What is a BDIT?
Introduction to a somewhat controversial third-party planning technique
This is a continuation of the series on everything you ever wanted to know about estate planning trusts. For an intro and index to this series, please click here. The linked article will have a series index that gets updated periodically as well, so please bookmark it.
“…the true “gimmick” of the BDIT is that it allows the beneficiary, instead of the settlor, to sell their own assets to the trust in exchange for a promissory note, and in so doing to avoid gain recognition under the grantor trust deemed ownership rules. This creates a dynamic under which the beneficiary can control, and benefit from, the sold assets while still achieving the goals of (1) freezing the estate tax value of the sold assets, and (2) creating some creditor protection of trust assets, which is replaced by an unprotected … promissory note owned by the beneficiary.”
Table of Contents
Intro and Background
When we hear the term “BDIT,” its pronunciation may remind us of a popular Michael Jackson song from the 1980’s. But, it represents an interesting twist on the classic sale to a defective grantor trust under which the benefits of a third-party trust can be leveraged by a beneficiary to add their own assets to the trust – not by gift, but instead by sale.
Lifetime transfers of wealth to trusts can be made in two forms – (1) gifts, or (2) sales. These are not mutually exclusive, however. Each has a goal of freezing the estate tax value of wealth transfers, but each differs in the form of freezing. In the case of a gift, you are locking in (hopefully) the gift tax value of the lifetime transfer, which will then factor in to your estate tax calculation as an adjusted taxable gift. In the case of a sale, you are locking in the gift tax value – again – but instead of freezing the gift tax value, you are freezing the value of the exchange consideration to be paid that will be included in the gross estate at date-of-death values.
In terms of exchange consideration, we have a couple of basic tax problems. But, these crash headlong into broader considerations that affect our ability to freeze asset values to be discussed below.
First, a sale of assets usually results in recognition of gain if we sell appreciated assets. It can also result in an inability to deduct a recognized loss under related party rules. This is where a grantor trust comes into play. Since a grantor trust is disregarded for income tax purposes but respected for gift and estate tax purposes (under current law), we can sell assets to the trust without gain recognition but still achieve the value-freezing objective.
Second, we can’t actually get exchange consideration into a grantor trust without making a gift and using applicable credit. But, the trust’s promise to pay can stand in as valid exchange consideration if certain requirements are met. We generally must have a legally-enforceable promise under state law. In addition, the trust must have some creditworthiness, often established through seed funding to the trust itself. Often, it is recommended that around 10% of the purchase price be transferred to the trust – usually by gift – in order to establish the creditworthiness of the trust. This creates a somewhat imperfect value freeze, as the note must also bear interest – which reintroduces some growth to the gross estate, in the form of an interest-bearing note and payments of principal/interest thereon, each of which will be subject to gross estate inclusion at date-of-death values to the extent not spent or consumed during life.
(For a broader discussion of some of the issues with sales to a trust for a promissory note, this article outlines some specific considerations that may fly under the radar.)
The broader issue with lifetime wealth transfers, however, can be found in the application of Code Sections 2035-2038. Many individuals who give away wealth during life want to retain control, or possible benefit, from the transferred assets. However, the aforementioned Code Sections prevent the freezing of value if one retains benefit or control at the time of death, or relinquishes benefit or control within three years of death. And, under proposed Treasury Regulations, these Code Sections could also result in a clawback of gift tax basic exclusion used for making lifetime gifts.
In addition, these issues crash headlong into asset protection issues. It is difficult to transfer your own wealth into a trust and claim the protection of a spendthrift clause. Some states treat this type of transfer as being void per se, at least with respect to present creditors. Other states may respect the transfer, but might ignore the spendthrift clause to allow a creditor to obtain the maximum benefit that could be distributed to the settlor from their transferred property. But, there is a growing class of states respecting spendthrift protection for self-settled trusts, in the form of what is often known as a domestic asset protection trust (DAPT).
Both of these issues operate to allow creditors – including the IRS as the apex creditor – to ignore certain lifetime transfers over which a transferor retains benefit or control (i.e., a self-settled trust). But, these issues usually do not apply to third-party trusts nor do they apply to bona fide sales. In other words, if we sell an asset for adequate consideration in money or money’s worth (sometimes subject to the requirements of a significant non-tax motive or a lack of intent to defraud creditors), especially to a third-party trust, our lifetime transfers may not be disregarded.
The beneficiary defective inheritor’s trust, or BDIT, represents a way to get there. But, to understand the BDIT, we must understand some of the other grantor trust dynamics at play.
Beneficiary Sales to Trusts
Sometimes, the hat of “settlor” is a hat that cannot be removed when it comes to a self-settled trust for both estate/gift tax purposes and creditor protection purposes. But, if you are a beneficiary and not a settlor, you can exert significant control over a trust created for you (i.e., a third-party trust). You can be trustee of that trust, and so long as your distribution powers to yourself are limited to an ascertainable standard, you will not be treated as the tax owner of the trust. You can also hold a nongeneral power of appointment over the trust. A spendthrift clause will usually apply to protect the trust assets from claims of your creditors, subject to certain exception creditors (like for child support and alimony depending on the state).
A third-party trust tends to be more protected for tax and creditor protection purposes than a self-settled trust. A third-party trust also creates more flexibility for a beneficiary to control the trust. But, could a beneficiary have their cake and eat it too? Could they add their own assets to a third-party trust?
Generally, the recommendation is that a beneficiary should not do so. Any of their personal assets that get added to the trust, or that are deemed to get added to the trust (such as a refusal to exercise mandatory withdrawal or distribution rights), creates a self-settled trust which is subject to the same limitations described above.
What if, however, a beneficiary sells their own assets to a trust for adequate consideration? Could they leverage a bona fide sale exception? Generally, the answer is yes. But, this issue crashes headlong into the issue of recognizing gain or loss. If the grantor trust rules do not apply, this creates a sale by the beneficiary to a complex trust. If the grantor trust rules apply, this creates a sale by the beneficiary to the grantor as deemed owner.
There is a carve-out, however, under which a beneficiary can be treated as the deemed income tax owner of trust assets under the grantor trust rules. These rules are found in IRC Section 678. And, these rules create the backbone of the BDIT.
Beneficiary Deemed Ownership
Generally, in order for a beneficiary to be treated as the deemed income tax owner of trust assets, IRC Section 678(b) provides that the actual grantor (i.e., settlor) of the trust or the trust assets cannot be treated as deemed owner. In other words, if both the beneficiary and settlor could be treated as the deemed owner of the same trust assets, IRC Section 678(b) provides that the actual settlor/grantor will win out.
So, this creates our first test. We must have a trust over which the actual grantor retains no actual powers, benefits, or controls that would otherwise trigger the grantor trust rules under IRC Sections 671-677.
From there, it is possible for the beneficiary to be a deemed income tax owner in two ways. First, under IRC Section 678(a)(1), the beneficiary can be a deemed owner if they have a power exercisable solely by themselves to vest either trust income, or trust principal, in themselves. Second, if they have such a power (to vest income or principal in themselves) but either partially release or modify such power, then they can be the deemed owner if they continue to hold one of the powers or interests described in IRC Sections 671-677 that would otherwise cause the grantor to be deemed income tax owner. Both of these rules come into play where a BDIT is involved.
A better way to state this is that there are two sets of grantor trust rules. IRC Sections 671-677 typically only apply to the actual grantor of the trust (i.e., someone making a “gratuitous” transfer). IRC Section 678(a)(1) only applies to the beneficiary, and only if IRC Sections 671-677 don’t apply to the actual grantor. But, the powers of IRC Sections 671-677 can apply to a beneficiary who once was the deemed owner under IRC Section 678(a)(1), but later either (1) partially released such power, or (2) modified such power, and after such release or modification retained a power described in Sections 671-677.
The problem with any grantor trust situation is that it works best when you are all-in, or all-out. Partial grantor trust status is difficult to plan for, and usually means some recognition of gain on the sale of appreciated assets to a trust. In the context of a sale to a grantor trust by a settlor, we need the settlor to be the deemed owner of all trust assets – both before and after the sale – in order to avoid gain recognition on the initial sale and/or installment payments. Likewise, we need that same treatment for a beneficiary under the BDIT.
Why? Because the true “gimmick” of the BDIT is that it allows the beneficiary, instead of the settlor, to sell their own assets to the trust in exchange for a promissory note, and in so doing to avoid gain recognition under the grantor trust deemed ownership rules. This creates a dynamic under which the beneficiary can control, and benefit from, the sold assets while still achieving the goals of (1) freezing the estate tax value of the sold assets, and (2) creating some creditor protection of trust assets, which is replaced by an unprotected (from creditors) promissory note owned by the beneficiary.
So, the BDIT operates from a chassis of the beneficiary being a deemed owner under IRC Section 678(a). But, how can we get there without the beneficiary also being a deemed “settlor” of the trust? This is where some of the odd dynamics of IRC Section 678(a)(2) come in.
Withdrawal Right
The mechanism for creating deemed ownership of trust assets by the beneficiary under IRC Section 678(a)(1) comes in through having someone else, as settlor – often a parent or sibling – transfer some small amount of initial seed funding to the trust. Usually, this amount is limited to $5,000. Why? Because the mechanism for creating deemed ownership comes through a beneficiary’s right to withdraw this seed contribution, leading to deemed ownership of all (initial) trust corpus under IRC Section 678(a)(1). This should create a wholly-grantor trust at the moment of creating the withdrawal right, so long as the actual grantor is not the deemed income tax owner under the grantor trust rules. So, care should be taken to avoid creating any grantor-retained power that would supersede the beneficiary’s power of withdrawal in accordance with the priority rule set forth in IRC Section 678(b).
But, again, why $5,000? The limit to this amount stems from the desire to keep the beneficiary from being treated as a settlor of the trust for gift or estate tax purposes. Remember above how we mentioned that a beneficiary’s release, or refusal to exercise, a mandatory right to withdraw trust property can create a self-settled trust? There is a tax rule under IRC Section 2514(e) that prevents this from happening so long as the lapse of a lifetime general power of appointment (such as a withdrawal right) does not exceed the greater of $5,000, or 5% of the trust assets over which the withdrawal right could have been exercised. In this case, the greater amount that could create a complete lapse of the withdrawal right without adverse gift tax consequences is $5,000. So, by limiting the initial contribution and withdrawal right to $5,000, the problem of self-settling the trust is avoided for gift and estate tax purposes, and is also usually avoided under the creditor protection laws of several states (which often recognize exceptions for Crummey withdrawal rights).
The problem however, and where several thought leaders disagree, is on the mechanism of a lapse of this withdrawal right. Under a plain reading of IRC Section 678(a)(2), if the withdrawal right (over the $5,000 contribution) is either (1) partially released or (2) modified, then grantor trust status continues so long as the beneficiary retains a power described in IRC Sections 671-677. The beneficiary’s status as beneficiary and trustee should usually be enough to trigger this grantor trust status after the partial release or modification. But, can we classify a lapse of the withdrawal right as a partial release or modification? After all, IRC Section 2514(e) only applies to a lapse and not to a release, and a complete lapse semantically would not be a “partial” release or “modification” under 678(a)(2). I will not explain the tortured history of the interpretation of these conflicting statutes, but several private letter rulings have concluded that grantor trust status continues to apply with respect to a beneficiary under IRC Section 678(a)(2) after the lapse of a withdrawal right to the extent of the $5,000 lapsed portion.
So, if this conclusion is correct, we should have a wholly-grantor trust with respect to all trust assets – including those assets sold by the beneficiary to the trust – both before the lapse of the power under IRC Section 678(a)(1) (through a power to withdraw all $5,000 of corpus contributed by the actual settlor), and after the lapse under IRC Section 678(a)(2) (through the beneficiary’s retained rights to receive and control the distributions of income and principal under the other grantor trust powers of IRC Sections 671-677).
Thin Capitalization
The other issue with a BDIT, however, is thin capitalization. Recall above how, in a traditional sale by a settlor to a grantor trust, we looked for seed funding of around 10% of the purchase price (gifted to the trust by the settlor) in order to establish creditworthiness of the grantor trust to repay a promissory note? In the case of the BDIT, the limitation of the actual settlor’s seed funding to the trust to $5,000 keeps us from meeting this 10% threshold if the purchase price (for assets sold by the beneficiary to the BDIT) exceeds $50,000.
The risk encountered through inadequate capitalization of the trust is an IRS determination that the note was not intended to be respected, but instead that the beneficiary had made a gift to the trust. This would prevent the value freeze we seek, because this would force the beneficiary to wear the “settlor” hat for gift and estate tax purposes.
This is a topic worthy of its own separate discussion, but it is important to note that thin capitalization is just one of many factors that could be taken into account by the IRS in collapsing a note. It may not necessarily be the determining factor in isolation. Likelihood of the note being paid during the beneficiary’s life (through adequate income produced by the sold asset(s) and the note’s term), along with adequate security and interest, also come into play. Often, use of guarantees and other mechanisms of security can be used to offset some of the risks of thin capitalization.
There are aggregating factors to consider as well that may not be present with a traditional sale by the actual grantor/settlor, such as the beneficiary sitting on both sides of the transaction (as seller and trustee) – thus keeping the sale from being at arm’s length. Given this risk, it may make sense to have an independent trustee sign off on the sale of assets to the trust by the beneficiary. This independent trustee approval would extend to the determination of the purchase price, and a purchase price adjustment clause (which itself has a tortured history requiring multiple separate articles) could be a necessity to prevent a beneficiary from making a deemed gift to the trust if the exchange consideration paid by the trust is determined to be less than the value of the purchased property as finally determined for federal gift tax purposes.
Conclusion
Note that this is not a complete discussion of BDITs, but it is designed to give you a general overview of the basic mechanics of this wealth transfer strategy. When properly implemented, the BDIT allows a beneficiary with significant wealth (especially in the form of illiquid, income-producing assets) to self-fund a trust by sale instead of gift, which can alleviate the usual estate tax and asset protection risks of self-funding a trust. But, getting there requires navigating a lack of safe harbors in (1) determining wholly-grantor trust status with respect to the beneficiary under IRC Section 678(a), and (2) creation of a purchase and promise to pay by the trust that will be respected by the IRS for gift and estate tax purposes.
In the process, the beneficiary may still have to give up some control (at least temporarily). And, in an ideal world, the note will be paid off well in advance of the beneficiary’s death – thus favoring situations where the selling beneficiary has significant life expectancy.
In future installments, we will discuss some of the nuances of the beneficiary’s distribution rights, along with alternatives such as the beneficiary deemed owner’s trust (BDOT).