A Beneficiary Controlled Trust Carrying Significant Tax Savings and Asset Protection Benefits

What is a Beneficiary Defective Inheritor’s Trust (BDIT)

A BDIT is an irrevocable, grantor trust where the grantor grants specific powers to a primary beneficiary creating the “beneficiary defective” and authorizing the primary beneficiary full discretionary control of the trust. BDITs are ideal for asset owners holding assets with expected appreciation, such as operating businesses and real estate.

With a BDIT, control of, rather than the possession of, assets are passed to beneficiaries. The transfer of control may happen successively for multiple generations of beneficiaries safeguarding the assets in trust while optimizing tax liabilities.

How Does a BDIT Work

Typically, the owner of the appreciating assets utilizes a third-party grantor to establish a trust (or multiple trusts) where the third-party grantor names the assets’ owner as “primary beneficiary” with contingent beneficiaries. The third-party grantor funds, or “seeds,” the trust/s and appoints an independent trustee to make decisions such as discretionary distributions that would otherwise jeopardize a BDIT strategy.

The primary beneficiary then sells the appreciating assets–controlling interests of a company–in exchange for a promissory note paying interest transferring the ownership of the assets to the trust and thus, “freezing” the value of the assets for estate tax purposes.

Manage IRS Concerns and Scrutiny Using a Third-Party Grantor

Utilizing a third-party grantor (usually the parent of the owner of the assets) to establish a BDIT allows for the third-party grantor to assign roles to an independent trustee and a primary beneficiary as well as designate contingent beneficiaries. The third-party grantor must also “seed” the trust giving the trust the necessary economic substance to avoid unwanted exposure to the IRS. The responsibilities assigned to the primary beneficiary create the “beneficiary directive.”

Primary Beneficiary Acting As a Grantor Through Utilizing a “Beneficiary Defective”

The third-party grantor grants the primary beneficiary lapsing powers (Crummey powers), enabling the primary beneficiary to withdraw funds from the trust and creating the defect known as a “beneficiary defective.” Shifting responsibilities that the grantor typically assumes creates the beneficiary defective and allows the primary beneficiary to be treated as a grantor of the trust for income tax purposes.

The primary beneficiary has the right to make withdrawals, manage assets, and receive trust income as well as remove and replace the independent trustee.

Robust Tax Benefits Through Freezing the Assets’ Value

After the third-party grantor establishes the BDIT/s, the primary beneficiary may sell company interests (or other assets) to the trust at market value with a potential illiquidity discount in exchange for a promissory note with interest. Selling the company interests to the BDIT/s freezes the value at the date-of-contribution value. However, a BDIT is a grantor trust, and thus, the primary beneficiary must pay income tax on the BDIT income.

Establishing a BDIT and “freezing” the value of the company interests in trust insulates the company interests from estate, gift, generation-skipping (GST), and transfer taxes from any appreciation of the value of the assets in trust post-sale.

Furthermore, while the primary beneficiary must pay income tax on the trust, the income tax is then removed from the primary beneficiary’s taxable income and future estate, without impacting the value of the trust assets. Over time, the tax-savings derived from a BDIT are powerful and significant for the primary beneficiary and future generations.

Primary Roles

A Beneficiary Defective Inheritor’s Trust has four primary roles:

  1. Third-Party Grantor – Establishes and funds the trust (Often parent of the Primary Beneficiary).
  2. Primary Beneficiary – Designated by the Third-Party Grantor with decision-making responsibilities and authority and has discretionary control of the trust. The Primary Beneficiary sells assets to the BDIT in exchange for promissory notes.
  3. Contingent Beneficiaries – Designated by the Third-Party Grantor and/or the Primary Beneficiary (often the children of the Primary Beneficiary), creating a succession strategy for the assets in trust.
  4. Independent Trustee – Administers the trust and manages all tax-sensitive decisions related to the BDIT. May be removed and replaced by the Primary Beneficiary at the Primary Beneficiary’s discretion.

A Primary Beneficiary has discretionary control with a BDIT and may pass the control to Contingent Beneficiaries and Independent Trustees if and when the Primary Beneficiary decides.

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