Imagine being able to move assets out of an estate, nearly tax-free, and put them beyond the reach of creditors, potential lawsuits, and estate taxes, all while retaining control over those assets. Imagine being able to modify and add to those assets in the future, all while being free of future taxes on the growth potential of certain estate assets. The Beneficiary Defective Inheritor’s Trust (“BDIT”) makes this possible.
Beneficiary Defective Inheritor’s Trust
Irrevocable trusts (“IRT”) have long been a favorite tool among estate planners for clients who wish to reduce their tax exposure and create robust asset protection. Typically, the client creates an IRT for the benefit of their spouse or children. The client then either gifts the asset(s)or sells the asset(s) to the IRT in exchange for an promissory note. If properly structured, this installment sale effectively removes the asset(s) from the client’s estate; however, the client also relinquishes at least some level of control and rights to use the asset(s). This loss of control and right to use an asset are often too severe for clients. As such, the client elects to maintain control and use of the asset, effectively exposing themselves to taxation, creditors, and other predators like divorcing spouses. Balancing control and protection is a major dilemma for clients but there are solutions.
Like an IRT, a BDIT is a trust created by one person or entity (the “Settlor”, aka the “Trustmaker”) for the benefit of another person (the “Beneficiary”). Unlike a typical IRT, the tax responsible person is the Beneficiary, not the Settlor. This means that the Beneficiary is the “Grantor” for tax purposes. Further, the BDIT allows the Beneficiary to: manage, use, and control the property in a manner equivalent to outright ownership; obtain the income tax, transfer tax, and asset protection benefits of an IRT; and structure gifts, loans, business, and investment opportunities with a relatively risk-free and low tax transfer transaction.
The BDIT accomplishes this through a series of steps, frequently called “Squeeze, Freeze, and Burn,” all of which function quite simply to create a larger and much more complex working estate planning vehicle. Here is how the BDIT works: A parent, friend, business associate, or other family member “seeds” the trust with an initial investment of $2,000-5,000, becoming the “settlor” of the trust. The client, the client’s spouse, or descendants are the beneficiaries and the trustees of the trust. The client then transfers an asset into a family business (such as a Wyoming LLC) for discounting purposes, sometimes called a “squeeze.” At a later date, the client sells the LLC (or other asset) to the BDIT for a promissory note equal to the fair market value (“FMV”) of the asset. This is often referred to as the “freeze,” because the value of the asset is frozen at the FMV, as determined in the promissory note. This means that for estate tax purposes, any appreciation in value of the asset will not affect the client’s estate tax because their tax is limited to the value of the promissory note. The asset is now in the BDIT and the promissory note payments are the only assets exposed outside the BDIT. As the promissory note is paid out to the client, the client pays the taxes on the income. This is often referred to as the “tax burn,” because the client is spending the promissory note payments on taxes and expenses, thus “burning” the exposed asset.
Typically, the client has a third party guarantee the note, generally for about 10% of the overall value of the note itself; the guarantor is paid a reasonable fee for their promise to stand behind the note, based on a fair-market determination by an appraiser. No guarantee is necessary if the initial seed gift is sufficient to serve as collateral; although this is unlikely if the assets being sold are high value. There is no limit to the number of installment sales the client may sell to the BDIT, allowing the client to move multiple assets out of their estates and into the irrevocable trust for exemptions from transfer taxes, income taxes, and estate taxes. Additionally, the transfer to the BDIT takes effect immediately, unlike self-settled trusts like a DAPT (Domestic Asset Protection Trust), which takes at least two years to avoid creditors.
Other than the obvious benefits and implications in terms of control that a BDIT can offer, there are several other important benefits to consider about using this particular estate planning tool. For one, none of a client’s personal gift exemptions will ever be eaten into if a BDIT is used instead of gifting an asset to a family member outright. BDITs also offer robust asset protection during life, as they are irrevocable trusts, avoid probate, and bypass the estate tax after death. Assets inside a BDIT can grow, tax-deferred, without the headaches of administration and book-keeping commonly associated with Intentionally Defective Grantor Trusts (IDGTs) and certain retirement plans. And besides the income tax from the promissory note, assets held by a BDIT avoid taxation. Finally, the BDIT can simply purchase life insurance on the client’s life without the proceeds being included in the client’s estate. Thus, the same benefits of the ILIT are available to the BDIT without the Crummey transfers and record keeping.
For clients who are desirous of maintaining control, gaining superb asset protection, and utilizing all possible avenues to avoid estate and transfer taxes, BDITs are a straight-forward, efficient method of removing assets from their estate to accomplish all of their goals.