A tool allowing the super-wealthy to pass assets from one generation to the next without paying taxes is resurging in popularity among Hoosier investors.
So-called “dynasty trusts” were created decades ago to allow descendants of those who establish the trusts to avoid paying estate taxes for decades. Interest in the instruments has soared in recent months after a law went into effect this year increasing the amount of trust investment can be exempted from taxes.
Under the new law, an individual can put up to $5 million into a trust—or $10 million per couple—and not have to pay gift taxes on it. If that money is put into a dynasty trust, descendants who reap its benefits also won’t have to pay estate taxes on it, since the money technically remains in ownership of the trust.
So the amount can grow—free from estate taxes currently at 35 percent—until the trust expires, typically after about 90 years. And if an Indiana resident established a trust in a state such as Delaware or Alaska, the trust can have no expiration date, since those states have changed laws that used to limit the life of a trust. Indiana still limits a trust to 21 years after
the death of the last descendant who was alive when the trust was established.
It’s uncertain whether the $5 million exemption will last beyond the end of 2012, so many investors with the means to sock away that much money are doing so now.
“It’s almost a use-it-or-lose it,” said Kristine Bouaichi, a partner in the estate planning practice at Indianapolis-based Ice Miller LLP. “Some of the folks who otherwise may have sat on the fence have been called to action.”
While the trusts bring huge benefits that also include protection from creditors, they have some downsides for investors and, some experts argue, society.
With trusts whose life spans are unlimited, it’s impossible for those who set up the trust to know who might be receiving the money generations from now. And once in the trust, assets are difficult, if not impossible, to recover.
“Once you put it in the trust document, it’s locked in,” said Elaine Bedel, president of Indianapolis-based Bedel Financial Consulting, Inc. “It’s not like you can take it back and change your mind.”
Other experts have philosophical qualms about an instrument they say gets around a tax system designed to keep wealth from becoming concentrated in too few hands.
Evolution of the dynasty
The estate tax officially went into effect in 1916 as a way to balance a wealth distribution that some Americans felt had gotten out of sync with a meritocratic society. As of 1912, about 1 percent of Americans controlled 56 percent of the nation’s wealth, said Ray Madoff, a professor of estate and tax law at Boston College law school who criticizes the power of dynasty trusts in her recent book, “Immortality and the Law: The Rising Power of the American Dead.”
In the 1940s, the estate tax rate was increased to 77 percent, a percentage that was scaled back several decades later when President Ronald Reagan took office.
Meanwhile, estate planners came up with the long-term trust as a tool to get around paying some estate taxes.
Investors would establish dynasty trusts, paying gift taxes when they put money into the trust. But as long as money remained in the trust, those investors, as well as future generations would not have to pay estate taxes on the money when they died.
The taxes would be paid only after the trust expired and the descendant who took ownership of the money in it died, typically about a century after the trust was established.
During the life of the trust, its assets would be subject to income and capital gains taxes, based upon their increase in value.
In 1986, federal lawmakers tried to discourage people from setting up dynasty trusts by creating a so-called generation-skipping transfer tax. On top of the gift tax, those who established the trusts would have to pay the generation-skipping tax, which was the same rate as the estate tax, when they set up the trusts.
But Congress also provided an exemption on those taxes for investments of up to $1 million. So investors could set up plans that allowed them to avoid paying that tax on a $1 million investment.
Now, the maximum exemption is $5 million per individual for both gift and generation-skipping transfer taxes, which opens the door for more tax-free investment to grow into tens or hundreds of millions and be passed on to future generations. “It’s a planning opportunity we haven’t had before,” said Bill Pope, an estate-planning attorney at local law firm Barnes & Thornburg LLP.
Indiana residents also have established trusts out of state to take advantage of laws there that allow trusts to go on forever, which allows them to avoid paying taxes indefinitely.
Michael Gordon, a partner at Wilmington, Del.-based law firm Gordon Fournaris & Mammarella, said most of his work is with out-of-state clients who set up trusts in the state. He’s worked with 10 to 15 Indiana-based clients on establishing dynasty trusts since the beginning of the year.
Gordon projects that number will increase in coming months as more people become familiar with the trusts.
“Clients are going to say, ‘This is a once-in-a-lifetime opportunity,” he said.
‘Too much power’
Even with increased interest, the trusts remain an option for only the very wealthiest—about 1 or 2 percent of the population.
It’s most worthwhile to make an investment into the trust of at least $5 million to $10 million, experts say. That’s because the trusts are expensive and complex to set up.
Also, depending on the number of heirs someone has, the money each generation gets could be inconsequential if the initial investment is too small, said John Wortman, a financial planner at Indianapolis-based Valeo Financial Advisors.
Because the money is locked away once in the trust, those making the investment must have substantial assets to set aside that much money.
“It’s really going to be the wealthiest one percent of the population,” Wortman said. “It can be a powerful tool if you’re a 50-year-old worth $50 million who has two children.”
But even those who have the money to set aside should think carefully about the consequences.
Bedel likens investment in the out-of-state trusts without lifetime limits to “throwing money down into the unknown,” since those establishing the trusts will have no notion of who their descendants will be many generations in the future.
Also, there’s the practical concern that lavishing money on descendants may not be in their best interest.
“While a dynasty sounds like a great thing, it may not be all it’s cracked up to be,” Wortman said. “For kids going off to college and getting $20,000 a month from a trust, it’s going to be harder for them to maintain the kind of drive than it is the kids who know what it’s like to have to struggle.”
Madoff, the Boston College professor, has broader concerns. She contends the notion of holding wealth tax-free for generations has the effect of keeping a vast amount of wealth within a small percentage of the population.
That’s precisely what estate taxes were designed to prevent, she said.
“You have a small number of people that have too much power and too much influence,” Madoff said.
Moreover, because banks typically are the trustees for long-term trusts, the tool gives those institutions “inordinate control over resources,” Madoff said.
And because banks tend to be risk-averse, it can cause money that might be invested to benefit something such as a startup company to remain in a safer instrument.
After the $5 million exemption expires at the end of 2012, the exemption could drop to $1 million and the estate-tax rate could increase from 35 percent to 55 percent.
While few predict a new policy will be more favorable than the current one—given the federal government’s need for tax revenue—it’s difficult to ascertain pending a presidential election.
And Pope, the Barnes & Thornburg attorney, pointed out that he was equally pessimistic about the prospects before the law providing for the current legislation passed in 2010.
“We ended up getting a new law,” he said, “that I don’t think anyone would have predicted.”•