The Generation-Skipping Transfer Tax and How a Dynasty Trust Can Protect Your Heirs

Most clients seeking estate tax planning are not merely aiming to leave a few thousand dollars for their heirs—they aspire to build a lasting legacy. A major obstacle to this goal is the generation-skipping transfer tax, designed to prevent dynasties by taxing substantial transfers to grandchildren or unrelated individuals. However, a dynasty irrevocable life insurance trust (DILIT) can provide an effective solution to circumvent the GST tax and create a fund that supports heirs for generations.

The issue with a goal that big is that it can seem like the IRS is dead set against it. The generation-skipping transfer (GST) tax is a tax that’s specifically designed to prevent creating dynasties, even when you leave money behind in a trust. However, there are ways to work around this. When a client comes in who wants to build a dynasty, we find the best solution is often a dynasty irrevocable life insurance trust (DILIT). 

What Is the Generation-Skipping Transfer Tax?

The GST tax was designed to keep individuals from leaving or gifting assets to heirs without having to pay tax on them. It’s imposed when a grandparent leaves money or property to a grandchild in a trust, or when someone leaves money or property to a person not related to them who is at least 37.5 years younger.

For example, say someone wants to leave the family estate to his or her grandchildren. He or she takes the entire estate and holds it in a trust until the grandchildren come of age. At that point, the estate would be responsible for paying the taxes on the value of the property, even though it is held in a trust.

The GST tax is covered under the same tax law as the estate tax, meaning there is an exemption of $11.7 million. Mainly, the GST is designed to prevent people from trying to get around estate taxes by transferring their wealth out of their estate and to grandchildren, even through the use of a trust.

Also, it’s important to note that when the IRS states “trust,” it’s not just talking about traditional trusts, but any arrangement that may be similar to a trust. If something has substantially the same effect as a trust — meaning it’s designed to pay a second-generation beneficiary when the owner dies — it’s considered a trust and may be subject to the GST tax. However, there are ways to work around this. One way is to use a dynasty trust funded with life insurance.

How Life Insurance Can Be Leveraged in a Dynasty Trust

A DILIT offers many benefits for those who want to skip a generation and leave funds to grandchildren, or even great-grandchildren. Basically, the DILIT works the same way as an irrevocable life insurance trust. It removes the value of life insurance proceeds from an estate while at the same time helping individuals avoid the GST tax by leveraging the exemption of $11.7 million and using that to fund the trust.

Using life insurance within this type of trust works because the value of the trust isn’t established by what the policies pay out, but instead, the amount of premium paid for the policies. That means that the trust can be set up to cover multiple generations without exceeding the GST tax exemption of $11.7 million. However, there are some things that you might need to note regarding DILITs. One of the biggest is the rule of perpetuities.

The Limitations of Dynasty Irrevocable Life Insurance Trusts

A dynasty trust can become troublesome if you’re in a state that follows the rule of perpetuities. The rule of perpetuities is designed to prevent an individual from controlling the assets of his or her beneficiaries long after death. It specifically makes it so that trusts can only remain in effect for 21 years after the last beneficiary of the trust has passed away. If you’re attempting to set up a DILIT for the purposes of covering multiple generations, this rule could cause you some trouble.

However, not all states recognize the rule of perpetuities. In fact, many states have either significantly expanded the rule of perpetuities to hundreds or even thousands of years, while some have done away with it entirely. Below is a listing of all states that currently have no rule of perpetuities and allow trusts to continue indefinitely.

Luckily, you don’t have to be a resident of a state to set up a trust there. Usually, when someone wants to create a dynasty trust, the creator will simply establish it in one of the many states with flexible rules for dynasty trusts. By doing this, the trust creator can ensure the trust can pay out in perpetuity and not be considered invalid due to state laws.

When properly funded with universal life insurance policies, a dynasty trust can create a stream of income that will allow beneficiaries to receive benefits in perpetuity. The key to this is ensuring that these trusts are executed in the right states, meet all the criteria, and have enough funding in them to continue paying out beneficiaries for multiple generations. To find the right policies to create a dynasty for your heirs, contact a Howard Kaye advisor today at 800-DIE-RICH.