A beneficiary defective inheritor's trust (BDIT) is an irrevocable trust that combines elements of a beneficiary-controlled trust with estate planning benefits. It is a trust established by a third party (usually a parent) to benefit one or more beneficiaries, typically family members. The unique feature of a BDIT is that the beneficiary, or beneficiaries, can make certain decisions, specifically regarding the management of trust assets.
Key features and benefits of a BDIT
- Beneficiary control: The beneficiary of a BDIT has the authority to make certain decisions about the trust, such as the power to remove or replace the trustee, amend the trust terms, or make distribution decisions.
- Estate freezing: BDITs are often used as part of an estate plan to reduce the beneficiary-seller’s taxable estate. Placing assets in a BDIT will not only remove them from the estate, but any future appreciation on the asset is also outside of the estate.
- Creditor protection: Assets placed in a BDIT are typically protected from the beneficiary's creditors if the trust is structured correctly and adheres to relevant legal requirements.
- Tax benefits: BDITs can offer certain tax advantages. Since the beneficiary is considered the grantor of the trust for income tax purposes, the sale of assets to the BDIT does not trigger any immediate capital gains taxation. Further, any interest paid on the note does not trigger taxable income either. However, the beneficiary is responsible for any taxes on income generated from the assets within the trust.
Downsides of a BDIT
While BDITs offer several advantages, they are not without risks. It's important for individuals considering a BDIT in their estate planning to be aware of these potential drawbacks:
- Loss of grantor control: By creating an irrevocable trust, the grantor surrenders control over the trust assets. Once assets are transferred to a BDIT, they generally cannot be returned to the grantor or modified to benefit the grantor without adverse tax consequences.
- Complexity: BDITs are complex legal structures that require careful planning and documentation. Improper setup or administration can lead to unintended tax consequences or legal challenges.
- Costs: Establishing a BDIT requires significant liquidity by the third party setting up the trust. The amount seeded to the BDIT is typically at least 10% of what the beneficiary plans to sell to the trust. For example, if the beneficiary intends to sell an asset valued at $1,000,000, then at least $100,000 should be gifted to the trust initially. Maintaining a BDIT can also be costly, involving legal and administrative fees.
Life insurance and BDITs
Life insurance plays a significant role in a BDIT as part of an estate planning strategy. Here's how:
- Funding the BDIT: Life insurance policies are often utilized with a BDIT by having the trust purchase a policy on the beneficiary. It’s important to note that the beneficiary has no say in what policy type or how much is purchased. It’s entirely up to the discretion of the trustee. Otherwise, it may trigger estate inclusion and, thus, tax consequences.
- Providing liquidity for estate taxes: Life insurance can provide much-needed liquidity to the BDIT and the estate. When the beneficiary passes away, estate taxes may be due, and having a life insurance policy in place ensures that funds are available to pay these taxes without the need to sell valuable assets or disrupt the trust's structure.
- Estate freeze and growth: The value of the life insurance policies is often excluded from the grantor's estate, which means that any growth in the policies' cash value or death benefit after the transfer to the BDIT is not subject to estate tax. This can be a powerful way to leverage the estate freeze strategy. Further, any cash value accumulation can be indirectly accessible by the beneficiary if the trustee decides to borrow against the policy.
What policy is best?
Permanent life insurance policies, such as whole life or universal life insurance, are often considered best for BDITs for a few reasons:
- Guaranteed death benefit: Permanent life insurance policies provide a guaranteed death benefit, which ensures that there will be a source of funds for the trust when the beneficiary passes away. This predictability is important for estate planning purposes.
- Cash value growth: Permanent policies build cash value over time. The trust can access this cash value during the beneficiary’s lifetime to help cover premium payments or provide liquidity for income at the trustee's discretion.
It's important to note that the specific role of life insurance in a BDIT can vary based on individual circumstances and objectives. The trust document should be carefully drafted to address the ownership, beneficiary designation, and administration of the life insurance policies in compliance with the trust's overall goals and legal requirements. Additionally, working with experienced professionals, including estate planning attorneys and insurance advisors, is essential to ensure that the strategy aligns with your estate planning goals and that the trust operates as intended.
Utilizing a tech-enabled brokerage for BDITs
A tech-enabled life insurance brokerage, like Modern Life, streamlines the process for advisors seeking life insurance coverage for clients with BDITs by offering digital tools and resources. Here’s a quick look:
- Quick client onboarding: Modern Life streamlines client onboarding through digital forms and shareable links, enabling advisors to gather client information and minimize time-consuming paperwork effortlessly. With Modern Life, advisors can have clients complete documents, including sensitive health questionnaires, from the comfort of their homes.
- Seamless document and requirement tracking: Efficient document management is crucial in the insurance and wealth management sector to reduce misplaced paperwork and streamline case management. With Modern Life, advisors have a dashboard to retrieve, review, and upload files. Documents are organized under each case for easy reference, and when you need to share a file with the Modern Life team, you can simply upload it directly to the platform, ensuring nothing falls through the cracks.
- Carrier and product choice: BDITs are complex financial products that require time and consideration. Clients may want to view multiple quotes from different carriers before they decide. Modern Life offers a wide range of options for clients to choose from to ensure they’re getting the best coverage.
- Quick turnaround times: With Modern Life’s digital underwriting capabilities and strong carrier connections, our advisors have a 41% faster approval time and save their clients an average of 17% on their policies. In addition, we commit to responding to advisor questions within 24 hours to address client concerns and keep business moving smoothly.
- Access to expertise: Access to experienced professionals can be invaluable for advisors looking to make informed decisions and provide top-notch service to their clients. At Modern Life, our brokerage managers have decades of experience and can assist advisors with complex underwriting cases, such as clients with a stroke history or criminal record.
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