Many non-US persons have children, grandchildren and succeeding generations who are US citizen or resident individuals. The foreign person often wishes to create a trust for, or implement some other form of estate plan that will benefit these US individuals, whether during the lifetime of the foreign person or upon his or her death. When US individuals are to be the beneficiaries of such planning, extreme care must be taken so as not to run afoul of the numerous US tax rules that can result in harsh taxation to the US beneficiary who receives distributions from a foreign (non-US or “non-domestic”) trust. The creation of a so-called “Dynasty Trust” may be of benefit in some cases and can assist in the saving of significant US tax dollars.
What is a Dynasty Trust? How Does it Work?
In the past, many US States had laws in place that prevented a trust from continuing its existence through multiple levels of generations. This law was known as the “Rule Against Perpetuities.” This Rule was designed to prevent rich families from tying up family assets in trusts that continued through many generations of heirs. The Rule Against Perpetuities has been changed in many States, and as a result, the so-called “Dynasty Trust” appeared.
Generally speaking, a “Dynasty Trust” is a trust that can continue its existence indefinitely or for many years (often, 80 – 100 years is typical). Thus, a Dynasty Trust has the ability to skip one or more generations. Instead of being forced to terminate and distribute assets due to the Rule Against Perpetuities, the Trust can remain in existence with all of its assets intact. This means US estate tax can be prevented on the assets remaining in the Trust upon death of beneficiaries at different generational levels.
The Dynasty Trust is established so that it qualifies for US tax purposes as a “domestic” trust. A domestic trust is one that is considered to have a US tax location or tax situs. Such a trust is, broadly speaking, created under, and governed by, the laws of one of the States of the United States (Delaware is a popular State). A US court must be able to exercise primary supervision over the administration of the trust. In addition, one or more US persons (usually the Trustee, or Trustees) must have the authority to control all substantial decisions of the trust. A trust will qualify as a “domestic” trust only if it meets both of these requirements.
Learn Why the Dynasty Trust Must be a “Domestic” (US) Trust
When the beneficiary of a foreign trust is a US individual, adverse tax consequences result to that US beneficiary if he receives a distribution from the foreign trust which is made up of income that the foreign trust has been accumulating. Payment of such an “accumulation distribution” to the US beneficiary is taxed very harshly under the so-called “Throw Back” tax regime which incorporates certain interest charges being compounded on a daily basis. The Throw Back tax and interest charge rules apply only to foreign trusts. They do not apply to domestic trusts. If one has a domestic Dynasty Trust, this can circumvent the draconian “Throw Back” tax regime.
How Can the Dynasty Trust Help? A Typical Case
Many non-US persons have created so-called foreign “grantor trusts” under which, during the lifetime of the settlor or grantor, any income or principal that is distributed from the trust may be paid only to the grantor or his / her spouse. Typically, the trusts have not been paying out any income or principal. Instead, the trust income has been accumulating for many years.
Sometimes, the ultimate beneficiaries of such foreign trusts are US persons and upon the death of the foreign settlor, the trust will continue its existence and make distributions to these US beneficiaries. As discussed above, because of the Throw Back tax and compounded interest charge rules, adverse tax consequences will result to the US beneficiaries if the foreign trust continues accumulating income and pays out any “accumulation distributions” to them. A Dynasty Trust, when be used in conjunction with the foreign trust, can easily prevent this problem. Here’s how it works:
Setting Up the Dynasty Trust Structure
Creation of the structure is quite simple. Usually, the non-US settlor of the foreign trust will also create a so-called “Dynasty Trust” for each US person who is to ultimately benefit from the foreign trust. These Dynasty Trusts would be nominally funded at creation (each would have a single bank account with a small deposit). Each Dynasty Trust would be named as a beneficiary of the foreign trust. While the settlor is alive, the Dynasty Trusts would generally remain dormant and essentially be on “standby” status. Each Dynasty Trust would become “operational” only when the foreign settlor died. Upon the death of the foreign settlor, the foreign trust could terminate and distribute its funds equally to each of the Dynasty Trusts. At such time, the Dynasty Trusts would become well funded and would expectedly earn significant income.
Each Dynasty Trust would make distributions to its respective beneficiaries in accordance with the trust terms applicable to that particular Dynasty Trust. In this regard, each Dynasty Trust could be specially tailored to suit each US beneficiary’s specific circumstances (for example, one beneficiary may have young children, while another could have only adult children, thus requiring different dispositive provisions in each of the trust instruments).
US Taxation of the Dynasty Trusts
The Dynasty Trust itself would be a US taxpayer, paying Federal income tax, on income and gains in accordance with graduated tax rates. . At the initial “standby” stage, such tax should be nonexistent or minimal given the nominal funding of the Dynasty Trust. Once the Dynasty Trust began to earn significant income (i.e., after funding from the foreign trust), it would pay Federal income tax in accordance with graduated tax rates.
An important concept to understand with regard to taxation of trusts is that to the extent that a trust makes distributions of its income to a beneficiary, the beneficiary himself, and not the trust would pay the income tax. On the other hand, if the trust retains the income rather than distributes it, the trust will pay income tax and not the beneficiary.
Use of trusts in today’s tax environment can result in the trust paying LOTS of tax dollars that, had the income been earned by the individual beneficiary himself (rather than the trust), would not otherwise be paid. The current maximum income tax rate is now at 39.6% — plus – there is the possible additional Medicare surcharge tax of 3.8% on net investment income. The Medicare surtax of 3.8%, is applied to net investment income once this top bracket is reached. You can learn more about the Medicare surtax at my blog post here. Due to the very high tax rates on trusts, trustees are often paying out all income to the beneficiaries instead of retaining it in the trust. However the trustee must be careful to implement the wishes of the trust creator, so there may be times of conflict. To illustrate the harshness of the tax rates on trusts versus individuals, consider this: The maximum tax rate of 39.6% applies to all taxable income over $450,000 for taxpayers who are married filing jointly; but the maximum tax rate of 39.6% applies to all taxable income over $11,950 when the taxpayer is a US trust!
Once a trust reaches that top tax bracket of 39.6% on ordinary income, the trust will also pay the highest tax rate of 20% on any long-term capital gains and qualified dividends. A smaller trust having taxable income subject to rates below 39.6% will pay a 15% rate on long-term capital gains. This 15% rate will be reduced to zero if the trust is in the 15% tax bracket.
You must have proper tax advice before creating any kind of trust! The rules become far more complex if any foreign (non-US) trust is created or part of the overall planning. Make sure you understand the full tax impact of using a Dynasty Trust before it is incorporated into your estate plan.
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