Nevada Dynasty Trusts

Nevada Dynasty Trusts

A type of trust used by the wealthy to shelter assets from estate taxes for hundreds of years and is set to change by the fed at the end of 2012.

On October 1, 2005, certain provisions of Senate Bill 64 (“SB64”) from the 2005 Nevada legislative session became effective. Those provisions amended Chapter 111 of the Nevada Revised Statutes (“NRS”) to change Nevada’s rule against perpetuities to 365 years. This new law creates an opportunity for Nevada residents, as well as residents of other states, to pass assets in a Nevada dynasty trust that is not subject to estate taxes, creditors and divorcing spouses of the trust beneficiaries for 365 years.

Prior to the passage of the new law, Nevada’s rule against perpetuities under NRS Chapter 111 limited the duration of a trust under Nevada law to the greater of 90 years or “lives in being plus 21 years,” which generally allowed a trust to continue for approximately 90 to 120 years before the trustee would have to distribute the trust assets to the beneficiaries, thus moving the assets from an estate tax, creditor and divorce-protected environment to one which exposes the assets to estate taxes, creditors and divorcing spouses.

Because 17 states and Washington, D.C currently have laws allowing trusts to continue perpetually with no estate taxes, prior to passage of the new law, Nevada had been at a huge disadvantage to the other states and was losing significant revenue and jobs to the other more favorable jurisdictions. Now that trusts can be created under Nevada law for up to 365 years, very few Nevada residents will choose to create trusts under the laws of the other states, and any non-residents who otherwise would have created trusts under the laws of other states will now choose to domicile their trusts in Nevada. Nevada is now one of only a few states with a long perpetuities law as well as no state income tax.

President Obama’s proposal  of estate provisions in his 2012 budget, would limit tax-free "dynasty trusts" to 90 years.

The chances of passage are practically zero this year, say experts. But taxpayers should know that the idea is in play—and act accordingly. As proposed, the change would apply to new trusts or additions of money to existing ones, but not to those already funded.

Bottom line: If you are considering setting up a dynasty trust, move swiftly. Among them: the current generous terms of the estate and gift tax—a $5 million individual exemption and a top 35% rate, both of which are set to expire at the end of 2012.

I am encouraging people who want these trusts to set them up now.

 Dynasty trusts have gathered steam since the 1986 tax overhaul installed the current version of the "generation-skipping tax." This levy imposes taxes that would be avoided if taxpayers left assets to heirs who are more than one generation below.

Example: Robert, a widower, has a net worth of $15 million and his heirs include children, grandchildren and great-grandchildren. If he leaves everything to his children and they in turn leave everything to theirs and so on, there could be an estate tax toll with each generation.

Robert would like to put his entire estate into a trust and skip layers of tax. But if he does, the generation-skipping tax kicks in and replaces the lost taxes—except for an exempted amount, which is currently $5 million per individual or $10 million per married couple. That $5 million can be pumped up using discounts, life insurance and other leveraging techniques.

Dynasty trusts push that generation-skipping tax exemption to the max, putting the exempted amount beyond the reach of estate taxes for the life of the trust. That, in turn, means the heirs don't have to "spend" their own exemptions on those assets. These trusts are now allowed in 23 states and the District of Columbia , to the delight of companies that charge fees to manage them. Taxpayers don't have to live in a state to put a trust there.

To enable these trusts, most of the states allowing them had to get rid of an old common-law principle called the "rule against perpetuities," which allowed trusts to exist only for about 90 years. The Obama administration proposal would reinstate this old principle in a way by removing the federal tax exemption after 90 years. So the trust can go on indefinitely, but the exemption can't. (The pass applies to taxes on wealth transfers, of course; annual income taxes are always due.)

This type of trust creates a new tax-free, creditor-proof wealth.

The main benefit of long-lived trusts is that they protect family assets from being dispersed by creditor claims and divorce. For most trusts 90 years will be long enough.

For those opting into dynasty trusts, all the experts urge care in drafting because the distant future is full of unknowns. In particular, it should allow for the removal of the institution handling the trust so heirs won't be captive to high fees or poor performance.

What is a Dynasty Trust?

A dynasty trust is an irrevocable trust that leverages the estate, gift and generation-skipping transfer tax exemptions for as many generations as applicable state law permits.  Whereas most attorneys draft trusts to provide for mandatory distributions to the grantor’s children at staggered ages (e.g., one-third at age 25, one-half of the balance at age 30, and the balance at age 35), a dynasty trust is drafted to encourage the trustees of the trust to keep the assets in trust for the benefit of the beneficiaries and to allow the beneficiaries to "use" the trust property rather than receive it outright where it will be subject to estate taxes, creditors and divorcing spouses.

For estate tax purposes, it is not sufficient to plan for only one generation at a time. The potential estate taxes that the clients' children's estates may face as a result of such inferior planning are often not given enough consideration by the attorney in drafting the trust. As of 2006, the tax code allows each person to transfer up to $2 million without any federal generation-skipping transfer (“GST”) tax. Meanwhile, the exemptions in 2006 for federal estate and gift taxes are $2 million and $1 million, respectively.

Interestingly, the estate and gift tax exemptions are utilized in nearly every estate plan, yet all too often attorneys do not draft their trust agreements to utilize the GST tax exemption. Failure to use an individual's GST tax exemption is a horrific economic waste over the course of time. Most likely, this failure is a result of the attorney using a canned “form” agreement that is more suited for a very small estate but is not appropriate for a medium or large sized estate.

Designing the Dynasty Trust

Most dynasty trusts are designed as Beneficiary Controlled Trusts. The beneficiaries usually become trustees of their own trust upon reaching the age at which most attorneys’ trusts would distribute the trust assets outright to the beneficiaries. There are two general classifications of Beneficiary Controlled Trusts – discretionary trusts and support trusts.

Discretionary Trusts - For maximum creditor and divorce protection, an independent trustee is used to make discretionary distributions and other tax sensitive decisions. The primary beneficiary can be given the power to remove and replace the independent trustee with or without cause. Additionally, the primary beneficiary can be the investment trustee thereby being able to make all investment decisions over his trust assets.  Thus, the primary beneficiary has the control over and use of the trust property as though he owned it free of trust. However, by having the dynasty trust as the owner, if drafted correctly, the assets are protected from estate taxes and from the beneficiary's creditors, including divorcing spouses. This co-trusteeship, although slightly more complex than having just one trustee, provides the ultimate combination of control, estate tax savings and creditor protection.

 Support Trusts - Alternatively, the primary beneficiary can be the sole trustee. With this option, the beneficiary can only distribute assets to himself for his health, education, maintenance and support. This is often called a “support trust,” as opposed to a “discretionary trust” which uses an independent trustee for discretionary distributions. Although a support trust is simpler to administer than a discretionary trust, certain creditors of the beneficiaries of a support trust may access the trust assets, so it is less protective than a discretionary trust.

 The types of creditors that may access the assets in a support trust depend upon which classes of creditors the court allows as exceptions to the general rule that a spendthrift trust is protected from creditors. Some examples of these “exception creditors,” as defined in the Restatement Second of Trusts, include (1) alimony or child support, (2) necessary services or supplies rendered to the beneficiary (such as medical services), (3) a claim by the U.S. or a state to satisfy a claim against a beneficiary (such as a tax lien), and (4) services rendered and materials furnished that preserve or benefit the beneficial interest in the trust (such as attorneys’ fees to protect a trust).

Conclusion

The passage of SB64 has made Nevada one of the most favorable jurisdictions in the country in which to create a dynasty trust. Nevada residents, as well as non-residents, can use this new law to protect assets from estate taxes, creditors and divorcing spouses for up to 365 years. The combination of the new perpetuities law with Nevada’s lack of a state income tax makes Nevada an ideal jurisdiction. These attributes make this one of the most historically significant changes to Nevada trust law.