Dynasty Trust

A dynasty trust is an irrevocable trust designed to hold property for multiple generations of a family, or for a long fixed term, rather than distributing out and terminating within a generation or two. It is a practitioner label rather than a legal category. Neither the Internal Revenue Code, the Treasury regulations, nor any IRS guidance uses the phrase, and no particular provision creates the arrangement. What makes a dynasty trust possible is the combination of two things: a state whose law allows a trust to last long enough, and an allocation of generation-skipping transfer tax exemption large enough to keep the trust out of that tax as property passes down.

The constraint the structure exists to work around. For centuries the common law limited how long a private trust could control property through the rule against perpetuities: an interest had to vest, if at all, no later than 21 years after the death of some person alive when the interest was created. That limit was a policy judgment about dead-hand control, not a tax rule, and it is a matter of state law. States have gone their own ways on it, some keeping the common-law rule, some lengthening the period, some abolishing it for certain kinds of property. This site has read one state's statute rather than surveying fifty, so the honest guidance is that the answer for any actual trust is the law of the state that governs it, and it has to be checked there.

What one state's statute actually says, in full, because the summary version is misleading. Wyoming Statute 34-1-139 is often cited for a flat 1,000-year period. Subsection (b) does say that a trust created after July 1, 2003 "owning or holding property other than or in addition to interests in real property, shall continue for up to one thousand (1,000) years." But the section has three other moving parts. Subsection (a) keeps "the American common-law rule against perpetuities for interests in real property," and subsection (e) then splits a mixed trust: subsection (a) governs the real property inside it, subsection (b) governs the rest. And subsection (b) attaches conditions: the trust must be governed by Wyoming law, a trustee must maintain a place of business, administer the trust or reside in the state, and the trust terms must require that powers of appointment terminate and interests vest or terminate within the period. The long duration is a bargain with conditions, not a default.

Where the tax half lives, and why it is not on this page. A dynasty trust survives across generations without a transfer tax at each one only because generation-skipping transfer tax exemption was allocated to it, permanently fixing its inclusion ratio at zero. That allocation is made once, at funding, and is irrevocable; the arithmetic, the applicable fraction and what happens when exemption is allocated to only part of a trust are the subject of the generation-skipping transfer tax entry, which also records the point most relevant here: there is no portability of the generation-skipping exemption between spouses. It is used or it is lost.

The costs, and they are not only the obvious ones. Three deserve attention.

Irrevocability across a horizon nobody can forecast is the first. An instrument written today has to anticipate tax law, family structures and asset classes that will not exist in a century. State law and good drafting supply some flexibility, through court modification, nonjudicial settlement, decanting or a trust protector with amendment powers, and the irrevocable trust entry sets out how limited those routes are.

Administration is the second. A trustee has to exist continuously for the whole term, which usually means a corporate trustee rather than a family member, with fees for the duration. Where the state's long period is conditioned on the trustee's presence, as Wyoming's is, losing that connection can put the duration itself in question.

The income tax is the third, and it is the one families most often price wrongly. A trust that is never in any beneficiary's gross estate never receives a new basis at anyone's death. The property carries its original basis forward indefinitely, so the unrealized gain compounds along with the value. A dynasty trust converts a recurring estate tax exposure into a single permanent income tax exposure, and whether that is a good trade depends on the size of the estate, the state of residence and whether the assets are ever sold at all.

The design decisions, in the order they are usually made.

1. Choose the governing state. The maximum duration, the conditions attached to it and the state income tax the trust will pay are all set by that choice, and a state's long period may come with a residence or administration requirement.

2. Fund it irrevocably, during life by gift or at death, and allocate generation-skipping exemption to it so that its inclusion ratio is fixed at zero.

3. Set the distribution standard. Most instruments give a trustee discretion over distributions to a class of descendants rather than fixed shares, so that the trust can respond to circumstances the grantor will never see.

4. Build in a way to adapt. A trust protector with power to amend for changes in tax law, to change the governing state, or to replace the trustee is common precisely because the term is so long.

5. Keep the conditions satisfied for as long as the trust runs, including any trustee presence or governing-law requirement the chosen state imposes.

A hypothetical showing the cost that gets left out. Corinne funds a dynasty trust at her death with stock worth $2,000,000. Because the stock was in her estate, it takes a new basis of $2,000,000 then. Assume that sixty years and two generations later the stock is worth $12,000,000.

Across those sixty years the property was never included in a beneficiary's gross estate, so no death gave it a new basis. Its basis is still $2,000,000. A sale at $12,000,000 realizes $10,000,000 of gain, and at the top long-term capital gains rate of 20 percent plus the 3.8 percent net investment income tax that is $2,380,000.

That is the number to weigh against the transfer taxes the structure avoided at each intervening death. It is not an argument against a dynasty trust, and for a large estate the transfer tax avoided is normally the bigger figure. It is an argument for computing both rather than only one.

Pros

• Property can pass through several generations without a transfer tax at each one, where generation-skipping exemption was allocated at funding.
• The trust form protects the property from beneficiaries' creditors, divorces and inexperience for as long as it lasts, which for many families matters more than the tax.
• The grantor sets the distribution standard once, so the property is managed to a stated purpose rather than divided and spent at each generation.
• Choosing a favorable state can also bring a longer duration, better modification rules and, in some states, no state income tax on trust income.

Cons

• No basis adjustment ever. Property that is never in anyone's gross estate keeps its original basis indefinitely, and the unrealized gain compounds.
• The maximum duration is state law and it varies, so a trust is only as long-lived as the state whose law governs it, and the conditions attached to a long period have to be maintained.
• Trustee fees and administration run for the entire term, and a corporate trustee is usually unavoidable over that horizon.
• Irrevocability across generations means drafting for a future nobody can describe. Modification routes exist under state law but they are slow, limited and not guaranteed to be available.
• Trusts reach the top federal income tax brackets at a very low level of retained income, so a trust that accumulates rather than distributes pays tax at high rates along the way.