The benefits and risks associated with a beneficiary defective inheritor’s trust (BDIT)
An unusual estate planning vehicle that has the potential to convert thousands of dollars into millions is the beneficiary defective inheritor’s trust (BDIT). The trust is intended to operate effectively for younger entrepreneurs, especially those with technology businesses that are in their initial stages, and that can experience a rapid rise in value.
The trust is a third-party settled trust that is devised to grant the taxpayer, who is both a trustee and the first principal beneficiary of the trust, control and the right to enjoy the trust assets. The trust is written such that the beneficiary is considered the owner with respect to income tax. Usually, a parent, grandparent or other family member deposits $5,000 in the trust. The beneficiary, the child of the parent, is granted the right to make withdrawals right away. When the power to withdraw lapses, the child is then the only income tax owner, or grantor, of the trust.
The right to withdraw is then “defectively” changed, and the child remains in possession of the power to withdraw funds necessary for health, education, maintenance and support. At this time, the beneficiary can implement many measures, one of which is to make an installment sale to the trust. Examples of such a sale include an interest in a business, real estate or securities. Since the installment note is not yet due, the trust has time to increase its wealth to pay the note.
Some estate planners extol the benefits derived from using the beneficiary defective trust. One of its advantages is the reduction of the taxable estate by making payments on the income tax earned by the trust. It is also possible to establish the trust so that it is not income taxable to the beneficiary. In addition, the trust can protect assets from the reach of creditors and a divorce proceeding.
However, other estate planners have criticized such trusts as being too risky. One concern is that the trust could be viewed as a “step transaction.” Under the step transaction doctrine, a series of separate steps results in treatment by the IRS as a single event. The doctrine says that different steps that are interrelated in a transaction may not be treated independently of the entire transaction. In this case, the IRS can cause the transaction to collapse.
In fact, the IRS has identified BDIT sales as one of the transactions to which rulings or determination letters will not apply. A taxpayer could interpret this position as a statement from the IRS that it disfavors BDIT sales and that if individuals choose to engage in them, they do so at their own risk.
Nevertheless, if you are considering a BDIT, consult an experienced trusts and estates attorney, who can advise you as to its benefits and risks, and help you establish one that is appropriate for you and your family.