January 1, 2024, marked exactly two years until the planned reduction by half of the current Applicable Exclusion Amount (“AEA”). The AEA is the amount that an individual can pass to anyone either during their life or at death before imposition of a transfer tax. For those needing a refresher, the Tax Relief Act of 2010 set the AEA at $5 million (adjusted for inflation) and the Tax Cuts and Jobs Act of 2017 temporarily doubled that amount to $10 million per person ($20 million per couple), as adjusted for inflation. The inflation-adjusted number in 2024 is $13.61 million per person ($27.22 million per couple). Thus, in 2024 each United States resident or citizen may pass an unlimited amount to their spouse and $13.61 million to whomever they want without worrying about gift or estate taxes. The provisions of the Tax Cuts and Jobs Act of 2017 sunset on January 1, 2026, which means that individuals who may have an estate tax issue when the AEA returns to $5 million per person need to consider more sophisticated Estate Planning techniques. A “Dynasty Trust” presents a good opportunity for wealthy individuals to leverage the doubled AEA for future generations and prevent taxation of those same assets for several generations.
While many folks think Dynasty Trusts are complex, they don’t have to be. In simple terms, a Dynasty Trust continues for the longest possible time allowed by state law. Some states have a “Rule Against Perpetuities” (“RAP”) that limits the amount of time that a trust can exist. Under common law, the RAP provides that the asset must vest, if at all, no later than 21 years after the death of a “life in being” determined when the trust became irrevocable, typically the death of the grantor of the trust. In practical terms, this means that upon the death of the grantor, the Trustee needs to distribute the assets in the trust no later than 21 years after the death of the last of the beneficiaries alive at the grantor’s death. For example, let’s assume that the grantor establishes a trust for his children and grandchildren, the youngest of whom is 4 years old upon the grantor’s death. If that grandchild lives until their 104th birthday (100 years after the grantor’s death), the trust can continue for another 21 years or 121 years after the grantor’s death.
Many states have adopted the Uniform Statutory Rule Against Perpetuities, which allows a trust to last either the traditional RAP period (a “life in being” plus 21 years) or 90 years, if longer. Some states have modified the RAP so that a trust might last 150, 365, or even 1,000 years. Other states have repealed the RAP completely thereby allowing the trust to last forever! You may be wondering why anyone would want to leave their assets in trust that long. First, the grantor could name a professional Trustee to manage the assets to prevent the beneficiaries from squandering them. Second, leaving assets in trust this long ensures that the Trustee distributes the assets in the manner decided by the grantor for future generations. Finally, a Dynasty Trust helps save on taxes for those with a taxable estate thereby allowing the assets to grow for multiple generations without diminution by estate taxes.
Let’s look at a quick example. For the sake of simplicity, we will ignore the impact of the AEA on each estate, assume a tax rate of 40%, and assume that the inheritance grows at a rate of 7.2% annually. John (age 80)(1st generation) dies and leaves $5 million to his daughter, Sally (age 50)(2nd generation), outright. The $5 million turns into $40 million by Sally’s death. Sally’s estate will pay a tax of $16 ($40 million * .40). Sally leaves the $24 million ($40 million inheritance less $16 million tax) inheritance to her child, Beth (3rd generation). Beth lives another 30 years and the $24 million she inherited from Sally grows to $192 million. Beth’s estate will pay a tax of $76.8 ($192 million * .40). Beth leaves the $115.2 million ($192 million inheritance less $76.8 million tax) inheritance to her child, Josh (4th generation), who invests similarly. Thus, the $115.2 million he inherits grows to $921.6 million. At Josh’s death, his estate owes tax of $368.64 million ($921.6 million *.40), leaving $522.96 million for future generations. So, by the end of the 4th generation, the $5 million inheritance from John has grown, after transfer taxes, to $522.96 million in 90 years. That’s an impressive return however, each generation has paid taxes on the assets.
Savvy Trusts and Estate Practitioners know a better way, a way that avoids taxation at successive generations. If at his death John (1st generation) left the $5 million to a Dynasty Trust for the benefit of Sally (2nd generation) and her descendants and allocated his Generation-Skipping Transfer Tax exemption, the assets would have been excluded from Sally’s estate. At Sally’s death, the $40 million in the Dynasty Trust would have escaped the 40% reduction due to the estate tax. Instead, the full $40 million could have continued to grow for the benefit of Beth (3rd generation) and her descendants. After 30 more years it would have increased to $320 million and at Beth’s death, again, it would have escaped taxation and would have passed to Josh without further estate taxes. After another 30 years of prudent investing by the 4th generation, the inheritance would have grown to $2.56 billion, or approximately 5 times the amount that it was without using the Dynasty Trust.
Without a Dynasty Trust, the assets increased significantly; however, with a Dynasty Trust, the assets ended up 5x more over the same period and with the same investment assumptions. Our friends at Bott & Associates, Ltd. understand that a Dynasty Trust offers several benefits. It keeps the money in the family and may prove a better option than a nuptial agreement because the Dynasty Trust existed well before the couple and avoids the awkward situation of asking a fiancé to agree to a nuptial agreement prior to or just after the marriage. It allows the grantor to control distributions many years into the future. It provides the assets an opportunity to grow without imposition of estate taxes. Finally, it offers significant asset protection. While a Dynasty Trust may not work for everyone, it provides some great advantages if properly structured. Speak with a qualified estate planning lawyer about your options.