In the past two years, I have noticed an increase in the amount of our clients whose estate planning attorneys are forming a beneficiary defective inheritor’s trust (“BDIT”) to maximize the high federal estate tax exemption, currently $11,850,000 per person, in order to transfer assets with significant appreciation potential. Typical assets selected include those entitled to substantial valuation discounts, such as interests in limited liability companies and family limited partnerships. The BDIT includes many of the benefits of a traditional trust but does not require you to give up control of your assets, including property.
The laws behind other irrevocable trusts apply to BDITs, including a substantive one which makes BDITs possible. Assets transferred by a third party, such as a parent or other family member, to a properly structured trust for your benefit enjoy transfer-tax savings and creditor protection, even if you obtain control over those assets.
How it Works
A parent (third party) sets up a trust, a BDIT, for your benefit and the parent is considered the settlor. You are the primary beneficiary and you can make your children contingent beneficiaries. The parent should gift funds to the trust to establish economic substance. Many experts claim that the amount of funds should be equal to at least 10% of the purchase price of the property the trust will be purchasing.
The BDIT gives you the right to withdraw the gift made to the BDIT and this is the well-known “Crummey power” that is a part of insurance trusts. This right results in you being the grantor for income tax purposes of the BDIT and income of the trust is taxed to you. As a result, your parent is prevented from having any right that might cause the BDIT to be taxed to the parent as if the parent were the grantor for income tax purposes.
Since the BDIT is treated as a grantor trust to you, you can sell large appreciated assets to the trust without triggering capital gains tax. You can sell your family business or another appreciating asset to the BDIT and the BDIT will give you a note for the purchase price. There may be valuation discounts to apply to greatly reduce the transfer price and the value of the resulting note.
Now the appreciating asset or assets are outside of your estate and can appreciate in value outside of your estate, too. In effect, you have frozen the value of what can be taxed in your estate. A life insurance policy purchased by the BDIT can have its death benefit proceeds pay any estate taxes which may still be due for the value of the assets in the estate. The BDIT’s trustee can distribute income from the assets, like earnings from a business, to you and any other beneficiaries. In other words, the income and growth in assets inside the BDIT can benefit you and other descendants while never being subject to estate tax.
Because the BDIT is a grantor trust, you are responsible for paying tax on the income on all trust earning even if you do not receive any income. While this may seem like a negative, it is often perceived as a positive since these tax payments can further reduce the value of your estate while keeping all income and asset growth outside of your estate.
Benefits of a BDIT to You
Removes the value of the business and all future appreciation from your estate without triggering gift tax
Provides the trust assets with some protection against creditors’ claims
Retains the right as beneficiary to manage trust assets, to receive trust income, to withdraw trust principal for your “health, education, maintenance or support”, and to receive additional distributions in the independent trustee’s discretion
Retains the right to remove and replace the trustee
Retains the right to distribute trust assets if the distribution is not for your benefit
Can purchase life insurance and own it outside of your estate
If you are considering a BDIT, please consult an experienced trusts and estate attorney who can advise you as to its benefits and risks, and help you establish a BDIT which is appropriate for you and your family.
Jay C. Judas, JD M.Sc. is the CEO of Life Insurance Strategies Group, an independent and experienced life insurance advisory firm. He is also a part of our world class team.
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