Life insurance is an option for dynasty trusts

By Alan C. Brown, Eric N. Mann

Until the 1980s, American trusts could last only about 100 years. Then, many states repealed their laws that limited the duration of trusts. This new style of trust, often called a “dynasty trust” to reflect its unlimited duration, has largely taken over trust planning.

This trust planning reached its peak during the last few months of 2012, when families and professional advisers scrambled to lock in federal gift tax exemptions of $5.12 million because the maximum exemption was set to drop to $1 million after Dec. 31, 2012. Many old trusts with limited duration were raided of their assets to create new dynasty trusts. In some cases, we saw entire families participating in the process and cumulatively transferring more than $40 million to new dynasty trusts.

Now that this fire drill has ended and exemptions have been legislatively locked in at $5.25 million (adjusted upward annually for inflation), many families and family offices face a big question: How should these gifted assets be invested on an ongoing basis to ensure that assets are available for future generations?

Fiduciary duties have not changed

A trustee owes the highest fiduciary duty known in American law to the beneficiaries of the trust. State courts have raised the standard of care required for trustees higher than any other fiduciary relationship, owing in part to the power held by the trustee to affect the financial well-being of the current and remainder beneficiaries.

A trustee has a duty to deal impartially with all beneficiaries and to protect their interests equally. That duty is owed not just to the current beneficiaries, but also to all beneficiaries of the trust throughout the duration of the trust.

The duty of impartiality must be considered when the trustee invests trust assets. The trustee must weigh each investment in light of the purposes, terms, distribution requirements and other circumstances of the trust. This duty also requires that the trustee monitor all trust investments, even if the trust agreement authorizes the retention of particular assets.

Investing should change

Although dynasty trusts may last for as long as there is an American legal system, we do not anticipate trustees quickly responding to the unlimited duration of these trusts. The investments of a 100-year trust should look different from the investments of a dynasty trust: While a 100-year trust involves two generations of beneficiaries, a dynasty trust involves multiple generations of beneficiaries. We often see trustees focused more on meeting the financial needs of the current beneficiaries (the first generation, or G1) than the future needs of the children or grandchildren of the current beneficiaries (the second and third generations, or G2 and G3).

Given the unlimited duration of dynasty trusts, trustees should factor in G2 and G3’s likely needs 25 years and 50 years from now. A trustee’s duty of impartiality precludes the trustee from favoring one party over another. Recalibrating a trustee’s investment perspective is essential to discharging a trustee’s duty of impartiality.

Income tax rates have changed

Many of the trusts created at the end of 2012 were set up as “grantor trusts,” in which all items of income, deduction and credit will be reportable on the grantor’s individual income tax returns. However, as these trusts lose their grantor status as a result of the death of the grantors or otherwise, these trusts will become separate taxpayers, and trustees will have to be more attentive to the tax consequences of trust investments.

The federal income tax burden on trusts will increase significantly for 2013. For example, the highest tax bracket will increase from 35% to 39.6%. In addition, for tax years beginning in 2013, a special 3.8% surtax will be charged on the lesser of either (1) net investment income (for example, interest and dividend income) or (2) the excess of modified adjusted gross income. The threshold amount for this special 3.8% surtax for trusts is only $11,950. But for individuals filing joint income tax returns, the threshold amount for the 3.8% percent surtax is $250,000. The difference in these threshold amounts creates an opportunity to maximize tax savings among a trust and its beneficiaries.

Generally trustees of non-grantor trusts have the ability to determine whether the trust or the beneficiary pays the income tax on trust earnings. If the trustee retains income earned during the year, the trustee will be responsible for the payment of the income tax. If the trustee distributes income to the beneficiary, the beneficiary reports the income and the trust receives a corresponding deduction. Since a trust reaches the highest tax bracket at a much lower amount of income than an individual does, distributing income to a beneficiary generally results in lower taxes.

A trustee faces a difficult choice in determining whether the trust or the current beneficiary gets the income, since the trustee owes duties to both current and future beneficiaries throughout the duration of the trust. While distributing income to a beneficiary may reduce taxes, it also will reduce the investible assets available for future generations.

Life insurance as a multi-generational investment

Investment advisers for years have recommended that clients build a diversified portfolio of assets to protect against market fluctuations; however, these portfolios are not designed to support the needs of future generations. Advisers should consider lengthening the investment horizon for a portion of the portfolio to reflect the need for long-term performance that benefits multiple generations.

The tax aspects and flexibility of life insurance work well in the new environment of dynasty trusts. Tax is deferred on the growth in cash value of a life insurance policy, and the death benefit paid upon the death of the insured is not subject to federal and state income tax.

If properly structured, life insurance owned by a dynasty trust is not subject to the federal estate tax or the generation-skipping transfer tax. In addition, the trustee as policyholder has the ability to access cash value without income tax consequences through withdrawals of basis and policy loans. This flexibility to determine the timing of benefits without forfeiting the favorable income tax characteristics enhances the value of life insurance as a multi-generational investment.

Using a Series LLC

The trustees of new dynasty trusts should consider consolidating their investments into a single business structure such as a limited liability company with separate divisions, called a Series LLC. Having separate divisions protects the assets of one division from the liabilities of another division. A tax professional should review the tax consequences of contributing the trust’s assets to ensure that the formation of the LLC is tax neutral.

The trustees and advisers should identify how the assets of each division should be invested. Having separate divisions allows the dynasty trusts of different family members to participate in multiple asset classes in different amounts.

One of the divisions of the LLC should be dedicated to life insurance investments. The trustees and investment advisers of dynasty trusts should work with an experienced agent to assemble a portfolio of life insurance policies that will:

• Establish a new asset class for investment diversification.

• Insure multiple lives for diversification within the asset class.

• Provide superior tax planning both during the life and at the death of each insured.

• Provide liquidity after the death of each insured.

• Ensure that trust assets are available for the next -generation.

• Fulfill the trustee’s fiduciary obligation to provide for future generations of beneficiaries.

When multiple family members in each generation are insured, tax-free funds will become available for younger generations as senior-generation members pass away. The policies on the lives of the younger members remain in the portfolio for future generations.

Win-win strategy

The use of life insurance on multiple family members creates a long-lasting retirement fund for the family and allows the trustees to discharge their duty of impartiality to all current and future beneficiaries. G2 and G3 will be satisfied knowing that a small portion of the LLC’s portfolio is dedicated to assets that will mature when members of G1 pass away, replenishing the family coffers with tax-free cash that is creditor-protected. G1 will have an asset that can be drawn upon in a tax-efficient manner, if necessary. It’s a win-win situation for all the fiduciaries and beneficiaries involved. As the youngest members become old enough, the trustee can insure their lives, and the cycle can continue for the duration of the trust.

Dynasty trusts are intended to last into perpetuity. A simple shift in investment strategies, adding life insurance on the lives of all family members, will ensure that funds are available for future generations.

Alan C. Brown and Eric N. Mann are partners in the Private Wealth Services and Family Office Practice Group of the law firm Neal, Gerber & Eisenberg LLP (Chicago). They may be reached respectively at and









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September/October 2013