Ask the Taxman by Andy Biebl

Do I Need a Dynasty Trust?

Dynasty trusts are best used by high net worth individuals to postpone estate taxes for only a generation or two, but can last forever.

DTN Tax Columnist Andy Biebl is a CPA and tax partner with the accounting firm of CliftonLarsonAllen LLP in Minneapolis, Minn., and a national authority on agricultural taxation. To pose questions for upcoming columns, email AskAndy@dtn.com.

QUESTION:

We are in the process of doing estate planning. We are in our mid-60s and have two sons who are married. We are residents of South Dakota and our assets are worth approximately $8 million, with the farm land about $5 million of that total. Our attorney is proposing a Revocable Trust for each of us, but is also proposing a Dynasty Trust provision in the Revocable Trust. This is explained to us as protection for our children from creditors, particularly from a divorcing spouse.

I understand a third party must be involved as a trustee, but it seems it could really handcuff our children. What are your thoughts regarding a Dynasty Trust and when it should be used? Is there anything else we should consider to protect the land other than a Dynasty Trust?

P[L1] D[0x0] M[300x250] OOP[F] ADUNIT[] T[]

ANSWER

Years ago, various states had statutes that prevented a trust from extending through multiple generations. This was known as the "rule against perpetuities" and it was designed to prevent the wealthy from tying up assets in trusts that continued through many generations of their heirs. But those rules have been reversed in many states; a Dynasty Trust is one of the results.

The key feature of the Dynasty Trust is its ability to skip a generation or more with respect to distributing the assets to your heirs. If properly structured, it can avoid the estate tax on those assets to your heirs for one or more generations, assuming a willingness to "lock up" the assets for a long-term timeframe.

The best application for a Dynasty Trust is for those with high net worth who want to bypass the estates of their children and essentially skip a generation or two before the wealth comes out and is again exposed to another round of estate tax. But your question indicates a net worth of $8 million, which is less than a married couple's combined estate exemptions of $10.5 million. Your estates, as well as each of your sons, should be clear of the federal estate tax.

The negative, as you have identified, is that your sons are restricted from direct access to the assets within the Dynasty Trust. This Trust would come into existence at the second of your deaths, and essentially holds the land without distributing it to your sons. It does provide creditor protection, so you need to weigh protecting from that risk against the "handcuffing" of your sons.

The trust income will be taxed each year, whether it is taxed to the trust or to the beneficiaries (your sons or their heirs). If trust income is retained, beware of the high trust income tax rates. Essentially any undistributed income retained by the trust above about $12,000 per year is taxed at the top bracket. The annual income distributions can be flexible ("discretionary" in trust lingo), but in that case you should use an independent trustee, not a family member or beneficiary as trustee. In addition to the detrimental income tax rates, trusts are also prohibited from claiming the Section 179 first-year depreciation deduction; this could be important if the trust is ever going to purchase depreciable equipment.

If the primary objective for the Dynasty Trust is to hold the land together and protect against either son selling it or losing it to a creditor or ex-spouse (rather than estate tax "skipping"), you may wish to consider a Family Limited Partnership or other limited liability entity.

These FLP entities are taxed like a partnership, and have much more flexibility for the children. But the partnership agreement can effectively force them to hold the land together. The document can be drafted in a way that makes it hard for creditors to get much more than the annual share of the rent of any partner. Also, the document can contain lengthy buy-out terms that effectively are a disincentive to an heir who wants to cash out. And yet, if one of the sons or their family members want to operate the land, the agreement can assure that the family member has the first access under reasonable rental rates. In addition, the existence of the partnership with its restrictive terms in favor of family successorship will cause some discounting of the value within your estate and that of your sons, so as to further minimize the risk of any federal estate tax. Finally, because the net income all passes through to individual returns of the partners, there are no detrimental income tax rates or Section 179 rules.

EDITOR'S NOTE: For more articles on estate and succession planning go to the Senior Partners series at InDepth http://www.dtn.com/…

(MZT/CZ)

P[] D[728x170] M[320x75] OOP[F] ADUNIT[] T[]
P[L2] D[728x90] M[320x50] OOP[F] ADUNIT[] T[]