By temporarily doubling the gift and estate tax exemption, the Tax Cuts and Jobs Act (TCJA) opened a window of opportunity for affluent families to transfer assets tax-free. To take advantage of the higher exemption amount, many families that own businesses or other assets worth more than the pre-TCJA exemption amount are planning substantial gifts to their children or other loved ones during the next seven years.
Traditionally, parents use trust-based gifting strategies to transfer assets to their children. Even though these strategies offer significant tax-planning benefits, they also have a major drawback: They require you to relinquish much of your control over the assets, including the right to direct the ultimate disposition of the trust assets. One strategy for avoiding this drawback is to use a beneficiary defective inheritor’s trust (BDIT).
It’s better to receive than to give
The tax code prevents you from transferring assets in trust to your children or other beneficiaries on a tax-advantaged basis if you retain the right to use or control those assets. But similar restrictions don’t apply to assets you receive as beneficiary of a third-party trust. This distinction is what makes a BDIT work. The strategy is best illustrated with an example:
Let’s say Mollie owns a business valued at $12 million (just over the exemption amount) and it’s organized as a limited liability company (LLC). She’d like to take advantage of the exemption by transferring ownership of the business to her three children, but she’s not ready to relinquish control over the business. Mollie arranges for her parents to establish three BDITs, each naming her as primary beneficiary and one of her children as contingent beneficiary. She then sells one-third interests in the LLC to each trust for $3 million. The sale price of each interest reflects a 25% minority interest discount.
As a result, Mollie:
• Removes the value of the business and all future appreciation from her estate without triggering gift tax liability,
• Provides the trust assets with some protection against creditors’ claims,
• Retains the right as beneficiary to manage the trust assets, to receive trust income, to withdraw trust principal for her “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, and
• Enjoys a special power of appointment to distribute the trust assets (so long as it’s not for her benefit).
For this strategy to pass muster with the IRS, a couple of things must happen. First, to ensure that the BDITs have economic substance, Mollie’s parents should “seed” each trust with cash — typically at least 10% of the purchase price, in this case $300,000 per trust.
Second, to avoid negative tax consequences for Mollie’s parents, the trusts must be “beneficiary defective,” ensuring that Mollie is treated as grantor for income tax purposes. Typically, this is accomplished by granting Mollie lapsing powers to withdraw funds from the trust.
A powerful tool
If you’re looking for ways to take advantage of the current gift and estate tax exemption without ceding complete control, consider a BDIT. Implementing this strategy is complex, but it offers significant tax benefits. Your advisor can provide additional information.
This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.