Dynasty Trusts Under Delaware LawMarch 2013
This Insights discusses the transfer tax benefits of dynasty trusts under Delaware law. It also includes funding and investment management strategies to consider.
When considering how best to pass on your wealth to future generations, there is one exemption in the transfer tax law that merits close attention: the lifetime exclusion amount. In 2013, the lifetime exclusion allows you to gift up to $5.25 million, as indexed for inflation, during your lifetime ($10.5 million if you are married and gift-splitting is elected) without incurring either a gift or generation-skipping transfer (GST) tax—a flat tax imposed on property transferred to grandchildren or more remote descendants.
By placing up to $5.25 million in a generation-skipping trust—also referred to as a dynasty trust—you can maximize this exemption because a dynasty trust’s assets, including any appreciation and accumulated income, can pass from one generation to the next, in perpetuity, free from GST and estate taxes. This means dynasty trusts can benefit multiple generations significantly more than outright gifts.
An Overview of Current Transfer Tax Laws
There are three different transfer taxes to consider when establishing and funding a dynasty trust.
Gift tax is imposed upon the value of gifts made during the giver’s lifetime, in excess of the current $5.25 million lifetime exclusion. This is somewhat mitigated by the annual gift tax exclusion which currently allows you to give annual gifts of up to $14,000 (or $28,000 if you are married and gift-splitting is elected) to each of your beneficiaries while you are alive, free of federal gift tax.
Estate tax is imposed upon the value of the assets you own at the time of your death. GST tax is imposed on the value of any assets passed on either to grandchildren or to more remote generations during your lifetime or at death.
GST tax is imposed in addition to gift or estate taxes.
THE BENEFITS OF A DYNASTY TRUST UNDER DELAWARE LAW
There are four primary benefits of creating a dynasty trust under Delaware law:
• While most states have a law that limits the length of time assets may remain in trust for the benefit of future generations, the state of Delaware allows trusts to continue indefinitely. This means that most types of assets in the trust can pass to descendants on a continuing basis without being subject to transfer taxes.
• Delaware law also provides that as long as there are no Delaware beneficiaries, there will be no Delaware income tax imposed on the trust income and capital gains tax realized in the trust.
• Because Delaware law waives the usual requirement that trusts be filed with a court, the confidentiality of a trust created outside your will is preserved. Similarly, trust accountings are not required to be filed with a court, resulting in lower costs in the administration of the trust.
• Under Delaware law, if you do not want beneficiaries to be informed for a period of time of their interests in a trust that you have created, you may provide such language under the trust agreement.
You can create a Delaware trust by naming a Delaware trustee, such as Fiduciary Trust International of Delaware.
CREATING A DYNASTY TRUST
Generally, you may create a trust at the time of your death or during your lifetime. There are advantages and disadvantages to both options. For example, while creating a dynasty trust at death allows you to enjoy the benefits of the assets during your lifetime, there are significant transfer tax advantages to creating the trust now. That’s because the $5.25 million you place in trust now may grow to be substantially more at the time of your death. If you select this option, both the $5.25 million placed in trust and the appreciation it enjoys during your lifetime, if any, are removed from your estate and thus are not subject to estate taxation.
This means that creating the trust while you are living would result in less total tax paid and more assets available to your heirs and beneficiaries.
STRATEGIES FOR FUNDING THE TRUST
Once you create the dynasty trust, careful consideration should be given to selecting the property you add to it and the timing of those additions.
Low Cost Basis Property
There are disadvantages to funding the trust with property that has a low tax cost basis. Doing so results in that property’s basis remaining low after the gift is made, and foregoing the opportunity for that property to acquire a new cost basis at death, equal to its then fair market value. Your legal and financial advisors should be consulted in selecting assets to maximize any valuation discount available to you, or to identify property that can be expected to appreciate.
If you do not fund the dynasty trust entirely in one year, consider minimizing transfer taxes by funding over several years. The current $14,000 (or $28,000) per year per beneficiary annual gift tax exclusion can be used to offset or supplement future gifts. In addition, the lifetime exemption is now indexed for inflation, which means that you can “top off” your gift by contributing the annual adjustment to the trust.
Under certain circumstances, it may be advisable to make taxable gifts during your lifetime. However, you must live at least three years after making a taxable gift in order for the gift tax you pay to escape estate taxation.
STRATEGIES FOR INVESTING THE TRUST
Because a dynasty trust is designed for multiple generations, the trust’s investment objective, presumably, would be long-term growth. The appropriate level of growth to seek (and the accompanying level of risk) depends largely on how this trust fits into your family’s total financial picture. If the trust represents a relatively small portion of your family’s future wealth, growth objectives can be set fairly aggressively. If, however, the trust represents a more substantial portion, a more conservative growth and risk profile might be appropriate.
Under Delaware law, trustees can invest in assets providing long-term growth, while at the same time, insuring that the income needs of current beneficiaries are fulfilled.
What’s more, under Delaware law, trustees can convert “income only” trusts to unitrust payout arrangements—without court involvement. That is, Delaware trustees can now elect to change the terms of a trust, upon consent of all beneficiaries, to pay out a specific percentage of trust assets (no less than 3% and no greater than 5%) to current income beneficiaries.
Another option under Delaware law to provide trustees with flexibility in defining the income of a trust is the power to adjust. This allows the trustees to increase or decrease the trust income by allocating principal to income, or vice versa, in amounts determined each year.
A good financial plan will take your family’s financial future into account—setting appropriate investment objectives and creating a plan to achieve those objectives
at a minimum level of risk.
A properly structured, funded and invested dynasty trust can be a powerful tool in achieving significant transfer tax savings across generations. Your lawyer or professional advisor is the best person to determine if it is an appropriate tool for your family. Your advisors should also be consulted in determining when to establish and how to structure the trust to achieve optimal transfer tax results.
This communication is intended to provide general information. The information and opinions stated herein are as of March 2013, unless otherwise indicated, and do not represent a complete analysis of every material fact. We undertake no obligation to update this information. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual tax or investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.
About the Author
Dorothy K. Scarlett
President, CEO and Trust Counsel Fiduciary Trust International of Delaware
Dorothy heads Fiduciary Trust International of Delaware and supervises all trust activities in connection with the administration of Delaware trusts for individual clients.
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