This post addresses a question I frequently receive from clients: what are the advantages of dynasty trusts, and should I have one?
From an estate planning perspective, dynasty trusts have many advantages for high-net-worth individuals and families. To start with perhaps the most obvious, a properly established dynasty trust with sufficient flexibility could last for generations. Your trust could last longer than the Ming Dynasty, but the trust must be established in a state that does not require trust to terminate after one or two generations. A few examples are South Dakota, Tennessee, Nevada, and Alaska.
For those with taxable estates, dynasty trusts offer tremendous tax savings over the long run. Without a dynasty trust, transfers to your heirs are taxed at each generation. The Generation-Skipping Transfer Tax or GSTT generally applies to gifts over the GST exemption amount given to grandchildren or beneficiaries who are at least 37½ years younger than the donor. Today, the GSTT rate is 40%, and the exemption amount is $12,920,000. That means that in 2023, an individual grantor can gift up to $12,920,000 to grandchildren and subsequent generations in a dynasty trust. This amount could compound over generations and never be subject to GSTT.
Dynasty trusts protect your inheritance from irresponsible or gullible heirs, by ensuring that assets will be managed for them and not squandered by them. Dynasty trusts also protect your inheritance from a beneficiary’s potential ex-spouses, from lawsuits, from creditors including bankruptcy creditors, and from what we call predators – that is, people who may manipulate or trick your loved ones out of their inheritance. Some devices enhancing this asset protection include the use of independent third-party trustees to manage assets and to distribute them only at the trustee’s discretion. If the beneficiary does not have the ability to manage the assets and demand withdrawals, then the beneficiary’s creditors will not be able to reach those assets either.
The grantor is the person who funds the trust. By rewarding certain behaviors with distributions from the trust, the grantor can incentivize future generations to follow the grantor’s values. For example, the grantor can limit distributions to the wages earned by the beneficiary, thereby ensuring that no beneficiary lives off the trust without working. Similarly, the grantor can require for distributions earning good grades, completing a degree, volunteering or working for a non-profit, choosing a certain profession, avoiding substance abuse, or even entering a prenuptial agreement.
What does a grantor put in a dynasty trust? The process of transferring assets to a trust is called “Funding.” Many types of assets can be used to fund a dynasty trust. Life insurance is an excellent asset because it provides the trust with liquidity. Grantors often fund dynasty trusts with real estate and closely held business interests, to provide continuity for family businesses. Grantors may also contribute non-taxable income generating assets such as tax-free municipal bonds. One must determine how to fund a dynasty trust carefully, taking into consideration such factors as the Grantor’s remaining exemption amounts, the loss of a step-up in basis at death, and the potential of the assets to appreciate in the future. I mention these considerations only in passing, but they require a good deal of analysis by tax and estate planning experts.
Dynasty trusts do have downsides. We already mentioned the loss of step-up in basis at death. Another downside of dynasty trusts that merits mention is the management costs. These costs may be multiplied where the trust divides responsibilities of the Trustee among various roles. Moreover, the roles should be fulfilled by third parties in the most favorable jurisdictions for forming Dynasty Trusts – including for example Nevada and South Dakota. This may entail hiring additional professionals outside the Grantor’s home state. While such bureaucracy enhances the protection and effectiveness of the trust, it may also frustrate beneficiaries and slow things down.