November 01, 2002

Using Trusts Effectively in Retirement Planning, Part II (2002, 16:06)

Using Trusts Effectively in Retirement Planning, Part II: Planning and Drafting Suggestions


Probate and PropertyNovember/December 2002, Volume 16, Number 6

By Thomas W. Houghton and Harvey B. Wallace II

Part I of this article, Prob. & Prop. 16 (July/August 2002), described how, under the final regulations issued in April 2002 under Code §§ 401(a)(9) and 408, trusts can be used in planning for distributions from qualified plans and IRA accounts. This part of the article discusses the choices that estate planners and their clients face when property that is in a qualified plan or IRA is used to fund a bypass or marital trust combination or to fund continuing trusts for descendants. The article also offers suggestions for implementing the decisions that the limitations in the final regulations will require them to make.

Safe Harbor Trusts

In light of the final required minimum distribution (RMD) regulations and PLR 200228025 discussed below, few trusts as they are now drafted will qualify for the maximum payout period that is available to individual designated beneficiaries after a participant’s death. Beneficiary designations naming trusts as beneficiaries and trust provisions drafted to obtain the maximum distribution period for income tax purposes may require that estate and GST tax planning objectives be partially compromised and/or that normal dispositive objectives be altered. The limited guidance now available describes only two kinds of trusts that have clear RMD consequences and provides no conceptual framework from which to analyze many common flexible estate planning trust provisions. The two kinds of trusts with clear RMD consequences are:

1. A Conduit Trust—All amounts received by the trustees during the lifetime of the oldest individual look-through beneficiary of the trust are, upon receipt, distributed by the trustees to that individual (or to other individual trust beneficiaries). Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c)(3), Ex. 2. A trust over which the individual look-through beneficiary has a full immediate right of withdrawal likely will also be considered to be a conduit trust. PLR 199903050.

2. An “Example 1” Trust—A trust that requires that all of the income of the trust (including the income of an IRA or qualified plan account of which the trust is beneficiary and which the trustees are entitled to withdraw) be distributed to the oldest look-through designated beneficiary (DB) and that has identifiable remainder beneficiaries all of whom are younger than the oldest look-through DB. Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c)(3), Ex. 1. This minimalist example appears to assume that the younger remainder beneficiaries will receive the trust principal outright upon the oldest look-through beneficiary’s death. Because the example describes a QTIP trust, the requirement that trust income be distributed is probably not material to the look-through treatment. But the fact that no remote contingent beneficiary is named to receive benefits if the younger identified contingent beneficiaries fail to survive is likely material.

Private Letter Ruling 200228025

As noted in part I of this article, the final regulations provide that, if any portion of the plan or IRA benefits that a trust receives may be accumulated and distributed after the death of the oldest look-through beneficiary, any trust beneficiary who may receive distributions in the future may not be disregarded as a beneficiary whose receipt of benefits is contingent upon the death of a prior beneficiary. In PLR 200228025 (issued under the proposed 2001 regulations), a discretionary trust was established for the participant’s two minor grandsons with each grandson having the right to withdraw his entire share at age 30. If either beneficiary should die before attaining age 30, the surviving beneficiary would receive all of the trust’s distributions and, if both the beneficiaries should die before attaining age 30, contingent beneficiaries (the oldest age 67 at the time of the participant’s death) would receive the trust benefits. In holding that the 67 year old beneficiary must be taken into account, the ruling states that “[i]n this case, the discretion the trustee of Trust X has with respect to the payment of trust amounts to the Grandchildren, who are the primary beneficiaries, is a contingency over and above the death of a prior beneficiary.” Before this ruling (based on earlier private letter rulings such as PLR 9846034 and PLR 199903050), it had appeared that the IRS applied an actuarial analysis to the succession of trust beneficial interests. As a result of that actuarial analysis, if a look-through beneficiary who lived out his or her life expectancy would receive from the trust all of the plan or IRA benefits, any older successor beneficiaries could be disregarded.

Marital Trust Bypass Planning

Safe harbor Example 1, read in conjunction with PLR 200228025, seems to confirm that marital deduction bypass trust planning that is not intended to provide for shelter trusts that continue after the surviving spouse’s death can be accomplished. In that case, however, only individual beneficiaries who are younger than the spouse may be named as successor trust beneficiaries and those successor trust beneficiaries must receive outright distributions upon the death of the primary beneficiary who is the oldest designated beneficiary (DB) whose life expectancy determined the RMD period. The possibility that a named successor beneficiary will not survive until the trust’s termination and that a successor beneficiary’s estate may thus receive the trust distributions after the primary beneficiary’s death presumably does not affect the RMD period if the identified younger beneficiaries are living on the date of the participant’s death. This is because the Example 1 statement that, aside from the participant’s spouse and children, “No other person has a beneficial interest in Trust P,” has meaning only if it refers to named (or otherwise identifiable) trust beneficiaries. Example 1 does not consider the possibility that all of the younger identified remainder beneficiaries could predecease the oldest look-through DB. Some commentators on the similar example contained in the 2001 proposed regulations suggested that a clause requiring that the trust terminate and distribute all plan assets to the surviving oldest beneficiary might be required to assure that an individual beneficiary receives the trust assets in such an event.

A participant’s estate plan frequently provides for continuing trusts for children in order to obtain protection from creditors (including divorcing spouses), avoidance of estate tax upon a child’s death, asset management guidance and the budgeting of distributions to assure lifetime support, and a coherent dispositive plan for the continuance of benefits in trust for lower generation family members. In that case, a decision must be made as to whether plan and IRA benefits should be payable to a trust subaccount (or subtrust) that provides for the disposition of plan benefits (outright or, perhaps, as described below, in a manner that restricts trust distributions to individual beneficiaries) that will permit the look-through rules to apply.

In considering the alternatives, it is important to keep in mind that, although the RMD rules that apply to a trust that has a look-through DB produce essentially the same RMD payout period regardless of whether the participant’s death occurs before or after the participant’s required beginning date (RBD), the failure to have a look-through DB will require the distribution to the trust of all benefits before the end of the calendar year in which the fifth anniversary of the participant’s death occurs if the participant dies before the RBD. In contrast, the lack of a DB in the case of a post-RBD death will result in distributions over the remaining fixed single life expectancy of the participant (a period of five or fewer years only if the participant dies after attaining age 88). If the participant’s spouse is intended to be the oldest beneficiary of both the marital trust and the bypass trust, the spouse is one or more years older than the participant, and the participant dies after the RBD, the post-death RMD payout period will not be increased by assuring that the trust qualifies for the look-through rules. Thus, if the participant and spouse are close in age, the participant may well decide that the preservation of the estate plan’s dispositive pattern is more important than qualifying for the look-through rules. In that case, the participant may plan, after reaching the RBD, to use the default payout rule rather than to name a subtrust designed to meet the look-through rule requirements.

If the participant has not reached the RBD and it appears that plan and IRA benefits will be needed to fund the bypass trust up to the then applicable exclusion amount, a bypass trust subtrust will be needed. The participant, however, may make a judgment not to fully fund the bypass trust on the participant’s death because that failure will not likely result in increased estate tax on the surviving spouse’s later death in light of the value of the couple’s combined assets, the future scheduled increases in the per person applicable exclusion amount, and the participant’s spouse’s age and health. If the participant and spouse have the same successor beneficiaries and the participant does not believe that marital trust protections are needed for the spouse, the designation of the spouse, individually, as beneficiary would maximize the post-death RMD payout period over the spouse’s survivorship period. This would also permit the spouse (via a rollover or “own account” election) to name the children or shelter trusts for the children as beneficiaries upon the spouse’s later death, further extending the RMD period over the fixed life expectancies of the children (or the eldest child).

Leaky Shelter Trusts

In the case of a single participant or a participant whose surviving spouse is not named as a bypass trust beneficiary, trusts that follow the Example 1 model (continuing for the lifetime of the child who is the primary beneficiary and oldest look-through DB and then distributing outright to the child’s children) may be an option. In most cases, however, the participant’s dispositive plan would provide for a child’s siblings to be successor beneficiaries if a child has no descendants at the time of the child’s death. Moreover, depending upon the age of the children, the number of children, and how prolific the children are, the participant may be unwilling to risk having the benefits pass under a deceased beneficiary’s estate rather than expressly providing for a “clean up” disposition that may involve collateral family lines that have family members older than the children or charitable organizations. Subject to the comments below regarding continuing trusts that are intended to benefit individuals only, a conduit trust may be an appropriate vehicle.

Although it is true that the benefits for which a continuing shelter trust for a child is formed are diminished over time as plan and IRA distributions to the trust are passed through to the trust’s primary beneficiary, the rate of that diminishment will correspond to the beneficiary’s increasing maturity. Even a beneficiary who attains age 60 in the calendar year following the participant’s death will receive an initial RMD equal to only 4% of the previous year-end benefit fund value unless the conduit trust trustees accelerate distributions from the plan or IRA. A beneficiary age 40 would receive only 2.29% of the fund value. Compared to naming a child, individually, as the beneficiary of an IRA or plan account, naming a conduit trust gives the conduit trust trustees spendthrift control over the undistributed plan and IRA benefits. Moreover, plan or IRA benefits distributed after the death of the conduit beneficiary are no longer subject to pass-through and may be retained in trust for successor beneficiaries.

Continuing “Individuals Only” Subtrusts

Under the final regulations, the members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it is possible to identify the class member with the shortest life expectancy. Treas. Reg.§ 1.401(a)(9)-4, Q&A 1. If a subtrust for a class of beneficiaries, such as the participant’s descendants, must by its terms terminate and distribute all assets including accumulated plan and IRA benefits to living members of the class before the death of the last living class member, it may be possible to measure RMDs by the life expectancy of the oldest member of the class without including conduit provisions. For example, the trust provisions might require that the subtrust terminate at the end of the rule against perpetuities period or when only one descendant of the participant is living, if earlier (or, perhaps, when there are two or three descendants living to avoid a common disaster possibility). Although this kind of tontine disposition may not reflect the typical plan that a participant would provide for other assets, the plan/IRA subtrust would not limit the ability of the trustees to make discretionary distributions from the subtrust before the subtrust’s termination date (encompassing members of each family branch).

Without further guidance from the IRS, it is not clear whether an individuals-only trust will allow RMDs to be made over the oldest class member’s life expectancy. The example subtrust wording accompanying this article (see page 39) is presented as a drafting starting point and is not recommended for use until the IRS has provided more guidance unless the participant’s beneficiary designation provides for safety valve disclaimers by the trust’s trustees in favor of the trust beneficiaries individually. Further subtrust limitations for an individuals-only trust must be provided if the class of beneficiaries is expanded to include spouses of descendants (so as to limit the spouses taken into account to those who are younger than the trust’s primary beneficiary who is the oldest look-through DB) or if trust beneficiaries have the power to exercise nongeneral powers of appointment (so as to limit appointees to the participant’s descendants and younger spouses and, if exercisable in further trust, to require that all subtrust dispositive restrictions continue to apply).

Beneficiary Designations

Projections demonstrate that the tax-free growth of plan and IRA funds compensates for the income tax burden imposed on distributions. Nevertheless, conventional wisdom states that, because plan and IRA benefits are income in respect of a decedent and subject to income tax when distributed following the death of the first spouse to die (without any offsetting deduction for estate tax paid if a marital deduction bypass plan is in effect), qualified plan and IRA benefits should be made payable to the participant’s surviving spouse or a marital trust so that income tax payable will reduce the surviving spouse’s taxable estate. Accordingly, currently drafted revocable trusts or wills typically provide for the allocation of qualified plan or IRA benefits to a martial trust for the participant’s spouse except to the extent that, based upon the participant’s nonplan/IRA assets, such an allocation would result in insufficient assets being available to fund the bypass trust up to the full amount of the applicable exclusion available for the year of the participant’s death. In the case of a bypass trust of which the participant’s surviving spouse is not a beneficiary (or if there is no surviving spouse), the trust agreement often provides that the plan and IRA benefits that are payable to a bypass trust or to a children’s trust are to be divided into per stirpetal shares (like the other assets receivable by the trustees) and allocated to separate trusts for the benefit of each child or descending family line.

As noted in part I of this article, allocations made by the trustees of an original trust named as beneficiary to the resulting trusts will not be recognized for purposes of applying the RMD requirements separately to the resulting trusts unless a specific allocation (equating to the establishment of separate accounts) is made in a beneficiary designation. This rule applies whether the allocations are made pursuant to the trustees’ discretionary power to allocate assets or under a specific trust agreement direction amounting to a specific bequest. In the case of a children’s trust that will divide into separate trusts effective upon the participant’s death, standardized beneficiary designation forms may provide sufficient space to name the separate resulting trusts. In many cases, however, a child’s siblings will be contingent beneficiaries of a separate children’s trust if the child dies without issue and, as a result, the settlor’s oldest descendant will often be the oldest DB of each of the trusts. In the case of marital/bypass resulting trusts, the insertion of a lengthy marital deduction formula allocation will require a customized beneficiary designation.

Whether IRA sponsors will become more receptive to customized beneficiary designations in light of the final regulations that more often require them to properly plan for benefits remains to be seen. In the meantime, the use of disclaimers to obtain the desired division of plan and IRA benefits between marital and bypass trusts may provide a solution with the caveat that disclaimers place a premium on having professional advisors involved in the immediate post-death planning period. The two basic approaches are:

1. To designate the participant’s spouse or the marital trust as the primary beneficiary of the plan and IRA benefits and provide that, if the spouse fails to survive the participant or to the extent that the spouse (or marital trust trustees) disclaims (or disclaim) the benefits, the benefits will pass to the bypass trust (or separate resulting trusts) as the contingent beneficiary; or

2. To designate the bypass trust (or separate resulting trusts) as primary beneficiary and provide that, to the extent that the bypass trust trustees disclaim the benefits, the benefits will pass to the spouse (or to a subaccount of the marital trust that the marital trust trustees may in turn disclaim in favor of the spouse, individually) as contingent beneficiary.

The choice of designation may depend upon a pre-death projection of the expected division of the participant’s assets between the marital and bypass trusts. Naming the bypass trust as primary beneficiary has the advantage of relying on the bypass trust’s trustees (rather than the participant’s surviving spouse) to carry out the disclaimer and of permitting the surviving spouse to retain a nongeneral power of appointment over the bypass trust. This power  also would have to be disclaimed if the plan/IRA benefits pass to the bypass trust pursuant to the spouse’s disclaimer.

Conclusion

Until more explicit guidance is promulgated by the IRS, the balancing of estate planning objectives with the goal of obtaining the income tax advantages of extended RMD payout periods apparently will require compromise. The Example 1 model, which does not identify remote contingent remainder beneficiaries, may not be appropriate or acceptable in many family situations (for example, when there are substantial plan and IRA benefits and few descendants). The conduit trust alternative may be a workable alternative for continuing children’s trusts (particularly when the children are adults) but, in the case of a surviving spouse, will eliminate trust protections too rapidly. Finally, a trust designed to benefit only individuals may or may not meet the evolving RMD rules and, if currently employed, should only be used in those situations in which the application of the default rules that apply if the participant has no DB are an acceptable risk.

The Editors thank Harvey Wallace for his revisions to this article.


Thomas W. Houghton, who practiced law in Houston, Texas, was the original author of this article. Because of Mr. Houghton’s illness and subsequent death on May 27, 2002, from pancreatic cancer, he was unable to revise his article to reflect the final regulations that were issued on April 17, 2002. Editorial Board member Harvey B. Wallace II was asked to revise the article to reflect the final regulations. Mr. Wallace is a member of Joslyn Keydel & Wallace, LLP, in Detroit, Michigan, and is the editor of the magazine’s “Retirement Benefits Planning Update” column.