As a result of current population trends as well as the flexibility and control that can be drafted into modern trusts, the Dynasty Trust remains extremely popular; especially in a dynasty friendly state like South Dakota.
A Dynasty Trust is a trust designed to exist in perpetuity to provide a substantial legacy for current and future generations, and/or to promote family values. A Dynasty Trust can be free of estate taxes and protect the assets from potential creditors. Further, Dynasty Trusts can take the greatest possible advantage of a grantor’s gift tax exemption (currently $11.2 million per taxpayer and $22.4 per married couple in 2018) and generation-skipping transfer tax exemption ($11.2 million per taxpayer and $22.4 per married couple in 2018).
There are numerous discussions about repealing the Estate and Generation Skipping Transfer taxes but retaining the Gift taxes. If this were to happen, most individuals would continue to utilize and gift to trusts due to the likelihood that the estate tax might come back. In addition, as a result of all of the other reasons to establish a trust, i.e., promotion of family values, asset protection, privacy, state income and death taxes, etc…
How long can a Dynasty Trust last?
Generally, a generation-skipping trust can last as long as allowable under state law (also depending on the trust agreement). In most states, trusts are subject to the “Rule Against Perpetuities” (RAP). This common law rule requires a trust to terminate no later than the end of 21 years after the death of the last survivor of the class of persons who are alive at the time of the creation of the trust. Some states have adopted the Uniform Statutory Rule Against Perpetuities (USRAP), which allows the trust perpetuity period to be the longer of the time period stated previously or 90 years. Thus, a generation-skipping trust subject to the RAP has a limited duration.
Many states allow a dynasty generation-skipping trust to have a duration longer than the common law RAP or the Uniform Rule Against Perpetuities. South Dakota allows for a trust to exist in perpetuity, i.e., for an unlimited duration.
The South Dakota Advantage:
South Dakota followed the Murphy case approach to abrogating or abolishing its RAP which is key according to most GST and RAP experts. The Murphy case approach to the RAP shifts the perpetuities inquiry from remoteness of vesting to suspension of the power to alienate. For example, if the trustee has an explicit or implied power to sell, the trust jumps outside the rule of suspension of alienation, which limits the duration of the trust. South Dakota has also abrogated their RAP, which addresses the timing issue. As a result, South Dakota addresses both the timing and the vesting issues associated with doing away with their RAP as required by the Murphy case. States that have taken this approach:
- Pre-1986 States: Idaho, South Dakota, and Wisconsin.
- Please note: these states are the “bellwether” states because they made changes to their applicable laws prior to the imposition of the generation-skipping transfer tax in 1986. Consequently, the statutory purpose of these three states’ statutes cannot be found to have been to circumvent the Internal Revenue Code.
- Post-1986 States: Alaska (partial), Delaware, Kentucky, New Jersey, Missouri, New Hampshire and North Carolina.
Estate of Murphy v. Commissioner
The only reported case involving IRC section 2041(a)(3) is Estate of Murphy v. Commissioner, 71 T.C. 671 (1979). In this case, the Tax Court held that the exercise of a limited power of appointment to create another limited power of appointment did not spring the Delaware Tax Trap because, under applicable Wisconsin law, the exercise of a limited power of appointment did not commence a new perpetuities period. Consequently, the Delaware Tax Trap was not violated in Wisconsin, which had a perpetuities statute expressed in terms of a rule against suspension of the power of alienation rather than a rule based on the remoteness of vesting. The IRS acquiesced in Murphy.
Please Note: The Murphy case was relied upon by Idaho, South Dakota and Wisconsin in the creation of their RAP laws prior to 1986 and the imposition of the generation-skipping transfer tax. Alaska and Delaware have since amended their RAP laws to partially rely on the Murphy case. Both of these states still have issues if limited powers of appointment are utilized. Kentucky, Missouri, New Hampshire, New Jersey and North Carolina are other states that have relied on the Murphy case in designing their RAP statutes, but have other trust, income tax and/or asset protection limitations.
In “Unconstitutional Perpetual Trusts,” Steven Horowitz and Harvard Professor Robert H. Sitkoff raise interesting questions about the constitutionality of perpetual trusts in certain states that have prohibited them in their constitutions. They also raise important questions about possible conflict-of-law issues when a trust settlor’s resident state may have a strong legitimate public policy against perpetual trusts. The article notes that 11 states have had constitutional bans on perpetuities. Of those 11, California and Florida are the only states to later repeal those bans, thereby leaving nine states that currently have them. The nine states are: Arizona, Arkansas, Montana, Nevada, North Carolina, Oklahoma, Tennessee, Texas and Wyoming. Of these states, Arizona, Nevada, North Carolina, Tennessee and Wyoming have enacted longer term perpetuity statutes. With respect to constitutional questions and conflict-of-law issues, practitioners should look at the quality of the perpetuities laws of the subject jurisdiction, the quality of other laws that are available to benefit the client and the jurisdictional “nexus” requirements that have been defined on behalf of prospective clients.
Benefits of Unlimited Duration:
Generation-skipping trusts in non-dynasty trust states without the longer or unlimited duration statutes maybe subject to disadvantageous tax and asset protection situations. When a trust is forced to terminate pursuant to the RAP (or by any mandatory termination provision in the trust agreement, or with distributions to beneficiaries of 1/3 at age 25, 1/3 at age 30, and 1/3 at age 35), the trust assets are distributed to the living beneficiaries of the trust. These distributions may be subject to wealth transfer taxation. Further, the distribution could be available to creditors of the beneficiaries. A Dynasty Trust in an unlimited duration state can endure for the longest possible time and circumvent additional death taxes on the trust assets at each generation. A Dynasty Trust should also maximize state income and death tax savings and asset protection.
Preserving Family Values:
Wealthy individuals also establish Dynasty Trusts for non-tax reasons. They are a means through which wealthy senior family members can pass their values and goals on to younger generations. For instance, through trust incentive clauses, a senior family member can tie trust distributions to: W-2 income, earning an advanced degree or high academic grades, entering a particular profession or working for charity, avoiding substance abuse, staying married, remaining at home to care for young children or aging parents, etc. Such clauses can promote family values in perpetuity. These types of trust provisions generally work best with directed trusts and family distribution committees.
Some of the more commonly used non-tax incentive clauses are: $1 of trust income for every $2 of earned income; provisions for medical expenses; enhanced distributions for marriage and/or starting and maintaining families (i.e., vesting schedules); floating spouse clauses for in-law beneficiaries; restrictions on distributions to beneficiaries at certain net-worth levels; and restrictions on distributions to beneficiaries who marry without prenuptial agreements.
Additionally, many of Dynasty Trusts require distributions to be made directly to charities once the trust attains certain levels. Incentive clauses, as well as the asset protection afforded by the modern Dynasty Trust, make these trusts attractive vehicles for promote both fiscal and social responsibility within a family as well as ensure that the great-great grandparents and their values will never be forgotten.
While a Dynasty Trust in an unlimited duration state can last forever, there is the flexibility to both reform or modify the trust or terminate the trust sooner, if desired. Typically this is done by utilizing a Trust Protector, see Directed Trust section.
The current population trends as well as the flexibility and control that can be drafted into modern trusts regarding investments and distributions only increases the popularity of the Dynasty Trust; especially in a dynasty friendly state like South Dakota. South Dakota’s favorable laws combined with SDTC’s experience make South Dakota a very beneficial jurisdiction. For more information on the Dynasty Trust in general, and its many advantages, please contact us!
Economics: Dynasty Trust vs. Outright Gift:
[Assumptions – $5million; Trust lasts for 120 years; 50% federal/state transfer tax every 30 years]
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