VERY SIMPLE CONCEPT
This blog examined the dynasty trust in the past but it is time to reexamine certain aspects of the dynasty trust. The dynasty trust is a trust designed primarily to avoid the generation skipping transfer tax when a person wants to leave money to their grandchildren or great grandchildren (or even generations beyond that). Before getting into the nuts and bolts of what a dynasty trust is, it is best to outline some of the basic tax issues inherent in the generation skipping transfer tax.
Grandfather wants to leave an asset to his son, with the intention that he will leave it to his son and for him to leave it to his son and so on. Just to make the dollar figures simple, let us assume that it worth $10 million. For further simplicity, let us also assume that grandfather’s estate already went through the federal (and state) estate tax exemption. That means that son has to pay the current top estate tax rate of 40%, which means that the asset is no longer worth $10 million. Instead it is only worth $6 million. For further simplicity, father’s estate also passed through all of his estate tax exemption, so instead of the asset being worth $6 million when it passes to the grandson, it is now worth $3.6 million in light of the 40% estate tax. And the process goes on and on.
Certainly this is an extremely simplified version of the math that is involved but it conveys the simple premise that tax liability will slowly but surely eat away at the value of the asset. A dynasty trust will allow you to avoid the higher tax liability on these assets as they pass; not only estate tax liability but also the generation skipping transfer tax, which is a whole different tax, although the same principle applies, which is tax liability swallows the asset which you are looking to transfer.
Historically, dynasty trusts suffered from that strange hangover from Elizabethan England: The rule against perpetuities. Not only is the rule against perpetuities archaic in the extreme, it is also the bane of law students everywhere. To simplify it, it basically requires that the trust and all beneficiaries in the trust (such as future unborn children who may benefit) be alive at the time that it is created or within 21 years of its creation. Fortunately, many states have thrown out the rule, although New York has not.
That means that you can create a trust in one of the several states that allow for such as dynasty trust to exist, for all intents and purposes, for forever. For example, Nevada created the 365 year trust and South Dakota approved the 500 year trust. It is good for ongoing businesses which will keep the trust income to a select, discrete group of individuals, lest the basic ground of beneficiaries grow too large and unwieldy. It also helps to protect the beneficiaries from creditors, insofar as it allows them to enjoy the income, without risk that a creditor will seize the principal.