The Beneficiary Deemed Owner Trust – A Creative Estate Planning Strategy

Whitney Gagnon Headshot
Whitney A. Gagnon
Director, Trusts & Estates Department
Published: New Hampshire Bar News
March 16, 2022

The “Beneficiary Deemed Owner Trust” (or BDOT) is an innovative technique designed to achieve favorable income tax treatment of trusts, among other purposes.

The Internal Revenue Code (IRC) rules governing the income taxation of trusts are complex but, in general, provide that trusts are either taxed as a “grantor” trust or a “non-grantor” trust.  This distinction is important since non-grantor trusts pay federal income tax at the highest rate of 37 percent with taxable income of only $13,450, while individual single taxpayers only reach this rate with income over $539,900.  Because of these tax brackets, it could be advantageous to design a trust as a grantor trust, meaning that the grantor will be treated as the trust’s “owner” for income tax purposes, and the trust income will be reported on the grantor’s personal income tax return.

With a grantor trust, although the income will be included on the grantor’s personal income tax return, the assets held in the trust are removed from the grantor’s taxable estate, saving federal estate, gift, and possibly generation skipping transfer (GST) taxation.

In some situations, it would be useful for a beneficiary, rather than the grantor, to be treated as the trust’s owner for income tax purposes.  For example, to enable an elder generation to pay the income taxes on funds gifted to a younger generation while also utilizing certain family member’s federal gift and estate tax exemption and GST tax exemption amounts.  This creative strategy is often referred to as the Beneficiary Deemed Owner Trust.

In order for an individual other than the grantor to be treated as the substantial owner of a trust for income tax purposes, the requirements of IRC Section 678 must be met. The general rule provides that “[a] person other than the grantor shall be treated as the owner of any portion of a trust with respect to which: (1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself.”  Notably, the rule requires a power to vest either the corpus or the income of the trust, which can be achieved by granting a beneficiary the unilateral right to withdraw only the trust income.

The definition of income is crucial.  The traditional language granting a beneficiary the right to withdraw net income will only result in the accounting income being attributable to the beneficiary.  However, if income is defined to include traditional accounting income and net taxable income attributable to principal, including capital gains, payable by the trust income or principal, the entire trust income (including the accounting income, distributable net income, and taxable income) should be attributable to the beneficiary.

While the beneficiary needs to have the power to withdraw income to create a BDOT, there is no requirement that the income actually be withdrawn.  All trust income not withdrawn would be retained by the trust, allowing the trust assets to grow on an income tax free basis within the trust because the beneficiary is paying the income taxes on behalf of the trust.

In designing a trust to shift the income taxation to a desired beneficiary, it is important to consider any adverse gift and estate tax consequences to the beneficiary and the beneficiary’s estate.  Under IRC Section 2041(a), the value of the gross estate includes any property with respect to which the decedent has at the time of his or her death a general power of appointment.  Thus, if the beneficiary dies during such time when the beneficiary has the withdrawal right (treated for tax purposes as a general power of appointment), the undistributed income would be includable in the beneficiary’s estate for estate tax purposes.  Depending on the size of the trust and the net income generated in that year of the beneficiary’s death, this may not be a major concern, but by limiting the period of time over which the beneficiary has the withdrawal right, the potential estate tax exposure can be limited.  The period of time should be sufficient to uphold IRS scrutiny.

Under IRC 2514(b), the release of a general power of appointment is a transfer subject to gift tax and, in general, a lapse of a power is considered a release for such purposes.  To address the gift tax considerations, upon the expiration of the beneficiary’s withdrawal right, the beneficiary could be granted a second, springing right to withdraw an amount equal to the income for the prior year that was not withdrawn.  The springing withdrawal right could also be limited to a defined period of time.

In order to avoid a taxable event upon the expiration of the springing withdrawal right, the beneficiary could be granted a so-called “hanging withdrawal right.”  Under IRC Section 2514(e), a lapse is not considered a release during any year if the value of the property to which the lapse occurs does not exceed the greater of $5,000 or 5 percent of the value of the property out of which the power could have been exercised (the “5-and-5” exception).  Thus, the springing withdrawal right could lapse, but only to the extent that it would not be treated as a release of a general power of appointment for gift tax purposes.  To the extent the value of the trust income exceeds the above amount, such excess amount will “hang” and be subject to the beneficiary’s withdrawal in the following year.

The BDOT concept is derived from the IRC rules as well as treasury regulations and court cases (i.e. Regulation 1.671-3 and Mallinckrodt v. Nunan, 146 F.2d 1 (8th Cir. 1945)), and the IRS has not yet issued rulings on trusts of this type.  It is believed that with the design of these detailed withdrawal rights, the BDOT can achieve favorable income tax treatment as well as estate and gift tax benefits, among other purposes.