While President Bush renews his bid to eliminate the federal estate tax, a great number of families are taking matters into their own hands by moving their money into long-lasting trusts that can permanently avoid estate taxes.
For the past few years, many states have begun to allow so-called dynasty trusts to last for hundreds of years, possibly even forever, thereby undoing a centuries-old law that prevented perpetual trusts. New research has discovered that about $100 billion in assets has flowed into personal trusts in those states from the time the laws changed through 2003. For the financial-services firms administering them, the trusts amount to $1 billion in annual trustee fees.
The study comes at a time trusts such as these are being scrutinized by Congress. In a report released by the Joint Committee on Taxation, it described a way to crack down on dynasty trusts by limiting the perpetual tax breaks associated with them. However, there have been no bills considered by congressional committees on the matter this year.
Estate planners have been encouraging their clients to fund their dynasty trusts now, in case the trusts’ tax advantages go away. Congress is considering repealing estate and generation-skipping taxes altogether, thereby eliminating a major motive for setting up the trusts, which is saving taxes from generation to generation.
Currently, the estate tax is set to disappear in 2010, but only for that one year, and then it will return in 2011. Many financial planners are assuming that Congress will compromise by eliminating the federal estate tax for nearly everyone now affected by it but leave it in place for larger estates, such as those valued at more than $5 million.
There are other benefits with dynasty trusts. For example, the assets in the trusts are generally protected from creditors in case of lawsuits, bankruptcy or divorce. As a result, dynasty trusts might remain viable even if Congress should repeal the estate or generation-skipping taxes, or limits the trusts’ perpetual tax benefits.
Although dynasty trusts have been heavily promoted by banks and trust companies until now nobody had quantified nationally how much money has moved into the states that loosened their trust laws to allow them.
Recent research into dynasty-trusts examined federally reported personal-trust data from 1985 to 2003 and included only assets held by federally regulated professional trustees, such as banks and trust companies, rather than individual trustees, like family members.
In a typical dynasty trust, a grandparent transfers assets to a person or institution, the trustee, who holds and invests the money for beneficiaries, i.e., the children, grandchildren, great-grandchildren and beyond. As long as money remains in the trust and the trust is structured properly, it can then pass from generation to generation without additional estate or generation-skipping taxes, thereby allowing the trust to accumulate vast sums over a period of time. Estate and generation-skipping taxes can grab roughly half of a parent’s wealth as money moves to another generation.
Until recently, under a law called the Rule Against Perpetuities, trusts could effectively last only between 90 to 120 years,. Since the mid-1990s, several states moved to relax the term limits. There are now at least 18 states and jurisdictions, including Delaware, Wisconsin, New Jersey, Illinois, Virginia and the District of Columbia, that allow the trust to last forever. Several states have imposed term limits that allow for much longer durations. For example, Wyoming and Utah permit trusts to last 1000 years, while Florida lets them carry on for 360 years.
To set up a dynasty trust, families don’t need to live in a state permitting them. Only a trustee has to be located there, and many trust companies have operations in Delaware, Florida or other states that welcome long-term trusts. Moreover, some of those states, such as Alaska, have other trust-friendly benefits, such as no state income taxes on trusts and strong asset-protection laws.
The study found that simply changing a state’s perpetuities laws wasn’t enough to attract trust assets. Whether a state levied income tax on trust funds mattered, too. If a state abolished its rule against perpetuities, but still taxed trust funds attracted from out of state, the researchers found “no observable increase” on a state’s reported trust assets. By contrast, if a state allowed dynasty trusts but also didn’t tax trust funds created by nonresidents, the state’s reported trust assets increased by roughly $13 billion on average during the period studied.
The researchers tested for other variables, such as whether a state allows what are called self-settled asset-protection trusts. A handful of states allow individuals to set up these trusts for themselves to protect their assets from creditors. The authors found “tentative evidence” that permitting asset-protection trusts might increase a state’s trust business, but caution that the data set was limited.
Critics warn that dynasty trusts could hurt the economy in the long term. Tying up “a significant amount of our wealth” could eventually “have a damping effect on economic growth,” says Neil E. Harl, emeritus professor of economics, Iowa State University. “What is more, it could lead to the concentration of enormous economic power in the hands of banks and trust companies.”
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