Growth of the American Aristocracy: Dynasty Trusts!

[Vympel]

Now you can have trusts which are tax-free for all your heirs - forever!

AMERICANS have always assumed that wealth comes and goes. A poor person can work hard, become rich and pass his money on to his children and grandchildren. But then, if those descendants do not manage it wisely, they may lose it. “Shirtsleeves to shirtsleeves in three generations,” the saying goes, and it conforms to our preference for meritocracy over aristocracy.

This assumption is now being undermined, however, through the increasing use of so-called dynasty trusts. These estate-planning instruments enable affluent people to provide their heirs with money and property largely free from taxes and immune to the claims of creditors. And rather than benefit only children and grandchildren, dynasty trusts provide for generations in perpetuity — truly creating an American aristocracy.

Congress is feeling pressure to deal with taxes on inherited wealth, which have fallen to zero this year thanks to lawmakers’ inaction. In the process, it should address the more pernicious problem of dynasty trusts.

This type of trust is new because until very recently most states had a “rule against perpetuities,” which limited the term of any family trust to about 90 years, after which time the family members would own the property outright. This rule derived from the idea that property is best controlled by the living.

In the mid-1990s, however, many states repealed the perpetuities rule, and now any wealthy American can set property aside for his heirs forever, simply by hiring a trustee from one of these states.

What caused state legislatures to abandon a rule that had existed since the late 1600s? Banking industry lobbyists persuaded them that it would be a lucrative move because it would bring business to their states. But it was Congress that set the stage nearly 25 years ago.

In 1986, Congress instituted the generation-skipping transfer tax. This closed a loophole in the estate tax by ensuring that property would be subject to tax as it passed through each generation, even if it would otherwise have avoided estate taxes because it was held in trust. (It prevented “generation skipping.”) However, in enacting this tax, Congress gave each taxpayer a $1 million exemption, which was raised over the years to $3.5 million.

Naturally, estate planners began to create trusts that could take advantage of the exemption, and avoid taxes for the term of the trust. The term, however, was limited by the rule against perpetuities.

Bankers then realized that if they could persuade their state legislatures to repeal that rule (as well as state income taxes on trusts), they could attract business. And in more than a dozen states the banking lobbyists were successful. The rule against perpetuities was repealed, and dynasty trusts — tax-exempt trusts that could benefit generation after generation of heirs — were born.

This did generate business. One study found that nearly $100 billion in trust funds moved to states that repealed their rule against perpetuities.

Dynasty trusts can grow much larger than the $3.5 million exemption amount would suggest. A couple can, for example, put $7 million (their two $3.5 million exemptions) into a life insurance policy owned by the trust. They apply their exemption at the start, and the trust is forever free from taxes — even when, after the death of the second spouse, the life insurance policy pays off at $100 million. Alternatively, a trust can use the $7 million as seed money for a profitable business that the trust then owns.

An ordinary trust dissipates as money is distributed to the beneficiaries. But a dynasty trust can avoid this by discouraging outright distributions and instead encouraging trustees to buy, for the use of the beneficiaries, things like houses, artwork, airplanes and even businesses. Because the trust retains ownership, the assets can pass tax-free and creditor-proof to the next generation.

Beneficiaries don’t pay taxes on the use of this property. In contrast, a worker whose employer provides housing or other benefits is taxed on those benefits.

But tax breaks are not the only special advantages that dynasty trusts provide. Even more troubling, they commonly include a “spendthrift clause,” which provides that trust assets cannot be reached by a beneficiary’s creditors. If a beneficiary causes a car accident, for example, the victim cannot be compensated with assets from the trust, even if they are the driver’s only resources. So beneficiaries are free to behave as recklessly as they like, knowing that their money is forever protected for themselves and their heirs.

Surprisingly, dynasty trusts can also be bad for the beneficiaries themselves. Many wealthy people agree with Andrew Carnegie and Warren Buffett that it is not in their children’s best interest for them to be given so much wealth that they don’t need to work. Dynasty trusts rob future parents of the ability to decide this for their children, because the ancestor creating the trust is the one who determines how much wealth each generation of his descendants will receive.

What can be done to eliminate these trusts? A state-level solution is unlikely, since all 50 states would need to act in unison. But Congress could fix the problem by limiting the generation-skipping-transfer exemption to trusts that last no longer than two generations. After that, beneficiaries of a trust should be subject to tax, like everyone else. Then America would not have to face the uncontrollable growth of a new aristocracy.

[Patrick Degan]

Oh, but that's asking for something very nasty down the line for this society if this shit is allowed to fester.

[KlavoHunter]

So, how much plutocratic gangrene can society survive?

[Master of Ossus]

I don't have time to do a point-by-point, but suffice it to say this article is bullshit.

The Rule Against Perpetuities has not been eliminated in any state, although all states have modified it to make it simpler for attorneys to write within and courts to apply. The Uniform Statutory Rule Against Perpetuities creates a 90-year period which limits deadhand control. The 90-year statutory period is actually shorter than most attorneys estimated people could receive with properly drafted instruments that followed the common law rule, although it's much easier for weaker and therefore presumably less expensive attorneys to draft within. The cy pres doctrine has been adopted by most states which also makes it dramatically easier for attorneys, and alleviates problems caused by bad lawyering.

As for the estate tax, I have no idea why people still think that's a big deal. It's a complete failure by the standards of both sides of the aisle. It doesn't effectively prevent dynasties (how many poor DuPonts do you know? Wanna know how many rich ones I've met?), and it's probably a net revenue loser (see also: House Report on Estate Tax, and Tax Foundation, and Douglas Bernheim).

As for the generation-skipping trust, it's true that this is a tax-saving device under certain circumstances, but it doesn't do anything at all when there is no estate tax. In practice, it operates in virtually the same manner as a whole life insurance policy but with the advantage that you don't have to be young in order for your heirs to get the full benefits and it eliminates some of the inflationary risks from your "beneficiaries."

The comparison between a trust and wages (or job benefits) is also extremely inapt. It's more like saying that children don't pay taxes when their parents feed and shelter them, or that a husband and wife can make infinite tax-free transfers between the two of them. The money in the trust has already been taxed, and probably has already been taxed at several levels before it enters the trust.

Finally, the claim about the operation of spendthrift trusts is total bullshit. Spendthrift provisions have all kinds of exceptions to them, including for tortfeasors, so the car accident victim would be able to attach the assets of the trust to their lawsuit (as would the US government, for instance, if the trust's beneficiary stopped paying his taxes or was fined).

PS. I notice that the article author's last name is Madoff. Clearly we should all trust his financial acumen.

[Jalinth]

I don't have time to do a point-by-point, but suffice it to say this article is bullshit.

The Rule Against Perpetuities has not been eliminated in any state, although all states have modified it to make it simpler for attorneys to write within and courts to apply. The Uniform Statutory Rule Against Perpetuities creates a 90-year period which limits deadhand control. The 90-year statutory period is actually shorter than most attorneys estimated people could receive with properly drafted instruments that followed the common law rule, although it's much easier for weaker and therefore presumably less expensive attorneys to draft within. The cy pres doctrine has been adopted by most states which also makes it dramatically easier for attorneys, and alleviates problems caused by bad lawyering.

I'll give Alaska as one example - AS 34.27.051. They've adopted a 1,000 year vesting rule as long as the trustee has the right to sell the trust's property. I'd call that pretty well abolishing the rule. This table seems to show that a number of states have essentially abolished the rule in many instances http://www.abanet.org/rppt/meetings_cle ... stlaws.pdf

Finally, the claim about the operation of spendthrift trusts is total bullshit. Spendthrift provisions have all kinds of exceptions to them, including for tortfeasors, so the car accident victim would be able to attach the assets of the trust to their lawsuit (as would the US government, for instance, if the trust's beneficiary stopped paying his taxes or was fined).

PS. I notice that the article author's last name is Madoff. Clearly we should all trust his financial acumen.

The biggest tax gap in the UUS is the step-up in basis upon death rather than the estate tax itself. The US should adopt the Canadian rule - no estate tax but everything you own is considered to be sold at death with some exceptions. Give some generous deferral provisions for family businesses, farms, etc... and a lengthy time period to actually pay the tax (put liens on assets if we are talking about a NY Yankees size estate). That way you minimize leakage out of the tax system via a dodge the stupendously wealthy can use since most people don't have $million in assets with massive pregnant capital gains. Canada also essentially severely restricts domestic dynastic trusts by the "21 year rule" - basically, unless certain limited exemptions are met, every 21 years the trust either needs to pay tax on any unrealized gains or needs to transfer the assets to the beneficiaries. The limited exceptions are certain spousal trusts (the 21 year rule doesn't start until the spouse also dies), and trusts set-up for people with significant mental or physical challenges.