Creating Dynasty Trusts
When New Jersey repealed its rule against perpetuities last summer, the state joined a growing number of jurisdictions that have amended their laws to permit the creation of “dynasty trusts”.
These trusts last for a number of future generations beyond the life of the grantor. A “true” dynasty trust lasts in perpetuity. Implemented properly, they are among the most powerful estate planning techniques available today.
A dynasty trust can be drafted to grant each generation of beneficiaries significant access to trust income and principal, as well as control over administrative decisions. Notwithstanding these benefits, as properly drafted trust will – combined with proper allocation of the generation-skipping transfer (GST) tax exemption – avoid estate and GST tax on the trust assets in perpetuity. Moreover, the trust assets will not generally be subject to claims of the beneficiaries’ creditors.
New Jersey’s repeal of its rule against perpetuities became effective on July 9, 1999. Although the Legislature enacted a new rule in its place, practitioners will find that it’s easy to avoid violating it, making New Jersey one of the growing number of states in which true dynasty trusts are possible. Creating a dynasty trust on or after the effective date of the repeal is relatively straightforward.
Therefore, the primary focus of this article will be the extent to which trusts created before July 9, 1999, can be brought under the new rule as dynasty trusts that are “grandfathered” for GST tax purposes.
Lawmakers repealed New Jersey’s rule against perpetuities as part of the Trust Modernization Act of 1999, N.J.S.A. 46:2f-9 et seq. In its place, the Legislature enacted a new rule that prohibits the unlimited suspension of the power of alienation of interests in real or personal property. Conversely, the old rule prohibited the unlimited suspension of the vesting of interests in real or personal property.
The new rule offers two ways of avoiding any suspension of the power of alienation: (1) granting the trustee the power to sell trust assets; or (2) granting an unlimited power to terminate the trust in one or more persons then alive. Given the fact that the “unlimited power to terminate” language is somewhat ambiguous when read together with the words “then alive,” granting the trustee the power to sell trust assets would appear to be the safest way to avoid any suspension of the power of alienation under the statute, and thereby create a trust that can last in perpetuity.
There are two ways to form a trust under the new rule: (1) Establish a trust on or after July 9, 1999, that does not suspend the power of alienation; or (2) Exercise a power of appointment that causes the transfer of assets from a trust created before July 9, 1999, to a newly created trust that does not suspend the power of alienation. Thus, New Jersey’s new rule presents dynasty trust planning opportunities for new, and possibly, existing trusts.
Dynasty trust planning is possible for trusts created on or after July 9, 1999, to which as GST exemption has been allocated (GST tax-exempt trusts), and pre-July 9, 1999, trusts under which an individual has a general or limited power of appointment.
The latter can be divided into the following two categories: (1) Trusts that are created and irrevocable on or before September 25, 1985, (grandfathered trusts) which grant an individual a general or limited power of appointment over the trust assets; and (2) GST tax-exempt trusts created after Sept. 25, 1985, but before July 9, 1999, that grant an individual a general or limited power of appointment over the trust assets.
Clearly, practitioners can create dynasty trusts in New Jersey on or after July 9, 1999. Proper allocation of GST exemption will be paramount, as well as drafting to ensure maximum flexibility for future generations without subjecting the trust assets to estate or GST taxation. While GST exemption allocation and drafting concerns are critical when creating dynasty trusts, they are not the focus of this article.
The GST tax applies at a flat 55 percent rate of the value of property transferred either outright, or from a trust, to “skip persons.” The tax applies in addition to any applicable estate or gift tax. Persons who are skipped are usually individuals who are two or more generations below the transferor. For example, skip persons can include grandchildren and great grandchildren.
Persons not related to the transferor can be deemed a skip person if they are more than 37.5 years younger than the transferor. Each person has a $1 million GST tax exemption allocable to generation-skipping transfers that can be used during lifetime or at death. That GST exemption is indexed annually for inflation, currently at $1.03 million.
Treasury Regulation Sec. 26.2601-1(b)(1)(i) provides that the GST tax does not apply to any transfer under a trust that was irrevocable on Sept. 25, 1985 (referred to throughout this article as “the effective date regulation”). These trusts are commonly referred to as “grandfathered trusts”.
Grandfathered status is extremely valuable since the trust assets can remain exempt from GST tax without any allocation of the GST exemption. It is therefore vital to know that the GST tax does apply to the extent that a transfer under a grandfathered trust is made from property added, or deemed to be added (known as a “constructive addition”), to that trust after Sept. 25, 1985.
Thus, notwithstanding that a trust may be grandfathered because it was irrevocable on or before Sept. 25, 1985, it may partially or totally lose its grandfathered status if actual or constructive additions are made it.
Avoiding actual additions to a grandfathered trust is relatively straightforward. However, constructive additions are more problematic. Section 26.2601(b)(1)(v) of the Treasury Regulations (or “the constructive addition regulation”) currently treats a taxable release, exercise or lapse of a power of appointment over trust assets as if the trust assets over which the power was held had been withdrawn and immediately retransferred to the trust.
To the extent trust assets remain after the deemed withdrawal and retransfer, the regulation provides that a constructive addition has occurred. Conversely, limited powers of appointment (with the exception of the “Delaware tax trap,” discussed below) and wholly nontaxable general powers (such as “5 and 5” powers) do not result in constructive additions because such powers are not taxable.
The broad issue in creating a dynasty trust is whether the transfer of assets pursuant to the exercise of a general or limited power of appointment from a grandfathered trust to a newly created dynasty trust is a constructive addition to the trust that results in full or partial loss of grandfathered status; or whether the exercise is a protected transfer under the trust.
Transfers Under A General Power of Appointment
Two cases, collectively known as “The Peterson/Simpson Dilemma,” address the issue of whether assets passing from a grandfathered trust in which an individual held a general power of appointment are subject to the GST tax. E. Norman Peterson Marital Trust v. Commissioner, 102 T.C. 790 (1994), aff’d 78 F.3d 795 (2d Cir. 1996); Simpson v. United States , 183 F.3d 812 (8th Cir. 1999).
The effective date regulation provides that a transfer under a grandfathered trust is not subject to GST tax. A plain reading of that provision would lead to the conclusion that the exercise of a general power of appointment under a grandfathered trust would be a transfer “under” a trust for this purpose and, therefore, would not be subject to GST tax. In other words, the grandfathered status would not be lost.
On the other hand, to the extent assets remain or are deemed to remain in a grandfathered trust under the constructive addition regulation due to the release, exercise or lapse of a general power of appointment, a constructive addition to the trust is deemed to have occurred and grandfathered status is partially or totally lost. Thus, the regulations appear to distinguish between the lapse and exercise of a general power of appointment, the former resulting in a constructive addition, while the latter does not where no assets remain in the trust after the exercise.
This interpretation of the regulations, insofar as the lapse of a general power is concerned, was adopted by the U.S. Tax Court and affirmed by the Second U.S. Circuit Court of Appeals in Peterson. In this case, E. Norman Peterson died in 1974 and left a will that created a marital trust for the benefit of his second wife, Eleanor. Under the trust, Eleanor Peterson held a testamentary general power of appointment (an I.R.C. Sec. 2056(b)(5) marital trust). Eleanor Peterson allowed the power to lapse upon her death. As a result of the lapse, the trust property passed to her grandchildren.
The entire value of the trust property as of the date of Eleanor Peterson’s death was includible in her gross estate for federal estate tax purposes by virtue of the general power of appointment she held over the trust assets. The issue under litigation concerned whether the GST tax also applied since the trust property passed to grandchildren (i.e., skip persons).
Both the Tax Court and the Second Circuit held, consistent with the constructive addition regulation – which was issued as a temporary regulation at the time – that Eleanor Peterson’s failure to exercise her general power of appointment resulted in a constructive addition to the trust. Therefore, grandfathered status was lost and distributions of trust property to her grandchildren were subject to GST tax.
Each court based its holding in large part on the fact that Eleanor Peterson could have avoided the GST tax if she had exercised her general power of appointment in favor of non-skip persons (for example, children). The courts also noted that the grandfather provisions in general were intended to protect those taxpayers who formulated their estate plans on the basis of then applicable law, and now, due to the irrevocable nature of the trusts that they established, could not make arrangements from which to escape the GST tax.
Three years later in Simpson v. United States , the Internal Revenue Service sought to extend the Peterson holding to a situation where the surviving spouse actually exercised a general power of appointment in favor of skip persons. The Simpson facts were essentially identical to those in Peterson. However, while Eleanor Peterson allowed her power to lapse, Mary Simpson exercised her power in favor of grandchildren. As was the case in Peterson , the existence of the power held by Mary Simpson caused the entire value of the trust assets to be included in her gross estate for federal estate tax purposes. The sole issue before the court was whether GST tax also applied.
On its face, Simpson would appear to be a clearer case for application of the GST tax than Peterson since Mary Simpson affirmatively made a generation-skipping transfer, while Eleanor Peterson did so only by default. However, the effective date regulation clearly provides that a transfer “under a grandfathered trust” is not a transfer subject to GST tax. Addressing the issue in Technical Advice Memorandum 963003, the IRS held that, notwithstanding the regulation, Eleanor Peterson’s exercise of the power was a constructive addition to the trust. This conclusion was upheld in an unreported U.S. District Court decision.
However, the Eighth Circuit reversed. That court held that the exercise of the power was a transfer “under a trust” that was irrevocable on Sept. 25, 1985, and not out of property actually or constructively added to the trust after that date. Accordingly, under a plain reading of the effective-date regulation, the exercise of the power was not a generation-skipping transfer.
IRS Proposed Regulations
The IRS recently issued a nonacquiescence to the Simpson decision, indicating that it would not follow the court’s holding on a nationwide basis, except for cases appealable to the Eighth Circuit. Prior to the nonacquiescence, in an effort to provide parity to the effect of an exercise, release and lapse of a general power of appointment and essentially “fix” its regulations – the IRS proposed modifications to the effective date regulation. The proposed modification adopts and expands the Second Circuit’s holding in Peterson by directly contravening the Eighth Circuit’s holding in Simpson .
Under the proposed modification, the effective date regulation would provide that the “transfer of property pursuant to the exercise, release or a lapse of a general power of appointment” created in a grandfathered trust is not a transfer “under the trust” (Emphasis added), but is rather a transfer by the power-holder. Therefore, despite Simpson , a taxable transfer of property pursuant to the exercise of a general power of appointment would not be protected from GST tax.
Based on the foregoing discussion, practitioners faced with a grandfathered trust that grants an individual a general power of appointment over the trust assets should consider advising that the power be exercised. Clearly, the exercise of the power in favor of non-skip persons would attract estate or gift tax, but would avoid any possible GST tax consequences. A lifetime exercise would be the lesser of two evils in this situation because the power-holder can remove the property and all appreciation attributable to it from exposure to estate and gift taxation, as well as the amount of any gift tax paid in connection with the transfer, subject to I.R.C. Sec. 2035(b).
A more aggressive approach would be to exercise the power in favor of skip persons, or to a newly created dynasty trust, on the theory that Simpson is the controlling law. If that approach is taken, consideration should be given to making a formula allocation of GST exemption to minimize potential adverse GST tax consequences if the position does not prevail. Where the power is exercised in favor of a newly created dynasty trust, consideration should also be given to creating two trusts: one to receive a portion of the assets equal to the power-holder’s remaining GST exemption, and the other to receive the balance.
Finally, to minimize exposure to potential penalties, practitioners might also advise clients to file an IRS form 8275-R to disclose a position contrary to the Treasury Regulations.
Generally, with the exception of the “Delaware tax trap,” discussed below, exercising a limited power of appointment is not considered a taxable transfer for federal estate and gift tax purposes. Therefore, given the fact that the exercise of a general power of appointment is a taxable transfer, transferring assets from a grandfathered trust to a newly created dynasty trust by the exercise of a limited power of appointment is the more tax-efficient approach.
However, the following three provisions must be negotiated before this can be accomplished:
1. The so-called Delaware tax trap;
2. A proposed addition to the treasury regulations that deals with modifications to grandfathered trusts; and
3. The existing constructive addition regulation.
The Delaware Tax Trap
Before 1995, Delaware’s rule against perpetuities applied to trusts created by the exercise of a power of appointment as of the time of the exercise rather than at the time of the trust’s creation. Thus, a perpetual trust was possible in that state by simply creating and exercising successive powers of appointment.
In response to the Delaware law, Congress enacted I.R.C. Secs. 2041(a)(3) and 2514(d). Those power of appointment statutes (known collectively as “the Delaware tax trap”) generally provide that the exercise of a power of appointment, including a limited power of appointment, will cause the property applicable to the exercise to be included in the decedent’s gross estate if the power of appointment that can be exercised in such a manner so as to suspend the absolute ownership or power of alienation of the property for a period ascertainable without regard to the date of the creation of the first power.
The foregoing would appear to preclude the use of a limited power of appointment to create a dynasty trust under New Jersey law without significant estate and gift tax consequences, since it would clearly postpone the vesting of the interests in the original trust. However, in the case of Estate of Murphy v. Commissioner , the Tax Court held that if the state’s rule against perpetuities is not violated, neither is the Delaware tax trap. 71 T.C. 671(1979), acq. 1979-2 C.B. 2 (1979)
In this case, decedent Mary Murphy held a limited power of appointment over trust assets and exercised that power in favor of a new trust created under her will. Under that trust, the Murphy’s husband was also granted a limited power of appointment over the trust assets. The IRS argued that the exercise of the power over the trust assets by the decedent to create a new limited power of appointment in her husband was taxable, notwithstanding that it was a limited power, because it violated the Delaware tax trap.
Murphy involved Wisconsin’s version of the rule against perpetuities. That state’s rule is similar to New Jersey’s new rule in that it addresses the suspension of the power of alienation rather than suspension of vesting. It can also be easily avoided by granting the trustee the power to sell trust assets.
Since the newly created trust did grant the trustee the power to sell trust assets, the creation of the power in the decedent’s husband did not violate the Wisconsin rule. Accordingly, the court held that the Delaware tax trap could not be violated; to hold otherwise would be to impose its own rule against perpetuities on the taxpayer.
Whether Murphy can be relied upon to avoid the Delaware tax trap when exercising a limited power of appointment granted under a grandfathered trust to transfer assets from the trust to a newly created dynasty trust is uncertain. However, given the similarity of the Wisconsin rule and the new Jersey rule, a reasonably strong argument can be made that it should. Alternatively, the safest approach would be not to create additional powers of appointment in the new trust. However, this would result in a significant loss of flexibility.
Modifications And Constructive Additions
With minor exceptions, neither the statute nor the existing treasury regulations address the extent to which modifications to grandfathered trusts will or will not result in the loss of grandfathered status. Consequently, the IRS has been inundated with private letter ruling requests from taxpayers requesting guidance on the effect of a proposed modification to a grandfathered trust for GST tax purposes.
The IRS ruling position has been that a modification will not cause the trust to lose its grandfathered status if the modification does not result in any change in the quality, value or timing of any beneficial interest under the trust. In those circumstances, the modified trust is viewed as the same trust that was in existence on Sept. 25, 1985 (see PLRs 200014009, 199944027, 199942016, 19994-13 and 199942003).
Accordingly, the IRS has also proposed specific guidance concerning modifications to grandfathered trusts to reduce the number of ruling requests. Four types of modifications to grandfathered trusts are addressed: (1) the transfer of assets from a grandfathered trust to a new trust; (2) a court-approved settlement of a controversy regarding the administration of a grandfathered trust; (3) The judicial construction of a governing instrument; and (4) a modification of a governing instrument.
Since the focus of this discussion is upon the transfer of assets from a grandfathered trust to a newly created dynasty trust, only that proposal will be addressed.
Pursuant to proposed Treasury Regulation Section 26.2601-1(b)(4)(i)(A), a transfer of trust property from a grandfathered trust to a new trust will not cause the new trust to be subject to the GST tax, provided that (1) The terms of the existing trust permit the trustee to make the transfer without the approval of any court or beneficiary; and (2) The terms of the new trust do not postpone or suspend the vesting, absolute ownership or power of alienation of interests in the trust beyond the period provided in the original trust.
Similar to the Delaware tax trap, the second requirement appears to foreclose the ability to transfer grandfathered trust assets by exercising a limited (or general) power of appointment to a newly created dynasty trust without loss of grandfathered status.
Moreover, the constructive addition regulation would treat such a transfer as a constructive addition to the trust, thereby resulting in the full or partial loss of grandfathered status. Under that regulation – at 26.2601-(1)(b)(v)(B) – the exercise of a limited power of appointment under a grandfathered trust that postpones or suspends the vesting, absolute ownership or power of alienation of an interest in property beyond the period provided in the original trust is a constructive addition.
However, the Eighth Circuit’s holding in Simpson essentially overrules both of the regulations regarding the exercise of limited power of appointment. Simpson stands for the proposition that under the effective date regulation, a transfer under a grandfathered trust does not result in the loss of grandfathered status for GST tax purposes.
Thus, a reasonable basis exists for the position that, notwithstanding the regulations, grandfathered status should not be lost as a result of the transfer of trust assets pursuant to the exercise of a limited power of appointment. If that argument fails and the regulations stand insofar as the exercise of a limited power of appointment is concerned, practitioners can look to Murphy in support of the position that the regulations would only be violated if the then-applicable rule against perpetuities is also violated as a result of the exercise.
Therefore, notwithstanding the treasury regulations – both existing and proposed – Simpson and Murphy lend reasonably strong support to the argument that the assets of a grandfathered trust can be transferred to a newly created dynasty trust by the exercise of a limited power of appointment, without loss of grandfathered status and without triggering a taxable gift.
However, given the present uncertainty of the state of the law n this area, this technique should be reserved for those aggressive clients who are willing to challenge the IRS. Strong consideration should also be given to the preventative measures discussed earlier, such as a protective allocation of the GST exemption and the filing of IRS Form 8275-R to disclose a position contrary to Treasury Regulations.
A GST exempt trust created after Sept. 25, 1985, but before July 9, 1999, which grants a limited or general power of appointment over the trust assets, provides a safer opportunity for creating a dynasty trust compared with a grandfathered trust. For this type of trust, the grandfather provisions contained in the existing and proposed Treasury Regulations will not apply since those rules apply only to grandfathered trusts. However, where the dynasty trust is created by the exercise of a limited power of appointment, the Delaware tax trap must still be considered.
The repeal of New Jersey’s Rule Against perpetuities presents practitioners with the opportunity to create “true” dynasty trusts. The clearest opportunity lies with trusts created on or after July 9, 1999. Where a GST tax grandfathered trust (irrevocable before Sept. 25 1985) grants an individual a general or limited power of appointment over the trust assets, those assets may be transferred to a newly created dynasty trust under the power.
However, to do so risks the loss of grandfathered status, and, in the case of the exercise of a limited power of appointment, application of the Delaware tax trap. Finally, where a nongrandfathered trust created before July 9, 1999, which is exempt from GST tax grants an individual either a general or limited power of appointment over the trust assets, those assets may be transferred to a newly created dynasty trust without loss of GST tax exempt status. Where this is accomplished by the exercise of a limited power of appointment, however, the Delaware tax trap still presents an obstacle.
This article is reprinted with permission from the May 29, 2000 issue of the New Jersey Law Journal ©2000 NLP IP Company.