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Traditionally, trusts were viewed primarily as a means to protect immature or dysfunctional beneficiaries from themselves. Traditional trusts typically terminated when a minor child attained a certain age. Dynasty Trusts, on the other hand, seek to maximize all of the benefits of the trust arrangement, which include asset protection and tax savings, as well as the traditional objective of protecting immature or spendthrift persons. In fact, the Dynasty Trust can serve as the centerpiece of an estate plan.
The Rule Against Perpetuities, which prevents multi-generational transfers of property, has been abolished in Delaware. Accordingly, a trust whose length may have been limited to 100 years may now be of perpetual duration in Delaware. The Delaware Dynasty Trust is, therefore, an irrevocable trust which lasts in perpetuity, preserving wealth for future generations.
B. Favorable Transfer Tax Attributes
Initial transfers by each parent to a Dynasty Trust can be sheltered from gift tax by the $1 million gift tax exclusion, and from the generation-skipping transfer (GST) tax by the $1.1 million GST tax exemption (GSTE). If properly structured — and GST tax planning is extremely complex — the Dynasty Trust will continue to grow without the imposition of gift, estate or GST taxes. (See, Negotiating the Generation-Skipping Tax.) However, to make a transfer complete for gift, estate and GST tax purposes, the trust must be irrevocable. This means that no transferred assets may be reacquired by the Settlor. In addition, either the trust or the Settlor (depending upon whether the trust is a “grantor” trust for income tax purposes; see discussion below) will be required to report and pay federal income tax on trust income, as would any non-exempt trust. [Delaware currently imposes no income tax on trust assets; however, New York could conceivably seek to impose income tax on a New York resident’s income generated by a Delaware trust under Quill v. North Dakota, 112 S.Ct. 1904 (1997).]
To illustrate its potential tax benefits, a Dynasty Trust funded with the available $2.2 million GSTE (for both spouses) would be worth more than $19 million in 100 years, assuming a 10 percent rate of return. By comparison, if no trust were used, the assets would be worth less than $1 million after 100 years. To the extent sheltered by the relevant exclusions, trust assets could be distributed to beneficiaries without the imposition of any transfer taxes. The disparity between the two scenarios reflects the huge cost of estate tax being imposed at successive generations.
Delaware is an excellent situs for a Dynasty Trust for diverse nontax reasons: Delaware fastidiously respects the privacy of trust arrangements, and requires little if any judicial oversight of trusts. Delaware observes the “Prudent Investor Rule,” which accords the Trustee significant latitude in making investment decisions. Finally, Delaware permits “directed” trusts, in which someone other than the trustee, most likely the Settlor, may make investment decisions for particular trust assets. In exchange for the favorable income tax treatment, asset protection features, privacy attributes and efficient judicial system which trusts sitused in Delaware enjoy, the state requires that the trustee be situated in Delaware.
The Dynasty Trust can be designated as the governing trust document for the receipt of all lifetime gifts to children and grandchildren. If this is the case, the terms of the Settlor’s will can be simplified: Assume the Settlor’s will creates a marital trust and credit shelter trust for the surviving spouse. At the death of the surviving spouse, the will provides that remaining assets of both spouses, after payment of estate taxes, are “poured over” to the Dynasty Trust. The trust that received lifetime gifts and now a pour-over inheritance upon the surviving spouse’s death are identical. Avoiding the creation of another trust for the children in the Settlor’s will reduces administrative expenses and avoids confusion that would result in having multiple trusts for each child.
The Dynasty Trust may or may not be made a “grantor” trust, as defined in the IRC §§ 671 et seq., in which the grantor (i.e., Settlor) is taxed on trust income. Usually grantor trust status will be avoided for the following reasons: First, although higher income tax rates apply to nongrantor trusts, the reduction of marginal income tax rates makes this factor no longer of paramount importance; second, although the grantor’s obligation to pay income tax on the trust income does result in a tax free “gift” of the income tax liability to the trust, enabling trust assets to appreciate more rapidly, the grantor may not wish to be burdened with the income tax liability of the trust; and finally, to apply the GSTE to the Dynasty Trust, there must be no “estate tax inclusion period” (ETIP). (See discussion of ETIP; p. 2, col. 2). For there to be no ETIP, there must be no possibility that the trust assets could be included in the grantor’s estate. There is always a risk with a grantor trust that the IRS could seek to include the trust assets in the grantor’s estate because of the retention of too many “strings.” If this occurred, the initial GSTE allocation, presumably made when trust assets were within the $1.1 million GSTE, would be nullified, with unfavorable GST tax consequences.
C. The Dynasty Trust is Actually a “Trust Arrangement”
A Dynasty Trust is not a single trust, but actually a “trust arrangement.” The governing trust document typically creates separate trusts for each family branch. Each trust will also contain GST “exempt” and “nonexempt” trusts. Initially, the trustee of all trusts will be the same. Thereafter, each family “branch” will have its own trustee. This arrangement is preferable to having a single trust with a single trustee who must satisfy every beneficiary. After the parents who create the Dynasty Trust are no longer alive, the trust can provide that each child will assume responsibility for his or her own trust, and may choose his or her own Trustee.
Other benefits of having separate trusts for each family include the following: (i) Separate trusts and trustees will reduce sibling conflicts. One sibling will not be required to obtain approval from the other sibling for trust investments or administrative actions. Each family branch may choose its own trustee, accountants, bankers, etc.; and (ii) trust administration will be simplified if siblings are located in diverse states or countries. The administration of the trust can be moved to the location of the beneficiary without disturbing the other siblings’ trusts.
Neither the Settlor nor the Settlor’s spouse should be a beneficiary of the Dynasty Trust. The “split gift” election under IRC § 2513 applies to gifts made to any person except that person’s spouse. (A gift is “split” where a non-donor spouse elects to use his or her gift tax exemption with respect to all or part of the gift, thus sheltering a greater portion of the gift from gift tax.) Moreover, distributions made from the trust to the Settlor’s spouse would increase that spouse’s taxable estate, a result inconsistent with the gift, estate and GST tax objectives of the Dynasty Trust.
D. Trust Distribution Models
Two basic models for distributions from a Dynasty Trust exist: (i) the “totally discretionary” trust distribution pattern; and (ii) the “entitlement” distribution pattern. The totally discretionary pattern offers the greatest flexibility, since the trustee is not bound by any fixed standards in making distributions. Instead, the Trustee will be able to meet future family circumstances in the most effective manner in furthering what the trustee believes were the Settlor’s objectives. This model also maximizes protection against (i) an overreaching spouse; (ii) creditors; and (iii) taxing authorities, since the beneficiary will have no enforceable rights against the trust. Since the trustee will possess discretionary powers which could influence sensitive tax provisions, the trustee must be independent.
The entitlement distribution pattern fixes the beneficiary’s entitlement and provides for routine distributions to the beneficiary. Flexibility is reduced with this type of trust, since the trustee will have less discretion in determining distributions. Compared to the totally discretionary distribution pattern, the trustee may not be as well equipped to deal with changed circumstances. However, the entitlement model is not without its own distinct advantages: First, since neither the Settlor nor the Settlor’s spouse exercises significant discretion, either could probably be named trustee without risking adverse tax consequences; second, the Settlor’s desire for certainty in distributions may be more important to him or her than the advantages of flexibility; and third, although flexibility is reduced, if distributions are made subject to an ascertainable standard, considerable flexibility may still be achieved.
The Delaware Dynasty Trust provides excellent tax benefits, tremendous flexibility in distributing assets to beneficiaries, and is truly multigenerational. Inter vivos transfers to such trusts are an effective method of utilizing the benefits of the GST tax exemption. These trusts may also provide a hedge against the possibility that transfer taxes will not be repealed.