BDIT Strategies: How to Strengthen Validity in Estate Planning

Problem: BDIT is an All or Nothing Strategy

The BDIT (Beneficiary Defective Inheritors Trust) is not found in any Code Section of the IRC and has not been tested in Court. Like most complex advanced strategies, it is a compilation of many code sections, court cases, Private Letter Rulings, etc. They are so controversial that the IRS has refused to issue a Private Letter Ruling on any aspect of the BDIT.

For most clients, if the BDIT stands uncontested and we take it out of the equation, your Estate Tax liability would be maybe $4 Million or so because of your unused $11 Million in Exemption. However, if the BDIT fails and is included in your Taxable Estate, then your Taxable Estate increases by an additional $140,000,000 causing an additional $56 Million in Estate Tax Liability. We believe that is an extremely high risk to take and do nothing.

Understanding Why a BDIT is so Controversial

Generally, the goal of a client is to take a pile of assets out of the Estate Tax system by transferring them to a Trust for the benefit of someone else, and yet the client still wants to receive an economic benefit from the Trust.

Generally, to remove assets from your Estate, for Estate Tax purposes, the Trust must be:

The Trust must be Irrevocable;

It must be created by someone for the benefit of someone else (must not be a “Self-Settled Trust”);

The client must not have the power to “alter, amend, or revoke” the terms of the Trust;

Furthermore, the clients cannot have the ability to change the beneficiaries or change the timing or amounts of distributions to beneficiaries; and

Finally, the clients cannot be the transferor into the Trust and at the same time retain any economic benefits of the Trust.

It is easy to achieve the results above and remove assets beyond the reach of the Estate Tax system if the client is the transferor and sets up this type of Trust for the benefit of his kids and grandkids. Generally, the client cannot be the Trustee and cannot retain any of the benefits described above.

BDITs are controversial because it looks like the client created a Trust for their own benefit and retained the ability to take income and principal from the Trust.

IDGTs – Economic Benefit from the Promissory Note

Usually, the client will fund the Trust for the kids and grandkids using the gifting rules. But, because the gifting rules into the Trust are limited, or the client has used all of his gifting exemptions and exclusions, the client sells assets to the Trust in exchange for a promissory note. In the end, the client has “frozen” his estate subject to Estate Taxes inside of the promissory notes. Yet, all of the growth and appreciation of the assets takes place inside of the Trust and outside of the Estate Tax system. Rather than retaining an economic benefit from the Trust, the client instead has the cash flow from the promissory note. And the best part is that Revenue Ruling 85-13 says that since this is a Grantor Trust, and ignored for income tax purposes, there is no capital gains on the sale of the assets to the Trust. Some planners say this is the greatest Estate Planning Tool of all time.

BDIT – Payments from the Note + Being a Beneficiary of the Trust

However, what if the client wants his cake and eat it too? He wants the cash flow from the promissory notes, and the creditor protection of the Trust, and the growth and appreciation out of his Estate (all of the benefits described above), and he also wants the economic benefit of the growth and appreciation of the assets inside the Trust. In other words, he wants to be a beneficiary of the Trust and receive distributions of income and principal. We know he can’t be the grantor of the Trust and the beneficiary at the same time or the objectives will not be achieved. Those assets will still be includable in his or her Estate. Well, that is where BDITs were conceived. The client is not the creator of the Trust, usually it is his or her mom or dad. The client can be a beneficiary and a Trustee.

The client was not the creator or Grantor of the Trust. So, in theory, the client didn’t retain any benefit whatsoever. He is merely a beneficiary of a Trust created by his mother. But the grantor (his mom) doesn’t have the wealth to contribute, gift, or sell assets to the Trust. But client does. So, the client sells assets to the Trust in exchange for a Promissory Note. Because the Notes represent “fair and adequate consideration,” no gift occurs, and no gifting rules apply. Because the client was not the creator of the Trust, the “grantor” for Estate Tax purposes, the client can be a beneficiary. The client retains two benefits from the Trust:

The assets in the Trust produce income that can be used to satisfy the note payments back to the client.

The client is a beneficiary of the Trust and can receive distributions of income and principal.

The end result 20 years later is you have growth and appreciation in the asset values which are substantial. Yet, that growth and appreciation is out of the estate of the client for Estate Tax purposes as well as for creditor protection purposes. Wow, what a strategy. Why wouldn’t any client with high net worth want this strategy?

We call the Trust “defective” because for income tax purposes it is ignored. This is necessary to avoid triggering capital gains when the client sells the assets to the Trust. They are essentially selling assets to themselves. So, for income tax purposes, the Trust doesn’t exist, and all of the income is reported on clients’ personal income tax returns. But, for Estate Tax purposes, the assets are out of the estate and not subject to creditor claims and Estate Taxes when the client dies. A great result.

What are IRS Problems with a BDIT

IRS’s biggest problem is that it looks and feels like the client created a Trust for themselves. Although the client’s mother or father created the Trust, they are limited in the initial funding of the Trust to $5,000. Yet, the Trust was able to purchase assets with a value of $30 million or more. The IRS takes the position that the Trust really was created by the client for the benefit of the client. The client is the Trustee and a beneficiary. The client looks like the creator of the Trust. The IRS will try to collapse it as a sham and subject all of the assets to Estate Tax. How can you say this is not a “self-settled Trust” when substantially all of the assets were funded into the Trust from the clients?

The Trust must be “defective”, or a “grantor trust” as to the beneficiary of the Trust, which is the client. To accomplish that, the client must have the right to withdraw $5,000 from the Trust and let that right “lapse”. As such, the client now becomes the grantor for income tax purposes and can sell assets to the Trust without triggering capital gains.

Who wins in an IRS audit? We really don’t know much because they haven’t been litigated. It appears that the IRS is waiting for the perfect case that they know they can win to attack. Does the client realize he or she is rolling the dice on an “all or nothing strategy”?

Walk Away and Start Over

Most of the BDITs in Arizona I have noticed were prepared by small boutique Estate Planning Law Firms. The large firms, for whatever reason, will not represent BDITS. And, we have all seen in the Phoenix metro area some attorneys from the big firms lecturing on the risks of BDITS. I know from firsthand experience that they are recommending to clients to rip them up, bring all of the assets back into the Estate and start over. Our firm sees a lot of problems and challenges in doing that. These are Irrevocable Trusts with named beneficiaries. Wouldn’t they have a say in what happens? Plus, what are the tax consequences to walk away and start over?

Four Prong Approach to “booster” the BDIT

Based upon our knowledge and experience dealing with BDITs, our firm believes that the better approach is to keep the BDIT, but “booster” its chance for success in the event of an audit. We have essentially developed the following steps in “boosting” a BDIT. In essence, we want to reduce the value of the BDIT if it is brought back into the Estate, and at the same time, try to prevent it from being brought back into the Estate.

Clean up the BDIT –Most commentators believe that the IRS’ best chance to succeed in an attack on a BDIT will be to attack the lack of administration of the Trust. Was the sale of the pile of assets to the Trust properly appraised and valued? In this case, there were “discounts” of 35% taken in the valuation. That is another sore subject with the IRS and another discussion. Were the terms of the promissory note commercially reasonable? Was there appropriate interest? Was there collateral? What about guarantees? Were payments made timely on the Note? Did the Trust file tax returns, accountings, etc., etc., etc.? The more of those in our favor the better our chances to defend an IRS attack. The more that are against us the more it looks like a sham and the IRS wins. I will call all of these factors singularly a “badge.” The more badges we have the better off we are.
1. Make quarterly distributions to your children so that you are not the only person benefiting from the BDIT financially.
2. Remove the client from management roles either as a Trustee or as a “manager” of an LLC inside of the BDIT.
3. Consider decanting the BDIT. Review all provisions related to the Trust Protector, the Successor Trustees, how the BDIT flows down to children and grandchildren, situs, etc. A complete “make-over’. Authorize the BDIT to create a BDOT as discussed below.
Shrink the Size of the BDIT – If the BDIT is audited, we want the assets to be shown inside of the BDIT to be at least cut in half of where they are now. Here are some techniques we can use to shrink the BDIT.
1. Upload assets back to the client and back into a “Red Box”. And use traditional Estate Planning tools with respect to the uploaded assets to move them into traditional “Green Boxes”. The upload is accomplished by paying off the Promissory Notes in full.

Restructure the assets inside of the BDIT to qualify for discounts in the event they are included in the Estate. Embrace another round of “discounting” and “double discounting” with respect to the assets owned by the BDIT to reduce value of the assets upon your death.

Consider “downloading” assets into the GST Sub Trusts for the kids early. Look to see if the client has Powers of Appointment to download. Maybe a Trust Protector has the power to “download”.

Stop the BDIT from growing larger – In essence have the BDIT create and IDGT inside of the BDIT by creating a BDOT. As we discussed, for a freeze technique to work you need to have a sale of assets from a Trust you are trying to “freeze the value” (the BDIT) (“Red Box”) into a Trust that is valid for Estate Tax purposes but is ignored for income tax purposes. (“Green Box”)

BDOT – we need to have the BDIT create a Trust that is defective for income tax purposes but effective for Estate Tax purposes.
Then we will use a “freeze technique” of selling assets from the BDIT to the BDOT.

Create a Washing Machine at the Termination of the BDIT

Primary Benefits

“Zero-out” any estate tax liability related to a BDIT; and
Reduce the risk of an IRS estate tax audit.

Discussion

The final way that we “boost” the BDIT is by adding a “washing machine” to clean out any “dirty” assets that would cause an estate tax liability at the client’s death. The washing machine in this case is a testamentary Charitable Lead Annuity Trust (“CLAT”), that only comes into existence after the client has passed away. The Testamentary CLAT vehicle is a strategy that allows the BDIT to create a trust upon the primary beneficiary’s death that (i) pays to charity an annuity for a term of years, (ii) while providing the remainder (i.e. generally the growth of the donation, less applicable interest based on then current IRS interest rates) to the BDIT remainder beneficiaries.

This strategy may be deployed to effectively “zero out” the federal estate tax liability, meaning that we could eliminate all estate taxes that would otherwise be payable because of the possibility of the BDIT “failing” an IRS audit at the primary beneficiary’s death, while allowing the remainder beneficiaries to participate in the upside of any market growth above the IRS interest rate of the BDIT assets.

This strategy also lessens the risk of an IRS estate tax audit. Essentially, since any audit that results in an increased taxable estate would only serve to increase the amount that passes to charity, the IRS would never gain any tax dollars with an audit. The best they could hope for would be to increase what goes to charity.

While this strategy is interest rate sensitive, it is possible, in today’s low-rate environment, for the client to recognize a financial benefit for assets that were otherwise permanently going to charity.

BDITs – Strategies to “Boost” the Validity