A Beneficiary Defective Inheritor’s Trust (BDIT) is an effective wealth transfer tool for business owners and other high-net-worth individuals in New York City (also referred to herein as NYC) because it helps them transfer appreciating assets, such as business interests, from their taxable estate. It is particularly useful for those looking to enhance their asset protection and reduce potential estate taxes for those who do not have federal gift tax exemption remaining.
How Does a BDIT Operate?
A BDIT gives beneficiaries access, control, and flexibility over trust assets through:
Initiation by a Third Party
A BDIT is typically established by a family member or close friend who makes an initial contribution of $5,000. The intended recipient is named as the primary beneficiary and, depending on the jurisdiction in which the BDIT is formed, could serve as Investment Advisor and Distribution Advisor. There is also an Independent Trustee that is authorized to handle distribution decisions and other tax-sensitive matters.
Grantor Trust Status
The beneficiary is given a temporary right to withdraw the initial gift (a “Crummey” power), which under IRC §678 makes them the owner of the trust for income tax purposes. As a result, the trust’s income is taxed to the beneficiary while the trust assets themselves remain outside their taxable estate and protected from creditors. The beneficiary paying the income tax personally also produces a “tax burn” effect: the trust grows income-tax-free while the beneficiary’s otherwise-taxable estate is steadily depleted, compounding the wealth transfer benefit over time.
Selling Assets to the BDIT
The beneficiary can sell assets to the BDIT in exchange for a promissory note, which would be includible in the beneficiary’s taxable estate. This technique is referred to as an “estate freeze”, because the value of the promissory note which is includible in the beneficiary’s estate is locked in while the appreciating asset that is owned by the BDIT is removed from the beneficiary’s taxable estate. Given the modest initial funding, a third party often serves as a guarantor of at least 10% of the sale price, which can be structured through an irrevocable trust established for the beneficiary’s descendants.
Ongoing Administration
If a jurisdiction such as Delaware is used, the beneficiary can serve as Investment Advisor and retain control over the BDIT’s investment and management decisions. Further, in Delaware the beneficiary could serve as Distribution Advisor and have the discretion to make distributions to himself or herself for health, education, maintenance and support. An Independent Trustee can make distributions to the beneficiary for any purpose, and the beneficiary can have the authority to remove and replace the Independent Trustee at any time with or without cause. The beneficiary is also permitted to have a special power of appointment, allowing them to direct who receives the assets upon their death. This is essentially a built-in “re-write” power that adds flexibility to the estate plan by adjusting the ultimate disposition of assets as circumstances change throughout the beneficiary’s lifetime.
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—Tommaso Marasco, Associate Attorney
