For my clients who own a small business, I always stress the importance of incorporating a business succession planning component into their overall estate plan. Once of the most importance aspects of that plan should be a roadmap for how the business will be passed down to the next generation if that is the intention. With that in mind, allow me to explain how a Beneficiary Defective Inheritance Trust (BDIT) might fit into your business succession plan.
Why Can’t I Just Leave the Business to My Children in My Will?
Your Last Will and Testament is a legal document that can distribute your entire estate, including your business, after you pass away. Just because you can pass down a business in your Will does not mean that is the best way to accomplish the transfer though. There are several reasons why passing down a business directly may not be the best option, including:
- Estate taxes. If you wait until your death and pass down the business directly in your Will, the overall value of the business could be subject to federal (and in some cases state) gift and estate taxes. At the federal level, the tax rate is 40 percent, meaning you could lose a substantial portion of the value of the business to Uncle Sam.
- Marriage and divorce. When you pass down your business to a son or daughter, you undoubtedly do not intend to pass the business down to their future spouse; however, that could happen if your adult children marry and divorce.
- Creditors. If the business is part of your probate estate, creditors of the estate could have a claim to the business assets. Even if the business gets through probate intact, it could still be at risk because of your children’s debts, now or in the future.
How Can a Beneficiary Defective Inheritance Trust (BDIT) Help?
A specialized irrevocable trust, a Beneficiary Defective Inheritance Trust (BDIT) is established by a nominal Grantor who initially funds the trust with cash or property but then relinquishes control over it and is administered by a professional Trustee (though that is not a requirement). To help with tax avoidance, provisions within the trust guarantee that the assets held within the trust are not considered the property of the Grantor or the beneficiary. The trust agreement grants the beneficiary the right to withdraw trust funds for a brief period (typically 30-60 days) after the trust’s creation. For the BDIT to work as intended, the beneficiary must have the right to withdraw the funds; however, the beneficiary should not exercise the right.
A trust’s beneficiary is deemed the owner, for federal income tax purposes, of any portion of the trust they can independently vest in themselves. By giving the beneficiary the right to withdraw funds, the beneficiary becomes the Grantor for federal tax purposes, even if they do not exercise this right. The beneficiary can then sell business assets to the trust in exchange for a promissory note with an interest rate equal to at least the Applicable Federal Rate (AFR). While the assets are expected to appreciate significantly in value, the value for tax purposes is locked in at the time of transfer plus the interest rate in the promissory note. Any increase in value beyond that amount accrues as a tax-free benefit to the trust.
Although the beneficiary (seller of assets) is not the Trustee, they can serve as a manager or investment advisor, allowing them to retain a considerable degree of control over what happens to the trust assets. Additionally, the trust agreement includes provisions allowing the beneficiary (and others, if applicable) to receive distributions and discretionary income from the trust. In addition to tax benefits, a BDIT also offers asset protection by shielding assets from divorce, creditors, and even bankruptcy. Finally, when structured correctly, assets transferred into a BDIT do not count against the beneficiary’s lifetime exemption limit since the transfers are not deemed “gratuitous.”
A BDIT offers numerous benefits within a business succession plan, including:
- Asset protection. The trust structure acts as a protective shield against creditors, divorce, and bankruptcy, ensuring the preservation of business assets for the designated beneficiaries.
- Retained control and management. Despite transferring ownership, the business owner, now a beneficiary, maintains a substantial level of control over the trust assets, assuming roles such as a manager or investment advisor.
- Tax planning. Utilizing a BDIT proves effective in minimizing estate taxes by fixing the value of business assets during the transfer, shielding the business and beneficiaries from heightened tax obligations as the business appreciates in worth. In addition, assets moved into a BDIT may not be considered against the beneficiary’s lifetime exemption limit, given that the transfers are strategically structured as non-gratuitous, offering an additional layer of advantage in terms of wealth transfer.
Do You Have Questions about Business Succession Planning?
If you have additional questions about including a Beneficiary Defective Inheritance Trust in your business succession plan, contact our Chapel Hill business succession planning attorney at Clarity Legal Group by calling us at 919-484-0012 or contact us online.
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