USC Gould School of Law 2010 Tax Institute: Tax Planning Strategies for Transferring Family Homes -- Dynasty Trusts by Nancy G. Henderson

If a property owner intends for property to remain in trust for the use and enjoyment not only of the owner's children, but for future generations of descendants, a "dynasty trust" can be an excellent vehicle to accomplish this objective. Careful consideration must be made as to the effect of the generation-skipping transfer tax upon the donor, the trust, and the trust beneficiaries. In this Analysis, Nancy G. Henderson discusses the general gifting of property interests in trust, family home transfers and dynasty trusts. She writes:

     An alternative to gifting direct interests in a family home to children, the donor could establish a Trust for the benefit of children or other family members and make gifts of interests in the property to such a trust during life and/or at death. In many cases, it is the intent of the donor that the property will remain in trust for the use and enjoyment not only of the donor's children, but for future generations of the donor's descendants. A trust of this nature, sometimes referred to as a "dynasty trust", can be an excellent vehicle to accomplish this objective so long as careful consideration is provided to the effect of the generation-skipping transfer tax upon the donor, the trust and the trust beneficiaries. A significant assumption for purposes of this article is that there are federal estate and generation-skipping transfer (GST) taxes.

General Gifting of Property Interests in Trust

     While there are many issues to consider in drafting a trust as an alternative to making outright gifts of fractional real property interests or creating a family partnership or LLC, certain issues bear particular mention in the context of family homes. First, the trust agreement should establish the rules for the use of the property by the trust beneficiaries, as well as a plan for the succession to a beneficiary's interest in the trust upon the beneficiary's death. In this respect, a significant benefit of holding a family home in a trust is, so long as no beneficiary possesses the right to withdraw the trust property (or other similar powers that constitute a general power of appointment), and so long as the trust instrument includes a spendthrift clause prohibiting the transfer of a beneficiary's interest in the trust or its property, the trust property should be protected from the claims of the beneficiary's creditors. Further, the terms of the trust could insure that, for as long as the trust is permitted to continue under applicable state law, the trust property will remain in the family.

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Dynasty Trusts

     When transferring a family home to a trust, unless the donor's GST tax exemption is applied to the transfer, or the transfer qualifies for the GST tax annual exclusion, the GST tax will be imposed upon the initial transfer if that transfer is a "direct skip." The transfer of a residence to a trust will be a "direct skip" only if the trust is a "skip-person" for GST tax purposes. A trust that will hold a residence for the collective benefit of the donor's children and grandchildren will not be a "skip-person" and, therefore, the GST tax will not be imposed upon the initial transfer of the residence to the trust. On the other hand, unless the donor's GST tax exemption is applied to each transfer that is made to the trust (or a late allocation of the exemption is properly made), and unless the portion of the donor's GST exemption so applied is sufficient to render the "inclusion ratio" of the trust zero (0) for GST tax purposes, a GST tax will be imposed upon each distribution from the trust to a "skip-person" (a "taxable distribution"). Further, a GST tax will be imposed upon the entire trust upon the first date that the only remaining beneficiaries of the trust are skip-persons (a "taxable termination"). In either case, the amount of the GST tax imposed will depend upon the inclusion ratio of the trust. If the trust has an inclusion ratio one (1), meaning no portion of the donor's GST tax exemption was applied to the trust, then the GST tax will be imposed at the maximum estate tax rate, which, applying 2009 tax rates, is 45%. If, however, the inclusion ratio of the trust is, for example, .4, meaning the donor's GST tax exemption was only sufficient to exempt 60% of the value of the trust from the imposition of GST tax (a "mixed inclusion ratio), the GST tax will be imposed at 40% of the highest marginal estate tax rate, which, applying 2009 tax rates, would be 18% (40% of 45%).

(footnotes omitted)

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