Beneficiary Defective Inheritor’s Trust (BDIT)
A Beneficiary Defective Inheritor’s Trust (BDIT) is an irrevocable trust settled by a third party that grants the taxpayer both control and beneficial enjoyment of the Trust property. The taxpayer may manage the Trust assets while avoiding transfer taxes upon one’s death and protects 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 (e.g., grandparents are settlors and child is both Trustee and Primary Beneficiary of Trust).
How Does a BDIT Work?
In a BDIT, a Third Party (such as a trusted friend or grandparent) establishes a BDIT and names the person who owns the asset to be transferred to the Trust as both the Trustee and the initial Beneficiary of the BDIT.
In order for the Trust to be “beneficiary defective,” the Trust language includes the power to withdraw funds from the BDIT. This “defect” ensures the Trustee/Beneficiary is treated as the Grantor of the BDIT, thus also becoming the income taxpayer of the BDIT.
The Third-Party additionally names an Independent Trustee to make decisions the Trustee/Beneficiary cannot make without jeopardizing the strategy (e.g., discretionary distributions, tax, and insurance issues). The BDIT may also name the Trustee/Primary Beneficiary’s children as contingent Beneficiaries.
The BDIT may then purchase assets from the Trustee/Primary Beneficiary with the trust’s seed money and a promissory note (The Third Party must have previously seeded the BDIT with funds for the asset purchase). The promissory note must be market-reasonable based on the current applicable federal rate.
Generally, seed money equals approximately ten percent (10%) of the purchase price or $5,000 with a guarantee for the balance. Where assets are divided among several BDITs, significant minority ownership valuation adjustments (AKA discounts) may be applied, thus reducing the amount required to seed the Trust and dramatically enhancing the strategy.
The BDIT allows the Trustee/Primary Beneficiary to remove assets from one’s estate, thereby also protecting those assets from creditor claims, but one has retained some control and beneficial use of the assets. The Trustee/Beneficiary retains the right to manage and receive income from the Trust; invade the principal for the health, education, maintenance, or support; and the right to request additional discretionary distributions from the independent Trustee.
As long as the Trustee/Beneficiary does not direct discretionary distributions toward oneself, s/he also may have a special power of appointment to make broad discretionary distributions to others.
Ideal Assets for BDITs
Assets that have significant appreciation potential or are entitled to substantial valuation discounts, such as:
- Shareholder interest in a closely held corporation.
- Member interest in LLC.
- Interest in an FLP.
The Benefits of a BDIT
- Control of the asset and beneficial enjoyment of the Trust property.
- Tax mitigation for assets is expected to appreciate significantly.
- Remove growth of transferred assets out of grantor’s estate.
- Protection from creditors.
- Payment of income taxes results in an additional gift-tax-free transfer.
- There is no allocation of the unified credit required.
- Additional assets may be added in the future.
Disadvantages of a BDIT
- There are greater complexities involved in a BDIT, requiring annual administration cost.
- BDITs are not vehicles usable for annual gifts to beneficiaries (other strategies, such as Intentionally Defective Grantor Trusts, are better suited for annual gifting to others).
A Beneficiary Defective Inheritor’s Trust has four primary roles:
- Third-Party Grantor – Establishes and funds the trust (often a parent of the Primary Beneficiary).
- 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.
- 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.
- 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 their 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.