With the fate of the federal estate tax hanging in the balance, many financial advisors are seeking to avoid the uncertainties by placing high-net-worth clients in something that bypasses the problem—dynasty trusts. These complex vehicles seek to shelter wealth transfer taxes on larger estates once each generation.
Dynasty trusts are proliferating today because of the increasing numbers of high-net- worth individuals in the U.S. who wish to avoid sharing their wealth with Uncle Sam. Indeed, the latest Merrill Lynch/Capgemini World Wealth Report calculates that one in every 125 Americans today is a millionaire, reflecting a growth rate not witnessed since the late 1990s at the peak of the stock market bubble. Much of this wealth is flowing into trusts like the dynasty trust, which has several advantages over other trusts of more limited durations. The dynasty trust has become particularly attractive to the wealthiest families that wish to preserve a legacy over several generations and avoid paying taxes at the same time.
Moreover, today there is much more interest generally in the effect of federal and state so-called “death taxes” because of the Bush administration’s multiple, yet so far unsuccessful, attempts to repeal the federal estate tax and generation-skipping tax, known as the GST. If these taxes were repealed they would eliminate a major motive for setting up such trusts.
Recently, the House voted to repeal the estate tax permanently. There is talk of compromise in the Senate. Even so, there are enough benefits in dynasty trusts, say estate planning attorneys and financial advisors, that it still might remain viable.
“I’m confident they will continue to be a viable planning tool, regardless of whether the estate tax is repealed, because of the asset protection benefits,” says Scott A. Farber, vice president of Woodstock Corp., a wealth investment management firm in Boston. “Dynasty trusts have been around well before there was an estate tax.”
In a study forthcoming in the Yale Law Journal, Robert H. Sikoff and Max Schanzenbach, two professors at Northwestern University School of Law, found that through 2003 about $100 billion in assets has flowed into personal trusts in those 20 states from the time a centuries-old law was changed that prevented perpetual trusts. This amounts to roughly 10% of all noncommercial trust funds held by institutional trustees. The authors have posted the study on the Web at http://ssrn.com. To find the study, type 666481 in the “Quick Search” field.
The research was based on data reported by institutional trusts such as banks and trust companies, rather than individual trusts, such as those set up by family members. The researchers lacked access to individual account data, so they couldn’t calculate how much specifically went into dynasty trusts. The time frame covered was 1985 through 2003.
Until recently, trusts could effectively last only about 90 to 120 years under a so-called Rule Against Perpetuities (RAP). Since the mid-1990s, however, it is believed that at least 20 states have moved to relax the term limits. Some states, notably Alaska, Delaware and South Dakota, have completely abolished their the rule as to trusts of financial assets, as the study points out, while others have chosen not to abolish it altogether but to lengthen the terms. Wyoming and Utah, for example, permit trusts to last 1,000 years, while Florida lets them carry on for 360 years.
In choosing between states that have abolished the rule, the study showed that only states that do not tax income in trust funds attracted from out of state experienced an increase in their trust funds. Indeed, the competition for trust funds is keen among states. According to the study, the reason so many states are loosening or abolishing their trust laws is to avoid losing money to those states that are more trust-friendly.
In a typical dynasty trust, assuming it is structured properly, assets stay in the trust, and can pass from generation to generation without incurring estate or generation-skipping taxes, allowing vast sums of wealth to build up. The rule against perpetuities mandates that assets get disbursed to beneficiaries at some future time. The dynasty trust allows the assets to be retained in the trust forever. In this way, it differs from a nondynasty type of trust that preserves assets for a limited time or limited generations (e.g., outright distribution at age 50).
“Typically, when a person uses the dynasty trust, it is for the sole purpose of providing benefit to some future generation of beneficiaries,” says Mark LaSpisa, a certified financial planner and president of Vermillion Financial Advisors in South Barrington, Ill., with assets under management of $550 million.
One benefit of the trust, assuming it is set up properly, is that assets are generally protected from creditors of the beneficiary in the event of bankruptcies, lawsuits and divorce. “The grantor (or person who created the trust) has no idea what will occur over the life of the beneficiary, whether the beneficiary is getting sued or divorced, for example, or what will happen any time following the grantor’s death, so the assets can be retained until a future time when it is more beneficial for the beneficiary to be distributed,” says LaSpisa.
According to Gregg Parish, a professor of estate planning at the College of Financial Planning in Denver, to set up a dynasty trust one doesn’t have to live in the state that has abolished the Rule Against Perpetuities, but the trust has to be established in such a state. Moreover, the trust has to abide by the laws of that state. “For example, you may have to settle the trust in that jurisdiction, which means that the existence and operation of the trust are subject to that state’s laws,’ explains Parish.
Estate planning attorneys and financial advisors alike are marching to the drumbeat. Gideon Rothschild, a partner at law firm Moses & Singer in New York, says he regularly recommends that clients fund dynasty trusts during their lifetime. During their lifetime, they can make gifts to a trust of up to $1 million (or $2 million if married). “Clients,” he says, “are just as interested in the asset protection offered by such trusts as the tax savings.”
The drafting of the trust is essential to provide creditor protection for beneficiaries, believes Rothschild. The trust should also carry a provision for a third-party trust protector, who has the ability to both change the trustee, and, secondly, amend or change the trust provisions. This is more important in a dynasty trust, which by design can extend out over hundreds of years, as opposed to a more traditional short-term trust.
The trust should also include provisions that make clear the different roles of trustees and beneficiaries and bulletproof the trust against creditors, as well as give the trustee complete discretion on distributions.
Jonathan J. Rikoon, a partner in the trusts and estates group of New York law firm Debevoise & Plimpton, agrees that a trust protector provides “flexibility that is essential for a dynasty trust to work.” Other means to the same end would include allowing beneficiaries to participate in deciding who inherits the trust after their own death, and in the selection of successor trustees.
For financial advisors, dynasty trusts can provide lucrative fees. For one thing they allow the advisor to serve as trust protector, executor, co-executor or investment advisor on the assets of the trust. This generates fees. Advisors can charge hourly fees as the liaison between other professionals to complete the estate plan. Dynasty trusts also can help an advisor to capture assets that would otherwise go to a bank trust department.
Charles M. Aulino, first vice president and director of financial planning at The Glenmede Trust Co. in Philadelphia ($14 billion in AUM) and author of The Family Trust Planning Guide, recommends dynasty trusts to clients. “They seem to feel it’s nice to know that no matter how many future generations are succeeded, there will always be a trust fund there for them,’’ says Aulino. “Families that have successfully transferred wealth over several generations have the confidence that if they establish a dynasty trust it will be there for future generations, and won’t cause their descendants to become lazy and unproductive.”
Aulino has estimated that $1 million in a dynasty trust grows to about $19 million after four generations even after passing out 3% annual distributions to beneficiaries. In contrast, if that wealth were taxed at each generation, at the end there would be slightly less than $2 million left.
LaSpisa has placed the majority of his 190 clients in dynasty trusts since legislation was changed in Illinois to abolish the rule against perpetuities. He says he often converts clients from a traditional living trust into a dynasty trust. “For the most part,” LaSpisa says, “there are few negatives to the client if he’s working with an attorney that understands the dynasty trust. Beneficiaries can have access to the trust principal based on the ascertainable standard of the trust, which will allow the distribution of income or principal based on need.”
Likewise, Farber of the Woodstock Corp. recommends dynasty trusts for most of his wealthier clients. “Generally,” he says, “most beneficiaries that initially object are concerned about losing control of the assets. Once we sit down and make sure they understand how the trust works and they don’t have to completely lose control, they usually end up liking the idea. They realize that when they get into situations where they can lose assets owned in their name such as in divorce proceedings, they find the protection of the trust very attractive.”
One client had decided against an outright distribution to their children in favor of the dynasty trust format. While they trusted their children implicitly, they had significant concerns about allowing their children’s spouses access to the funds in the event their offspring died. Keeping the assets in trust sheltered the assets from the spouses.
Since Massachusetts has not abolished the rule against perpetuities, Farber has to establish the trusts in those states that have modified or abolished the rule. Usually, that requires using a trustee from that state, as well as transferring custody of some or all of the assets to that state.
Though Rikoon has placed clients in dynasty trusts, he harbors a few reservations about them. “They’re more attractive for the $20-million to $50-million-net-worth range than those persons wealthier,” he says. “That’s because for the wealthier, the amount permitted to be contributed to a dynasty trust without exposing it to the equivalent of estate taxation at every generation is a small percentage of their net worth.
“Secondly, many clients have trouble projecting what would be in the best interests of their descendants generations down the road, possibly hundreds of years. You’re trying to use today’s concepts to micromanage the manner in which your family and family’s advisors will be permitted to invest and distribute resources dozens or hundreds of years from how, and today’s concepts are almost certainly not going to be the best ones available at the time.
“For those clients who do want to set up dynasty trusts,” says Rikoon, “we try to build in the utmost flexibility and the least onerous restrictions.”
Since the laws on these matters could possibly change in the near future, it remains to be seen whether dynasty trusts will endure. Meantime, they remain a viable way for the wealthy to shield assets over generations, and for financial advisors they can be a lucrative source of fee income.