Seeking tax benefits now, and a legacy that can last for generations.
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 If these taxes were repealed they would eliminate a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planning tool, regardless of whether the estate tax is repealed,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.
Bruce Fraser, a freelance writer
based in New York, has written for many publications. He can be reached
at [email protected]. Visit him at www.bwfraser.com/home.