IRC Section 678 and the Beneficiary Deemed Owner Trust (BDOT)

Abstract

This article explores Section 678 of the Internal Revenue Code and how and when a beneficiary is deemed to be the owner of a trust for income tax purposes (called a beneficiary deemed owner trust, or BDOT). More specifically, the article explores when and how this may be done without granting a withdrawal power over the entire principal of the trust, but only over its taxable income.

Income tax benefits of such trusts include simpler tax reporting, exploiting lower tax brackets of beneficiaries, using capital gains tax exclusions for sales of residences, obtaining much more favorable Section 179 expense deductions, engaging in disregarded transactions, better exploitation of GST exemption and many more benefits often overlooked. The recent passage of the SECURE Act gives much greater impetus to use BDOT designs as a solution to the new "10-year rule" applicable now to most trusts receiving taxable retirement benefits, which can otherwise be disastrous when combined with the highly compressed trust tax brackets.

Asset protection for such trusts, while seemingly substandard, is hardly a disaster. Any ill effects of a withdrawal power can not only be counteracted but even turned into an advantage over other trust designs. A comprehensive 50-state comparison chart at the end summarizes the various state asset protection statutes and law around powers of withdrawal and lapses.

Keywords: Section 678, Grantor Trust, Income Tax, irrevocable grantor trust

JEL Classification: K34