The Esther family gathers with its Legacy Project planning team this summer to learn about dynasty trusts and to map out a plan for asset transfer.
A dynasty trust will pass on assets for generations
Spread out before him on a large oak table, the numbers on paper look daunting. Even to Chet Esther, who has managed his multiple-entity farming operation for decades with confidence, the idea of bequeathing large volumes of money to multiple generations is scary.
Chet and his wife, Lori, who farm in Beardstown, Ill., have dreamed of passing on the fruits of their labor to sons Chad and Ryan and to their grandchildren and great-grandchildren. They specifically want to keep the land they own in the family so that estate taxes can’t rob future generations of inheritance.
The Esthers, who farm 4,700 acres and own a construction company and semi-truck and trailer dealership, are participating in the Farm Journal Legacy Project as a succession planning case study family.
The 2010 Tax Relief Act makes it possible to fund a $5 million trust without incurring a gift tax bill. It raises the exemptions for the gift tax and the generation-skipping tax, a levy applied when assets are transferred to relatives who are two or more generations below the donor. Last year, the exemption for those taxes was raised to $5 million per person, or $10 million for a couple, for 2011 and 2012. In 2012, both exemptions are further adjusted for inflation. Prior, the gift-tax exemption was just $1 million per person.
As a result, the use of so-called dynasty trusts, or trusts for the benefit of multiple generations,
are becoming popular. "In working with high-net-worth farm families like the Esthers, we may recommend a dynasty trust to keep land assets in the family and provide financial security," says Kevin Spafford, Farm Journal succession planning expert. From the start, the Esthers have said they want the land to remain with family members. This estate planning tool allows them to:
- reduce the estate tax and protect the land for generations;
- protect assets from the creditors of trust beneficiaries;
- exclude assets from future divorce settlements;
- apply specific terms and conditions to trust distributions; and
- remove appreciating assets (land) from the grantors’ estate.
Building a Dynasty. "Dynasty trust" is not a legal term and it is not found in the tax code. A dynasty trust is an irrevocable trust that is designed to benefit two or more younger generations, says Josh Sylvester, Certified Financial Planner and member of the Legacy Project team.
A dynasty trust will continue as long as legally possible, given state law (see sidebar). It will provide income, and possibly principal, to beneficiaries without transferring ownership of the trust property to the beneficiaries.
A dynasty trust can be established during a person’s lifetime, upon his or her death, or both. A person can transfer up to the gift-tax-applicable exclusion amount ($5 million in 2011). If two spouses each contribute assets to the trust, up to twice this amount can be transferred without incurring a gift tax.
"No one can foresee the future, including the Esthers, but the trust will protect the assets and create a family legacy," Spafford says.
The trust builds a long-term vehicle to hold the Esther farm, says Scott Reynolds, a Legacy Certified Advisor and financial planner with Lincoln Financial Advisors Corp., based in Joliet, Ill. Reynolds is part of the Legacy Project team helping the Esthers.
Their trust will be established in the following manner: The Esthers will provide funds to the trust as well as guidance on the operation and rules governing distributions. Beneficiaries of the trust are descendants of the grantors, including generations and persons as yet unborn.
A trustee will be named. Reynolds suggests the trustee not be a beneficiary, but it could be a secondary relative. Chet and Lori would have access to all assets through the independent trustee’s discretionary powers. "Chet would have managerial authority over assets until he relinquishes or is incapable of management," Reynolds adds.
The trustee typically handles day-to-day operations of the trust, including investment of the trust assets, administrative issues and distributions. However, since the trust is being established during Chet’s lifetime, Chet is treated as the owner for income tax purposes but not for transfer tax purposes (this also is called a "grantor trust").
Act Now. Most estate planners urge action on dynasty trusts sooner than later. There is political uncertainty about the permanence of the gift and estate tax exemptions, and with Washington looking for ways to reduce the budget deficit, such tax exemptions could be targeted.
"It is a little bit like predicting next year’s weather today," Reynolds notes. He points out that the gift tax exemption moved from $1 million to $5 million overnight last year.
"If Congress makes a decision to revert back, it is likely to be swift," he adds. "If estate tax credits are reduced in 18 months when the current law expires, the economic burden to the next generation of Esthers could be overwhelming."
If both Chet and Lori die today, the estate would need $1.5 million in liquid assets to pay taxes and estate costs. If the law reverts to the 2001 level, costs would exceed $5 million. As a result, the Esthers are heeding Reynolds’ warning and are working with their accountant and attorney to get the paperwork ready for a dynasty trust.
Is Your State Favorable Toward Trusts?
The key to a dynasty trust’s longevity is that it must be located in a jurisdiction that does not limit how long or for how many generations the trust can last. About half of all states have such favorable laws, including farming states Colorado, Ohio, South Dakota and Wisconsin. In these states, there will never be a transfer tax imposed on dynasty trusts.
South Dakota, for example, is most favorable to a trust arrangement because it allows for a perpetual trust and is a state that has no income tax, so farm assets are not subject to state taxes. This allows a trust investment to grow for as long as possible, free of state taxes, which can save significant sums of money. Alaska, Delaware, Florida, Nevada and Wyoming are attractive because they don’t impose taxes on trust assets.
Best States for Trusts
The states that are highlighted in blue on the map below allow landowners to establish a perpetual dynasty trust.
- September 2011