PDF DownloadPrincipal and Income Act Amendment Saves the Marital Deduction for Retirement Plans
By Steven B. Gorin

Probate & Property Magazine: March/April 2009, Vol. 23, No. 2

Real Property|Trust & Estate

Steven B. Gorin is a partner in the Private Client practice group of Thompson Coburn LLP and a past chair of the Business Planning Group of the Real Property, Trust and Estate Law Section. He served as ABA Advisor to the Uniform Law Commission Drafting Committee for the amendment to the Uniform Principal and Income Act described in this article.

In summer 2008, the Uniform Law Commission amended section 409 of the Uniform Principal and Income Act (the "UPAIA"). For the text of the amendment, see the appendix to this article. The amendment responds to the IRS's criticism of how the UPAIA treats individual retirement accounts (IRAs) and certain qualified retirement plans held by marital trusts. This article provides the necessary background, describes the IRS's concerns, explains the UPAIA amendment, and discusses the planning implications.


By way of background, let's consider when an IRA or a defined contribution qualified retirement plan (in either case, a "Fund") should or should not be payable to a marital trust. As used in this article, "marital trust" refers to a general power of appointment trust under Internal Revenue Code ("Code") § 2056(b)(5) or a trust for which a QTIP election is made under Code § 2056(b)(7). From an income tax perspective, ideally a Fund should be payable outright to the surviving spouse, so that the surviving spouse can roll over the distribution into the surviving spouse's own IRA. Code §§ 402(c)(4), 402(c)(9), 408(d)(3)(A), and 408(d)(3)(C)(ii)(II). This enables the surviving spouse to maximize income tax deferral by allowing the surviving spouse to use the "Uniform Lifetime Table" found in Treas. Reg. § 1.401(a)(9)-9(A-2). The only time a surviving spouse might want to roll over less than all the Fund is when the surviving spouse has not attained age 59½ and might need distributions before reaching that age. Distributions before that age generally would be subject to a 10% penalty if they come from the surviving spouse's own IRA, Code § 72(t)(2)(A)(i), but not if they come from the decedent's account, Code § 72(t)(2)(A)(ii). Thus, the surviving spouse would estimate what might be needed before age 59½, leave that in the decedent's account if possible, and roll over the rest into the surviving spouse's IRA.

A Fund should be payable to a marital trust only if the estate planning objectives outweigh the benefit of the income tax deferral. For example, suppose the client has children and is no longer married to the other parent. The client has remarried and wants to provide for the new spouse. Ideally, the client would give part of the Fund to the new spouse and part to the children, so that all beneficiaries can maximize income tax deferral. That might not be possible, however, if the surviving spouse needs the Fund's income for living expenses and the client is willing to make the children wait until the new spouse dies. In such a case, the client would likely use a marital trust so that any principal not required for the new spouse's living expenses would be accumulated and pass to the children on the new spouse's death. If the client had made the surviving spouse the outright beneficiary, the client would have had no assurance that the surviving spouse would not use the entire Fund for a use other than what the client intended.

Another good candidate for a marital trust is a client who does not trust the surviving spouse to manage the Fund wisely. The client might not trust the spouse's ability to make good investment decisions or to hire appropriate investment advisors. The client might not be comfortable with the spouse's spending habits and therefore might want a third party to determine distributions to make sure the spouse lives under an appropriate budget.

Rev. Rul. 2006-26

Rev. Rul. 2006-26 (the "Ruling"), 2006-1 C.B. 939, requires that the Fund itself qualify for the marital deduction under the same rules as any marital trust. In a marital trust, the surviving spouse must be entitled to all of the trust's income for life. Although a very common drafting approach is to require that all income is paid to the surviving spouse no less frequently than annually, relevant regulations require only that the surviving spouse have the right to withdraw the income no less frequently than annually. Treas. Reg. §§ 20.2056(b)-5(f)(1), (8) and 20.2056(b)-7(d)(2).

The Ruling also has a safe harbor. The safe harbor has two basic requirements. First, the Fund's income must be determined as if the Fund itself were a marital trust. Second, the surviving spouse must have the right to receive this income without regard to the income of any trust to which the Fund is payable.

This safe harbor raised a problem with respect to UPAIA § 409. Before the recent amendment, section 409 generally allocated 90% of any receipt from a Fund to principal and 10% to income. The problem arose because this allocation did not necessarily correspond to the Fund's internal income. Although section 409 also provided that receipts could be reallocated to income to the extent necessary to qualify for the marital deduction, the Ruling concluded that this ability to reallocate would not satisfy the safe harbor. Furthermore, section 409 did not address the safe harbor's requirement that the surviving spouse have the right to receive the Fund's income if the Fund did not distribute all of its income to the trust. Section 409 also did not address the safe harbor's requirement that this income be computed independently of the trust's other income.

The safe harbor is not the only way to qualify for the estate tax marital deduction. But in light of the importance the IRS placed on these issues by going to the trouble of issuing a revenue ruling, the concern arose that many attorneys might draft estate plans not complying with the safe harbor. Hence, section 409 was amended.

The Amendment of UPAIA § 409

As amended, UPAIA § 409 provides that distributions from a Fund are allocated to income to the extent of the Fund's income, determined as if the Fund were a separate trust. To the extent that the trustee does not withdraw and distribute the Fund's income to the surviving spouse, the surviving spouse may require the trustee to distribute the Fund's income. The surviving spouse, however, might prefer leaving part of the Fund's income inside the Fund to accumulate on a tax-deferred basis. If the surviving spouse chooses to do that, the amendment provides that the surviving spouse may require the trustee to distribute other assets equal to that year's accumulated income. The trustee can decide the extent to which these distributions are made from the Fund or other assets. Therefore, the surviving spouse should discuss the trustee's plans before making a formal demand.

Broader Implications

The policy behind the Ruling's safe harbor—that income must be determined based on what the asset generates rather than the 90/10 rule—might be used by the IRS for assets other than a Fund, for example, annuities, defined benefit plans, and other assets payable to a marital trust. The changes to UPAIA § 409 suggest a mechanism for determining such assets' income. If the trustee cannot calculate the income, the trustee could try to find out the asset's value and then make unitrust payments. Unitrust payments would be a fixed percentage of the trust's assets. The fixed percentage would be set by the enacting state somewhere between 3% and 5%, based on an entirely separate safe harbor under Treas. Reg. § 1.643(b)-1 that is incorporated by reference into Treas. Reg. § 20.2056(b)-5(f)(1). If the trustee cannot re-determine the value, each year the trustee would determine the present value of the expected payments, using present value factors that apply to annuities under Code § 7520. The trustee would multiply the present value by the Code § 7520 interest rate then in effect, and the resulting product would be the income subject to the general requirements for a Fund.

In an audit it is hoped the IRS would accept this process as a reasonable approach for determining income in light of uncertainty. But, if the IRS updates the Ruling to reflect the changes to section 409, the IRS is not likely to express an opinion on fact patterns involving assets other than a Fund.

Retroactivity of the Amendment

During the process of amending UPAIA § 409, representatives of the IRS and the U.S. Treasury informally urged that the amendment be adopted with at least some retroactive effect. The author drafted a letter that the ABA's Real Property, Trust and Estate Law Section sent to the IRS, requesting a formal approval of the amendment as retroactively saving the marital deduction. As this article goes to press, we await a reply.

Two key issues in implementing the amendment retroactively are (1) determining how to account for distributions already made and (2) determining the effect on income tax returns.

For example, if the trustee received a distribution that was formerly classified as principal but is retroactively classified as income under the amendment, the trustee must distribute that reclassified amount to the surviving spouse. It is possible that, because of discretionary distributions already paid to the surviving spouse, the reclassification of income might not require the trustee to make additional distributions.

Any required additional distribution might have income tax effects under which the trust would receive an additional deduction and the surviving spouse would report additional income. Treas. Reg. § 1.661(a)-2 deducts from a trust's taxable income the lesser of the trust's distributed net income or the sum of the amount required to be distributable to the beneficiary and any additional amounts properly paid or credited to the beneficiary. Treas. Reg. § 1.662(a)-1 requires a beneficiary to include in income the amount a trust deducted for that beneficiary under Treas. Reg. § 1.661(a)-2.

If this affects years for which income tax returns were previously filed, the trustee would have to consider amending the prior returns and giving the surviving spouse an amended Schedule K-1, which would then cause the surviving spouse to need to file an amended income tax return. The trustee would not be obligated to amend a prior return that was filed without fraudulent intent. If the trustee were to file an amended return, however, the surviving spouse would need to file a return so that the income reported on the surviving spouse's income tax return matches the Schedule K-1 income. If the trustee does not file an amended income tax return, then the trustee would have to consider whether an adjustment should be made if the surviving spouse later receives this additional amount without the trust receiving an income tax deduction. UPAIA § 506(a).

In addition, suppose the surviving spouse had the right to withdraw the Fund's income but did not know it. The surviving spouse should be authorized to exercise the withdrawal right for any period covered by the retroactivity within a reasonable time after the effective date of this change.

To avoid the income tax issues and the need for make-up distributions covering many years, the section 409 amendment would be retroactive until January 1 of the year in which these changes are enacted if the marital trust has been funded for more than one taxable year. If the marital trust is not funded until the year of enactment, or will not be funded until a later year, the amendment would be retroactive to the date of death.

General Estate and Gift Tax Planning Implications of the Amendment

The UPAIA amendment is a default rule. It applies only if the grantor does not choose to override it. Before we discuss the implications of the amendment for the drafting of marital trusts, consider some background information.

Providing the surviving spouse with the ability to withdraw other assets is not required by the IRS's safe harbor. But doing so facilitates income tax planning by allowing the surviving spouse to receive the same amount of money without being taxed on the accumulated retirement income. It also avoids an unintentional gift (described in the next paragraph) to the extent that the spouse receives a distribution to replace what was permitted to be accumulated.

To the extent that the surviving spouse permits income to be accumulated and added to principal and does not receive a make-up payment from other assets, the surviving spouse has permitted the lapse of a general power of appointment. Generally, to the extent that this lapse exceeds 5% of the trust's assets, including the Fund, the spouse has made a gift. Code § 2514(b) provides that a lapse is considered a gift to the extent it exceeds the greater of $5,000 or 5% of the assets out of which it can be satisfied. The $5,000 figure is coordinated with other lapses, so it might or might not be available. Code § 2702 provides that, generally, the value of the surviving spouse's right to income and any discretionary distributions are not subtracted from this gift because they are not in the form of an annuity or unitrust interest. Furthermore, because any gift to the remainder beneficiaries is not a present interest, the Code § 2503(b) annual gift exclusion is not available.

To minimize or avoid the gift:

  • Use a Power of Appointment to Convert a Taxable Gift to an Incomplete Gift. If the surviving spouse has a power of appointment (even a limited power) over the trust's assets, the lapse constitutes an incomplete gift. Treas. Reg. § 25.2511-2(b).
    —If the trust was created for protection from creditors, from the surviving spouse's potential future spouse's rights, or to prevent excess spending during the surviving spouse's life, the estate plan might already grant the surviving spouse a power of appointment over the remainder.
    —Another alternative is not to lapse the withdrawal right immediately. Instead, grant the spouse "hanging" Crummey powers that lapse each year only to the extent that the lapse is not a taxable gift.
    —If the natural objects of the surviving spouse's bounty are different than the remaindermen, the author tends to use "hanging" Crummey powers that never lapse. Instead, the surviving spouse has an inter vivos and a testamentary general power of appointment. This theory is based on the fact that the surviving spouse has every incentive to fully exercise withdrawal rights rather than let them lapse. Using nonlapsing hanging powers incentivizes the surviving spouse to leave the assets in the Fund to accumulate on a tax deferred basis, which presumably would benefit the surviving spouse and the remaindermen.
  • Minimize Taxable Gifts. If the surviving spouse is entitled to a unitrust distribution (Treas. Reg. § 25.2702-3(c)(1)(i)) out of the remaining assets, the value of that unitrust distribution is subtracted from the value of the gift.
    —If a power of appointment is not included, a lawyer drafting an estate plan might consider whether avoiding gift tax complexities is a significant enough factor that the trustee should be required to distribute enough to the surviving spouse to avoid a possible taxable gift.
    —Some attorneys view permitting the accumulation of the Fund's income to constitute over-lawyering, particularly when (1) it is obvious that the surviving spouse is going to need the income anyway or (2) the attorney is drafting a conduit trust under Code § 401(a)(9) and the required minimum distributions are expected to exceed the Fund's income. They would simply require that all of the Fund's income be distributed to the surviving spouse.


The amendment to UPAIA § 409 helps save the unwary from a fight over the marital deduction. Therefore, all states are encouraged to adopt the amendment. But those who write estate planning documents should consider possible gift tax issues if the amendment is adopted and the surviving spouse does not withdraw all of the Fund's income.

Return To Issue Index

Premium Content for:

  • ABA Section of Real Property, Trust and Estate Law Members
Join Now

Already a member? Log In