The purpose of a Beneficiary Defective Inheritor’s Trust is to allow an individual with a federal estate tax problem to maintain control of the assets to the maximum extent permitted by law. The assets placed in a BDIT will not be included in the individual’s taxable estate when they pass away. As explained in the article “Special trust helps protect inheritance funds” from Times Reporter, this type of trust is an excellent estate planning technique to consider when creating an estate plan.
This type of trust will most benefit anyone with an estate tax issue upon their death. While the current tax exemption is $12,920,000, the exemption is expected to drop from $5 million to $6 million in 2026. The estate tax rate is 40% of any asset over those estate tax exemption amounts. The BDIT helps reduce the estate tax.
How does a BDIT work?
An independent settlor creates the BDIT, and a different independent person is named the trustee. The settlor executes the trust agreement and gives the trust a check for $5,000.
The person with the estate tax problem is the trust beneficiary and has the right to move the $5,000 from the trust.
Due to the right to remove the $5,000 from the trust, the beneficiary is considered the owner of the trust assets for income tax purposes. However, the IRS does not consider the beneficiary the owner for estate tax purposes.
The trust also has a protector, an independent individual with various responsibilities, including the right to remove and replace the trustee.
The Beneficiary Defective Inheritor's Trust allows the beneficiary as much control as possible without including the assets in the beneficiary’s estate.
The beneficiary reports all income on the beneficiary’s individual 1040 tax return.
The beneficiary then sells assets—stocks or units of a closely held business—in exchange for a promissory note. Thus, the Beneficiary Defective Inheritor's Trust owns the securities or the closely held business.
The BDIT then receives distributions from the business and, in return, makes payments to the beneficiary on the promissory note.
The promissory note is included in the beneficiary’s estate. The beneficiary continues to receive payments on the promissory note until the note is paid off. Paying off the note reduces the assets in the individual’s estate.
The Beneficiary Defective Inheritor's Trust also provides that the beneficiary is to receive income and principal for health, education, maintenance, and support, so when the note is paid off, the individual still gets these payments from the BDIT.
On the beneficiary’s death, the contingent beneficiary can be the beneficiary’s descendants. The assets in the BDIT are never included in anyone’s taxable estate.
This somewhat complex estate planning technique should be considered only after thoroughly reviewing your unique situation with an estate planning attorney.
Reference: Times Reporter (Jan. 8, 2023) “Special trust helps protect inheritance funds.”
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