Why do BDITs work?

Most investors’ most important asset is their carried interest. Last week, we wrote about the BDIT, one of the most common tax-reduction strategies for carry. A BDIT allows you to assign your carried interest to the trust, and because the trust “lives” in another state — a state with no taxes — you’ll pay less taxes and create more wealth for yourself.

Why does this work? Two key principles: Federalism and corporate/trust personhood.

Trust tax rules

Federalism. That first principle — federalism — is simple and intuitive, probably because it’s familiar from mainstream conversations around U.S. law and politics. Under the U.S. tax system, the states are allowed to tax their citizens separate from the federal government, and each state gets to choose its own tax rate. the result is a patchwork of more than 50 different tax regimes (when you include Washington, D.C., and territories like Puerto Rico). To some, that sounds like a nightmare. To savvy investors, it sounds like an opportunity for arbitrage; if you can manage to have your earnings taxed only in a low- or no-tax state, you’ll save money.

One way to do that is by moving to a different state. The flood of high earners from the Bay Area and New York City to places like Tahoe, Miami, or Austin suggests that this is a real option. Moving is impractical for many people, though. Enter trusts.

Trusts are people too. Is it possible to arrange your affairs so that your earnings are taxed in a no-tax state? It is, and the method is straightforward but unfamiliar to most people. Trusts, like corporations, can be treated as individuals — in this context, individual tax payers. Trusts, moreover, can be set up anywhere. Combine those two principles with the federalist tax system, and you have a recipe for the BDIT strategy: Set up a trust in a state that doesn’t tax income, transfer your asset to the trust, and the trust will pay no state taxes on the income.

In practice. Because a trust is simply a legal document that you (or Valur, to be precise) will draft, you have the freedom to choose where your trust will live. (Much easier than moving your flesh-and-blood family!) If you live in New York but set up a properly structured BDIT trust in Nevada, for example, you’ll pay Nevada taxes (0 percent!) instead of New York taxes (up to 13% if you live in New York City).

What comes next. We’ll get to this in a second, but, very briefly, the benefit of these tax savings isn’t just that you pay less today. Because you are able to reinvest the savings, which will continue to grow — inside the trust, in a no-tax state, tax free — you’ll create additional wealth for you and your family much faster. As a reference point, our BDIT clients typically earn additional returns of between 20 and 40 percent over time with this strategy.

Why don’t high-tax states step in?

A brief aside before we outline the steps to creating a properly structured BDIT. Unsurprisingly, high tax states hate it when residents move assets elsewhere, because they lose tax revenue. As a result, several high-tax states, including New York, have passed laws in an attempt to cut off these planning opportunities. The courts, however, have not played along. Citing the fundamental principle of federalism, the courts have noted that no-tax states are free to capitalize on their tax advantages, which create jobs and revenue (from people moving for the low tax rate, and from new industries like trust administration).

How to set up an effective trust in a no-tax state

As a result of these court rulings, the states have been ordered to do more than simply try to tax their former residents and money that has moved across state lines without regard to context of the situation. As a result, states have defined the rules of when out-of-state trust income is taxable.

Take New York, which has defined a three-factor test for determining whether it may tax a resident’s income coming from an out-of-state trust. If any of these features does not apply, the income is taxable. Accordingly, when establishing a BDIT, the goal will be to comply with this test.

1. Trustee Domicile. If the trustee, or anyone with power over trust decisions, lives anywhere besides New York, this test is usually satisfied.
2. New York Assets. As long as the trust does not own any assets that are physically in New York, you’re fine. All of the trust’s intangible assets, such as stock and bonds, are considered to be situated where the trustee lives, so, once again, as long as the trustee lives somewhere else and the trust doesn’t own any tangible assets in the state — say, Manhattan real estate, or cars — this test will also be satisfied.
3. New York Source Income. Finally, if the trust can avoid receiving any “source income” from within the state, the trust will avoid New York taxation. What, exactly, counts as source income — income from New York — will depend on the type of income, but, in general, investment income and anything else not derived from physical work in New York will qualify.

That’s just a taste of one (important) state’s approach to these questions. Each state has come up with its own rules, but the takeaway is that the law limits states’ power to tax out-of-state income, which allows residents of high-tax states to leverage trusts to shield their valuable and appreciating assets from high state taxes.

Next Steps

As taxes continue to rise, more and more people are looking for effective solutions to reduce their taxes and maximize their returns from carried interest. If you want to set up your own income- or estate-tax-advantaged structure for carried interest, sign up here, or access our calulator to learn more.

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 the setup and ongoing overhead, we make take care of it and make it easy.