My goal in this business is to help advisors give better advice to clients on different topics.
While estate planning is one of them, I’m a bit embarrassed to say that until recently I was not familiar with BDOTs. I’m even more embarrassed to say that one can be beneficial to my kids in the estate plan I put in place.
BDOTs aren’t for most clients, but you want to be familiar with them for the right opportunity.
Ed Morrow, III, JD. LL.M’s Two Educational Pieces
Ed is an attorney who has written extensively on BDOT. He’s got a really good article he wrote for Leimberg’s publication and really detailed mini-book/white paper (200 pages). To download both pieces, click on the following link:
https://advisorshare.com/bdot-downloads
What is an Irrevocable Grantor Trust?
Let me start by reminding everyone how a classic irrevocable grantor trust works.
First, it’s irrevocable.
Second, it’s defective for income taxes purposes. The grantor is stuck with phantom income that is created in the trust. So, income is taxed at the grantor’s rate, not the higher trust income rate of 37%.
Then all of the appreciation on assets in the trust (including the income created in the trust) is out of the grantor’s estate and will be distributed to the heirs per the trust document.
What is a BDOT?
It’s a grantor trust, but where the income is attributed to the beneficiaries, NOT the grantor.
Why BDOTs can make sense? Most of the time the beneficiary’s income tax rate is lower or significantly lower than the grantor and certainly is lower than the trust tax rate.
Example: Parents set up a grantor trust that is defective for income tax purposes and fund it with $2 million in assets. Say the trust assets generate $80,000 in income.
Normally, the parents would take the $80,000 as phantom income, and if their top tax rate is 35%, the imputed income tax = $28,000.
BDOT to the rescue—Let’s say the beneficiary is married, and they earn $150,000 in gross income. The total federal taxes paid (assuming using the standard deduction) is: $15,340
The BDOT moves the income to the beneficiary. Let’s see the tax and total tax savings:
-New gross income of beneficiary = $230,000
-New total tax = $32,940
–Tax increase = $17,600
Total tax savings and increased wealth to the trust and, in turn, the beneficiary:
$28,000 – $17,600 = $10,430
Parents live in California, and the beneficiary lives in Florida:
Parent’s total imputed tax if NOT a BDOT = $35,440
Total tax savings increased to $17,840!
Where does the beneficiary get the money to pay the tax? The trust can make a distribution to the beneficiary to cover the tax.
Everyone wins, right? The IRS gets less money, and the trust has more net assets.
BDOT’s caveats that make it imperfect
If the above was all there was to BDOTs, we all would have heard about them before.
So, what’s the catch? In order for a BDOT to work, the beneficiaries MUST have a unilateral right to withdraw/vest income or corpus in themselves. IRC §678 says the beneficiary is treated as the owner of the portion over which they have a power, exercisable solely by themselves, to vest the corpus or income in themselves.
Problem? Maybe. The beneficiary does not actually have to take the income out. They need the right to take it. If they leave it in the trust, the trust can retain and reinvest the money.
So, this structure works when the beneficiaries “get it.” They understand that mom/dad are trying to move wealth to an irrevocable trust for their benefit and WITH THEIR HELP, the trust will end up with more wealth.
There are some further limitations to BDOTs that are outside the scope of this article. The good news is that I found some really good material you can read to fully understand how BDOTs work.
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