Madison Eubanks

Jun 11, 2024

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Beneficiary Deemed Owner Trust (BDOT): What You Need to Know

When it comes to planning for the future, trusts are helpful tools that can protect your money and make it easier to pass it on to others. Some trusts are simple, while others are more advanced and offer special tax benefits. One of the more advanced types is called a beneficiary deemed owner trust, or BDOT. Although the name sounds complicated, the main idea is that the trust is set up in a way that makes the beneficiary, not the person who created the trust, responsible for paying income taxes on the money the trust earns. This can sometimes save money on taxes.

In this article, we will explain what a BDOT is and how it works under Internal Revenue Code Section 678. You will learn what rules must be followed to set up this kind of trust, the benefits it can offer, and the possible downsides. We will also talk about how a BDOT can help lower taxes, protect assets, and support long-term planning goals. Whether you are new to trusts or just want to learn more, this guide will help you understand the basics of BDOTs in a clear and simple way.

What is a beneficiary deemed owner trust (BDOT)? 

A beneficiary deemed owner trust (BDOT) is a sophisticated trust strategy where the beneficiary of the trust pays income taxes on the trust’s income. This is done through specific provisions in the trust document that give the beneficiary certain rights like the power to withdraw assets or the taxable income of the trust. Under tax rules, the beneficiary must have a certain level of power for the BDOT to be effective—however, the beneficiary doesn’t actually have to exercise those powers in order for the trust to be effective. This type of trust falls under Section 678 of the Internal Revenue Code, which is why a BDOT is sometimes referred to as a Section 678 trust.

What is IRC Section 678? 

Internal Revenue Code (IRC) Section 678 is largely about designating the income tax responsibilities of a trust’s income and assets as it relates to estate and tax planning. IRC Section 678 can create tax savings by allowing for the tax burden of trust assets to be shifted to a beneficiary who may be taxed at a lower rate than the grantor or the trust. 

Specifically, Section 678 deals with tax situations in which someone other than the grantor is considered the owner of a trust for income tax purposes. Section 678 outlines what powers constitute full or partial ownership of a trust for income tax purposes, which determines the amount of trust income that is taxed and at what rates. 

What are the requirements of IRC Section 678 for BDOTs? 

As noted, Section 678 states that, in order to be deemed the owner of a trust, the beneficiary must have sufficient powers over it. According to the code, a person is considered the owner of any portion of a trust over which they have the exclusive power to vest the principal or income of the trust in themselves. Any income attributable to the portion that this person (in this case, the beneficiary) has power over is included in their taxable income rather than the grantor’s or the trust’s. 

There are some exceptions in which a person would not be treated as the owner despite meeting the requirements. These include if the grantor is treated as the owner under certain other IRC sections or if the person relinquished their power over the trust and it is exercisable by another person. 

Advantages of a beneficiary deemed owner trust

Minimize income taxes

The primary advantage of a BDOT is to shift the tax burden of assets in a way that’s favorable to the grantor’s goals. The purpose of this shift is to transfer the income tax to someone who will be taxed at a lower rate than the original owner or the trust itself. 

Asset protection

Like many types of trusts, a beneficiary deemed owner trust can serve to grant a beneficiary access to trust assets while also protecting assets from creditors or a beneficiary’s poor spending decisions. 

Customization 

As long as the beneficiary is granted sufficient control to be considered the owner, there is room for flexibility in how BDOTs are set up. The trust document can grant certain controls to the beneficiary in alignment with the grantor’s wishes, although the beneficiary is often allowed to withdraw income from the trust in order to obtain the income tax benefits. 

Estate Planning

By removing assets from the grantor’s estate, a BDOT can help reduce estate taxes for the grantor. This is one of many strategies that can be used to ultimately optimize taxes and preserve wealth. 

Disadvantages of a beneficiary deemed owner trust

Complexity

To be effective, a beneficiary deemed owner trust must meet strict requirements as outlined by the tax code. A BDOT document must be drafted to comply with Section 678, and then the trust must be carefully maintained for ongoing compliance. 

This means the trustee is responsible for adhering to the trust provisions and staying up to date on any changes in tax laws. Like with other trusts, the trustee also needs to keep up with administrative tasks like documenting income distributions. 

Tax implications

Though a BDOT’s purpose is to optimize income tax rates, there are some cases where the strategy can backfire. For example, if the beneficiary is in a high tax bracket or lives in a high-tax state, it’s possible that they’ll be taxed at a higher rate than if the income were taxable to the trust or the grantor.

Additionally, depending on how the trust is structured, the trust assets may be included in the beneficiary’s estate. This could potentially result in estate tax implications that negate the intended income tax benefits. 

In some cases, a BDOT needs to be carefully planned to avoid invoking generation skipping transfer tax consequences. `

Loss of grantor control

Because the beneficiary must have certain powers over the trust and its assets, the grantor’s control over how trust assets are managed or distributed can be dramatically reduced or eliminated. Even though the grantor chooses who the beneficiary is, that person may make decisions that aren’t financially sound or in accordance with the grantor’s wishes. 

As far as trusts go, the beneficiary deemed owner trust is a sophisticated one that should be entered into with extreme caution. However, when created properly and under the appropriate circumstances, it can have significant positive tax benefits for the grantor and his or her family. 

Is a BDOT right for your estate plan?

Planning for the future often means finding smart ways to protect assets and reduce taxes. A beneficiary deemed owner trust, or BDOT, can offer tax benefits and flexibility when it is used correctly. By making the beneficiary responsible for income taxes, this type of trust may help lower the overall tax burden and support long-term estate planning goals. Because it must follow strict rules under Section 678 of the tax code, it is important to plan carefully and manage the trust properly.

For people with more complex estates or specific tax goals, a BDOT can be a valuable part of a larger strategy. To learn more, take time to explore other advanced estate planning strategies. If you are an advisor, attorney, or planner who wants to explain these ideas more clearly, Vanilla can help. Request a demo today to see how Vanilla’s estate planning software can turn complex plans into easy-to-understand visuals your clients will appreciate.