After working hard your entire life to build your net worth, it is normal to not want to give up control of your property, as is required for certain estate and asset protection strategies. A relatively new trust — the beneficiary defective inheritor’s trust (BDIT) — provides powerful estate tax planning benefits while allowing you to retain control of your property.

ABCs of a BDIT

The BDIT strategy is based on the principle that, unlike the person who establishes a trust (the grantor), a trust beneficiary can receive substantial rights in a trust without causing the assets to be included in his or her taxable estate.

A BDIT is set up by a third party — typically, a parent or grandparent — who names you as beneficiary and trustee. As trustee, you manage the trust assets and exercise certain other rights over the trust.

To ensure the desired tax treatment, however, the trust should also name an independent trustee to make decisions regarding discretionary distributions, tax issues and trust-owned insurance on your life. Usually, BDITs are structured as dynasty trusts, so the trust can continue to benefit your children, grandchildren and future generations without triggering gift, estate or generation-skipping transfer tax liability.

For this strategy to work, the BDIT must have “economic substance.” So it is critical for the third-party grantor to “seed” the trust with his or her own funds.

If you give the funds to the third party, the IRS likely will treat you as the trust’s creator and the BDIT’s benefits will be lost. If you sell assets to the BDIT in exchange for a note, an oft-cited rule of thumb says that the seed money should be at least 10% of the purchase price. If the grantor lacks the resources to contribute that much, many experts believe that having a creditworthy third party (such as your spouse) personally guarantee the note is sufficient to lend the transaction economic substance.

Creating the “Defect”

A BDIT is structured to be intentionally “income tax defective.” (The preferred method of creating the “defect” is to grant you, as beneficiary, carefully designed lapsing Crummey withdrawal rights with respect to the entire trust contribution.) This accomplishes two important objectives:

1. It ensures that you are treated as grantor for income tax purposes. By paying the trust’s income taxes, you enable the trust to grow tax-free and you reduce the size of your estate.
2. It allows you to enter into tax-free transactions with the trust.

The second item makes it possible to leverage the BDIT to produce significant estate planning benefits. It allows you to sell appreciating, discountable assets to the trust tax-free, thus removing those assets from your estate and allowing you and your heirs to enjoy all future growth transfer-tax-free.

To ensure the transaction is not treated as a disguised gift, it is critical to sell the assets for fair market value and to ensure that the interest rate and other terms of the note are comparable to those in arm’s-length transactions.

Professional Help Required

As with all sophisticated estate planning strategies, the devil is in the details of the planning and execution. If your BDIT is incorrectly set up, you could be in for a surprise from the IRS. An estate planning attorney should be the person who drafts the trust.

For questions, contact Renee Andrews-Tushinski at 312.670.7444. Visit orba.com to learn more about our Wealth Management Group.