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Using a BDIT Trust To Avoid Taxes On Carried Interest

What can you do to reduce the taxes on your carried interest? With traditional appreciated assets, the answer is simple: Some version of a charitable trust will bring the highest return on investment. Things are more complicated with carry, but there is a solution that can help you defer or eliminate your state taxes and protect your assets from creditors. It’s called a “parent-seeded trust,” a “beneficiary defective inheritor’s trust,” or, in short, a BDIT trust. Let’s take a look.

Benefits of A BDIT Trust

Set up properly, a BDIT trust can provide many benefits.

  1. Avoid state income taxes on any appreciation when you sells carried interest
  2. Create an extra layer of protection from any future creditors (lawsuits etc.)
  3. Allow you to retain control of the assets

How Do BDITs Work?

BDITs have a simple structure. Let’s use an example to demonstrate. Take Ethan, a VP at a private equity fund in New York who has carried interest that he expects to appreciate in value. To take advantage of a BDIT to avoid the state taxes on his carry, Ethan would:

There are many different trusts that address many different concerns. One of the more interesting options is the parent seeded trust. The tax code and the IRS prohibit the use of trusts to transfer assets to others on a tax-advantaged basis if the grantor retains control over said assets, but a parent seeded trust (pronounced “bee-dit”) provides a clever end-around by creating a way for someone to get assets into a trust for their own benefit without being the grantor.

1. Set Up The Trust
  • To be precise, someone other than Ethan and his spouse would set up an irrevocable trust in a no-tax state such as Nevada or South Dakota and fund that trust with a nominal amount. Ethan, meanwhile, would be the the beneficiary of the trust.
  • Why is this important? The irrevocable trust will be the owner of the assets, and it will be the taxpayer. By setting up in a no-tax state, the trust will pay 0% in state income taxes when it realizes capital gains in the future.
2. Transfer the Assets
  • Next, Ethan would sell his carried interest to the trust at its current fair market valuation.
  • When to transfer? People typically sell their carry to the trust when it has a low value (usually around when the fund is formed, or before portfolio assets have been marked up significantly).
  • Why? This makes sense because if you place the asset in the trust before it has appreciated, most of the appreciation — and most of the taxes — would go to the trust, which pays a 0% state tax rate.
  • Transferring the assets early also smooths the transfer process. It is common for the BDIT trust to purchase assets with a structured loan from the original owner (Ethan in our example). The trust will typically pay 10% down, and the lower the asset value the less startup capital is required.
3. Eliminate State Taxes
  • When income is realized inside the trust, the trust will pay only federal taxes! And the less you pay in taxes, the more you’ll have to reinvest, and the faster your assets will grow.
  • If Ethan sells his carried interest to his BDIT for ~$10,000, for example, and ends up collecting $1,000,000, he will save about $110,000 state and city taxes. He can then reinvest those savings inside the trust to create even more wealth over the long term.
4. Distribute Trust Assets
  • The trust will distribute assets to you when you need them.

Why Do BDIT Trusts Work?

You’d like to move your carry to a no-tax state. The government will tax you — at your own state’s tax rate — if you retain the right to use or control the assets, because they’ll argue (reasonably) that you really still own the assets, so you should pay taxes on them.

Importantly, though, those rules don’t apply to assets that live in a trust owned by someone else. So, simple question: How to get assets you currently own into a trust set up by someone else?

Enter the BDIT. With a BDIT, you sell your asset (at the fair market value) to the trust, and the trust becomes the legal owner. That trust pays zero state taxes (because it’s set up in Nevada or another no-tax state).

And because you are the named beneficiary of the BDIT, you can still receive distributions from the trust when you need them.

Next Steps

A BDIT trust offers a simple way for professional investors to reduce the taxes on their carried interest and protect their assets from creditors. Get in touch today to explore this option.

About Valur

We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all of the setup and ongoing overhead, we take care of everything.