Madison Eubanks

Jun 11, 2024

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

A beneficiary deemed owner trust (BDOT) is a specialized type of trust in which the beneficiary is considered to be the owner of the trust for income tax purposes. This structure is typically used to achieve income tax benefits.  

In this article, we’ll discuss the requirements, benefits, and drawbacks of a beneficiary deemed owner trust, and when one could be a good option for clients. 

What is a BDOT? 

A 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. 

A BDOT trust is sometimes referred to as a section 678 trust after the tax code if falls under. 

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. 

Learn about more advanced estate planning strategies here.

If you’re an advisor, attorney, or planner looking for ways to help clients visualize complicated estate planning concepts, Vanilla can help. Request a demo today.