BDIT Trusts — “Mamas, don’t let your babies grow up to be tax lawyers.”

This is a tax lawyer, technically-oriented blog post.   It is about a trust known in the trust / tax world as a BDIT (a beneficiary defective inheritor’s trust).  What is a BDIT and as a practical matter when might one use a BDIT?  This “why” touches on income tax advantages and asset protection.

BDIT Example — Assume Anne wants to make gifts to her daughter so her daughter can have a long-term investment nest egg.  Anne also wants to use a trust to provide her daughter with strong asset protection for this gifted property  (against divorce, bankruptcy, personal guarantees, uninsured claims, etc.). Anne wants this trust to be taxed to her daughter at the daughter’s own lower income tax brackets (the daughter no longer falls under the kiddie tax rules).

A BDIT fits this bill.

Anne’s income tax rates are much higher than her daughter’s rates in the above BDIT example, plus Anne is already in the 3.8% Medicare investment tax bracket.  The daughter is not.  Overall Anne saves income and Medicare tax in this BDIT example with her daughter being taxable on the trust’s income and gains.

By contrast, if Anne funds a non-BDIT trust for her daughter, in general either Anne will pay the trust’s income tax at Anne’s own higher income tax rates, or the trust will pay the income tax under its more costly, compressed rate brackets.  This depends on the trust design for Anne.

Now, what about BDIT asset protection?

In this example Anne is funding the BDIT trust for the benefit of her daughter.  This means Anne’s BDIT trust is a “third-party” trust (the third-party is Anne).  This is compared to a trust the daughter creates and funds herself.  If the daughter funds the trust, instead of Anne, the daughter’s trust will be a “self-settled” trust.  That is, self-settled (funded) by the daughter.

Self-settled trusts (compared to third-party trusts) – as general rule – in many cases don’t provide asset protection.  This means the daughter cannot fund her own trust and then try to use the trust as a shield for asset protection purposes.  Whereas, the daughter is in a much better position to use Anne’s third-party funded BDIT trust as an asset protection shield.

I don’t discuss in this post how to design a BDIT.

But, with BDITs being relatively new in the trust world, and as with any trust subject to various trust, asset protection, lapsing withdrawal right, and tax laws, there is a vast array of differing views on how best to design the BDIT.

I enjoy digging into the nuances of how to optimize this BDIT planning.  And this is an example of a highly technical thicket of complexity that, throughout the years, makes me recall the old Willie Nelson tune, which I often sing under my breath with the lyrics slightly changed to “Mamas, don’t let your babies grow up to be tax lawyers.”

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