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- Dynastic wealth — when families pass money down from one generation to the next — is a problem in America, according to Warren Buffett.
- Transferring wealth to the next generation usually starts with a trust, a legal relationship created to hold money for someone.
- Transfer taxes are set up to help prevent dynastic accumulation of inherited wealth, but wealthy families can pass money down without being subject to estate taxes through GST trusts and dynasty trusts.
Dynastic wealth occurs when families pass money down from one generation to the next. It’s a cyclic process: Each generation can grow the previous generation’s money, leaving it to the next generation to continue to grow.
This pattern of keeping assets within the family helps explains why the combined wealth of America’s three richest families — the Waltons, the Kochs, and the Mars — increased by 5,868% since 1982, totaling $348.7 billion, according to the left-leaning Institute for Policy Studies’ "Billionaire Bonanza" report.
But how is this generational wealth continually transferred? It usually starts with a trust.
A trust is created to hold money for a third party
A trust is a legal relationship "designed to hold assets," Alicia Waltenberger, director of wealth planning strategies at TIAA, told Business Insider. There are different kinds of trusts, but they all essentially consist of three parties:
- The grantor/trustor — the person who creates the trust
- The trustee — the person responsible for managing trust assets in accordance with trust terms
- The beneficiary — the person or organization who benefits from the trust assets
"A trust is established when the grantor transfers legal ownership of an asset to the trustee to be held for the benefit of the beneficiary," Waltenberger said. Trusts can be revocable, in which they can be changed, or irrevocable, in which they can’t be changed.
A lifetime trust refers to trusts established to take effect as soon as they’re created; a testamentary trust is established to take effect upon death.
"The trust ‘fund’ refers to the assets held by the trustee in trust for the beneficiary," Michael Rosen-Prinz, a partner in the Private Client Practice Group at McDermott, Will & Emery who works with ultra-high-net-worth clients, told Business Insider. "When people derisively talk about ‘trust-fund babies’ they are often referring to beneficiaries who receive assets from a trust without having earned that money or even having had to manage it while in trust."
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Why set up a trust in the first place?
The purposes of a trust can vary, but many people set up trusts to make sure their children and descendants will be taken care of after death, according to Rosen-Prinz.
"Parents often want to leave their children enough money to be able to do anything, but not so much money so their children can get away with doing nothing," he said. "Trusts can be drafted with provisions that restrict how much money is distributed to beneficiaries, or requirements that beneficiaries be employed or otherwise active and engaged in society to receive any distributions."
"Some common purposes of trust planning include tax planning (delay or reduction of estate taxes), wealth transfer planning (as a means of transferring assets to beneficiaries), probate avoidance, protection planning (special needs beneficiary, protection from creditors or ex-spouses, etc.), and charitable giving," Waltenberger said.
Estate taxes and other transfer taxes like gift taxes and generation-skipping transfer (GST) taxes are set up to prevent dynastic accumulation of inherited wealth by charging a tax rate of 40%, Rosen-Prinz explained. When that tax rate is implemented on transferable assets, it "in some way redistributes wealth from the very rich."
However, the wealthy can avoid getting taxed by taking advantage of tax exemptions.
Wealthy families can pass down money through a tax-exempt GST trust
One way rich families can transfer assets from one generation to the next is through a GST trust — a generation-skipping transfer tax trust — according to Waltenberger.
"With the use of this type of trust, wealth can be transferred from one generation to the next free from federal estate tax," she said.
The beneficiary in this case is known as a "skip person" — "someone who is more than 37.5 years younger than the grantor," Waltenberger said. "This can be anyone, not necessarily a relative; but it is commonly a trust established for the benefit of a grandchild."
The GST tax is separate from the federal estate tax and gift tax — it’s imposed on the transfer of the assets to the skip person.
However, a GST trust can be exempt from the GST tax if it’s worth $11.4 million or less, according to Waltenberger. If the assets exceed this amount, the 40% GST tax will be implemented.
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"Through the use of the GST exemption, assets in the family can be passed through multiple generations without being subject to estate taxes at each successive death," Waltenberger said.
She added: "In my experience, many families establish GST trust planning by establishing lifetime trusts for the benefit of their children, allowing their child and potentially their child’s descendants, to benefit from the trust assets during that child’s lifetime, then at the child’s death, allowing the assets to pass to the grandchildren in a lifetime trust for their benefit. This cycle can continue as long as state law provides and/or assets remain inside the trust."
Waltenberger described a hypothetical scenario to illustrate her point:
Jane establishes a life trust for the benefit of her son, Adam. Adam’s trust is funded with $2.5 million. The trust is structured so that Adam has use of trust assets to meet his needs during his lifetime, but also to keep the trust assets out of the hands of any potential creditors and to retain the assets in the family.
At Adam’s death, the balance of the trust has grown to $7 million. Because Jane applied her GST exemption to this trust, the $7 million trust will then pass entirely free of federal estate tax to Adam’s children.
Wealthy families can set up multi-generational dynasty trusts
According to Rosen-Prinz, instead of leaving assets at death to children or giving them away during life, families can take advantage of relatively straightforward estate planning to set up a multi-generational dynasty trust that’s only subject to transfer taxes when initially funded.
A dynasty trust is a long-term, irrevocable trust that can exist for many generations, in which distributions can be made to beneficiaries without incurring further transfer taxes. There is generally no estate or gift tax on a distribution from a trust, according to Rosen-Prinz.
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"A dynasty trust typically means a trust that keeps its assets in trust for multiple generations and doesn’t distribute assets outright to beneficiaries at a set point," he said. In order to function efficiently, a dynasty trust generally needs to be GST-exempt, he added.
But, there can be a number of drawbacks.
"For small sums of money, sometimes the hassle of maintaining the trust overshadows the tax advantage," Rosen-Prinz said. "Some people don’t like the idea of keeping money in trust for a long time, or perhaps have had bad experiences with overly restrictive trusts in the past that discourage them from keeping assets in trust."
He added: "Given the relatively high level of estate tax exemption at $11.4 million per person, most Americans don’t have to worry about ever paying estate taxes whether they use trusts or not. But even for those families who have enough assets to have a potential estate tax liability, by using trusts, they really just need to worry about the potential taxes needed to get the assets into the trust in the first place. Efficiently funding these trusts is where many sophisticated estate planning transactions are used."
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