When clients' assets increase to levels that beg the need for advice that goes beyond retirement planning, it is time to work with a true wealth manager, one who has experience with the more advanced tools and strategies that can safeguard a fortune and transfer it to future generations.
While many advisors consider tax savings to constitute efficient estate planning, sophisticated clients may be thinking of something quite different. This becomes especially clear when advisors realize their clients are looking for ways to maximize control of their wealth from the grave. These clients want to ensure that their children and children's children don't squander the fortunes built by their lifetime of work and sacrifice.
The Dynasty Trust
While trusts are the most common estate planning vehicles for controlling estate assets after the grantor's death, not all trusts are equally effective. We have found that a dynasty trust is a powerful planning tool for protecting the assets of such wealthy clients and maximizing control of the amount of wealth transferred, while incurring minimal or no out-of-pocket transfer tax at each generational stop.
A dynasty trust is an irrevocable trust created to preserve trust property for the benefit of multiple generations. The number of generations eligible to benefit from the trust is generally determined by state law. The concept of the dynasty trust centers on its ability to hold assets for beneficiaries without ever having the beneficiaries take outright title to the trust assets. Unlike common provisions found in many trusts, the dynasty trust provisions attempt to avoid triggering outright distribution of assets to a beneficiary. Not only will dynasty trust provisions preserve wealth for following generations, but they may also provide powerful asset protection from creditors and divorce settlements.
To maximize tax efficiency, the dynasty trust aims to leverage the federal tax exemptions available to individuals. Fully funding the dynasty trust using gift and generation-skipping transfer tax (GSTT) exemptions allows for the most successful and tax-efficient outcome.
Clients seem best served by funding the trust with an amount that fully consumes their available GSTT exemption of $2 million per individual (scheduled to increase to $3.5 million in 2009). A married couple in 2008, for example, could fund a dynasty trust with $4 million--fully allocating their GSTT exemptions to the trust to ensure that it escapes any GSTT as beneficial interests pass between generations. Because the initial funding is a gift, it is advantageous for clients to use any available lifetime gift tax exemption ($1 million per individual) to offset gift taxes owed due to the transfer of assets to the trust. Gift tax liability incurred as a result of the transfer of assets above the lifetime gift tax exemption would have to be paid out of pocket, but would be deducted from the transfer tax base, in turn reducing the estate tax.
The Advisor's Role
The allocation of a client's transfer tax exemptions to the dynasty trust creates a wonderful opportunity to develop a large pool of assets that grow free of estate and GSTT. Because the trust's primary goal is accumulation and preservation of wealth for multiple generations, asset allocation should reflect that goal. Growth stock, life insurance on the grantor, and possibly, interests in a closely held business are all appropriate investments to provide the kind of appreciation that maximizes the dynasty trust strategy.
Typically, upon the grantor's death, the trustee is charged with distributing income to the beneficiaries. The trustee may also make trust principal available to the beneficiaries under an ascertainable standard (e.g., health, education, maintenance and support). At the same time, it affords the possibility of creditor protection by ensuring that all beneficial interests remain in trust. Some dynasty trusts may be drafted to include a provision that bases the beneficiary distributions on a unitrust amount, rather than on the usual definition of income such as rent, interest and dividends, among other items. A unitrust payout requires that trust assets be valued annually; the distribution to the beneficiaries is based upon a percentage of the fair market value of trust assets. A common unitrust payout would be in the range of 4 percent to 7 percent.
The unitrust payout is advantageous because the amount distributed to beneficiaries will increase as the value of the underlying trust assets increases. It also serves as a hedge against inflation, especially in a low-yield environment.
Recommended: A Corporate Trustee
The choice of trustee is extremely important--not only to avail the trust of the most advantageous laws, but also to provide effective administration. I always recommend a corporate trustee because they have the required experience and their corporate entity can continue--along with the trust--into perpetuity.
State Law Considerations
Many state laws--like the rule against perpetuities (RAP)--are rooted in English common law. Enacted to ensure that the term of a trust would eventually come to an end, RAP imposes a time limit measured by 21 years after the death of the last identifiable person living at the time the trust was created.
Many states have adopted the Uniform Statutory Rule Against Perpetuities. While it provides more flexibility than the original common law version, the uniform rule eventually forces a trust to dissolve at a certain point in the future. Some jurisdictions--Alaska, Delaware, and New Jersey, to name a few--have recognized RAP as outdated and abolished it. Some even allow dynasty trusts to continue in perpetuity.
Another benefit occurs if the dynasty trust is established in a jurisdiction that does not have state income tax. Therefore, when deciding to create a dynasty trust, the state where the trust is formed must be carefully considered. While the grantor doesn't have to be a resident of that state, the trustee must.
Complex but Effective
The dynasty trust is a complex estate planning tool not suited to all clients. But for UHNW families, it may provide for the transfer of wealth in a manner that can preserve significant benefits for future generations while providing tax efficiency and creditor protection.
Gavin Morrissey, JD, (firstname.lastname@example.org) is the director of advanced planning at Commonwealth Financial Network in San Diego, Calif.