About Dynasty Trusts.
Dynasty trusts are now more en vogue than ever due to the highest federal gift, estate and generation-skipping transfer (GST) tax exemption amounts in history. In addition, more states have modified or abolished the common law rule against perpetuities, and the modernization of trust law under the Uniform Trust Code (UTC) now allows for a variety of ways to modify irrevocable trusts. Consider that trusts funded in 2022 with the $12.06 million of available exemption stand to grow to over $30 million in just 20 years when compounding at a modest 5% rate of return. This means that trusts established and funded with that amount today are likely to last more than just one generation, warranting a perpetual trust structure. Many states’ laws now allow for such dynastic trusts, permitting assets to be held in trust without running afoul of the maximum duration for trusts under common law. The cherry on top is that in UTC jurisdictions, clients need not shy away from a perpetual trust for fear of creating a static vehicle that can’t be modified for unanticipated changes in family circumstances. Moreover, decanting, modification agreements and nonjudicial settlement agreements are now available in many states, adding newfound flexibility to planning with long-term trusts.
Separate Share Trusts
For many years, the default trust design was to divide trust assets immediately into either per stirpital or per capita shares to be held in separate share trusts for descendants. This was especially true with lifetime trusts that give the trustee complete discretion in making income and principal distributions. This tried-and-true method of drafting addresses the majority of clients’ goals in: (1) treating children equally in the initial division of trust assets, and (2) protecting the beneficiaries’ inheritances from the claims of creditors. And yet, while this common approach to trust structuring does address most clients’ main objectives in architecting their estate plans, rarely do clients understand that the immediate splitting of the trust estate into separate trusts can result in disparate treatment of beneficiaries just one generation lower.
Take, for example, a situation in which one child proves to be more of a spendthrift than their siblings or another very common situation in which one child chooses to have more children than their siblings. In either scenario, a client’s grandchildren may inherit disproportionate fractions of the assets the grandparents left in trust for the family based solely on decisions made by their parents. Rarely, if ever, however, does a client endeavor to treat their grandchildren differently, yet clients aren’t always advised of this consequence when defaulting to a separate share trust structure. A hyperbolic example is a family with two children in which one child has 10 children, and the other child has one child. In this example—assuming all else is equal—the one grandchild ends up with 10 times what their cousins inherit in traditional per stirpital planning. Each generation only compounds this problem.
The Long-Term Pot Trust
A single share or pot trust is held for the benefit of a group of beneficiaries rather than for only one primary beneficiary. A typical pot trust may include a large class of beneficiaries, such as the descendants of a client’s maternal and paternal grandmothers, to preserve the flexibility for the dynasty trust to serve as a “family bank,” benefiting more than just the client’s nuclear family should the trust assets be of exceptional size or should family circumstances change. If the trust is structured such that the trustee maintains full discretion over trust distributions, the inclusion of additional family members as merely permissible beneficiaries may be that much more desirable as this design merely provides the opportunity—but not the requirement—to benefit other family members should a need arise.
This highlights one of the most attractive features of the pot trust structure: the flexibility to defer decisions on hard-to-answer questions until later on down the road. One of the most challenging questions for clients to answer can be whom they ultimately want to benefit from the trust assets. It’s nearly impossible to imagine or foresee how family circumstances may change and evolve decades into the future, and yet trusts funded with high exemption amounts today have the potential to continue for several generations. Asking clients to choose up front as to the total pool of beneficiaries to be included now may not be prudent or desirable for many clients. As such, the best recommendation may be to offer up a structure that allows the client to defer that decision until the client or a trustee is better equipped to make such a choice after seeing how trust assets perform over time and how the client’s family matures.
Benefits of Pot Trusts
One of the key benefits of a pot trust is that it allows the flexibility to defer decisions on hard-to-answer questions until later. But there are other benefits to consider.
A pot trust allows the trustee to distinguish among beneficiaries just as the settlor likely did during life. One beneficiary may have the skills and temperament to thrive in an Ivy League setting, while another beneficiary may be much better suited to art or design school. One beneficiary may have substantial health needs while another is fit as a fiddle. While some parents may ultimately try to equalize overall distributions between these two beneficiaries, our experience tells us that most parents don’t keep score this way, focusing instead on giving each beneficiary what they need. Removing the temptation to equalize allows the trustee significantly better chances of responding to each beneficiary’s actual needs and interests.
Families with dynastic intent who want to see their wealth grow and support not only children and grandchildren but also descendants further down the line often may find the pot trust a better option. In working with what we call “100-Year Families,” we notice that pot trusts lend themselves to more effective management by bringing members from different branches of the family tree who have different life experiences and goals into the management of the trust. A grandchild who participates on a trust advisory board with members from both older and younger generations will likely develop strong relationships with their family members, which will, in turn, lead to decision making that fosters multigenerational benefit from the trust. Involving younger family members in the management of the trust also keeps the trust relevant and meaningful over the years.
Income tax planning is another benefit of a pot trust structure. If the trustee can pick from a large group of beneficiaries, they can make distributions that shift taxable income to lower bracket taxpayers. They might also decide to make distributions in kind to reduce tax recognition. In the aggregate, these tax savings should result in more wealth to reinvest, increasing the family’s overall wealth.
Overall costs of administering a single share instead of separate shares should be lower. Record keeping, accounting, costs associated with managing real estate and back-office costs will be incrementally higher with five or six shares than with only one share. Pot trusts allow trustees to take advantage of economies of scale, saving costs in performing basic trustee functions.
Duty of Impartiality
Balancing the needs of many beneficiaries will be more difficult than managing the needs of a single beneficiary with a separate share.
The biggest concern is the duty to act impartially in administering assets held for multiple beneficiaries with different needs, tolerance and risks. Without a specific waiver of this duty in the trust document, a provision that would require careful discussion with the settlor, the conflict exists even if the trustee has absolute discretion over distributions. This duty (and the related duty of acting in good faith) doesn’t mean that overall distributions among beneficiaries should result in equitable distributions. Instead, it means that the trustee can’t make decisions based on personal favoritism or animosity toward a beneficiary. A trustee shouldn’t make “better” distributions to a beneficiary who simply has more access to the trustee or is more aggressive than other beneficiaries. This may be more complicated with multiple beneficiaries, but it’s no less or more important than in a separate share trust.
Trustees should always communicate with their beneficiaries, but this is especially true while administering pot trusts. To satisfy the duty of impartiality (and the related duty of acting in good faith), a trustee must take reasonable steps to discover a beneficiary’s needs, and consistent communication with the beneficiaries of a pot trust is vital in that respect. Conversely, the trustee has a duty to keep beneficiaries informed, including the reasons discretionary distributions have been or will be made. Regular discussions with beneficiaries along with written reports or emails summarizing discussions and decisions sent to all or at least a fairly representative group of beneficiaries will offset the worry a trustee feels in making discretionary decisions for a pot trust. Creating a family advisory board or a committee of trustees composed of a fairly representative group of beneficiaries may help achieve the trust’s purpose (as discussed above); it may further reduce the risk a single trustee may feel in making discretionary decisions.
Perhaps the most helpful tool for a trustee with discretionary authority is a letter or statement of wishes from the settlor. The trustee’s duty to comply with the terms of the trust and their duty of impartiality require the trustee to discern the purposes of the trust from the trust document and other contextual information about the trust’s objectives. That can be exceedingly difficult once the settlor can’t answer questions from the trustee. Although letters and statements of wishes are precatory in nature, they guide the settlor on various matters, including the special issues discussed above, giving trustees much needed information to consider in making discretionary decisions.
Unique Investment Assets
Certain assets are better suited to the unified ownership structure provided by a pot trust: for example, a vacation home that multiple individuals use across generations in a family. Owning such an asset in a pot trust allows the trustees to coordinate use, maintenance and improvements without requiring the cooperation or consent of numerous family members.
Holding personal use real estate in separate trusts for different family members, by contrast, raises issues of fairness and coordination. Although ownership of the property could be unified by titling it in the name of a limited liability company (LLC) with the various trusts as members, the LLC manager would be in the unenviable position of allocating usage of the home and seeking pro rata reimbursement for expenses from different trusts, whose trustees and beneficiaries may have greatly differing opinions regarding the property, its use and upkeep and even whether it should be retained or sold. Unless the LLC is funded with significant liquid assets, its member trusts will occasionally be required to make additional capital contributions to maintain and improve the property. If one beneficiary never or rarely uses the property, they (or their trustee) are unlikely to agree to an expensive renovation. Even if the LLC operating agreement contemplates that a majority or supermajority vote can compel all members to make additional capital contributions, doing so may cause resentment and family conflict. While the overall economics may be identical in the pot trust and separate trust scenarios, pot trust ownership discourages the perspective of “mine” versus “yours” money among family members, which is likely to give rise to intrafamily tension.
Not all assets are well-suited to a pot trust ownership structure, however. Consider a closely held operating business in which some, but not all, family member beneficiaries participate in running the business. While a settlor might be tempted to transfer such a business into a pot trust to ensure continuity and consolidation of ownership, there’s significant potential for conflict between beneficiaries involved in the business’ operation and those who aren’t. The family business managers may prefer to boost their compensation rather than increase income or appreciation that benefits the trust because trust assets must be shared among a larger class of beneficiaries.
General Investment Considerations
Even in the absence of unusual assets, different investment approaches may be appropriate for pot trusts and separate trusts. The larger size of a single pot trust might seem to permit a higher risk investment strategy, and its larger purchasing power may open up investment opportunities unavailable to smaller trusts. However, the fiduciaries of a pot trust must consider the circumstances of all beneficiaries, and it may be difficult to appropriately balance the risk appetites of beneficiaries of different generations and life situations. Separate trusts permit a more individualized investment approach. In either case, the trust instrument should be drafted to reflect the settlor’s wishes regarding investment strategy.
The Best of Both Worlds
Pot trusts offer flexibility that can’t be found in separate share trusts. They: (1) allow planning for families with young children whose needs and interests aren’t yet clear, (2) reduce the risk of inequity for future generations based on access by earlier generations, (3) reduce the costs of administration, and (4) provide opportunities for involving multiple generations in trust management. They also offer unique investment advantages for various assets. However, separate share trusts may still be a better choice based on a specific client’s facts and circumstances, particularly when primary beneficiaries are older and have clearer needs, a relationship with a primary beneficiary is difficult and keeping things separate will likely reduce family tension, particularly when multigenerational planning isn’t as important.
Like so many estate-planning decisions, those around multigenerational trust structure require careful discussion with clients, particularly because pot trusts can be designed to split into separate shares on a certain event (for example, the young beneficiary’s reaching a certain age) or at any point the trustee determines separate shares make more sense. The trustee can divide the entire pot or bifurcate a particular percentage in creating separate shares. These options allow clients to have their cake and eat it too. As a result, divisible pot trusts deserve to be considered more often than the current default regime of per stirpes.