United States: Tax Advice For The Well-Heeled, The Idle Rich, And The Vastly Over-Compensated

In the grand tradition of the Tax Geek’s rabid, tire-biting attack on offshore asset protection trusts, we now tackle another trend du jour: dynasty trusts. This idea’s been around a long time but has picked up that trendy marketing-driven monicker.

Park your fortune in this special trust for the benefit of your kids, your grandkids, your great-grandchildren, and generations yet unknown. You, of course, have an iron will. But maybe the weaker junior members of your bloodline (gene pool invariably diluted by those pesky but necessary spouses) need protection from themselves, from the assorted outlaw and in-laws, predators and creditors. Soon your trust has more money than there is money. Your spawn will Rule the World. Ahahahahaha! Fund that trust and roll out the begats.

Uncle Sam’s a member of your family. Really. Blood relative. In your will and everything. Every time your family fortune passes to a younger generation, Uncle Sam is there for half. Everyone else gets to split the half Uncle Sam leaves behind. But what if you can disinherit Sam? What if the younger generation can take spend the fortune if they want but never pay that 50% to Uncle Sam first?

Estate taxes are the single biggest impediment to accumulating wealth over the Really Long Run. So let’s avoid estate taxes and keep the fortune growing.

That’s the lure of the Dynasty Trust. You create what amounts to a family bank. Your beneficiaries pull out cash if they need it (voracious greed restrained by cruel bank trustees, usually). But the bulk of the money stays in the trust, generation after generation, growing free of those 50% amputations Uncle Sam periodically administers.

As long as stuff stays in the trust, it goes on to help all of the beneficiaries you name, with no estate taxes forever. Imagine the investment results when you don’t lose half of your principal to estate taxes every 30 years!

You have $10M to go to your kid. You die. Pay half in estate tax and the kid ends up with $5M. Your kid dies with the $5M in his pocket, leaving everything to his kid (your grandchild). Uncle Sam takes another 50% and your grandchild has $2.5M.

Until 1986 you’d cheat the taxman (scratch that phrase!) by giving the entire $10M to your grandchild in your will. So you pay the 50% tax. At least the grandkid ends up with $5M. To pointy-headed tax lawyers, that’s a generation skipping transfer: your will skipped over your child and gave everything to your grandchild.

It was too good a deal for the savvy taxpayer, and Uncle Sam was losing money. In 1986 the rules changed. The IRS said, "Sure, make a generation skipping transfer. But we have this here brand new tax: the generation skipping transfer tax." A loophole for the Bloated Plutocrat is closed. Everyone cheers.

But they left an exemption. You can give your grandchild $1M and not pay this new tax. And it’s here where we work, making that $1M into the Vast Fortune of Wealth Rivaling that of Louis XIV. In 120 years.

We’ve inherited an ancient rule of law from Elizabethan England. Still applies to trusts, 500 years later. Yup, even in Los Angeles next Friday.

It's the Rule Against Perpetuities. For a variety of reasons, most related to the government fisc, the Queen didn't like trusts that existed in perpetuity.

This rule put an outside limit on how long a trust can exist. Arcane doesn't begin to describe the rule. It's a favorite of law professors and bar examinations. (That tells you how relevant it is to the real world.) But as a practical matter it means that any normal trust created today must be terminated in about 90-100 years.

Pretty good. Even with the Rule Against Perpetuities you can escape estate tax for 2 or 3 generations. But then the game’s over and all of the assets are decanted to the heirs, and Uncle Sam starts taking his half again.

So there’s your lawyer’s secret. That's all there is to it. Take your everyday run of the mill trust (not quite—see below) and remove the Rule Against Perpetuities provision. Then park the trust in a jurisdiction where the Rule Against Perpetuities has been abolished. In the USA, that means South Dakota, Delaware, some other states.

Or set up your dynasty trust offshore in the Bahamas, British Virgin Islands, Cayman Islands, or other tax heavens, ummm…havens. Offshore is far better if you’re thinking about the Really, Really Long Run. You want your wealth to be a bit more, shall we say, mobile.

It isn’t quite THAT simple for an obvious, common-sense reason. You really do need a pointy-headed tax lawyer to do a dynasty trust right. Trusts are usually pretty rigid: they say what’s going to happen and leave no wiggle room. And that’s fine until you realize this thing’s going to be in place 400 years from now. You WANT some wiggle room. Who knows what the world will be like then?

Think of it this way. Where was the world, the economy, investments, money, politics, etc. in 1600? OK. Now make a guess about what the world will be like in 2400 and bet all your money on your guess. Can you create a trust that will operate then? How will it invest? Who are the heirs? What if money doesn’t exist anymore?

True story. The Tax Geek went to one of the many, many tax seminars he attends about two months ago. On just this topic: trusts that last (maybe) forever. Maybe 100 lawyers in attendance. On a lark, one speaker asked how many of us created these beasts. About six of us raised our hands. (Yes, the Tax Geek is one of the guilty). But that informal poll told me a lot: there's a lot of noise but maybe not many of these trusts being created.

And I think that’s right. When I talk to clients about this, here's the response: they love their kids and their grandkids. But beyond that? Who thinks that far? And they might just need the money in their old age, so they want to hang onto it.

Who uses dynasty trusts? I find that people with perhaps $10M of liquid assets and up are decent candidates. My "dynasty" trusts are usually concerned with a 100 year or so horizon: enough to cover great-grandchildren. At least you have a good shot at knowing the parents of those beneficiaries!

The Tax Geek says put your thoughts of an immortal bloodline in your pocket for a moment. The economics of the dynasty trust are compelling, if you’re thinking about making an unborn great grandchild extremely wealthy. But don’t try to make some one rich in the year 2299. After all, what has posterity ever done for you?

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