If you have a lot of money and want to control its use long after your death—and ensure that succeeding generations of your descendants pay as little tax as possible—then a dynasty trust may be for you.
Dynasty trusts can, in theory, last forever. Assets in dynasty trusts can grow and be protected from your descendants’ creditors, former spouses, and their own wasteful habits. Dynasty trusts can also avoid estate taxes, saving large sums of money over the years.
An old legal principle, called the “rule against perpetuities,” used to prohibit trusts that could potentially last forever. Still, even with this rule, trusts could last a long time. To oversimplify, the rule stated that a trust couldn’t last more than 21 years after the death of a potential beneficiary who was alive when the trust was created. Some states (California, for example) have adopted a different, simpler version of the rule, which allows a trust to last about 90 years. (This is called the Uniform Statutory Rule Against Perpetuities.)
About half the states have done away with the rule against perpetuities altogether, clearing the way for dynasty trusts. Some—Delaware and Florida, for example—go further, luring trust-makers with tax breaks and flexibility, including strong protection if beneficiaries divorce or get into debt. Financial institutions in these states benefit handsomely from the sizeable fees they charge to manage dynasty trust assets.
The biggest advantage of a dynasty trust is that it can save your descendants a significant amount of money in estate taxes. The assets you put in the trust (plus any increase in their value over the years) are subject to the federal gift/estate tax just once, when you transfer them to the trust. They are not taxed again, even though multiple generations benefit from them.
By contrast, if you simply left a very large amount of money to your children (without a trust), it would be subject to the estate tax. And whatever they left to their children would be taxed again. If you tried to avoid one of those “tax events” by leaving assets directly to your grandchildren, the federal generation-skipping transfer tax could apply. (Though keep in mind that only very large estates, worth more than several million dollars, are subject to federal estate or generation-skipping transfer tax.)
For example, say you and your spouse leave $10 million to your daughter. If her inheritance grew, over 30 years, to $30 million, it would be subject to estate tax at her death—and if federal estate tax rates and exemptions in effect then were about what they are in 2016 ($5.45 million exemption, 40% top rate), more than $9 million would go to pay estate tax. That amount wouldn’t be owed if the money were in a carefully drafted dynasty trust—it would stay in the trust, where it could be invested and keep growing.
Income taxes are still due on income generated by trust assets. For this reason, people generally prefer to put non-income-producing assets into dynasty trusts—assets such as growth stocks that don’t pay dividends, or tax-free municipal bonds. It’s also common to transfer life insurance policies to a dynasty trust. After the policyholder’s death, the policy proceeds can be used to pay estate tax that’s owed on other assets in the estate.
You have a lot of control over a dynasty trust—your descendants have little. This offers both benefits and disadvantages. You get to decide who your beneficiaries are and what rights they have. Typically, children are the first beneficiaries; after their deaths, the grandchildren are next in line.
You appoint a trustee—usually a bank or trust company—to manage the money and spend it on beneficiaries’ needs according to the terms you set out in the trust. Those rules can be as vague or as detailed as you wish. You can also give the beneficiaries power to give away some of the trust assets or leave them to others at their own deaths.
But because dynasty trusts are irrevocable, you can’t change your mind later, and your descendants can’t alter the terms of the trust when family or financial circumstances change. You’re guessing about what will be good for your distant relatives, decades in the future.
The rule against perpetuities was based on the idea that it’s bad for society—and especially a society that prides itself on social and economic mobility, like the United States—to reward strategies that concentrate wealth in families over many generations. Why give tax breaks to dynasty trusts, which give descendants of wealthy families access to wealth that can’t be touched by taxes or creditors?
Many people don’t really want to control events so long after their deaths, in any case. After all, you will never know your distant descendants—and genetically, you won’t share that much with them. In 150 years, the average person can expect to have 450 descendants, according to law professor Larry Waggoner. And while you share half of your DNA with your children, a descendant six generations has no more than 1.6% of it. (See Professor Waggoner’s 2010 report, written for the American Law Institute.)
Needless to say, these trusts are complex and must be carefully prepared by a lawyer who has experience with trusts, taxes, and investments. No one knows what the future may bring, so flexibility is important. For example, you don’t want to tie beneficiaries to a trustee (a bank or trust company) that may not manage trust assets well.
And as anyone who has been paying attention knows, federal gift and estate tax rules—which have a big effect on a trust that’s designed to avoid these taxes—have changed significantly in the last few years and are likely to be amended again soon.