Required Minimum Distributions: Accumulation Trusts

This is Part II of the promised summary with regard to when to name a Trust as the beneficiary of retirement plan accounts and IRAs. Earlier I provided a summary of a conduit trust. This is a summary of the see-through trust known as an accumulation trust. I will not repeat the earlier summary of the 4 requirements for a see-through trust or the basic required minimum distribution (RMD) rules. Those rules require the search for the trust beneficiary with the shortest life expectancy which will control the Trust’s applicable distribution period for the withdrawals from the IRA.

Accumulation Trust: The obvious distinction from a conduit trust is that with an accumulation trust the Trustee is not required to immediately distribute the RMDs to the trust beneficiaries. Rather, the Trustee is permitted to accumulate the RMD in the Trust. While the Tax Code does not expressly authorize the use of an accumulation trust the IRS has provided an example of an accumulation trust.  With regard to an accumulation trust the IRS directs:

“…if the first beneficiary has a right to all income with respect to an employee’s [or IRA owner] individual account during that beneficiary’s life and a second beneficiary has a right to the principal but only after the death of the first income beneficiary (any portion of the principal distributed during the life of the first income beneficiary to be held in trust until that first beneficiary’s death) both beneficiaries must be taken into account in determining the beneficiary with the shortest life expectancy, and whether only individuals are beneficiaries.”  26 C.F.R. 1.401(a)(9)-5. A-7(c).

Applicable Distribution Period: The challenge with an accumulation trust then is the need to identify who the beneficiaries are under the Trust instrument who must be considered when determining the oldest of those trust beneficiaries, whose life expectancy controls the applicable distribution period for the required minimum distributions taken by the Trustee from the IRA.

Powers of Appointment: The existence of a power of appointment under the Trust instrument can control who may become a beneficiary of the Trust. As such, the class of permissible appointee-beneficiaries needs to be limited and must include: (i) only permissible appointees who would qualify as ‘designated beneficiaries;’ and (ii) who must be younger than the target beneficiary for purposes of determining the applicable distribution period. If a potential appointee under a limited power of appointment is not limited, then arguably a much older person could have the Trust’s assets appointed to them, in effect grossly shortening, if not completely eliminating any applicable distribution period available to the Trustee.

‘Issue:’ A Trust distribution provision that authorizes distributions to a trust beneficiary or to his or her issue creates a problem, since an older person could be legally adopted and thus become that person’s issue, unless the Trust instrument expressly prohibits an adult who is adopted from falling within the definition of issue.

‘Outright and Immediate Distribution’ Test: Since it is not always clear who is, or who are, the beneficiaries of a Trust that is to receive retirement plan or IRA distributions, to distinguish those beneficiaries from those who are ‘mere potential successors’ [who can essentially be ignored when conducting the search for the beneficiaries of the Trust to determine the applicable distribution period] a ‘test’ is  applied to the Trust to isolate those trust beneficiaries. In general, the beneficiary chain needs to be scanned until a beneficiary is found who would be entitled to an outright and immediate distribution from the Trust. This is the ‘test’ that Natalie Choate coined in her seminal book Retirement Benefits, Section 6.3.08.  Applying this ‘test’ identifies the first person/beneficiary who would possess the right to the whole of the IRA or retirement account. The ‘test’ is equivalent to the transfer of the entire IRA to an individual/beneficiary who could then empty out the IRA if they chose to do so.

Searching the Beneficiary Chain: All persons in the Trust’s chain of beneficiaries, up to and including the first beneficiary who is entitled to an outright and immediate distribution,  must be included as ‘beneficiaries’ for purposes of determining the applicable distribution period for distributions from the IRA. All of these beneficiaries are taken into account when the search is for the oldest individual beneficiary with the shortest life expectancy.

Decedent’s Estate or Charities: Remember that the decedent’s estate or a charity is not an individual, and thus they have no life expectancy. Consequently,  if the decedent’s estate or a charity satisfies the outright and immediate distribution ‘test’ then there will be no applicable distribution period other than the five year IRA  distribution period calculated from the IRA owner’s death. This is why naming a charity in the chain of beneficiaries is problematic when using a see-through trust.

Mere Successor Beneficiaries: All persons who only take if a person/beneficiary who is higher in the beneficiary chain who is entitled to an outright and immediate distribution dies are called mere potential successors. Those identified mere potential successor individuals do not count; they are ignored.

Unborn Issue: In applying the ‘test’ only those individuals who have already been born are to be considered. Unborn issue are ignored when applying the ‘test’ since they may never be born. Nor are individual beneficiaries who predeceased the IRA owner counted in applying the ‘test.’

Applying the Test to a Conduit or Accumulation Trust:

• Step #1:  Determine if the Trust is a see-through trust, meaning that it meets the four requirements i.e. it is valid, it is irrevocable, the beneficiaries are identifiable, and a copy of  the Trust is timely delivered to the IRA custodian . If it is not a see-through trust, then it cannot be the designated beneficiary of the IRA and the applicable distribution period for the IRA will be limited to five years from the IRA owner’s death.
• Step #2:  Determine who is to receive the IRA assets that are to be distributed to and from the Trust. All beneficiaries of the Trust must be individuals, or other see-through qualifying trusts. If there are some non-qualifying beneficiaries of the Trust, e.g. a charity, can they be eliminated before the beneficiary finalization date, which is September 30 of the year following the IRA owner’s death? If those non-qualifying beneficiaries cannot be eliminated by that deadline, then the Trust cannot be a designated beneficiary for the IRA as it will not be a see-through trust.
• Step #3:  Determine who would initially be entitled to receive the IRA assets upon the IRA owner’s death. Following the Trust’s terms, must all RMDs and any and all other assets received from the IRA (e.g. accidental or excess IRA distributions)  be immediately distributed to the beneficiaries? If the answer to this question is ‘yes’ then it is a conduit trust. If it is a conduit trust then all successor trust beneficiaries can be disregarded and treated as mere potential successors. If all distributions from the IRA do not have to be immediately distributed to the trust beneficiaries, then treat the initial beneficiaries as if they were then deceased, and proceed to test the next beneficiary(s) in the beneficiary chain, i.e. will it qualify as an accumulation trust?
• Step #4:  Determine if the next beneficiary in the beneficiary chain entitled to an outright and immediate distribution of the entire IRA account (or at least a separate and identifiable portion of that account.) If that beneficiary can be identified, that is the end of the beneficiary chain; at that point, all of the trust beneficiaries who are identified at or above this one identified beneficiary will be counted for purposes of determining the applicable distribution period, meaning the oldest of this group will have the life expectancy that governs the applicable distribution period. Note, however, that all of these beneficiaries must either be individuals or be other qualifying see-through trusts. If the next beneficiary is determined to not be entitled to an outright and immediate distribution, then you must treat that beneficiary as also deceased, and repeat this Step #4 until a beneficiary (or beneficiaries) are identified who would be entitled to an outright and immediate distribution.

When to Use an Accumulation Trust:  Since the distributions are actually accumulated by the Trustee, they are subject to income tax rates that are applicable to irrevocable Trusts and not the trust beneficiaries. Thus, any income accumulated in the Trust in excess of $10,400 will be exposed to the highest marginal federal income tax bracket, i.e. 39.6%, leading to more income taxes paid, but perhaps this is the cost to be incurred if the trust beneficiary is a spendthrift or the beneficiary receives means tested governmental benefits. Obviously, if a Roth IRA is paid to the accumulation trust that would be the most tax efficient asset to use, since no income tax is paid on the Roth distribution amounts that are accumulated in the Trust.

IRS’s Approach to Accumulation Trusts: Notwithstanding all of these convoluted rules, sometimes  even the IRS does not always apply them consistently when it identifies the trust beneficiary with the shortest life expectancy to determine the applicable distribution period.  See PLR 200228025 (April 18, 2002); PLR 201320021 (February 19, 2013).

IRS Example:

Example #1: Facts: IRA owner Husband is age 55 when he dies. Husband names a Trust as the beneficiary of his IRA. Husband names his Wife, age 50, as the Trust’s lifetime beneficiary, with his children named as contingent trust beneficiaries. Wife is entitled to all of the Trust’s  income, and she may, if she elects, have the Trustee pay the remainder of IRA’s RMD to her if that amount exceeds the Trust’s income. Result: This is an accumulation trust because the Trustee is not required to distribute the entire RMD to Wife each year, unless Wife makes the election, but Wife’s election is not automatic. Consequently, the children are not mere successor beneficiaries, and as such they must be considered beneficiaries for purposes of determining the Trust’s applicable distribution period. Fortunately, since the children are younger than their mother, this does not pose a problem when determining the applicable distribution period. But note that Wife is also not the sole beneficiary of Husband’s Trust for purposes of deferring the RMD until the year the IRA owner, Husband, would have turned at 70.5 [the special rule under 26 U.S.C. 401 (a)(9)(iv).] Consequently, Wife cannot defer taking a distribution until the year her late husband would have turned 70.5;  thus, distributions from the Trust to Wife must begin no later than the end of the calendar year following the year in which Husband died.  26 C.F.R. 1.401(a)(9)-5, A-7(c)(3), Example 1.

Example #2: Facts: Husband, age 65, leaves his IRA to a Trust upon his death. Husband’s Wife is the lifetime beneficiary of the Trust. Upon Wife’s death the Trust leaves the remaining assets to Husband’s adult sons, Cain and Able. The distributions to Cain and Able are to be outright and immediate in light of their ages. The Trustee is not required by the terms of the Trust to distribute the RMD to Wife; rather, the Trustee may accumulate or distribute assets to Wife in the Trustee’s sole discretion. The Trust instrument also provides that if either Cain or Able does not survive his mother, his share of the Trust’s remainder passes to a Charity. Result: Again, this is an accumulation trust since the Trust instrument does not direct the Trustee to distribute all of the RMD to Wife. Thus, both Cain and Able are to be taken into account in identifying the Trust’s identifiable beneficiaries. If both Cain and Able survive their mother, Wife, then Charity is a mere potential beneficiary, and thus Husband’s Trust passes the RMD ‘test.’

Example #3: Facts: Close to Example #2. Husband age 65 leaves his IRA to a Trust for the lifetime benefit of his Wife upon his death.  Under the Trust instrument, the Trustee is directed to pay all of the income for the Trust to Wife for her lifetime. Any remaining assets held in the Trust at the time of Wife’s death are divided into shares of equal value, one share for Cain, the other share for Able, but those shares are to be continued to be held in trust for each of Cain and Able. If Cain or Able is not living when their mother, Wife, dies, then their share of the Trust’s remainder passes to a Charity: Result:  In the absence of trust definitions, there is uncertainty with regard to this Trust’s classification as a see-through trust. If income is defined to include all distributions received by the Trustee from Husband’s IRA, and the Trustee is directed to immediately distribute all income to Wife, then it is a conduit trust. In contrast, if income is not so defined, then the Trustee may accumulate part of the RMD, and the Trust may be classified as an accumulation trust. If the Trustee is not required to distribute all assets received from the IRA to Wife, and Cain and Able are successor beneficiaries of the Trust upon their mother’s death, the question then is whether Cain and Able are given the right to outright and immediate distributions of the RMD from their respective continuing trust shares? If if Cain or Able possess that withdrawal right, then the Trust continues to qualify as an accumulation trust using Wife’s life expectancy to determine the RMD’s the Trustee must take from Husband’s IRA. But if discretionary trust shares are to continue for both of Cain and Able, with the Charity named as the remainder beneficiary of Cain or Able’s continuing trust shares, then Husband’s Trust fails to qualify as a see-through trust since the Charity must now be counted in identifying all of the trust beneficiaries that are entitled to the outright and immediate distribution from the Trust. By failing this ‘test’ Husband’s IRA must be distributed to the Trust over a period of five years from Husband’s death as it will not meet the definition of a see-through trust.

Uniform Principal and Income Act Complication: In addition to all of these complex required minimum distribution rules so a Trust might qualify as a see-through trust, is the application of the Revised Uniform Principal and Income Act that most Trust instruments adopt to guide the Trustee when allocating receipts to and disbursements from the Trust. Section 409(c) of the Act addresses the allocation of a distribution from an IRA to an irrevocable Trust. The Comments to that Section confirm that not all of an IRA distribution to a Trust will be treated by the Trustee as income:

“An amount received from an IRA or a plan with a payment provision similar to that of an IRA is allocated under Section 409(c), which differentiates between payments that are required to be made and all other payments. To the extent that a payment is required to be made (either under federal income tax rules or, in the case of a plan that is not subject to those rules, under the terms of the plan), 10% of the amount received is allocated to income and the balance is allocated to principal. All other payments are allocated to principal because they represent a change in the form of a principal asset; Section 409 follows the rule in Section 404(2), which provides that money or property received from a change in the form of a principal asset be allocated to principal.”

If the goal is to have a Trust classified as a conduit trust then the Trust instrument needs to say that all distributions from the IRA, not just the income from the Trust, must be distributed to the trust beneficiary. Otherwise, if the Trust instrument is governed by the Revised Uniform Principal and Income Act, some of the IRA distribution will be allocated by the Trustee to trust principal, and thus not all of the IRA distribution will pass through the hands of the Trustee and out from the Trust to the trust beneficiary, and it will be treated, instead, as an accumulation trust.

These rules are admittedly hard to follow and apply. Maybe they will soon become irrelevant if Congress decides to repeal the stretch IRA rules and go with a fairly simple mandatory 5-year-payout rule for all retirement assets including IRAs. Until that repeal, however, these are the rules that Trustees will have to ‘play by.’