Beyond Estate Planning: Incentive And Dynasty Trusts

A dynasty trust is usually created with its situs in a jurisdiction that has either repealed the rule against perpetuities (RAP) or has extended it for a period of time beyond 100 years. Having a trust's situs in such a state would allow the trust to continue to exist with no discernable end date. For states that have retained the RAP, the duration of a trust is limited to the common law time period, which is usually "the time period encompassing the lives in being at the time of creation of the trust, plus 21 years." A dynasty trust can be created in a state that has retained the RAP with the trust continuing in existence for as many generations as the time period under the RAP would allow, and then terminating at the end of that period.

In the context of life insurance, if the insured had no incidents of ownership in the life insurance policy at any time within 3 years prior to his or her death, the policy proceeds will not be included in the insured's taxable estate. To assure that the life insurance policy is excluded from the grantor's estate, the original policy applicant should be a third party, such as a dynasty trust. The grantor then gifts the premiums to the third-party owner when they are due.

The trustee can make distributions to the trust's beneficiaries based upon the trust's provisions. To maximize the value of the trust, the trustee may purchase a life insurance policy on the grantors and use trust assets to pay premiums. The tax-free death benefit proceeds that would be received upon the deaths of the grantors would further magnify the value of the trust's assets. (See example 1 in chart.)

A dynasty trust offers an effective way to both maintain and retain wealth within a family for generations of beneficiaries, especially if there are beneficiaries who are minors or who lack investment management skills. When life insurance is used, the value of the family legacy can be further magnified on a tax-free basis. This technique may also provide creditor protection in certain states. And the trust can incorporate spendthrift provisions to guard against irresponsible spending.

Finally, grantors often include certain incentive provisions in the trust document to reflect their own values and ultimate wishes for beneficiaries. Incorporating such provisions can help influence the behavior of beneficiaries and guard against negative lifestyle choices.

Intentionally defective grantor trusts

Attorneys will often design dynasty trusts to be of a type called "intentionally defective grantor trusts." The trust is intentionally defective because the grantor has retained one or more certain ownership rights in the trust. This irrevocable trust is considered a separate entity for gift and estate tax purposes. Thus, assets in the trust will still be excluded from the grantor's estate for estate tax purposes.

However, due to the retained ownership rights, the grantor and the trust are considered the same entity for income tax purposes. As a result, the grantor is taxed on any trust income and the trust avoids trust income tax liability. If the grantor pays any trust income tax liability, the trust retains more of its assets and the trust value can increase faster.

Drafting an intentionally-defective trust also allows for more flexibility in dealing with the trust assets. For instance, since the trust is not a separate entity for income tax purposes, a sale by the grantor of assets to the trust will not be a tax recognition event for the grantor.

The need for informed legacy planning is growing. Dynasty and incentive trusts provide opportunities for clients to carefully plan out their legacies and the lasting mark they will leave on the world.