A dynasty trust is a trust designed to hold assets for many generations. Most other trusts are designed so that the trust assets will be distributed to the beneficiaries at staggered ages (e.g., one-third at age 25, one-half of the balance at age 30, and the balance at age 35). A dynasty trust, on the other hand, is drafted to encourage the trustee to hold as much of the assets in trust for as long as possible. The beneficiaries are permitted to have some limited access to the trust property but they generally will not receive it outright. By keeping the funds in trust, it keeps the funds safe from estate taxes, creditors, and divorcing spouses.
To understand more than that barebones definition of a dynasty trust requires some understanding of a different aspect of trust law — the “Rule Against Perpetuities.” The Rule Against Perpetuities is one of the most storied rules in law — and the bane of law students because of its complexities. This centuries-old rule requires that every trust’s terms provide that the trust will terminate within a prescribed time frame. Given the goal of a dynasty trust to persist for a very long time, the Rule Against Perpetuities is a significant impediment. It is impossible to understand dynasty trusts without understanding the Rule Against Perpetuities.
Under the Rule Against Perpetuities, When must a Trust Terminate? The Rule Against Perpetuities directs that a trust must terminate by its terms within 21 years after the death of all of the trust beneficiaries who were alive when the trust was created. The common language of the rule is, “No interest is good unless it must vest, if at all, not later than twenty-one years after the death of some life in being at the creation of the interest.” So if a grandparent creates a trust in 2016 when the youngest beneficiary of the trust who is then alive is ten years old, and that grandchild then dies at age 90 in 2096, the trust will have to dissolve by 2117 — 21 years after the grandchild’s death.
The story of Wellington R. Burt is a recent example of the Rule Against Perpetuities. Wellington Burt made a fortune cutting and milling lumber and another mining iron, making him one of the eight wealthiest men in America. March 2, 1919, marked the end of his life — and the beginning of a countdown. For reasons that remain murky, Mr. Burt locked his estate away in a trust, leaving his children and grandchildren a relatively small yearly allowance (about the same amount he gave his cook). Per operation of the Rule Against Perpetuities, that trust has recently been dissolved — 92 years after its creation. Marion Stone Burt Lansill, the last living grandchild who was alive during Mr. Burt’s life, died on November 21, 1989. November 2010 therefore marked the expiration of 21 years after her death, allowing Mr. Burt’s great-great-great grandchildren to split with other family members a fortune that is valued at more than $100 million.
What is the purpose of the Rule Against Perpetuities? The Rule Against Perpetuities reflects a common law policy that a transferor should be allowed to tie up property for only as long as the life of anyone possibly known to the transferor plus the next generation’s minority (hence, lives in being plus twenty-one years). There are a couple of reasons behind this policy, including facilitating the alienability of property, helping to prevent uncertain title, and encouraging owners to make effective use of their property. In addition, keeping property locked away for too long can result in bizarre and often undesirable consequences as a result of unanticipated circumstances. By requiring that trusts must comply with the Rule directing the eventual termination of all trusts, the Rule Against Perpetuities effectively curbs the time during which property might be tied up in an undesirable arrangement. After all, forever is a long time.
What Exactly Does the Rule Against Perpetuities Have to Do with Dynasty Trusts? For estate tax purposes, it is rarely sufficient to plan for only one generation at a time. The potential estate taxes that a person’s child’s estate may face as a result of such inferior planning are easy to ignore when planning but very hard to swallow when paid out unnecessarily to the government. The purpose of a dynasty trust is to put money into trust for many generations, avoiding the payment of estate taxes when the money is passed from one generation to another. But if the Rule Against Perpetuities requires trusts to terminate within a certain timeframe, then it effectively makes dynasty trusts impossible to create.
Well, Then, Why Are We Even Talking about Dynasty Trusts If the Rule Against Perpetuities Makes it Impossible to Create a Dynasty Trust? True, the Rule Against Perpetuities does bar the creation of a Dynasty Trust — if that is the law of the state in which you are attempting to create the trust. However, in the mid-1990s, states began abolishing the Rule Against Perpetuities. In those states, a trust can continue forever. Now, many of the states have abolished the Rule Against Perpetuities completely or lengthened it so much that it is effectively abolished.
Why Have States Abolished the Rule Against Perpetuities? The Rule Against Perpetuities has long been maligned because it can yield unexpected and undesirable results. The story of the “unborn widow” illustrates this sort of problem. Consider Alexander, for example. Alexander was born in 1900 in abject poverty. Through hard work, great luck, and the occasional overlooking of law, though, Alexander had amassed a fortune. After retiring at age 59, Alexander finally got married. When his son Joshua was born in 1960, Alexander created a trust, instructing that it should go, “to the benefit of my son Joshua for life, then to benefit his widow for life, then outright to Joshua’s children.” Alexander died the next year. Fast-forward thirty-five years. Joshua met Ellen at a work happy hour and they got married. Ellen, born in 1965, never met her father-in-law (who had died before she was born), but she heard many stories about him from other family members, and so when they had a daughter in 1997 she was named Alexandra in memory of her grandfather. Sadly, a terrible accident claimed Joshua’s life the next year. Joshua was the only beneficiary who was alive when the trust was created and so the 21 year countdown by which the trust must terminate under the Rule Against Perpetuities started at the time of his death. The trust specifies that Ellen is entitled to the trust until her death. Because she was born in 1965, there is a good chance that she will live until 2025 and beyond — long after the expiration of the 21 years (which ends in 2019). That means that the trust will not vest in Rebecca within the time of allowed under the Rule Against Perpetuities. Consequently, the transfer to Joshua’s issue is invalid from the start.
Despite the unexpected problems that can arise from the Rule Against Perpetuities (the problem of the “unborn widow” being only one such), the Rule persisted for many centuries because the policy reasons for its existence outweighed the theoretical and perhaps infrequent problems that could arise. It is surprising, then, that the Rule Against Perpetuities was not eliminated as a result of careful scholarly thought and study by law committees. Instead, it was the result of federal changes in law, discussed below, which made very long-term trusts practicable. States quickly began competing to eliminate their Rules Against Perpetuities at the urging of local bankers who were anxious to manage the large sums which ultimately flowed into these dynasty trusts.
I Heard That Dynasty Trusts Were Especially Useful Right Now; Why Is That? This question requires just a bit of history to answer (but if you don’t care about the history, skip ahead to the last paragraph of this section). It is well known that many people have to pay estate taxes when they die. In fact, Congress has levied taxes on wealth transfers — transfers made at the time of death or by gift during lifetime — since the nineteenth century. Congress first levied a tax on inheritances to help fund the Civil War. It used the inheritance tax again in the 1890s to fund the war with Spain. During World War I, Congress levied a tax on estates and that tax has continued ever since.
The old saying is that death and taxes were the only certainties of life. But the estate tax was not actually always unavoidable. Well-heeled families were able to avoid the estate tax by giving an heir a life estate in some property rather than giving the heir the property outright. Because a life estate terminates at death, there is no estate tax due when a life tenant dies. This is because the estate tax applies only to a decedent’s transferable interests, and, after all, the life tenant has no interest to transfer if their interest terminated at death.
The successive-life-estates loophole was a clever and effective means of multi-generational wealth transfer without taxation. Consider, for example, Mrs. Smith. In 1950, Mrs. Smith created a trust for the benefit of her daughter for life, and then for the benefit of her grand-daughter for the grand-daughter’s life, with the remainder (i.e., whatever then still existed in the trust) outright to her great-grandchildren. Mrs. Smith had to pay estate tax on the value of her estate when she first created the trust (other than the small amount that was exempt from taxation in 1950), but more estate taxes would be due only when her great-grandchildren die — perhaps 100 years or more in the future.
This loophole ended in 1986 when Congress passed the Tax Reform Act. This law closed the successive-life-estates loophole by rewriting the Generation-Skipping Transfer (“GST”) tax (which was first created in 1976 but was so deeply flawed that it was entirely replaced in 1986). The GST tax is levied on any transfer to any person who is two or more generations below the transferor. The tax rate for transfers subject to the GST tax is 40%.
The GST tax is levied, however, only on transfers in excess of an amount set by Congress. When the Tax Reform Act was passed in 1986, Congress decided that the first $1 million of a person’s estate would be exempt from the GST tax. Therefore, each person was permitted to put as much as $1 million into a trust for the benefit of their grandchildren without paying GST taxes. And even better, the Tax Reform Act imposed a tax on funds going into a trust, but it did not limit how long the funds could remain in trust. Once in the trust, funds could pass from generation to generation, still without taxation, limited only by the Rule Against Perpetuities as enacted in the law of the state where the trust is sited.
And that is how the Tax Reform Act of 1986 made state laws regarding the Rule Against Perpetuities central to estate planning for larger estates.
But understanding the role of the Rule Against Perpetuities does not explain why dynasty trusts are so attractive right now. That is explained by the Economic Growth and Tax Relief Act of 2001, championed and signed by President George W. Bush. This law increased the amount of money that could pass to heirs without being subject to the federal estate tax in steps, ultimately raising the estate tax and GST tax exemption amounts to $3.5 million in 2009. However, as a legislative compromise, the law “sunsetted” at the end of 2009. For all of 2010, there was simply no federal estate tax at all; in 2011, the estate tax resumed and the exemption amount returned to $1 million, its pre-1991 level. Most lawyers and commentators assumed that Congress would pass a new bill before 2010, setting the estate tax exemption amount at about $3.5 or $4.0 million. That did not happen. Due to political pressures and bickering, a new law was not created until December 2010, when President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. That new law set the GST exemption amount at $5 million per person (or $10 million for married couples). Suddenly, dynasty trusts became enormously valuable.
Wait — How Exactly Did the Increase in the Gift Tax Exemption Amount Make Dynasty Trusts Enormously Valuable? Putting $10 million away for your children and grandchildren is a wonderful gift — but in fact that $10 million figure grossly understates the potential value of the gift. Dynasty trusts are typically designed so that little of the assets or income of the trust is distributed for the trust’s first five, ten, or twenty years (or more). The appreciation in the value of the trust during those years is exempt from gift or estate taxation for as long as the trust exists. A trust that starts with $10 million earning 8% interest will hold more than $22 million in ten years’ time (or, to put it in more accurate perspective, it will have the buying power that $16 million has today). And if the trust accumulates income without making distributions for twenty years, it will have nearly $30 million in buying power.