By Jason R. Johns, Esq.
A Beneficiary Defective Inheritor’s Trust, also known as a “BDIT,” is one of the most powerful estate tax and asset protection strategies available to taxpayers. A BDIT is an irrevocable trust created by a third party (“Third-Party Grantor”) that grants the taxpayer (who is both a trustee and the initial primary beneficiary of the trust, or the “Primary Beneficiary”) both control and beneficial enjoyment of the Trust property. The Primary Beneficiary may manage the Trust assets while avoiding transfer taxes upon one’s death and protect the assets from creditors.
Generally, IRS rules disallow a taxpayer to transfer assets to beneficiaries on a tax-advantaged basis while still retaining the right of use and control of those assets. These rules don’t apply to assets transferred by others to a beneficiary-controlled trust.
How Does a BDIT Work?
In a BDIT, the Third-Party Grantor (usually a trusted friend or grandparent) establishes a BDIT and names the Primary Beneficiary (the person who owns the asset to be transferred to the Trust) as both the Trustee and the initial Beneficiary. The Third-Party Grantor contributes their own cash (usually $5,000) or other equivalent property to the Trust but retains no powers or strings of control over the Trust that would cause the Trust to be taxed to the Third-Party Grantor.
Additionally, the Third-Party Grantor names an Independent Trustee to administer the Trust and manage all tax-sensitive decisions related to the BDIT. This Independent Trustee may be removed and replaced by the Primary Beneficiary at their discretion. The BDIT may also name the Primary Beneficiary’s children as contingent Beneficiaries. A Primary Beneficiary has discretionary control with a BDIT and may pass that control to Contingent Beneficiaries and Independent Trustee(s) if and when the Primary Beneficiary decides.
For the Trust to be “beneficiary defective,” the Trust language includes the power to withdraw funds from the BDIT. This “defect” ensures the Primary Beneficiary is treated as the Grantor of the BDIT—thus also becoming the income taxpayer of the BDIT—and freezes the value of assets for gift and estate tax purposes when such assets are sold to the trust.
The trust instrument will provide the Primary Beneficiary with a withdrawal right over the initially-contributed-funds and the withdrawal right will lapse if it’s not exercised within a specified timeframe, typically 30 days. Because the Primary Beneficiary had the ability to withdraw the entire trust corpus, the Primary Beneficiary will continue to be considered the Grantor of the entire Trust for federal income tax purposes even after their withdrawal right has lapsed.
Estate Freezing Transfer
The BDIT will purchase assets from the Primary Beneficiary with the original contribution from the Third-Party Grantor and a promissory note. The promissory note must be market-reasonable based on the current applicable federal rate. This transaction locks in the value of the transferred assets at their transferred value plus the interest rate required by the note. Any appreciation in the value of the transferred assets exceeding that rate will occur outside the estate of the Primary Beneficiary, instead accruing to the benefit of the Trust. As a result, assets expected to appreciate significantly in value, such as interests in a closely held business, are ideal assets to transfer.
The Primary Beneficiary can serve as an investment advisor of the trust and/or in a managerial position with the business in which the interests were sold to the trust, thus maintaining a considerable degree of control over the economic fate of the assets. The Primary Beneficiary retains the right to manage and receive income from the Trust; the right to invade the principal for the health, education, maintenance, or support; and the right to request additional discretionary distributions from the Independent Trustee.
A BDIT can provide a significant degree of asset protection. Since the Primary Beneficiary makes no gratuitous transfers to the Trust, the BDIT would not be considered self-settled for bankruptcy (and most state law) purposes. The BDIT allows the Primary Beneficiary to remove assets from one’s estate, thereby also protecting those assets from creditor claims.
Because the BDIT is a grantor trust to the Primary Beneficiary for federal income tax purposes, neither gain on the sale itself, nor the interest paid on the note that generates any taxable income. Moreover, any income of the BDIT is taxed to the Primary Beneficiary, which further reduces the Primary Beneficiary’s taxable estate and allows the trust assets to grow at an incrementally faster rate.
In short, a BDIT is an irrevocable trust that allows one to enjoy the benefits of a traditional trust without giving up control of their property. The BDIT is structured in a way that allows the beneficiary to continue managing and using their assets without causing the assets to be included in their taxable estate.
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