Dynasty trusts and state law

In short

A friend of mine once said that the hardest part of building wealth is not the building, it is the handing over. If you are thinking about leaving money to grandchildren who have not been born yet, a dynasty trust is the tool people have in mind. It is a trust built to last for generations, and whether it can last depends mostly on the state whose law governs it. Some states let a trust run for hundreds of years, and some states end it within a lifetime or two. The federal tax rules sit on top of all of that, so the trust has to be written with both in view. Plan on a lawyer and a corporate trustee, because the paperwork is heavy and the mistakes are slow to show. None of this is a recommendation to do anything. It is a plain look at how the thing works and what it costs.

The whole of it

What it is

I once watched an old rancher walk his grandson across a pasture he would never own outright. He said the land was a loan from the next fellow down the line, and he meant it kindly. A dynasty trust works in something like that spirit. A person, called the grantor, puts assets into a trust, and the trust holds them for children, grandchildren, and later descendants. The trust, not any one heir, owns the property. Because no heir owns it, it generally does not get pulled into each heir's estate when that heir dies.

The word that matters here is perpetuities. For centuries, English and American courts held to a rule against perpetuities. It limited how long a person could tie up property after death, often to about a lifetime plus twenty one years after someone alive when the trust began. That rule would end a long trust fairly soon. Over the last few decades, many states changed or repealed it, and that change is what made true dynasty trusts possible. Each state decides for itself how long a trust may run.

How it works

You have probably heard that a trust is just a set of instructions with a bank account attached. That is close enough. The grantor signs a trust agreement. The agreement names a trustee, who holds and manages the assets. It names beneficiaries, who may receive money. It spells out when and why distributions happen.

Here is the part that surprises people. The trust usually does not have to be created in the state where the grantor lives. A family in a state with a short trust limit can often pick a different state's law, if the trust has a real tie to that state. A common tie is a trustee located there, such as a trust company. The state with the friendlier rules then governs how long the trust lasts and how well creditors can reach it.

Three state law questions shape the whole plan. How long may the trust last? Some states allow a set number of years, some allow it to run forever, and some still keep the older rule. Does the state tax the trust's income? Some states tax a trust based on where the trustee sits, where the beneficiaries live, or where the grantor lived, and the rules differ widely. How strong is the protection from creditors and from a divorcing spouse? States write these rules differently, and courts read them differently.

Then comes the federal layer. Gifts into the trust can use up the grantor's lifetime gift and estate tax exemption. Money that grows inside the trust may also be hit by the generation skipping transfer tax, called the GST tax, when it passes to grandchildren or later. The grantor can assign a GST exemption to the trust, which lets the assets pass down without that tax. Done right, the trust is built to be exempt from the start, and the growth stays exempt too.

The numbers, and where to find yours

A neighbor of mine kept a shoebox of old tax papers and swore he knew where everything was. He did not. Numbers like these are easier to check than to remember, so here is where each one lives.

The lifetime gift and estate tax exemption is set by federal law and changes. It is the current figure, which the official source publishes each year. The GST exemption is tied to the same figure and is the current figure, which the official source publishes each year. The top federal rate on estates and large gifts is the current figure, which the official source publishes each year. The Internal Revenue Service publishes these each year, and the Internal Revenue Code sections on estate tax, gift tax, and GST tax are the source. Form 709, the United States Gift and Generation Skipping Transfer Tax Return, is where gifts and GST exemption allocations get reported.

Trust income is taxed on a steep schedule. A trust reaches the top federal bracket at a much lower income level than a person does. The current bracket thresholds are the current figure, which the official source publishes each year, and the Internal Revenue Service lists them in its yearly tax tables.

For the state side, the numbers are the state's own. Look for how many years or generations the state allows a trust to run, and whether it taxes trust income. Each state's statutes and its department of revenue answer those questions. The Uniform Law Commission also publishes a model law on the perpetuities rule, which some states adopted in part. Read the statute for the state in question, not a summary of it.

A worked example

A woman named Margaret Ellis built a manufacturing company and sold it. Say she funds a dynasty trust with $20,000,000. She lives in a state that ends trusts after about ninety years, and she would like the money to last longer. So she works with counsel and picks a state with a long limit. She names a trust company in that state as trustee, which gives the trust its tie there.

Assume she uses $20,000,000 of her lifetime exemption on the gift. If her exemption were $15,000,000, the gift would go beyond it. Her gift is $20,000,000 and her exemption is $15,000,000, so the part over the exemption is $20,000,000 minus $15,000,000, which is $5,000,000. That excess would be taxable. Margaret will want to keep the gift within what her exemption covers, so she chooses a smaller gift instead. Say she funds the trust with $12,000,000. That is under $15,000,000, so no gift tax is owed, and she has $3,000,000 of exemption left. These exemption figures are illustration only. The real ones come from the Internal Revenue Service.

She assigns GST exemption equal to the $12,000,000 gift. That means every dollar in the trust is covered. Now suppose the trust grows to $36,000,000 over the years. Because the full gift was covered, the growth is covered too, so the extra $24,000,000 passes to grandchildren without GST tax. That is $36,000,000 minus $12,000,000, which is $24,000,000.

Costs matter too. Say the trust company charges 0.75 percent a year on assets. On $12,000,000 that fee is 0.0075 times $12,000,000, or $90,000 a year. Add legal setup, tax returns, and investment costs. A trust that lasts many generations pays these costs many times over.

Where it goes wrong

I have seen good plans spoiled by one missed form. That is the first trap. If the GST exemption is not properly assigned, tax can apply that the family never planned for. Filing Form 709 on time and correctly is not a small thing.

The second trap is a weak tie to the chosen state. If the trustee, the assets, and the family are all somewhere else, a court may decide the borrowed state's law does not really apply. Courts have not all treated this the same way, so the result can be uncertain.

A third trap is state income tax. Picking a state with a long trust limit does not by itself settle which states tax the income. A trust can still owe tax to the state where a beneficiary lives or where the grantor once lived, depending on that state's rules.

Fourth, control. A trust built to last forever is hard to change. Tax law moves, families change, and an agreement written today may fit poorly in fifty years. Many agreements include a trust protector, a person with power to adjust terms, and some states allow a court to modify a trust. Whether that works depends on the state.

Last, cost and complexity. The trust needs a trustee, filings, and advice for as long as it lives. Tying up money for generations also means the grantor's own family cannot reach it freely. That is the design, and it is also the price.

Questions to answer before you leave this page

Have you asked yourself what you really want this money to do for people you may never meet? Do you know which state's law would govern the trust, and what real tie it would have to that state? How long does that state let a trust run, and does it tax the income the trust earns? Which of your children and grandchildren live in states that might tax the trust? Is your GST exemption assigned in a way that covers the whole gift and its growth? Who will serve as trustee, what will the trustee charge each year, and who watches the trustee? Is there someone with power to adjust the terms if the law changes? And have you sat down with an estate lawyer and a tax adviser who know both your state and the state you are considering?