For many years, most states required that any trust had to terminate after a certain number of years. These rules usually were based on the life expectancy of the youngest beneficiary plus a certain term of years.
Now, South Dakota and a few other states allow trusts to be perpetual or for a term that can exceed 500 years. For many, these dynasty trusts sound like a wonderful vehicle to maintain farm ownership in the family for multiple generations. But will they work for you?
Advantages and Disadvantages. The first key advantage of a dynasty trust is estate taxes may be postponed for many generations. Under current estate tax law, an estate tax may be owed every time an asset passes to an heir.
With a dynasty trust, the imposition of this estate tax may be postponed for multiple generations. Heirs are only entitled to income from the trust and possible principal distributions.
Suppose we have a farmer with a total estate value of about $10 million. The estate may be put into a dynasty trust or left to heirs and passed through the estate. Let’s assume the net assets would grow at 2% per year and that every 30 years, an additional estate tax of $5 million would be paid (I am assuming estate exemption will increase at 2% each year). Let’s also assume the $10 million initial bequest does not incur an estate tax.
After 30 years, the estate has grown to about $18 million in value. The dynasty trust retains this value and does not owe any estate tax. However, the heirs will owe an estate tax of $5 million, dropping their net value to about $13 million. After 60 years, the trust has grown to $32 million, while the heirs net only $17 million after paying the second $5 million of estate tax.
Now let’s jump to 150 years. The dynasty trust is up $194 million while the heirs, who have incurred $25 million of total estate taxes, only have $69 million of assets. After the full 500 years, the dynasty trust reaches almost $200 billion. Heirs only have $52 billion.
The great power of the dynasty trust is the full compounding of assets with no estate tax slippage.
Second, a dynasty trust keeps the farm in the family. The farmer puts in place a legal entity that will own and manage the farm for generations. Family members or professionals can be managers.
Let’s now consider some of the drawbacks to a dynasty trust. First, there is a compounding of family members. For example, 1,000 acres of land worth $10 million supplies a nice return on investment for heirs of the first generation. Let’s assume that a farm family begins with three kids, each of whom goes on to have two children. For subsequent generations, each kid has two children of his or her own. After three generations, there are about 45 beneficiaries.
For 45 people, the 1,000 acres could provide a decent return for each beneficiary. However, once we surpass 1,000 beneficiaries, the administrative burden will quickly be out of control. If the assets of the dynasty trust do not grow greater than inflation, it is likely the heirs will break the trust.
Therefore, unless the intent of the dynasty trust is for the trust to be a true operating business, it is highly unlikely any dynasty trust would last much longer than four or five generations.
Second, future estate law changes pose risks. By placing assets into a dynasty trust, you are locking up these assets for multiple generations, and the current favorable estate tax laws could change.
Weigh Options With Care. A dynasty trust sounds great in theory, but before setting up one of these trusts, make sure you know the positives and negatives. Often, the negatives might outweigh the positives.