Beneficiary Deemed Owner Trusts (BDOTs)

Take-Away: An irrevocable trust faces a marginal federal income tax bracket of 37% on accumulated income in excess of $12,750 each year. One way to mitigate that tax erosion is to establish a beneficiary deemed owner trust, or BDOT. With a BDOT the beneficiary is taxed on the trust’s income each year, at the beneficiary’s individual marginal income tax rates, not the trust’s, which will be substantially lower.

Background: We are familiar with a grantor trust concept where the trust is created with certain provisions so that the settlor is intentionally taxed on the trust’s income. A similar result can be achieved with regard to the beneficiary of an irrevocable trust.

Tax Code: IRC 678 provides:

“ a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which such person has a power exercisable solely by himself to vest the corpus or income therefrom in himself.”

Estate Tax Implications: A trust that is created by the settlor for the beneficiary will have its assets excluded from the settlor’s taxable estate, and also excluded from the beneficiary’s taxable estate.

Income Tax Implications: As a grantor trust, a BDOT will have its income taxed to the beneficiary, just like a conventional grantor trust where the settlor pays all taxes on the trust’s income. With the BDOT it is the trust beneficiary who must report all of the trust’s income.

Trust Instrument Implementation: If the trust beneficiary is given the right to withdraw all of the net taxable income of the trust, not to exceed 5% of the value of the trust assets, and all of the trust assets are available to satisfy the beneficiary’s withdrawal right, then this provision will cause the trust to be treated as a grantor trust with regard to the beneficiary of the trust, and usually without any creditor exposure or estate tax issues with regard to that beneficiary. [IRC 678 (a)(1).]

5% Limitation: The 5% limitation on the withdraw right held by the beneficiary is used to avoid the beneficiary being treated as a transferor of assets to the irrevocable trust. If a larger amount is available to be withdrawn, but that right is not exercised, then the lapse of the excess amount (over the 5%) will be treated as a contribution to the irrevocable trust by the beneficiary and it will result in a portion of the irrevocable trust’s assets being taxed in the beneficiary’s taxable estate. [IRC 2041(a)(2), 2041(b)(2), 2514(b) and 2514(e)(2).]

Observation: In the past this Tax Code section was not regularly used due to the right conferred on the beneficiary to withdraw the trust’s corpus, which was viewed as the beneficiary’s ability to disrupt the settlor’s estate plan. But in those situations where the settlor is in a higher marginal income tax bracket than the trust beneficiary, or the settlor is in the same income tax bracket as the irrevocable trust, it might be wise to establish a BDOT.

Practical Example: Assume that a married couple want to obtain a second income tax basis ‘step-up’ on the death of the surviving spouse. But as is often the case, there is some unease with an outright distribution of all marital assets to the surviving spouse on the first spouse’s death- a fear of exposing the transferred assets to future creditor claims, or a fear that the surviving spouse will remarry and divert the marital assets to their new spouse. So an outright bequest to the surviving spouse, in order to gain a second basis ‘step-up’ is not in the cards.

Goal of Second Basis Step-Up: Due to these fears, the decision is instead to adopt a conventional estate plan with a Marital (deduction) Trust (the assets of which will be ‘stepped up’ on the surviving spouse’s death) and also a conventional credit shelter or Bypass Trust (but its assets will not be included in the survivor’s taxable estate, and thus there will be no income tax basis ‘step up’ to its assets on the surviving spouse-beneficiary’s death.)

Both Trusts as BDOTs: Both the Marital Trust and the Bypass Trust can be structured as a BDOT. [Reg. 20.2056(b)-5(f)(8) and IRC 678(a)(1).]  In each Trust the surviving spouse must either possess the right to withdraw both all of the trust accounting income and the net taxable income for life (the marital deduction requirement), or the surviving spouse must possess the right to withdraw all the net taxable income and the right to require the accounting income to be distributed to the survivor. With those rights conferred on the surviving spouse beneficiary, both the Marital and Bypass Trusts will be treated as BDOTs.

Implications of Trusts as BDOTs: With these rights held by the beneficiary, both Trusts will be treated as grantor trusts with regard to the surviving spouse. Any sale of assets between the Marital Trust and the Bypass Trust will be ignored for income tax reporting purposes, because both Trusts will be treated as owned by the surviving spouse for income tax reporting purposes. Any loans between the two Trusts will also cause the interest charged on the loan to not be recognized as taxable income.

Benefits of BDOT Classification: A few of benefits that arise from the Bypass Trust’s classification as a BDOT include: (i) the Bypass Trust can sell its appreciated assets to the Marital Trust without any capital gain recognition; if those appreciated assets are held in the Marital Trust at the time of the surviving spouse’s death, they will obtain a ‘second’ income tax basis ‘step-up;’ (ii) if the Bypass Trust holds the survivor’s principal residence, and that residence is later sold, that sale will qualify for the $250,000 capital gain exclusion from the survivor’s income under IRC 121; and (iii) any withdraws from the Bypass Trust’s income and donated to charity at the beneficiary’s direction can be deducted by the survivor as a charitable income tax deduction [IRC 170] and thus avoid the limitations a trust faces when it makes a charitable contribution. [IRC 642(c).]

Conclusion: If clients are inclined to pursue the conventional Marital-Bypass Trust estate, plan, it makes sense to add provisions that will cause both Trusts to be classified as beneficiary deemed owner trusts. With that classification appreciated assets can be shifted from the Bypass to the Marital Trust prior to the surviving spouse’s death to gain a second income tax basis ‘step-up’ and more flexibility can be obtained with the administration of both Trusts.

Sources:

Eastland, Best Estate Planning Techniques Under TCJA-Part 4 BDOT,  45 Estate Planning (September 2018)

Pack, Income Tax Planning Strategies for Estate Plans under the TCJA, 46 Estate Planning (February 2019)