A BDIT, also known as the “Beneficiary Defective Inheritor’s Trust,” is one of the most powerful estate tax and asset protection strategies available to taxpayers. Essentially, it’s a third-party settled trust designed to give the taxpayer (who is both a trustee and the initial primary beneficiary of the trust) control and beneficial enjoyment of trust property such that the taxpayer can use and manage the trust assets without compromising the trust’s ability to avoid transfer taxes at the client’s death, and to protect the trust assets from the client’s creditors.
How a BDIT works
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 the tool is important
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.
The classic BDIT strategy works like this: Let’s say Mary 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 Mary as primary beneficiary and trustee and one of Mary’s children as a contingent beneficiary.
To ensure that the BDITs have the economic substance necessary to avoid an IRS challenge, Mary’s father “seeds” the trusts with cash. He also appoints an independent trustee to make decisions that Mary 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 Mary carefully structured lapsing powers to withdraw funds from the trust. This “defect” ensures that Mary is treated as the grantor of each trust for income tax purposes.
After the BDITs are set up, Mary 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, Mary 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 Mary 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.” In addition, Mary can remove and replace the independent trustee and 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 bottom line
If you’re considering creating a BDIT, make sure you work with a qualified estate tax advisor. He or she can help you create the BDIT and ensure it works for your family.