Some well known planners, such as Stacy Eastland, are recommending consideration of the BDOT for families with significant wealth to plan with the existing $11.2 million exemption. Most of you are aware of the Beneficiary Defective Inheritor’s Trust (BDIT), which is funded with only $5,000, and provides that all of that $5,000 may be withdrawn when the trust is created. The problem with the BDIT is engaging in a transaction of significant size with the beneficiary where the trust is funded with only $5,000.
With the BDOT, the beneficiary of the third-party-created trust is given the unilateral power to withdraw all of the net taxable income of the trust from all of the assets of the trust. This makes the BDOT a grantor trust with respect to the beneficiary.
These planners argue that the beneficiary can grow the BDOT without estate inclusion by not withdrawing income from the trust up to the lapse protection (the “5 and 5” protection of IRC Sections 2514(e)(2) and 2041(b)(2)). If the trust has income in excess of 5% in any year the trust loses the lapse protection at least with respect to the excess. Accordingly, the beneficiary should withdraw this excess amount. Additionally, use of hanging powers could mitigate transfer tax concerns.
The main risk with this technique are creditor rights issues. If a creditor potentially can get to the trust, estate inclusion results. Accordingly, state law should be reviewed.
Regardless of state law creditor rights issues, a creditor issue will exist if the BDOT enters into a leveraged sale with the beneficiary for less than adequate and full consideration. Of course, such a sale would raise inclusion issues under Code Section 2036 or 2038. Accordingly, care should be exercised in determining the selling price, and use of a value adjustment clause should be seriously considered.
For a family willing to take on some planning risk, the BDOT offers the ability for a family of multigenerational wealth to adequately fund a BDOT at the parent level, so that children with significant wealth can transfer that wealth on a leveraged basis to future generations.