The beneficiary defective inheritor’s trust (BDIT) is a powerful estate planning tool that allows you to enjoy the benefits of a traditional trust without giving up control over your property. You can continue managing and using the BDIT assets without compromising the trust’s ability to reduce transfer taxes and shield assets from your creditors.
BDITs can hold a variety of assets, but they’re particularly effective for assets that have significant appreciation potential or that are entitled to substantial valuation discounts, such as interests in family limited partnerships and limited liability companies (LLCs). And by designing a BDIT as a “dynasty” trust, you can provide benefits for future generations without triggering transfer taxes or exposing the trust assets to creditors’ claims.
When to use one
Popular estate planning tools such as grantor retained annuity trusts and intentionally defective grantor trusts offer many benefits. They enable you to leverage valuation discounts to reduce gift, estate and generation-skipping transfer taxes. And they allow you to “freeze” asset values at their date-of-contribution levels, protecting all future appreciation from transfer taxes.
These tools also take advantage of the grantor trust rules to generate additional estate planning benefits. The trust’s income is taxed to you, as grantor, allowing the assets to grow tax-free and preserving more of your wealth for future generations. Essentially, your tax payments are additional, tax-free gifts to your children or other beneficiaries. And, because a grantor trust is your alter ego, you can sell it appreciated assets — removing them from your estate — with no income tax consequences.
Despite these benefits, most traditional trusts suffer from a significant disadvantage: You must relinquish the right to control, use or direct the ultimate disposition of the trust assets. If you wish to take advantage of trust-based estate planning techniques but you’re not ready to let go of your wealth, a BDIT may be the answer.
Why it works
The BDIT’s benefits are made possible by one critical principle: Assets transferred by a third party (such as a parent) to a properly structured trust for your benefit enjoy transfer-tax savings and creditor protection, even if you obtain control over those assets.
IRS rules prohibit you from transferring assets to beneficiaries on a tax-advantaged basis if you retain the right to use or control the assets. But those rules don’t apply to assets you receive from others in a beneficiary-controlled trust. The challenge in taking advantage of a BDIT is to place assets you currently own into a third-party trust.
How it works
The classic BDIT strategy works like this: Let’s say Molly owns her home and several other pieces of real estate in an LLC. She’d like to share these properties with her two children on a tax-advantaged basis by transferring LLC interests to trusts for their benefit, but she’s not yet ready to relinquish control. Instead, she arranges for her father to establish two BDITs, each naming Molly as primary beneficiary and trustee and one of Molly’s children as contingent beneficiaries.
To ensure that the BDITs have the economic substance necessary to avoid an IRS challenge, Molly’s father “seeds” the trusts with cash. (See the sidebar “Planting the seeds for a BDIT.”) He also appoints an independent trustee to make decisions that Molly can’t make without jeopardizing the strategy, including decisions regarding discretionary distributions and certain tax and insurance matters.
In addition, in order for each trust to be “beneficiary defective,” the trust documents grant Molly carefully structured lapsing powers to withdraw funds from the trust. This “defect” ensures that Molly is treated as the grantor of each trust for income tax purposes.
After the BDITs are set up, Molly sells a one-third LLC interest to each trust at fair market value (which reflects minority interest valuation discounts) in exchange for a promissory note with a market interest rate. When the dust settles, Molly has removed the LLC interests from her taxable estate at a minimal tax cost, placed them in trusts for the benefit of herself and her heirs, and provided some creditor protection for the trust assets.
Unlike a traditional trust strategy, however, this strategy allows Molly to retain the right to manage and use the trust assets, to receive trust income and to withdraw trust principal in an amount needed for her “health, education, maintenance or support.” She also has the right to receive additional distributions, at the independent trustee’s discretion, in any amount.
In addition, Molly has the right to remove and replace the independent trustee and to use a special power of appointment to distribute trust assets as she sees fit (so long as she doesn’t direct distributions to herself, her estate or her creditors).
The best of both worlds
Traditional estate planning techniques often involve a trade-off between tax and asset protection benefits on one hand and control over your wealth on the other. A properly structured BDIT can provide the best of both worlds. Talk with your advisor to determine if a BDIT makes sense as part of your estate plan.
Sidebar: Planting the seeds for a BDIT
To ensure that a beneficiary defective inheritor’s trust (BDIT) will withstand an IRS challenge, it’s critical for the sale of assets to the trust to have “economic substance.” Generally, that means that the third party establishing the trust must “seed” the trust with a meaningful contribution of his or her own funds. If you give the third party the seed money, the IRS will likely view the transaction as a sham.
According to a common rule of thumb, seed money should be at least 10% of the asset purchase price. This may not be feasible, however, if you plan to transfer millions of dollars in assets to a BDIT. If the third party lacks the means to contribute sufficient seed money, you may be able to make up the difference by obtaining a personal guarantee from a financially sound and creditworthy party (such as your spouse).