Why Rich Kids Don’t Pay Taxes

By: Steven Abernathy and Brian Luster

One of the greatest tricks up the proverbial sleeves of rich families wanting to preserve generational wealth is their ability to pass along their assets to their heirs in perpetuity. They’re able to do this free from the grip of creditors, the IRS, state and local tax authorities, litigators, ex-spouses, and, perhaps most importantly, estate and gift taxes. Sound too good to be true? It’s not. Using a straightforward estate planning technique—the dynasty trust, could create a substantial reduction in taxes.

Historically, wealthy matriarchs and patriarchs would create trusts whereby the trust’s income was distributed to the children and grandchildren for their maintenance with the principal to be distributed to the grandchild at the child’s death. However, the IRS realized it was losing valuable estate taxes by allowing grantors to “skip” generations. As a result, Congress passed the generation-skipping transfer tax (GST) which goes after both outright gifts and transfers in trust to or for the benefit of unrelated persons who are more than one generation younger than the donor (such as grandchildren).

This affects two things: 1) outright gifts, and, 2) transfers in trust to, or for, the benefit of ‘unrelated persons who are more than one generation younger than the donor,’ such as grandchildren. However, as with estate and gift taxes, Congress allowed for an exemption. At present, this exemption, like that of the gift and estate tax, is $5.34 million for individuals and $10.68 million for couples. The magic of the dynasty trust resides in this exemption; wealthy families pass along at least $10.68M to their heirs indefinitely—thereby exploiting the dynasty trust’s advantage. If those assets continue to grow, gains on the original $10.68M gift are exempt from gift and estate taxes as well.

How does this work on a practical level?

A grantor (typically a matriarch or patriarch) will fund a trust through a gift of up to $5.34M (up to $10.68M if married). Since the GST exemption is also $10.68 million, the trust—and its appreciation—is forever free of GST tax. As with most tax-favored trusts, the dynasty trust is irrevocable. This ensures the trust stays out of the grantor’s estate at death. Moreover, because the beneficiaries do not retain enough control, the trust also avoids being dragged into their own estates at death, ensuring that it is passed on to the next generation (and so-on).

This ability to impart wealth to successive generations is traditionally precluded by a common-law principle known as the Rule of Perpetuities, a legal concept notorious for its complexity. Fortunately, many states such as Delaware have done away with this concept, clearing the path for trusts to be put on “auto-pilot.”

According to the customary “Rule against Perpetuities,” (the maximum period title may be held without transfer) the period extends to, at the latest, 21 years after the death of the last identifiable individual living at the time the interest was created. In other words, if the trust was created when the youngest heir was 5 years old, 21 years after her death would be the maximum period the dynasty trust could go unchanged. However, in certain states including: Alaska, Delaware, Nevada, New Hampshire, and South Dakota, the rule does not apply. In these circumstances the dynasty trust could, in theory, provide asset protection into perpetuity—with a few “beyond the grave” rules; the language of which will be specified in the trust documents. The grantor may also opt to extend the period with verbiage amending the rule against perpetuities; this could say something like, “…the period extends to, 21 years after the death of the last identifiable individual being living at the time, or 30 years, whichever is longer.”

The trust assets are under a trustee’s control as opposed to a profligate future heir—the key here is protecting the family fortune for multiple generations. Those who create a dynasty trust are doing so to have a seamless transfer of wealth to heirs with minimum tax implications. These trusts are usually set up for the benefit of a grantor’s children and descendants of the grantor—including generations not yet born. Due to the trust’s multi-generational duration, it is advisable to seek out an institutional trustee. Distributions can be made for a variety of reasons: the health, education, maintenance, support of beneficiaries, and the like.

To fully appreciate the dynasty trust, it helps to see the alternative. Unlike male-pattern baldness, estate and gift taxes hit every generational level. If assets are not properly protected, tax hits alone might substantially reduce them in just a few generations. Suppose a couple gifts $10.68M to their kids. By the time these kids reach old age, the original amount has grown to over $30M. If the estate tax exemption remains at current levels, when the grandkids get their parents’ inheritance, the first $10.68M is tax free. However, the other $20M+ will be subject to estate taxes—thereby reducing the grandkids’ fortune substantially.

The dynasty trust avoids this loss; the married couple can opt to gift up to the maximum amount of $10.68M—directly to the trust itself. In addition to being tax-free, since the GST exemption is also $10.68M, the trust itself, and its appreciation, is forever free of GST tax.

As with any legal documentation, the verbiage of the trust documents must be clear and precise. The head(s) of the family usually establish their trust with a lawyer or their family office. Once they are entitled to collect, the generation immediately following the head(s) of the family will begin to amass discretionary income distributions for life. If a beneficiary owes money, depending on how the documents are drafted, the dynasty trust could suspend payments to the beneficiary—and pay the creditor directly. At the end of the payment cycle, the trust’s discretionary income payout to the beneficiary would resume. If beneficiaries require ongoing care, (i.e. a nursing facility, treatment center, etc.), distributions can be set up to go directly to the provider.

While dynasty trusts may at first glance seem complex, they are an excellent mechanism to create structure around the family legacy and fortune and potentially avoid the familiar proverb of a wealthy family going from “shirtsleeves to shirtsleeves in three generations.”

Brian Luster is a Managing Member and Portfolio Manager of a long/short US event-driven value-oriented hedge fund. Founder and Chief Executive Officer of a Multi-Family Office. Portfolio Manager of discretionary shareholder activist Separately Managed Account strategy. Author of 50+ articles covering investing and multigenerational asset management featured in such publications as Forbes, Barron’s, The Wall Street Journal, The Huffington Post, Private Air Magazine, The American Association of Individual Investors, Family Wealth Report, Medical Economics, Physicians Money Digest, Chiropractic Economics, Medscape, Practice Link, Practical Dermatology, Physicians Practice, Dental Practice Management, Buyside Magazine, and The Bottom Line. For more information, visit www.abernathygroupfamilyoffice.com.

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