Take-Away: Each year nationally recognized estate planning attorney Steve Oshins publishes his ranking of state legislation that is intended to provide flexibility and creditor and tax protection to irrevocable trusts. Michigan appears fairly high in a couple of ranking categories while in others is simply does not appear ranked at all. Some of those rankings follow with a terse explanation of probably why Michigan’s laws compel its assigned rank. All of this attention on state statutes that deal with irrevocable trusts reflects the race to capture as much dynasty trust business as possible by a state.

Asset Protection Trust: Michigan’s Qualified Dispositions in Trust Act [MCL 700.1042] is ranked 5th out of 17 states that have some form of asset protection trust. Higher ranked states do not impose an income tax on trust income, which explains the perception that they are more favorable states in which to establish an asset protection trust. The other explanation for Michigan’s rank is that a preexisting creditor may have more time to pursue a claim and not be barred by the statute of limitations as that limitations period can be extended beyond two years if there was some delay in the preexisting creditor actually discovering the settlor’s transfer of assets to the Qualified Dispositions Trust. [Delaware is ranked 7th.]

Dynasty Trust: Michigan is not even ranked in this category. Almost all of the states that are listed in this ranking permit perpetual trusts, or the trust must terminate only after 1,000 years. Michigan’s rule against perpetuities is generally thought to require that an irrevocable trust  can last no longer than 360 years if it holds intangible personal property e.g. stock, and no longer than 90 years for real estate held in trust,  although the 90 year limitation for real estate held in trust seems to be easily circumvented if the trustee ‘wraps’ title to the real estate inside an LLC, which under Michigan law is treated as intangible personal property. [Delaware is ranked 8th.]

Trust Decanting: Michigan’s decanting legislation is ranked 21st out of 25 states that have formally adopted decanting authority legislation for trustees. [Note, many states consider the trustee to hold a power to decant under common law, so long as the trustee possesses discretion to distribute income or principal from the trust.] [MCL 700.7820a; MCL 556.115a] Michigan’s lower ranking is probably because a trustee cannot decant a trust if there exists an ascertainable standard in the original trust that restricts the trustee’s discretion. All of the states listed above Michigan in the ranking give the trustee the power to decant even if the trust’s distribution authority is limited by an ascertainable standard. The other distinction is that Michigan’s decanting statute requires the trustee to give notice to trust beneficiaries before it formally exercises the decanting power, while many other states do not require advance notice to be given to trust beneficiaries. [Delaware is ranked 5th: decanting can occur even if an ascertainable standard controls the trustee’s discretion, and no advance notice is required to be given to trust beneficiaries.]

Non-Grantor Trust Taxation: This last list deals with a growing ‘hot-topic’ in estate planning that deals with when states can impose a state income tax on accumulated income in a non-grantor irrevocable trust, i.e. a dynasty trust. We are already acutely aware of that high income tax burden the federal government imposes on accumulated income in an irrevocable trust. The search is for a trust situs where the state does not add to that tax burden on accumulated income in an irrevocable trust. You will recall that the federal government currently imposes a 39.6% income tax on income accumulated in a trust in excess of $12,500 in a calendar year. In addition, the trust might also attract the 3.8% net investment income tax on top of the 39.8% income tax rate. Thus a heavy tax burden already exists for the irrevocable trust that accumulates income, so there is a premium on avoiding the imposition of a state income tax if possible. Michigan imposes a 4.25% tax on trust income. [MCL 206.18(1)(c)] This income tax will be imposed on a Michigan irrevocable trust that accumulates income IF: (i) the trust is set up by the Will of a Michigan resident; or (ii) the settlor of the trust was a Michigan resident at the time the trust becomes irrevocable, UNLESS- (a) there is no Michigan trustee, (b) no Michigan assets and (c) no Michigan beneficiary. [For comparison purposes, Delaware imposes a 6.60% tax. [30 Del C 1601(8)-(9); 30 Del C 1636.] Delaware’s income tax will be imposed only if the trust is set up by the Will of a Delaware resident, or the settlor of the trust was a Delaware resident, or the majority of the trustees are Delaware residents for more than ½ of the year; and in all of these situations, the Delaware income tax will be imposed only if there is a Delaware trust beneficiary. In short, if there is no Delaware beneficiary, there is no imposition of Delaware’s state income tax.]

Why Are Dynasty Trusts Popular?:

  • Estate Tax Protection: When a dynasty trust beneficiary dies the value of the trust’s assets will not be included in the beneficiary’s taxable estate, and thus those assets will avoid the imposition of a federal estate tax over multiple generations.
  • Creditor Protection: In a state like Michigan, where the law is abundantly clear that the beneficiary of a discretionary trust does not possess a property interest in the trust [MCL 700.7505; 700.7815(1)], there is nothing for a creditor of the beneficiary to attach.
  • Divorce Protection: If the dynasty trust beneficiary is in a divorce, the divorce court cannot reach a trust where the beneficiary does not possess a property interest. At best, a divorce court can only attach assets when they are distributed from the dynasty trust to the beneficiary. [MCL 700.7503(1).] Nor can a divorce court compel the use of trust-owned assets by the beneficiary’s spouse. [MCL 700.7503(2)].
  • Income Tax Shifting: With multiple beneficiaries, the trustee can spray income to trust beneficiaries in the lowest marginal federal income tax bracket.
  • State Income Tax Avoidance: The opportunity exists to avoid paying state income taxes by accumulating trust income in the trust when the trust beneficiaries do not need or want the income, e.g. placing the situs of the trust in Delaware when there are no Delaware based beneficiaries so the accumulated trust income avoids state income taxation.
  • Tax Basis Planning: A trust protector can be given the power to grant to a trust beneficiary a general testamentary power of appointment over specific dynasty trust assets, which has the effect of causing estate tax inclusion over those appointive assets (whether or not the power of appointment is actually exercised) which will cause an income tax basis adjustment to the specific assets held inside the dynasty trust. This then permits the trustee to sell the identified assets, after the basis adjustment,  without any capital gain recognition.
  • Frustrate Elective Rights: All assets held in the dynasty trust will be used and enjoyed by the beneficiary but not owned by the beneficiary. As a result, upon the beneficiary’s death, when his/her spouse may assert elective rights against the deceased beneficiary’s estate, the dynasty trust’s assets will not be included in either the calculation of the survivor’s elective rights or the satisfaction of those statutory elective rights given to a surviving spouse under state probate laws.

Conclusion: Whether a dynasty trust continues to be a popular estate planning vehicle in the face of promised tax reform is open to question. Even if the ‘death tax’ is repealed, it will probably be for no more than 10 years, and consistent with prior efforts to kill the ‘death tax,’ the elimination of the federal estate tax will be phased in over those ten years. Ignoring the perceived estate tax savings benefits of a dynasty trust, there are still many other benefits that might be gained for clients who adopt a dynasty trust. Hence the ‘race’ among the states to adopt the most attractive legislation to induce dynasty trust business.