SECURE Act IV- Implications for Trusts

Take-Away: Earlier summaries have provided an overview of some of the SECURE Act changes and a look at the new 10-year distribution rule for designated beneficiaries of IRAs. This summary goes a bit deeper into the impact of the SECURE Act’s 10-year distribution rule on some standard estate planning trusts.

I. Marital Trusts: As previously reported, the surviving spouse of the IRA owner is an eligible designated beneficiary. Consequently, the option to leave an IRA payable to a trust for a surviving spouse have not changed much. If he/she is named outright as the designated beneficiary of the deceased spouse’s IRA, the surviving spouse still possesses the option to roll over the inherited IRA to his/her own IRA, or elect to treat the decedent’s IRA as his/her own IRA. If a marital trust is used, the results are pretty much the same.

Note: the spousal election rules either to treat the deceased spouse’s inherited IRA as their own, or to roll-over that inherited retirement account to their own IRA are not required minimum distribution rules, and as such, they  are not affected by the SECURE Act’s 10-year distribution rule.

Conduit Trust:  A conduit see-through trust established for the account owner’s surviving spouse will be entitle to stretch the minimum distribution benefits over the survivor’s lifetime, since survivor is considered the sole beneficiary of the conduit see-through trust. Consequently, the trustee will not have to commence taking required minimum distributions (RMDs) until the end of the year in which the deceased IRA owner would have reached age 72 years. [IRC 401(a) (9) (B) (iv) (l).] The surviving spouse’s life expectancy, recalculated annually, will thus be the Applicable Distribution Period. Restated, the SECURE Act’s 10-year distribution rule will not apply during the surviving spouse’s lifetime as the beneficiary of the conduit see-through marital trust.

QTIP Trust: This common trust established for a surviving spouse is a combination qualified terminal interest, or QTIP trust that is combined with conduit features. Under this QTIP trust, the surviving spouse receives the greater of (i) the trust’s income or (ii) the required minimum distribution from the IRA that is paid to the trustee each year. A QTIP trust will continue to work well during the surviving spouse’s lifetime. Upon the surviving spouse’s death, the 10-year distribution rule will then apply.

Accumulation Trust: A see-through accumulation trust for the retirement account owner’s surviving spouse will not be eligible for the stretch life expectancy payout, even if the surviving spouse is the only lifetime beneficiary of that trust, e.g. an income-only marital trust, since the surviving spouse will not be treated as the sole beneficiary of that accumulation see-through trust. A see-through accumulation trust will have to cash out the entire retirement account made payable to that trust within 10 years after the retirement account owner’s death.

II. Trust for Minor Children: A ‘Hobson’s Choice’ exists with a trust for minors. The choice is to either accelerate the income taxation of the distributed retirement benefits, or accelerate the children’s control over the post-distribution retirement assets.

Conduit Trust: A conduit see-through trust established for a minor child is entitled to the same treatment the minor child, as an eligible designated beneficiary, would enjoy, meaning the life expectancy payout, because as the conduit beneficiary, the child is considered the sole designated beneficiary of the IRA. However,  this treatment does not last for the child’s entire lifetime; rather, it lasts only until the child attains the age of majority, at which point the conduit see-through trust becomes subject to the SECURE Act’s 10-year distribution rule. [IRC 401(a) (9) (E) (iii).] Accordingly, the distributions from the retirement account will become accelerated once the child’s age-of-majority is reached, which may not be what the settlor wanted.

Children: The statute is clear that only the retirement account owner’s child will be an eligible designated beneficiary. A grandchild of the IRA owner will not enjoy the eligible designated beneficiary classification to delay the taxable distributions from the retirement account.

Age of Majority: Age of majority is a bit trickier to interpret- it could be a child’s age 18, 21 or even 26 years depending on the circumstances. Age of majority is normally determined by state law, and usually it is either age 18 or 21 years. However, the Tax Code’s definition age of majority also refers to another Code section, which states: “a child may be treated as having not reached the age of majority if the child has not completed a specified course of education and is under the age of 26. In addition, a child who is disabled within the meaning of section 72(m)(7) when the child reaches the age of majority may be treated as having not reached the age of majority so long as the child continues to be disabled.” [IRC 401(a) (9) (F); Treas. Reg. 1.401(a) (9)-6, A-15.] In short, a perpetual student could delay the SECURE Act’s 10-year distribution rule until he/she attains age 26. It is not yet clear if this is actually what Congress intends.

Minor’s Death: If the minor child dies prior to attaining the age of majority, then the 10-year distribution rule applies.

Accumulation Trust: If the parent establishes an accumulation see-through trust for the benefit of their minor child, leaving the trustee in control of the retirement account distributions until the child attains a later age of maturity, such a trust would not be an eligible designated beneficiary because the minor child is not considered the sole beneficiary of an accumulation see-through trust, even if the child is the only lifetime beneficiary of that trust. [Treas. Reg. 1.401(a) (9)-5, A-7(c) (1).] As a result, the trustee would have to cash-out the retirement account within 10 years of the parent’s death, which then accelerates the income tax bill at the trust’s very high income tax rates [37% federal income tax bracket on accumulated income in excess of $12,950 per year.]

Lingering Questions: A few questions arise with regard to the minor child’s eligible designated beneficiary classification.

• Age of Majority: As noted above, the age of majority is controlled by state law where the child resides, not federal law. In addition, if the child is a full-time student, it is not clear if that fact alone extends the age of majority to age 26 under the Tax Code’s definition of age of majority.
• ‘Pot Trust’: Consider a conduit see-through trust that is established for multiple minors, i.e. the conventional ‘pot trust.’ The IRS’s Regulations do not address in their examples a conduit see-through trust created for several minor children (that uses the oldest child’s life expectancy to determine distributions from the retirement account to the trust.) In the absence of any helpful examples, a ‘pot trust’ established for minor children should be avoided if funded with retirement account assets until some helpful examples are provided by the IRS in its upcoming Regulations.
• ‘Separate Share’ Rule: Consider a retirement account that is made payable to a trust with multiple trust beneficiaries who are the account owner’s children, but only some of whom are the account owner’s minor Even if the trust instrument directs that on the IRA owner’s death that the trust is to  be immediately divided into separate shares, one share for each child, it is unclear if those separate conduit see-through trust shares established for each minor child will qualify for the eligible designated beneficiary exception to the 10-year distribution rule. The problem is that under existing IRS Regulations, post-death trust divisions are ignored for the purpose of determining the applicable distribution period for each trust beneficiary. Accordingly, under current IRS Regulations, the division of the retirement account into separate shares must be done in the retirement account beneficiary designation form, and not under the trust instrument itself. [Treas. Reg. 1.401(a) (9)-4, A-5(c).]

III. Trusts for Disabled and Chronically Ill Beneficiaries: While trusts established for these individuals can continue to use the existing stretch distribution rules, the challenge will be meeting the technical definitions for these eligible designated beneficiaries.

Disabled: Disability is defined in IRC 72(m) (7). [IRC 401(a) (9) (E) (ii) (iii).] The definition of disability is: “an individual shall be considered disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.” Does the trustee possess the authority to obtain such proof of the beneficiary’s disability in the absence of a HIPPA waiver?

Chronically Ill: Chronically ill is defined with reference to IRC 7702(B) (c) (2). [IRC 401(a) (9) (E) (ii) (IV).] The definition of chronically ill is: “except that the requirements of subparagraph (A) (i) of section 7702B(c) (2) shall only be treated as met if there is a certification that as of such date, the period of inability described in such subparagraph with respect to the individual is an indefinite one which is reasonably expected to be lengthy in nature.” Again, how does the trustee obtain the necessary certificate regarding the trust beneficiary’s chronic illness needed to avoid having to follow the 10-year distribution rule?

Two Unique Rules: Two special rules apply to trusts that are established for the benefit of a disabled or chronically ill eligible designated beneficiary that do not apply to the other eligible designated beneficiaries who are the surviving spouse, minor children, and beneficiaries who are less than ten years younger than the retirement account owner.

1. ‘Separate Share’ Rule Ignored: If the retirement account is made payable to a trust that has multiple beneficiaries, all of whom qualify as designated beneficiaries, and at least one of the designated beneficiaries is also an eligible designated beneficiary by virtue of being either disabled or chronically ill, then if the trust instrument by its terms is required to be divided into separate shares for each beneficiary immediately upon the death of the retirement account owner, the stretch distribution rules will apply separately to the separate trust that is created for the disabled or chronically ill eligible designated beneficiary. Restated, the old ‘separate share rule’ that required the division of the retirement account into separate shares take place in the account beneficiary designation form will not be applied to this situation, and the stretch distribution for the disabled or chronically ill eligible designated beneficiary will still be available even when that separate share is created under the trust instrument. In other words, there is a special rule that separate sub-trusts can be treated as a ‘separate account’ an able to use the stretch distribution rule even if the sub-trust is not  separately named in the retirement account beneficiary designation form. [IRC 401(a) (9) (H) (IV) (l).]
2. ‘Sole Beneficiary’ Rule Ignored: Unlike the other eligible designated beneficiaries, e.g. a surviving spouse, a minor child,  the disabled or chronically ill eligible designated beneficiary does not have to be the sole beneficiary of the trust- just a life beneficiary.  If under the terms of the trust instrument [or subtrust that is created] no individual other than a disabled or chronically ill eligible designated beneficiary has any right to the interest in the retirement account until the death of all such eligible designated beneficiaries with respect to the trust, then the life expectancy (stretch) exception applies to the distribution of the account owner’s interest, and any beneficiary who is not an eligible designated beneficiary is treated as a beneficiary of the eligible designated beneficiary on the death of the eligible designated beneficiary. Accordingly, an accumulation see-through trust that is established for a disabled or chronically ill beneficiary could receive the life expectancy (stretch) distribution treatment, even though the disabled/chronically ill trust beneficiary is not considered the sole trust beneficiary. In contrast, with a surviving spouse, minor child, or less-than-10-years younger eligible designated beneficiary, the trustee would be able to claim the stretch distribution treatment only if the trust were a conduit see-through trust, since that is the only way the eligible designated beneficiary would be considered the sole beneficiary of that trust.

IV. Trust for Less-Than-10-Years Younger Beneficiary: This is a narrow exception to the SECURE Act’s 10-year distribution rule. The best example would be an unmarried, older IRA owner, who dies and who names his/her siblings as the beneficiaries of the deceased owner’s IRA account, or as the beneficiaries of a trust that is named as the IRA beneficiary. The drawback to this eligible designated beneficiary exception is that on the death of the less-than-10-years-younger eligible designated beneficiary, the 10-year distribution rule kicks-in.

Ambiguity on Death of Eligible Designated Beneficiary: One area of ambiguity when using a trust, as a retirement account designated beneficiary is the SECURE Act’s general rule with regard to the distribution of the retirement account on the death of the eligible designated beneficiary. An eligible designated beneficiary is entitled to a life expectancy (stretch) distribution, just like under the ‘old’ rules (except for minor children when they attain the age of majority, after which the 10-year distribution rule applies.) The SECURE Act provides that upon the eligible designated beneficiary’s death, “the exception under clause (ii) [granting life expectancy payout to the eligible designated beneficiary] shall not apply to any beneficiary of such eligible designated beneficiary and the remainder of such portion shall be distributed within 10 years after the death of such eligible designated beneficiary.” [IRC 401(a) (9) (H) (iii).]  While wordy, presumably this just means that the 10-year distribution rule kicks-in once the eligible designated beneficiary dies, which makes sense if the eligible designated beneficiary is an individual, and not a see-through trust, where the trust instrument controls the identity of the successor beneficiary, not the eligible designated beneficiary.

• Example #1: Assume that Harry, an IRA owner, names his wife, Wilma, as the beneficiary of his IRA. Wilma is an eligible designated beneficiary. Wilma can draw down (stretch) Harry’s IRA over her life expectancy. On Wilma’s death, the 10-year distribution rule then applies to the balance of Harry’s (inherited) IRA, despite whomever Wilma names as the successor beneficiary of that IRA.
• Example #2: Assume that Harry, an IRA owner, names a marital conduit trust to receive his IRA on his death for Wilma’s benefit. The trustee may use Wilma’s life expectancy (stretch) to take distributions from Harry’s IRA, as Wilma is an eligible designated beneficiary and the sole beneficiary of the marital trust. On Wilma’s death, the trust is to continue and to provide lifetime benefits for their son, Steve, who is disabled. On Wilma’s death, the required minimum distribution from the trust must be taken and reported by the end of the year of Wilma’s death (if not distributed to Wilma that year prior to her death.) The question is whether the continuing trust for Steve’s benefit must be distributed over the next 10 years. Harry, not Wilma, named Steve as the successor trust beneficiary to Wilma under the trust instrument. Following the SECURE Act’s language quoted above, Wilma did not have the option to name the successor beneficiary for Harry’s IRA- she never named the next ‘beneficiary.’ Consequently, there is some ambiguity that will need to be clarified in the IRS’ Regulations if the ten-year distribution will always apply on the death of an eligible designated beneficiary even if the successor beneficiary (Steve) also happens to be an eligible designated beneficiary.

Summary: Most retirement account beneficiary designations will still work, as will many of the existing see-through trusts, under the SECURE Act’s new 10-year distribution regime. However, naming a trust as the retirement account beneficiary will require some new thinking.

• Conduit Trusts: The problem with existing conduit see-through trusts is that they will not work as originally intended by their settlor. If a conduit see-through trust was created to address the trust beneficiary’s spendthrift tendencies, then the 10-year distribution regime will frustrate the purpose for which the trust was created.  In that case, a conduit see-through trust may have to be converted, via a modification, to an accumulation see-through trust to address the settlor’s concerns about the trust beneficiary’s spending habits.
• Accumulation Trusts: The problem with an accumulation see-through trust is that the trustee will now be faced with a substantially accelerated income tax bill since all assets must be distributed from the retirement account to the trust within 10 years of the account owner’s death. This, in turn, places an emphasis on how the trustee will pay those accelerated income taxes, which may very well be taxed at higher marginal federal income tax rates.