A Beneficiary Defective Inheritor’s Trust (BDIT) is an irrevocable trust created by a third party (e.g., your parent). You are the primary beneficiary, investment trustee, and the taxpayer for the trust. Beneficiary defective means all trust income from the BDIT is includable on your (the beneficiary’s) income tax return. The BDIT allows you to control and benefit from the trust assets without jeopardizing the trust's ability to avoid estate taxes at your death. The BDIT is a great strategy if you want to enjoy the benefits of a traditional irrevocable trust, but still maintain control of the assets, avoid transfer taxes at your death, and protect assets from potential creditors.
The BDIT follows the premise that assets transferred by a third-party to a trust for your benefit receive asset protection and estate tax savings even if you control the assets. The trust must be set up as a beneficiary-controlled trust for you (the beneficiary) to gain the advantage of being the taxpayer.
Mom or Dad transfers $5,000 in cash to a beneficiary-controlled trust for your benefit, and Mom or Dad gives up all rights to the money transferred to the trust. Mom or Dad appoint a corporate trustee (IconTrust) to handle discretionary distributions and administration of the trust so it is administered properly. You as the beneficiary of the trust will be given a 30 day right of withdrawal over the $5,000, which will lapse. Per Section 678 of the internal revenue code, because you, as the beneficiary, had the right to withdraw the funds contributed to the trust, you, as beneficiary, will be considered the “grantor/owner” of the trust for income tax purposes. The trust is “beneficiary defective,” and you are now the taxpayer. Because of this feature, you are now allowed to sell assets to the trust on an income tax-neutral basis (I.e. there would be no gain recognized on a sale of assets to the trust).
Once the BDIT is set up, you would sell assets to the trust on a tax-neutral basis in exchange for a promissory note. The interest rate on the note would be equal to the Applicable Federal Rate (AFR) rate (the lowest rate the IRS allows to be charged for private loans). You have essentially removed assets from your taxable estate, provided asset protection for you and your beneficiaries, and still maintained control over the assets.
The best assets to sell to a BDIT are ones that provide a decent cash flow and that you expect to grow significantly. The most common asset to transfer by sale to a BDIT is an interest in a closely-held business. If you sell your S-Corp stock to a BDIT for $1M and the business grows to be worth $10M, you have moved $9M out of your taxable estate while still controlling the business and enjoying the appreciation.
When using a BDIT for opportunity shifting, the best assets for the BDIT are ones that do not take a significant amount of capital in which to invest, but which have the potential for significant appreciation. Often a beneficiary will start a brand new business, which requires little capital, in the BDIT. Starting the business from inception in the BDIT negates the need for the sale of an asset that may have already appreciated.
The BDIT is an advanced strategy with many benefits but also carries a lot of risks if not structured and administered correctly. IconTrust has many years of experience administering BDITs and relationships with attorneys who draft them. When properly structured, a BDIT is an incredible estate tax freezing and asset protection mechanism.
If you have any questions, please email firstname.lastname@example.org or call 702-998-3700