The Tax Life of the Dynasty Trust
Congress gave life to the dynasty trust, and Congress yet may take it away.
If someone dies owning property, the estate tax must be paid within nine months. If someone does not own property, but has only the right to receive income from property, the property is not includible in their estate.
If someone had enough money so that his children could live on the income, then he could leave the income in trust to his children for life, then to their children for life, and so on. The assets would be taxed only once, when the original testator died. This is the dynasty trust, which, because the rule against perpetuities has been stretched or abandoned, could last forever.
Because each generation would have had no interest in principal, and only income which ended with death, no estate tax would be due. The person of modest wealth would have to leave his estate to his children, and the estate would be taxed as it cascaded down the generations, but the person of great wealth could satisfy his children's needs with an income-only trust, so no estate tax would paid on the death of each generation.
To stop this tax loss, in 1986 Congress established the generation-skipping transfer tax (GSTT), taxing property when it is ultimately distributed from a generation-skipping trust, subject to an exemption for an amount of principal originally placed in trust - initially $1,000,000, and raised to $3,500,000 on par with the estate tax exemption. A trust could be established with the exemption amount initially, and no estate tax would be paid when the property was eventually distributed, even though it had grown substantially.
The exemption provision, together with the relaxing or abolition of the rule against perpetuities, encouraged the establishment of dynasty trusts. There is now no GSTT - it was abolished with the estate tax, but will return in January, along with the estate tax, unless Congress acts sooner.
Tax experts are discussing a proposal to include, in the expected new tax law, a provision limiting the GSTT exempt period to two generations. This could seriously reduce the value of dynasty trusts as a way to save estate taxes. We will be following this, and will report developments in future NOTES.
