Understanding Dynasty Trust Planning

What legacies do you hope to leave your children and grandchildren? They could include values such as honesty, activities such as philanthropy, or even a family home passed down for generations. Many people, however, associate the word legacy with a financial inheritance.

For example, legacy trusts enable wealthy individuals to leave assets to loved ones while minimizing potential tax liability. What differentiates them from other types of trusts is that they’re designed to limit estate and gift taxes that might otherwise deplete bequests made over multiple generations. Here are some common FAQs about dynasty trusts.

Why Would You Need One? 

Here’s what usually happens without a dynasty trust: If a parent leaves assets to children, the bequest is subject to federal estate tax at the time of the initial transfer to the second generation. It’s taxed again when the assets pass from the children to the grandchildren. This can continue for generations. Although the federal gift and estate tax exemption continues to grow and can shield most assets from tax, the top federal estate tax rate on the excess is currently 37%, a hefty amount. Furthermore, the generation-skipping transfer (GST) tax of 40% applies to certain transfers made to grandchildren, thereby discouraging transfers that skip a generation.

By contrast, with an irrevocable dynasty trust, assets are taxed just once, when they’re initially transferred to the trust. There’s no estate or GST tax due on any subsequent appreciation in value. This can save some families millions of tax dollars over the trust’s duration. When the assets are subsequently sold, any gain will be taxable. Note that the basis of the assets will be determined at the time of the initial transfer, though depending on the circumstances, the “step-up in basis” rules may help to reduce the taxable amount.

What Role Does Your State of Residence Play?

Many states originally adopted a “rule against perpetuities,” which prohibited trusts from lasting more than a certain number of years. But in recent years, most have reversed these rules or extended the time period. 
For instance, California now limits a trust’s duration to a generous 90 years. And a handful of states, including Delaware, Alaska, and Florida, have not only abolished perpetuity limitations but encourage nonresidents to set up dynasty trusts in their jurisdiction. As you can guess, it’s important to work with a professional estate planner knowledgeable about your state’s rules.

How Do You Set One Up? 

A legacy trust can be established during your lifetime, as an inter vivos trust, or part of your will as a testamentary trust. With an inter vivos transfer of assets, you’ll avoid estate tax on any appreciation in value from the time of the transfer until your death. Generally, though, with an inter vivos transfer the assets won’t be eligible for a step-up in tax basis at your death.

Because the emphasis is on protecting appreciated property, consider funding your trust with securities, real estate, life insurance policies, and business interests. Naturally, you should retain sufficient assets in your personal accounts to maintain your lifestyle.

Don’t Do It Alone

You shouldn’t try to set up a legacy trust on your own. This is a sophisticated instrument that is typically used with other estate planning tools to accomplish multiple goals. Contact your estate planning advisor for more information.

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