation of this phrase from § 2642(a)(2): "the amount of GST exemption allocated to the trust."11

  • So long as the amount of GST exemption allocated to the trust is $5.12 million, there would be zero GST tax on whatever is in, or is distributed from, the trust thereafter.

  • However, if the GST exemption allocated is lower (say, $1 million) and the donor has made a $5.12 million gift to the trust, some percentage of GST tax would be levied on the assets distributed from the trust.12

Here’s the rub. The calculation of the "inclusion ratio" will occur in the future, after the 2010 Tax Relief Act is likely to have sunset. And importantly, the sunset provision of this tax act tells us that we are to apply the transfer tax rules to future generation skipping transfers "as if" the current provisions "had never been enacted."13 If the current law really had never been enacted, the GST exemption back in 2012 when the gift was made to the trust would have been a mere $1 million.

So, when calculating a GST tax rate in a future year, are we really supposed to turn back the clock and pretend that the donor never really had a $5.12 million GST exemption back in 2012? And do so even though we know, sitting here today, that the current law in fact does provide that $5.12 million GST exemption?

The most reasonable view is no; the relevant statutory language in § 2642(a)(2) refers to "the amount of GST exemption allocated to the trust." Even in the future, it will still be true that the GST exemption that was actually "allocated" to the trust back in 2012 was the $5.12 million that’s permitted today.

Moreover, the goal when interpreting any statute is to carry out its intent. The sunset provision was merely meant to re-introduce old rules for future transactions, principally because (let’s be honest) it provided a short-term political compromise in light of Congressional failure to come up with permanent provisions. It was not also intended to erase ex-post facto the newly created tax rules for the very few years that they are permitted to exist.

Given these considerations, it seems pretty safe to make the $5.12 million gift and take advantage of the current (and temporary) opportunities for passing large amounts of wealth to future generations.14

Conclusion

A dynasty trust may be an attractive solution for individuals and couples who are looking to create a meaningful family legacy that continues from generation to generation in a tax-efficient manner. Dynasty trusts offer the best plan for keeping assets permanently out of the transfer tax system. They are made possible by using a corporate trustee in a state where a trust is permitted to continue forever, and life insurance on successive generations can be used throughout the trust’s nearly immortal life.

1The 2010 Tax Relief Act (The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) raised the exemption for gift, estate, and GST tax to $5 million, but also indexed it for inflation, so that it is $5.12 million per person in 2012.

2Assuming the trust beneficiary has no right to exercise any control over trust property, which would typically be the case, the beneficiary will not have an incident of ownership over a policy on that beneficiary’s life, and therefore no estate inclusion under § 2042. The I.R.S. has said that estate inclusion will exist, however, when the insured/beneficiary is also a trustee. Rev. Rul. 84-179. This is an important reason to consider a corporate trustee.

3It is important that the trust document provide the ability to purchase insurance on successive generations.

4The rule has its origin in the Duke of Norfolk’s Case of 1682, in which the Duke created a trust purporting to shift beneficial interests based on conditions that might occur generations later. The court held that conditions could not exist indefinitely, believing that tying up property too long beyond the lives of people living at the time was wrong. Black’s Law Dictionary describes the rule as follows: 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.

5The following states have abolished their rule against perpetuities: Alaska, Idaho, New Jersey, Pennsylvania, Rhode Island, South Dakota, and Wisconsin. Several other jurisdictions have provided either a way to opt-out, or permit trusts for a really long time (varies from 150 to 1,000 years): Arizona, Colorado, Washington DC, Illinois, Maine, Maryland, Missouri, Nebraska, New Hampshire, Ohio, Virginia, Florida, Nevada, Tennessee, Utah, Washington, and Wyoming.

6Consider the effect of state income taxes when choosing a jurisdiction.

7Of course, if the assets are distributed to a beneficiary, and are not consumed, then they will be in that beneficiary’s estate at death.

8Well, maybe not forever. Machiavelli died 500 years ago in 1512. Assume his assets had passed to a dynasty trust. His trust might have survived to 2012, still purporting to be governed by the laws of the Florentine Republic it outlived by 480 years. Given that changes in laws and family circumstances are inevitable, no trust will endure forever. It’s just that, to the extent plans can be practically made for future generations, a dynasty trust provides the best option to keep an ample supply of funds in existence for as long as possible, all while avoiding any transfer taxes for multiple generations.

9For 2012, the $5.12 million GST exemption matches the gift and estate tax exemption. If sunset occurs, the GST exemption will decrease to $1 million, but could be a bit larger, as it was already indexed for inflation.

10For a detailed discussion, see our earlier article, Potential Clawback Should Not Discourage Gifts, Advanced Planning Bulletin, March 2011.

11§ 264 2(a)(2)

12The GST tax is imposed at the "applicable rate," which is found by multiplying the maximum federal estate tax rate by the "inclusion ratio" with respect to the transfer. § 2641. The goal is for the GST trust to have an inclusion ratio of "0", the result we get when the gift is completely sheltered by GST exemption. If a gift to a GST trust were only partly sheltered by the GST exemption, however, then the inclusion ratio would be between 0 and 1, and the applicable rate would correspondingly be higher than 0%, resulting in GST tax on distributions.

13The original sunset provision is in § 901 of EGTRRA from 2001, P.L. 107-16. It was adopted verbatim by § 101(a)(1) of the 2010 Tax Relief Act, P.L. 111-312, except that the new law changed the former sunset date of "December 31, 2010" to the current "December 31, 2012".

14If, despite this reasoning, you fear that any gift in excess of $1 million ultimately will not be protected by a GST exemption, you might want to consider creating at least two trusts, one that receives a gift of $1 million, and another to receive gifts in excess of that amount.

This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by the Advanced Planning attorneys of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual representatives, their customers, and the legal and advisors to those customers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. – To comply with Circular 230