In the course of my practice, I often run into situations like this: Robert and his wife have a net worth of $20 million, of which $15 million is an interest in a family business. Their heirs include children, grandchildren and great-grandchildren. If upon the death of the surviving spouse they leave everything to their children outright, the family business and any unspent assets may again be exposed to estate taxation at their children’s demise. The assets will also be exposed to dilution if their children divorce.

Robert wants to protect his assets from successive estate taxation in multiple generations and the effect of a child’s divorce on his transmitted wealth. He would consider transferring stock in trust. However, Robert is not interested in surrendering control of the company at this point.

Robert and his wife should consider transferring stock in the company to a dynasty trust. In 2013, an individual may transfer up to $5.25 million ($10.5 million per married couple) without paying a federal gift tax or generation-skipping transfer tax (assuming no prior taxable gifts). If Robert transfers non-voting stock or ownership, he will not lose any control in running the company. The net effect is that so long as the stock remains in trust, it will not be exposed to estate tax in later generations and, assuming the trust is properly drafted, the trust assets will be free from the claims of creditors, including divorcing spouses of his children, grandchildren and great-grandchildren.

What is a dynasty trust?

A dynasty trust is an irrevocable trust that leverages a person’s federal estate, gift and generation-skipping transfer tax (together referred to as “transfer tax”) exemptions for as many generations as applicable state law permits. Dynasty trusts enable wealth to be passed from generation to generation while minimizing or avoiding transfer taxes. Distributions to beneficiaries are structured to be discretionary, meaning that assets retained in the trust may grow for an unlimited number of future generations.

The beneficiaries of a dynasty trust are usually the grantor’s children, grandchildren and great-grandchildren. The trust’s operation is controlled by the trustee, who is initially appointed by the grantor. The dynasty trust is irrevocable, which means that once it is funded, the grantor will not have any control over the assets and will not be permitted to amend the trust terms.

Why create a dynasty trust?

Clients often create dynasty trusts to achieve a broad spectrum of personal, financial and tax goals:

• Benefiting many successive generations of family.

• Benefiting family members while preserving family values.

• Protecting trust assets from creditors. (Asset protection laws vary based upon governing federal and state law. The applicability of such laws also depends on the terms of the trust.)

• Protecting trust assets from divorcing spouses.

• Avoiding multiple levels of federal and state estate, gift and/or generation-skipping transfer taxes.

How dynasty trusts work

Dynasty trusts are usually established to last for an indefinite period and are normally funded with gifts. There is a practical limit on the amount that may be gifted without paying federal gift tax. Assuming no prior taxable gifts, each individual may make a lifetime gift of up to $5.25 million and incur no gift tax or generation-skipping transfer tax. A married couple may transfer up to $10.5 million. This amount is indexed for inflation and will increase each year. Taxable gifts will reduce the estate tax exemption available at death.

With family enterprises, additional leverage for the transaction may be achieved through the use of discounted values for transfer tax purposes. This is a reduction of the value of assets to be transferred, which serves to reduce the amount of the taxable gift. (Use of discounts, though legitimate where appropriate, is often the subject of IRS scrutiny. Valuation should be determined by a qualified appraiser. It is important to confer with your tax and legal advisers regarding the use of this technique.)

• The common approach is to restructure the ownership of a company to include both voting ownership and non-voting ownership. In a corporation this involves the recapitalization of the stock. In a limited liability company, it involves a change to the operating agreement.

• The non-voting ownership may then be gifted to the dynasty trust.

• The non-controlling or non-voting membership interests are often eligible for a reduced value from the standalone fair market value. This reduction is ordinarily 20% to 40% of the standalone value of the company’s assets. These reductions, or “discounts,” are attributable to a lack of a market for the interests transferred, and to the fact that there is no ability to control the outcome of (or vote on) company matters.

For maximum creditor and divorce protection, an independent trustee is used to make discretionary distributions and other tax-sensitive decisions. The primary beneficiary (usually the grantor’s children initially) can be given the power to remove and replace the independent trustee with or without cause. Additionally, the primary beneficiary can be the investment trustee of the discretionary dynasty trust and thus can make investment decisions over trust assets. This co-trusteeship, although more complex than having just one trustee, provides a greater combination of control, estate tax savings and creditor protection. When assets are owned by a dynasty trust, undistributed trust assets are protected from transfer taxes in future generations. Additionally, many dynasty trusts offer creditor protection as relating to the beneficiary’s creditors, including divorcing spouses.

Economic results of a powerful estate planning tool

Estate tax savings can be substantial with the use of dynasty trusts. Consider Robert’s situation. If Robert’s company is worth $15 million, and the value of the business appreciates at the rate of 7.2% per annum, that business will be worth $30 million in ten years. Using the techniques described above, Robert would restructure his company ownership to include both voting (1%) and non-voting (99%) interests. He would transfer only non-voting interests to the dynasty trust. A qualified appraiser advises the value of the non-voting interests is $10 million, for purposes of the transfer.

Without incurring any gift tax or generation-skipping transfer tax, Robert could transfer 99% of his company to the trust using his and his wife’s exemptions. As long as the stock stays in the trust, there would be no estate taxation on the future appreciation. With the current federal estate tax rate at 40%, the saving is self-evident.

Despite these benefits, it is important to recognize that assets in an irrevocable trust will not receive a step-up in basis upon the death of the grantor. Additionally, thought must be given to the annual income tax implications associated with the trust.

How to create a dynasty trust

Here are five tips for the successful planning of a dynasty trust (or any trust) and the issues typically involved:

1. Work with professionals. A financial adviser with specific expertise in estate planning, working in concert with an estate planning attorney, a tax adviser and, often, a valuation expert provides the necessary expertise to navigate a dynasty trust. A knowledgeable attorney, who understands the grantor’s situation, can also craft the appropriate discretionary clauses. Discretionary distributions can be conditioned on each beneficiary’s ability to support himself or herself. With so many options, dynasty trusts can be tailored to the client’s wishes.

2. When choosing your financial advisers, ask whether they deal with high-net-worth clients. Also ask about the types of fees you should expect to pay.

3. Be sure you understand how distributions will be made to your heirs.

4. Work with your adviser to carefully select the initial trustees and to determine the mechanism to select successor trustees. For instance, should your child be a trustee or co-trustee?

5. Determine how long you want your trusts to last; how you will fund the trusts; and if you will fund them during your lifetime, at death or both.

The friendliest ‘bank’

You can fund a dynasty trust with cash, stock or other assets, such as life insurance. Over time these assets may be converted to cash or cash equivalents such as marketable securities. Life insurance is often an excellent way to leverage the value of the assets to provide additional value. The dynasty trust may then serve as a “family bank” for future generations. The dynasty trust shares with a true bank the goals of accumulating, managing, preserving and distributing wealth. It can be a prime resource for funding family members’ financial needs for successive generations. Though a dynasty trust is not actually a bank, it could become the friendliest “bank” the trust beneficiaries might ever know.

A properly drafted, funded and operated dynasty trust can be a powerful and tax-efficient tool for helping to realize a family’s financial objectives. It can be especially appropriate for helping to preserve a family enterprise.

Quentin Sturm, J.D./CPA, is managing director at Creative Financial Group, a financial services firm in Newtown Square, Pa. (www.creativefinancialgroup.com). Creative Financial Group is a general agency of New England Life Insurance Company.

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