For over 50 years, Bloomberg BNA’s renowned flagship daily news service, Daily Tax Report® has helped leading practitioners and policymakers stay on the cutting edge of taxation and...
June 14 — An exotic estate-planning technique can possibly turn thousands of dollars into millions, but it doesn't come without risk.
The technique, known as the beneficiary defective inheritor's trust (BDIT), is designed to work especially well for younger entrepreneurs, particularly those with fledgling technology businesses that can quickly surge in value.
The trust is drafted so that its beneficiary is treated as the owner for income tax purposes under the grantor trust rules within the tax code, namely under Section 678.
Typically, a parent, grandparent or other relative places $5,000 into the trust. The beneficiary—usually the parent's child—is given immediate withdrawal power over the entire trust contribution, and when the right to withdraw lapses in accordance with exceptions under tax code Sections 2041 and 2514, the child becomes the sole and exclusive income tax owner, or grantor, of the entire trust.
The withdrawal power is then “defectively” modified and the child continues to hold power to withdraw limited funds needed for health, education, maintenance and support.
After that point, the beneficiary can take several actions.
One approach involves having the child make an installment sale to the trust, such as an interest in a business, real estate or a portfolio of securities. The installment note isn’t due for a while so the trust has an opportunity to build up wealth to pay that note, Ron Aucutt, a partner with McGuireWoods LLP, told Bloomberg BNA in a June 7 interview.
Steven Oshins, a member of Oshins & Associates LLC in Las Vegas, said he frequently uses this estate-planning technique to set up new business ventures in the trust, rather than the installment sale option.
Oshins said he refers generally to these types of transactions as beneficiary defective trusts. He uses the term “opportunity shifting” when referring to a lifetime-funded trust used to start a new business or invest in a new opportunity, and uses “inheritor's” in the name when the trust is set up with death-time funding.
Oshins said beneficiary defective trusts work well with startups. The technique is meant for the “new business that explodes and turns into the multimillion-dollar business,” he told Bloomberg BNA in a June 8 interview.
“Once any effort has gone into starting it, especially if deals have been made or money has been spent, it no longer is a ‘new' business and therefore causes potential tax and creditor protection risks if the business entity is subsequently set up in the new inheritor’s trust,” he said.
In an example of a success story, Oshins said 15 years ago one of his high-net-worth clients, who was making money on real estate referrals, wanted to set up a limited liability company to take in the referral income.
“Rather than start it in his name, I had his parent set up a beneficiary defective trust for the benefit of my client and his wife and descendants,” he said. “His parent gifted $5,000 to the trust and his trust is now taking in roughly a million dollars a year.”
The client’s net worth is more than $50 million, so “the added benefit is that he is reducing his taxable estate by paying the income tax on income earned by the trust,” he said.
Oshins noted that he has also successfully used these trusts for himself for businesses created outside of his law firm. “I’ve had a couple of them that have done extremely well, and therefore I have reduced my estate in order to avoid estate taxes whenever I die,” by a “sizable amount,” he said.
Oshins said in today's tax environment, his firm has shifted its focus from the estate tax benefits of the technique to the income tax advantages.
“We need to take a different look at it nowadays, because with roughly 99.8 percent of Americans not having a federal estate tax if they die today, we’re looking a little less at the estate tax reduction and much more on the income tax advantages,” he said.
“I will generally set these trusts up nowadays where it’s not income taxable to the beneficiaries,” Oshins said. “We tend to shift income to multiple taxpayers by making distributions to lower-bracket beneficiaries.”
At the same time, other benefits include creditor and divorce protection of assets, Oshins said. While estate tax benefits won't be realized until death, the creditor and divorce advantages exist at the trust's inception, he said.
Katarinna McBride, a partner at Harrison & Held LLP in Chicago, said she believes BDITs “are way too risky and somewhat shortsighted, considering there are other options that are not as risky that can get the client to a very similar position.” She said her role with respect to BDITs has been dismantling ones that haven't been created properly, and advising fiduciaries and accountants on how to deal with them.
Her biggest concern with the technique is that the trust could be regarded as a “step transaction.”
The trust is “clearly a prearranged agreement between the initial party that creates the trust—parent—and the beneficiary—child—to put this trust together and fund it with an exact amount, so that the beneficiary later becomes the grantor and enters into a sale with the trust. There’s no question about that,” McBride told Bloomberg BNA in a June 14 interview.
“Then, it’s clearly prearranged between the whole transaction that there’s going to be a sale to the trust and that the trustee is going to approve the sale,” she said.
The step transaction doctrine, a judicial policy that is applied to prevent tax abuse, “is really complicated in terms of how the IRS can go after it,” McBride said.
“If each step is not independent—if the steps are interdependent and without the steps the transaction wouldn’t be desirable—then the IRS can collapse it,” which is a significant risk of this technique, she said.
McBride recommends asking for a private letter ruling before setting up a BDIT, but noted that most people aren't doing that.
In terms of creditor and divorce protection benefits, those depend on what state the trust is set up in, McBride said.
If the trust is created in a jurisdiction outside of states like South Dakota, Ohio or Nevada that respect self-settled trusts and domestic asset protection trusts, “state courts may have a difficult time respecting these trusts for creditor purposes because they resemble disguised self-settled trusts,” she said.
While there have been cases where these trusts have survived creditor attacks, “you could do anything else for credit protection purposes, including something as simple as a properly structured defective trust,” McBride said.
Another option would be transferring assets between spouses. A spouse that doesn't have creditor risk could set up the trust—called a spousal access trust—and name the other spouse as a co-trustee, she said.
They can make gifts with no tax consequences so the first spouse could fund and create a trust for the other spouse’s benefit, McBride said. “In many states, that would be permitted provided that the creator spouse doesn’t directly benefit.”
In regard to divorce protection, “if the rest of the client’s estate is de minimis or all-leveraged, I think there could be arguments made that it was intended to defraud the marriage,” she said.
Aucutt said that overall, he views the beneficiary defective inheritor's trust as an “exotic” technique with too much risk and uncertainty.
Five-thousand dollars isn't a lot of equity for a trust, especially if an installment sale is made worth millions of dollars, he said.
“So the IRS would either ignore the note or treat the note as some kind of retained interest in the future performance of the trust, and that makes it the kind of retained interest that will subject the entire value of the trust at the date of the transferor’s death to estate tax,” Aucutt said.
“The transferor in this case is not the person who transferred the $5,000 and called it a $5,000 gift. It’s the child who transferred the millions and called it not a gift at all, but a sale,” he added.
Aucutt said he also hasn't heard of any cases where one of these trusts has been “proof tested” against an estate tax audit.
“You can’t tell if these things work until that child has died,” he said. “It’s in that child’s estate tax return where there could be a reckoning, and usually the children are younger, entrepreneurial types.”
McBride noted that “for estate and gift tax purposes there’s a lot of exposure, and the result is going to be one of many things: everything is included back into the estate of the beneficiary, or it becomes a complex situation where it’s a complex calculation” in which some of the assets are considered a gift by the beneficiary and some aren't.
McBride said for income tax purposes, it's “pretty clear” that BDITs work.
While she hasn't set up this type of trust for a client in the past, McBride said she isn't 100 percent against using the technique in the future “if all of the stars aligned and it was a great strategy for a particular client that had an asset that was worth very little,” such as a startup.
“It’s great provided the client understands the risks that exist,” which, among the others mentioned, can include large setup and administrative fees on the behalf of the beneficiary, she said.
To contact the reporter on this story: Allyson Versprille in Washington at firstname.lastname@example.org
To contact the editor responsible for this story: Brett Ferguson at email@example.com
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to firstname.lastname@example.org.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to email@example.com.
Put me on standing order
Notify me when new releases are available (no standing order will be created)