With wealth transfer tax exemptions at historical highs (in 2023, the gift and estate tax exemption is $12.92 million—$25.84 million per married couple), income tax planning is an increasingly important part of trust-based estate plans. This is particularly true when dealing with income tax-deferred retirement plans. Accordingly, beneficiary deemed owner trust (BDOT) provisions can lead to meaningful tax savings when applied appropriately within retirement trusts.
When administering a trust, it is important to understand that the Internal Revenue Code (I.R.C.) does not govern trust accounting income. The amount of a trust’s income for a particular taxable year (commonly referred to as fiduciary accounting income (FAI)) is determined under the terms of the governing instrument and applicable local law, such as a state’s principal and income act (see I.R.C. § 643(b)). This includes income required to be distributed from a simple trust and income that may be distributed from a complex trust.
This bifurcation of calculating taxable and fiduciary accounting income often means that the two amounts are not equal: The trust may be left with taxable income that cannot be distributed or shifted to a beneficiary for income-tax-reporting purposes, and the taxable income is taxed at the compressed rates applicable to trusts. For example, income in respect of a decedent (IRD), such as distributions from an individual retirement account (IRA) payable to a trust, may be allocated as 10 percent income and 90 percent principal under the principles of FAI, but 100 percent taxable income under the I.R.C. If a trust instrument provides that the trustee may only distribute the net income of the trust, 10 percent of the income may be distributed to a beneficiary and taxed at the beneficiary’s individual income tax rate, while 90 percent of the income allocated to principal remains in the trust to be taxed at the trust’s (likely higher) income tax rate.
Fortunately, I.R.C. § 678 provides a solution to this issue by allowing all taxable income to be shifted to a beneficiary. According to I.R.C. § 678, a person other than the grantor can be treated as the owner of any portion of a trust in which the person has sole power to vest the corpus or the income in themselves. Accordingly, a trust agreement grants a beneficiary the power to withdraw all taxable income and the power is exercisable solely by that beneficiary, the beneficiary is deemed the owner of the trust income. The taxable income can then be reported on the beneficiary’s individual Internal Revenue Service Form 1040 and taxed at the beneficiary’s income tax rate, and the trust is ignored as a separate taxpayer. For more information about this technique, see Edwin P. Morrow, IRC Section 678 and the Beneficiary Deemed Owner Trust (BDOT), SSRN, (Apr. 19, 2018), https://ssrn.com/abstract=3165592 or http://dx.doi.org/10.2139/ssrn.3165592.
Using BDOT Provisions in Subtrusts Created under a Wealth Docx® Standalone Retirement Trust
When designing a subtrust (that is not a conduit trust) under a Standalone Retirement Trust (specifically, a qualified terminable interest property trust (QTIP) trust, credit shelter trust, or general needs trust), Wealth Docx users can include a provision granting the beneficiary an annual noncumulative power to withdraw the greater of the taxable income or the accounting income. Users may design a subtrust (that is not a conduit trust) within the Standalone Retirement Trust interview by taking a couple of different paths. If a subtrust includes a BDOT provision, users will notice the following:
- The terms of the trust that govern the distribution of principal will carve out an exception for principal included in taxable income that is subject to the BDOT provision.
- For QTIP trusts specifically, the traditional language requiring the trustee to distribute all of the net income of the trust to the surviving spouse at least annually will be removed. However, the surviving spouse’s power to withdraw the greater of taxable income and accounting income annually satisfies the all-income requirement of QTIP trusts (see I.R.C. § 2056; Treas. Reg. § 20.2056(b)‐5(f)(8), ‐7(d)(2)).
- Any unexercised withdrawal right under the BDOT provision will enjoy lapse protection based on the fairly well-known five or five ($5,000 or 5 percent) principles under I.R.C. § 2514(e).
To learn more about dynamic income tax planning using BDOT provisions in Wealth Docx retirement trusts, contact a Practice Development Consultant today for a demo.
