The Case for Establishing a Dynasty Trust

Unless extended, the record-high lifetime gift and estate tax exclusion, and the generation-skipping tax (GST) exemption—both $13.61 million per person in 2024—are scheduled to revert to 2010 limits ($5 million in 2010 dollars, indexed for inflation) on January 1, 2026, effectively cutting the exemption in half. Estates valued above the new limit may be taxed at a rate as high as 40%.

Given this looming change, affluent families would be wise to do some tax-smart planning now. And for those looking to extend their wealth to their children, grandchildren, and beyond, a multi-generational trust—often referred to as a dynasty trust—can be an especially attractive option.

These irrevocable trusts are unique because they allow wealth to pass from one generation to the next without the trust being subject to estate and generation skipping taxes. And depending on where it's located, a properly structured dynasty trust can last in perpetuity, making it an ideal choice for families who want to build a long-lasting, tax-efficient legacy.

Let's explore some features of dynasty trusts and four key considerations when putting one in place. 

The main feature of a dynasty trust is its ability to avoid estate and generation-skipping taxes each time wealth is transferred from one generation to the next. In turn, assets in the trust are allowed to stay invested with the potential to accumulate additional wealth for each successive generation.

Consider the case of a wealthy grantor who wants to use her lifetime gift and generation-skipping exclusions to transfer $13 million to her child. If she transfers those assets to a dynasty trust before 2026, the estate will not owe transfer taxes on that money (though the child will owe income tax on distributions received from the trust). As shown below, those tax savings can add up meaningfully over time, adding potentially hundreds of millions to the estate by the time the fourth generation comes of age.  

Another feature of a properly drafted dynasty trust is the protection of the assets from a beneficiary's creditors. Since ownership of the assets transfers to the trust, creditors cannot use those assets to repay debts or settle a claim. Similarly, the trust's assets may be shielded from a beneficiary's ex-spouse in the event of divorce. 

A dynasty trust is a sophisticated legal vehicle that must be properly drafted to get the most benefit. Here are four decisions to consider before meeting with a qualified estate-planning attorney:

1. Where the trust is sited: The state in which your trust is established (sited) is critical for two reasons:

   a. Some states limit how long a trust can last, so you'll want to site your trust in a state that allows trusts to exist in perpetuity—such as Alaska, Delaware, Illinois, Missouri, New Hampshire, Ohio, Rhode Island, and South Dakota—or for several hundred years, as is the case with Florida, Nevada, Tennessee, and Wyoming.

   b. Not all states tax income. For example, if you site your trust in Nevada, which does not have an income tax, there will be no state tax levied on any income produced by the trust's assets. Further, if your beneficiaries happen to be Nevada residents, they will not have to pay state income taxes on their distributions. 

   It's important to note that, generally, trust laws aren't dependent on where you live, but where the trustee lives. In fact, appointing a corporate trustee with a physical presence in a state with more advantageous trust laws, can allow you to utilize a different state's laws to better help accomplish your legacy goals.

2. Which assets you transfer to the trust: A dynasty trust can be funded with almost any type of asset or property, including cash, investments, real estate, business interests, and valuable personal property. Grantors looking to lower their taxable estate and slow its growth often elect to transfer assets with high growth potential or that produce significant income. By contrast, those more concerned with reducing income tax for their heirs tend to fund their dynasty trusts with cash or tax-efficient assets.
3. When you fund the trust: Funding a dynasty trust can be done in a single lump-sum gift or spread out over time. If a grantor chooses the latter approach, they can use their annual gift exclusion (currently, in 2024, $18,000 per donor to an unlimited number of recipients) to help minimize their gift tax cost or reduce the amount of the lifetime gift exemption used. For lump-sum gifts, the grantor must report them on their gift and generation-skipping tax return (Form 709) for the year in which the gifts were made.

4. How assets will be distributed: Most generational wealth is depleted by the third generation. To help extend the life of their legacy, a trust's grantor can set certain rules for how the trust funds may be used. For example, rather than giving beneficiaries full access to funds, grantors commonly limit distributions to funds used for the health, education, maintenance, and support of the beneficiaries.

   However, a grantor may add additional incentives, such as authorizing the trustee to make distributions each time a beneficiary is awarded a degree from an accredited institution for higher education. Or disallowing distributions if the beneficiary does not have full-time employment, with certain exceptions.

Given the complicated structure of a dynasty trust, it's best to choose a trustee with experience administering and managing them. Income-tax management, in particular, is important because taxes can eat into the overall performance of the assets. On top of managing and investing the trust assets in a tax-efficient manner—which may include tax-loss harvesting or selling tax-inefficient assets to purchase more tax-efficient ones—a trust company also makes sense due to the long time period of the fiduciary obligation.