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DYNASTY TRUSTS

Utilizing Your Generation Skipping Tax Exemption to Protect Your Wealth for Generations
Many parents give their children the children’s inheritances directly. Others think multigenerationally. Instead of giving their wealth to their children directly, they give it in “dynasty trusts”—trusts that benefit one generation of family members after another without being subject to estate tax at each generation. Wealth that avoids the imposition of estate tax grows far more than wealth that is subject to estate tax at every generation, especially when that wealth is protected from creditors and failed marriages. Dynasty trusts are a golden opportunity for wealth preservation. By planning for children, grandchildren, and even great-grandchildren, you can give your family many generations of tax-protected, creditor-protected, failed marriage protected wealth. The Wyoming Legislature had the foresight to pass a law that allows a Wyoming trust to last up to 1,000 years. This lengthens the life of the trust and allows the family or Trustee— rather than a state statute—to dictate how long a trust can last for future generations. Congress only allows a certain amount of assets to be transferred estate tax free for multiple generations. This amount is called the “Generation-Skipping Tax Exemption” (GST). The American Taxpayer Relief Act of 2012 “permanently” set the GST equal to the Federal Gift and Estate Tax Unified Credit at $5,000,000, indexed for inflation. However, this “permanence” exists only until Congress amends the tax code. This article applies the 2014 inflation-adjusted GST exemption of $5,340,000 and the top estate tax rate of 40%.

A Tale of Two Families
Let’s take two hypothetical family planning situations, which are as different as night and day. The Knight Family. Nick Knight inherited $5,340,000 from his parents directly. The inheritance was titled in Nick’s name. He owned it. The Day Family. David Day did not inherit his $5,340,000 from his parents. They left his $5,340,000 to a trust that named him as the trustee and beneficiary. David could control the $5,340,000 as the trustee and could enjoy the $5,340,000 as the beneficiary, but he did not own it. His trust did. You might think that Nick, who inherited his $5,340,000 directly, would be happier than David, who inherited his $5,340,000 in trust. However, if Nick knew what the Day family knew, he would not be. If he could see the future, Nick would prefer to control and enjoy his wealth rather than own it. Let’s compare the Knight family’s future to the Day family’s future to see why. We will apply the 2014 GST exemption amount and top estate tax rate stated above.

THE KNIGHT FAMILY ESTATE TAXES. The maximum estate tax rate for estates equaling, or in excess of, $5,340,000 is currently 40%. Since the government taxes everything we own at death, Nick would pay estate taxes on his $5,340,000 (plus any appreciation) because, at his death, he owned it outright. If Nick’s descendants inherit this bequest outright, the government will tax these assets each time they pass from one generation to the next because each generation will own what they inherit. Q: Assuming no investment growth, what will happen if everyone in the Knight family is in the 40% estate tax bracket? A: Nick’s $5,340,000 will shrink by 40% to $3,204,000 when it passes to his children. It will shrink by 40% again to $1,922,400 when it passes to his grandchildren. It will shrink still further to $1,153,440 when it passes to his greatgrandchildren. In three generations, Nick will pay over 78% of his wealth to the government, leaving less than 22% for his family. CREDITOR CLAIMS. To make matters worse, judgment creditors can collect anything a member of the Knight family owns. Lawsuits can wipe out inheritances long before estate taxes do. SPOUSAL CLAIMS. Other risks come from within the family. Unless each family member diligently keeps inherited property separate from marital property, a soon-to-be-ex-spouse can claim half of it in a divorce, adding financial loss to a family member’s personal one. $5,340,000

$3,204,000
after children pay estate taxes, then

$1,922,400
after grandchildren pay estate taxes, then

$1,153,440
after great-grandchildren pay estate taxes

THE DAY FAMILY CONTROL AND ENJOYMENT WITHOUT OWNERSHIP. Unlike Nick Knight, David Day does not own his $5,340,000; David’s dynasty trust does. Even if David can spend all the trust income, enjoy the use of trust assets, and control the trust as trustee, he will not be deemed to own the trust’s $5,340,000, if the trust’s provisions sufficiently limit his access to trust principal and his choice of future beneficiaries. Even the slightest limitations can be sufficient to cause the trust assets to be owned by the trust rather than by David— limitations so slight that David will regard the trust’s assets as his own, even though legally they are not.
Copyright © 2014 Gonnella Adamson, PC

In a dynasty trust, $5,340,000 remains $5,340,000 for generations. YOU CANNOT LOSE WHAT YOU DO NOT OWN. Being the beneficiary of a dynasty trust is like having a millionaire uncle who gives you everything you need, whenever you want it. Though your lifestyle reflects your uncle’s wealth, you are not wealthy. Your uncle is. If you lose a lawsuit or suffer a failed marriage, your judgment creditor or spouse cannot make claims against your uncle’s wealth; they are your creditor and spouse, not your uncle’s. Similarly, when you die, the government cannot tax your uncle’s wealth in your estate because you never owned it. THE GENERATION-SKIPPING TRANSFER TAX There’s a catch, of course. The estate-tax-free nature of dynasty trusts did not go unnoticed by Congress. In 1976, Congress enacted a 55% generation-skipping transfer tax that applies whenever dynasty trust assets pass to a new generation free of estate taxes. In 1986, Congress gave everyone a $1,000,000 exemption from this onerous tax. In 1997, Congress again granted this exemption. Today, an individual can allocate up to $5,340,000 into a dynasty trust. The prior history of the GST exemption amounts and current changes are as follows: 2009 2010 2011 2012 2013 2014 $3,500,000 No exemption $5,000,000 $5,000,000 $5,250,000 $5,340,000

Growing Your GST Exemption Trust Tax-Free. Based on today’s tax rates and exemption amounts, if your parents put $5,340,000 into a dynasty trust, at an assumed growth rate of 5%, it could grow to over $668 million as it passed through four generations of family members, all without paying estate taxes. 1 All of this wealth would be exempt from taxation, not just the original $5,340,000. The $5,340,000 plus all its growth remains exempt both from estate taxes and from generationskipping transfer taxes. This is why you would prefer to inherit your wealth in a dynasty trust. This is the Day family’s plan.
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DAY CALCULATIONS: At a 5% rate of growth, $5,340,000 would grow to $668,777,825.62 in the years it would take for it to pass through four generations (100 years) if we assume a 25-year age difference between generations. The estate taxes would be paid at 25, 50, and 75 years (but are not actually due because of the GST exemption). KNIGHT CALCULATIONS: Using the same assumptions as for the Day family in the preceding footnote, $5,340,000 would grow to $144,456,010.33 if 40% is paid as estate taxes when it passes to the next generation of family members in years 25, 50, and 75, assuming a 25-year age difference between generations. Copyright © 2014 Gonnella Adamson, PC

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If the Knight family were to invest the same $5,340,000 at an assumed rate of an growth of 5% for four generations, they would have just $144 million after paying estate taxes three times.2 By investing the same $5,340,000 at an assumed rate of growth of 5% for three generations without it being eroded by federal estate taxes, the Day family has nearly five times as much as the Knight family.2 TERM LIMITS The longer a dynasty trust lasts, the more generations of federal estate taxation it will escape. However, just as federal tax law limits the amount you put into your dynasty trust, state laws limit how long it can last. Most states have a “Rule Against Perpetuities” statute that limits the duration of dynasty trusts to between 90 and 120 years. However, because of the foresight of the Wyoming Legislature, trusts governed under Wyoming law may be protected for up to 1,000 years. THE CHOICE: DISTRIBUTION OR DYNASTY TRUST? If your will, living trust, or irrevocable trust provides for an outright distribution of wealth to your heirs, consider distributing to a dynasty trust instead. You can include dynasty trust protections in any will, living trust, or irrevocable trust. Such protections should also be considered whenever you establish a life insurance trust in order to tax-proof your life insurance policies. You may facilitate many generations of tax-protected, creditor-protected, failed marriage protected wealth by making the right choice between outright distributions and dynasty trusts. They are as different as night and day.

Copyright © 2014 Gonnella Adamson, PC