Next generation planning with dynasty trusts

What are dynasty trusts?

A dynasty trust is a long-term trust created to pass wealth from generation to generation without incurring transfer taxes, such as estate and gift taxes. They are often used by very wealthy families to take advantage of the generation-skipping tax exemption of $12.92 million (in 2023). In order to act as a dynasty trust, the trust must be kept "alive"—meaning withdrawals that heirs or beneficiaries take cannot be so large as to deplete the account. If the trust is not depleted by the beneficiaries, and state law does not otherwise limit the duration of the trust, then, at least theoretically, a dynasty trust could last forever.

What happens without a dynasty trust?

Federal tax laws enable a married couple to transfer up to $25.84 million (in 2023) in assets during life or at death free of federal gift or estate taxes and generation-skipping transfer (GST) taxes, since each spouse can make full use of their own $12.92 million federal gift and estate tax exclusion amount and GST tax exemption amount.1 In addition, these amounts are scheduled to increase each year for inflation until December 31, 2025, at which point the exclusion and exemption will drop back to 2017 amounts, indexed for inflation.

Let's assume that a couple leaves $25.84 million to their son, and that over time the inheritance grows to $30 million. At the son's death, the proceeds could potentially be subject to federal estate taxes in the son's estate. Under the current federal estate tax exclusion and applicable estate tax rate ($12.92 million and a rate of 40%, respectively), the son's estate could incur a federal estate tax liability that approximates $6.8 million.  This liability could be reduced, an possibly even eliminated with careful planning and the use of a dynasty trust.2

How a dynasty trust works

When assets are placed in a properly established dynasty trust, the assets and their appreciation should never be subject to federal estate taxes again. In addition, they may be exempt from the generation-skipping transfer tax—even though future generations stand to benefit from distributions received out of the trust.

Assets in a dynasty trust are held under the control of a trustee that the grantor designates. The trustee is responsible for managing the funds according to the terms set forth in the trust document. Given the multi-generational duration that is characteristic of a dynasty trust, an institutional trustee (e.g., a financial services company or bank) is generally best suited to perform that role.

Dynasty trusts and income tax

For income tax purposes, note that a dynasty trust can be set up as either a grantor trust or as a non-grantor trust. With a grantor trust, any taxes on the income generated by the trust are paid by the grantor on their own income tax return. A non-grantor trust represents a tax entity separate and distinct from the grantor(s) who establish it. As such, the income generated by the assets in the trust (if not distributed to beneficiaries) is taxable. The taxes due from the trust are calculated on IRS Form 1041. Any income distributed to a beneficiary is reported on the beneficiary's personal income tax return. Please note that under current federal tax law, trusts reach the highest income tax bracket at much lower income levels than individuals.

Limitations of dynasty trusts

While there may be some limitations, the grantor of a dynasty trust generally has a wide degree of latitude in specifying when funds are removed from the trust and by whom. On the other hand, grantors should know that beneficiaries will not have the flexibility to alter the terms of the trust—even if their family or financial circumstances change in the future—which is something to consider before setting up a dynasty trust.

Some states have adopted the "rule against perpetuities," which undermines the usefulness of dynasty trusts by limiting their duration. Your attorney can help you understand any applicable laws in your state.

1. Please note that although the exclusion amounts are currently the same dollar amount, the gift and estate tax exclusion and the GST tax exemption are two different exemptions. The GST tax is assessed on any transfers to anyone that is more than one generation removed from the grantor, and is in addition to any gift or estate taxes that may apply. 2. Note that current law provides that the federal applicable exclusion amount will increase each year for inflation. However, there could still be a substantial estate tax at the son's death if the value of the assets increases faster than the inflation-adjusted exclusion.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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