Marital Trusts and Taxation: Should my Marital Trust be set up as a BDOT?

Oct 27, 2023 | Estates Planning and Asset Protection

Marital trusts are an estate planning tool that allows assets to be transferred to a surviving spouse tax-free. There are many types of marital trusts, including estate trusts, general power of appointment, and Qualified Terminable Interest Trusts (QTIP trusts).

For tax purposes, marital trusts can be structured in different ways, including as a Beneficiary Deemed Owner Trust (BDOT). But should you do this?

The answer to this question depends on your goals.

Let’s examine what a BDOT is and weigh the arguments for and against the taxation of a marital trust as a BDOT.

What is a BDOT?

BDOTs and their relationship with the Internal Revenue Code are complex and nuanced areas of tax law in the United States. 

The Internal Revenue Code regards as the owner of the trust any person who has the power, exercisable only by themselves, to receive trust principal or income (this is under IRC 678(a)(1)).

Advantages of taxing a marital trust as a BDOT

If you’re considering having your marital trust taxed as a BDOT (Beneficiary Defective Irrevocable Trust), you may be able to benefit from additional tax advantages, streamlined tax compliance, and individual deductions.

Income tax advantages

If your spouse, as the beneficiary, is in a lower income tax bracket than the trust, taxing the income of the trust to them under IRC 678(a)(1) could result in a reduced overall income tax liability.

Streamlining of tax compliance

In lieu of the trust filing its own tax return, the income could be reported on your spouse’s personal income tax return, which could facilitate tax compliance. 

Availability of individual deductions

If the income is taxed to your spouse, they may be eligible for tax deductions and credits not available to trusts, such as the qualified business income deduction.

Disadvantages of taxing a marital trust as a BDOT

BDOT taxation doesn’t come without downsides, though. If you choose to tax a marital trust as a BDOT, you may have to revisit your strategies for asset protection, tax payer statuses, individual tax brackets, and more.

Asset protection issues

If your spouse has substantial debts or liabilities, having the trust income taxed to them could expose those assets to their creditors, as it could be perceived that they have some degree of control or possession over those assets.

Loss of the separate taxpayer status of the trust

If the trust income is taxed to your spouse, certain tax strategies that depend on the trust being a distinct taxpayer may be compromised.

If the spouse’s estate is already close to or exceeds the estate tax exemption amount, having additional income or assets regarded as theirs could increase their estate tax liability.

Implications for the individual taxes of the beneficiary

If the beneficiary’s tax bracket is substantially higher than the trust’s, the trust’s overall tax liability may increase, which is the opposite of the scenario described in point 1. 

Problems with subsequent beneficiaries

After the initial beneficiary, considerations for subsequent beneficiaries may become complex and must be navigated carefully to prevent unintended tax consequences.

No step-up in basis (potentially)

If the spouse does not actually own the assets, they may not be included in their estate for the purpose of receiving a step-up in basis at their death, which could result in higher capital gains tax for the remaining beneficiaries when the assets are sold.

Consult our Texas tax attorneys to make the right choice for your marital trust

It’s essential to evaluate these factors in light of your specific circumstances, taking into account both your short- and long-term financial and estate planning goals. 

Due to the complexity of the tax issues surrounding marital trusts and BDOTs, it’s recommended to engage in a comprehensive consultation with a tax attorney or CPA.

Contact us to discuss how to structure your marital trust.

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