Dynasty trust: Planning for future generations

For families with significant wealth, an important part of legacy planning is ensuring an effective and tax-efficient transfer of wealth to children, grandchildren and subsequent generations.

Trusts are a primary vehicle for transferring wealth, but not all types of trusts last for as long as you might prefer them to. A dynasty trust, which can last for multiple generations and provide key tax benefits, is often an appealing option.

What is a dynasty trust?

A dynasty trust, sometimes called a legacy trust, is a type of irrevocable trust that facilitates the transfer of wealth to future generations while minimizing taxes. These trusts have traditionally been used by high net worth individuals and families to pass wealth to future generations without incurring estate taxes or generation-skipping transfer (GST) taxes.

“Dynasty trusts can be an effective tool for high net worth families to transfer assets to succeeding generations in the most tax-efficient manner,” says Justin Flach, managing director of wealth strategy for Ascent Private Capital Management of U.S. Bank.

Dynasty trusts enable long-term wealth growth for multiple generations that’s undiminished by estate and gift taxes, potentially resulting in decades of compounding returns for future beneficiaries.

One note: A dynasty trust is similar to a bloodline trust but with one key difference: A bloodline trust restricts beneficial interest in the trust to those who are blood relatives of the grantor. “In other words, it excludes spouses, partners and stepchildren,” says Flach.

Dynasty trust pros and cons

As with any financial vehicle, dynasty trusts offer upsides and downsides. It’s important to consider this type of irrevocable trust in the context of your overall legacy plan and tax strategy.

Benefits of a dynasty trust

• Dynasty trusts can minimize tax on assets. The top estate tax rate is currently 40%, and the GST tax applies when passing assets to grandchildren or later generations, instead of children. “By placing assets in a dynasty trust, families can avoid estate and GST taxes as long as the assets remain in the trust,” says Flach. “This can be a huge long-term benefit.”
• Dynasty trusts offer creditor protection. Assets held in a dynasty trust typically cannot be reached by creditors, because the assets belong to the trust, not the beneficiaries. This means family wealth is safeguarded from legal challenges. “This includes not just third-party creditors, but also matrimonial claims in some instances,” says Flach.
• Dynasty trusts preserve wealth and maximize compounding. A dynasty trust facilitates the continuation of wealth over multiple generations. “Earnings can be reinvested to generate more earnings, which permits many years of compounding to potentially increase the value of assets,” says Flach.
• Dynasty trusts give you control over the disbursement of assets. The grantor of the trust determines how, when and to whom assets are disbursed in the future. This helps prevent potential mismanagement of wealth by heirs, especially if they lack financial sophistication.

Risks of a dynasty trust

• Dynasty trust income is subject to tax. Therefore, it might make sense to place non-income-generating assets in the trust, such as growth stocks, life insurance and tax-exempt real estate and bonds. Additionally, establishing a dynasty trust in a state with low or no income tax can help to maximize the long-term growth of the trust assets.
• Dynasty trusts don’t receive a step-up in basis for inherited assets. “This means if they are sold by future generations, the basis will be very low, which could result in a large income tax liability for heirs,” says Flach. He recommends choosing assets that offer high appreciation potential and are intended to remain in the trust for the long term.
• Dynasty trusts are irrevocable. A grantor cannot revoke or amend the trust once assets are placed in it.

Which states allow dynasty trusts?

The laws governing dynasty trusts vary from state to state, with some states prohibiting them outright and others limiting the number of years a trust can operate.

“You want to establish a dynasty trust in a state that allows trusts to exist in perpetuity or for a very long time,” says Flach. “Also, choose a state with strong asset protection laws and one that does not levy state income tax on trust assets.”

Several states are commonly recognized as the best states for establishing a trust situs, including South Dakota, Nevada and Delaware. You don’t have to live in one of these states to establish a dynasty trust situs there, but you do need an in-state trustee. This trustee can be a financial institution with an office in your chosen state and that can meet the legal requirements for trusts sitused in that state.

Dynasty trusts: Is this type of trust right for you?

A dynasty trust cannot be easily changed if circumstances or needs change, which stands in contrast to a revocable trust, such as a living trust, which can be changed or revoked. Therefore, when comparing a dynasty trust vs living trusts or other options, you need to be reasonably sure that you won’t need access to assets held in a dynasty trust during your lifetime.

Flach also notes that dynasty trusts usually aren’t created unless there’s a significant amount of wealth involved.

Some families are concerned about the potential impact on future beneficiaries of decisions they make while establishing a dynasty trust. However, you can structure a trust to specify that beneficiaries meet desired incentives or achieve certain goals before assets are distributed, such as graduating from college or building a career.

A dynasty trust is just one of many tools that high net worth families can use to accomplish their estate planning goals. “Families should carefully evaluate the pros and cons of a dynasty trust in light of their goals and circumstances to determine if it’s the right tool for them,” says Flach.

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