Innovative (?) SECURE Act Trust Options

Take-Away: Much has been written about the use of a charitable remainder trust as one way to work-around the SECURE Act’s 10-year mandatory distribution rule for most inherited retirement accounts. Recently innovative, albeit somewhat obtuse, alternatives to the use of a charitable remainder trust have surfaced, that include an IRC 678 beneficiary deemed owner trust (BDOT) or a qualified subchapter S trust (QSST) which are intended to have a see-through accumulation trust named as beneficiary avoid the high income tax rates otherwise faced by an irrevocable trust.

Background:  We are well aware of the SECURE Act’s new 10-year distribution rule imposed on inherited retirement accounts, unless the beneficiary qualifies as an eligible designated beneficiary. An eligible designated beneficiary includes a surviving spouse, a minor child of the decedent, a disable or chronically ill beneficiary, or a designated beneficiary who is less than 10 years younger than the  deceased retirement account owner. That rule change means that most beneficiaries who inherit IRAs will be faced with the obligation to empty the IRA within ten years of the IRA owner’s death.

CRUT Alternative: With the loss of the stretch IRA many commentators started to suggest naming a charitable remainder unitrust (CRUT) as the designated beneficiary of the decedent’s retirement account. There would be no taxation of the distribution of the retirement account to the CRUT, a tax exempt entity. The CRUT would then pay to the CRUT non-charitable beneficiary the minimum amount required under the CRUT rules, or 5% of the CRUT’s assets, each year. Thus, the 5% annual distribution is viewed as an synthetic alternative to the lifetime required minimum distributions (RMDs) under the former stretch IRA rule, but those 5% distributions will all be taxed as ordinary income. However, not all individuals are willing to dedicate their retirement assets to the charity that holds the remainder interest in the CRUT. While an accumulation see-through trust might sound attractive to protect the retirement plan distributions from creditor claims, the accumulated income in the trust will be exposed to  very high compressed income tax rates of an irrevocable trust (37% on accumulated income in excess of $10,950 plus the 3.8% net investment income tax.)

Mitigating Income Taxation of Accumulation Trusts: A couple of new esoteric alternatives to a CRUT appeared in a recent Estate Planning Journal article written by Jonathan G. Blattmachr, Ladson Boyle, Mitchell Gans and Diana Zeydel: the Section 678 Trust, i.e. a beneficiary deemed owner trust (BDOT) Trust and an S corporation that is designated as the IRA beneficiary, with the S stock held in a qualified subchapter S trust (QSST.) Both are trusts are envisioned as tools to expose the taxable retirement plan distributions to the trust beneficiary’s marginally lower federal income tax rates, but maybe without the full 10-year payout option. Hence, this article and its suggestions addresses the reality that with the loss of stretch distributions there will likely be more immediate and higher income taxation of retirement plan distributions for most designated beneficiaries. How to mitigate that high burden of taxation of the trust’s income is the thrust of this article.

[Trust me, my eyes glazed over reading this article. My wife even caught me moving my lips while reading it. Really smart authors,  much, much smarter than I will ever be to come up with these creative approaches, but I do wonder just how practical they really are, like naming an S corporation as the beneficiary of my lifetime savings held in a traditional IRA?]

Section 678 Trust: The thrust behind this strategy is that if the retirement plan proceeds are paid to a trust that is taxed as a  beneficiary deemed owner trust (BDOT) under IRC 678, the retirement plan proceeds will be treated as owned by the deemed owner, i.e. the trust beneficiary. A see-through trust that also qualifies under IRC 678 should meet the SECURE Act’s 10-year payout rule, so this device is less about creating a synthetic stretch like a CRUT, and more about avoiding the high income tax rates to which an accumulation see-through trust would be exposed. The Section 678 Trust would expose the taxable retirement plan or IRA assets distributed to the trust to the individual beneficiary’s much lower marginal federal income tax rates and help to avoid the net investment income 3.8% tax.

• To meet the Section 678 requirements, the beneficiary must have the unilateral right to withdraw the entire trust estate. If the power to withdraw is partially released or otherwise modified but does not completely disappear, the trust will remain a Section 678 trust.
• As a Section 678 trust, the beneficiary, not the trust, will be taxed on all the retirement plan assets distributed to the trust at the beneficiary’s income tax rates, but without the need to actually distribute the retirement plan assets from the trust to the beneficiary.
• One drawback to the beneficiary’s power to withdraw assets is that there will not be any creditor protection afforded by the trust. If the power to withdraw lapses or is released, the power holder, i.e. the beneficiary, may be treated as making a transfer to a self-settled trust, thus exposing the trust’s assets to the claims of the beneficiary’s creditors.
• The beneficiary’s power of withdrawal will also cause a problem for a disabled trust beneficiary who is currently receiving governmental benefits, since the power of withdrawal will cause a period of ineligibility for those governmental benefits since the lapse of the withdrawal right is treated as a divestment of assets by the recipient beneficiary.
• The authors note: “Thus, using a Section 678 trust would likely produce the best overall income taxation although it does raise creditor rights issues. It also raises the specter of possible estate tax inclusion for the beneficiary although this may be of secondary importance to the potential immediate reduction of income taxation on the retirement plan proceeds, particularly if the trust otherwise would be subject to transfer tax (e.g. generation-skipping transfer tax) on the beneficiary’s death. One final thought about Section 678 trusts. Although the deemed owner of the Section 678 trust (just as in the case of the grantor of a grantor trust) is deemed for all income tax purposes to own the assets of the trust, it does not mean with complete certainty that the deemed owner is the sole beneficiary of the trust for purposes of Section 401(a)(9). So, if a disabled person is the deemed owner under Section 678 of the trust that is the retirement plan beneficiary, it does not mean with certainty that the payout over the life expectancy of the disabled person will apply. However, it seems that if the trust is structured as an accumulation trust for any designated beneficiary (whether or not an eligible designated beneficiary) it will qualify for the ten-year payout rule whether or not Section 678 is applicable.”

QSST Trust: A qualified subchapter S trust (QSST) is a permitted S corporation shareholder. To be an eligible QSST, the trust must have only one beneficiary who is a US individual income taxpayer, must be required to, or does, in fact, distribute all of its fiduciary accounting income [IRC 643(b)] each year to that beneficiary, and the beneficiary must elect to be treated as the income tax owner under Section 678, of the portion of the trust that consists of qualifying subchapter S stock, and as a result be treated as its shareholder.

• Thus, one of the results of a QSST is that the income of the S corporation is treated as being that of the shareholder, or in the case of the QSST, its sole beneficiary.
• Retirement plan proceeds can be made payable to a S corporation which has a QSST as its shareholder. This would be the result if the retirement plan owner wants the individual trust beneficiary to benefit from the retirement plan proceeds. Thus, the retirement plan distribution, or income, will be income of the S corporation, and then will be included in the gross income of the trust beneficiary.
• The retirement plan income will be taxed to the trust beneficiary whether or not he/she receives anything other than trust fiduciary accounting income. And the S corporation’s income will not be classified as fiduciary accounting income until the S corporation makes a distribution that constitutes fiduciary accounting income (as most dividends would.) [Section 409(b) of Uniform Fiduciary Income and Principal Act.]
• By making retirement plan distributions payable to an S corporation, those distributions will be income of the S corporation, but included in the income of the QSST beneficiary who may be in a much lower income tax bracket than the trust.
• In addition, distributions of the retirement plan proceeds need not be made from the S corporation to the QSST, and the QSST need not make any distributions to its beneficiary, other than fiduciary accounting income. The assets could therefore be retained in the QSST and sheltered from creditor claims.
• The trustee of the QSST might pay the income tax liability of the beneficiary without disqualifying the trust as a QSST and without causing the beneficiary to lose qualification of governmental benefits if the beneficiary of the QSST is either disabled or chronically ill.
• The authors note: “{B]ecause the IRS has held a decades long and official position that an individual who is deemed owner of a trust (such as one described under Section 678) owns the assets of the trust for income tax purposes, it seems the individual deemed owner should be treated as the retirement plan beneficiary. However, unlike treatment of a deemed owner of a grantor or Section 678 trust, the shareholder of an S corporation, while having the income of the corporation made his or her income, there are limitations and special rules, which prevent the shareholder from being viewed as the owner of the assets of the corporation. Accordingly, just having retirement plan distributions included in the gross income of an individual does not seem sufficient to cause that taxpayer to be treated as the retirement plan beneficiary. Indeed, it seems even more uncertain whether a beneficiary of a QSST will be treated as being the retirement plan beneficiary when the S corporation is named as that beneficiary. Hence, in planning, one probably should assume that the five-year payout rule will apply if an S corporation is made the retirement plan beneficiary. However, making an S corporation with a QSST shareholder as the retirement plan beneficiary may, in some cases, be preferable to naming an accumulation trust where the ten-year pay rule will apply.”

Conclusion: I do not advocate the use of either an IRC 678 Trust or a QSST trust to replace conventional conduit or accumulation see-through trusts to receive retirement plan distributions for a beneficiary who may need the protection of a trust to hold, and distribute, a substantial retirement account balance. Admittedly they are interesting concepts as a ‘work-around’ to the high income taxation of an accumulation trust, but I wonder how practical they are. Somehow I get the sense of saying to a client with a large IRA ‘hey, I got a great idea, let’s make your $1.0 million IRA payable to an S corporation’ is probably a non-starter when it comes to educating the client on how their estate plan will work to provide for a beneficiary while minimizing income taxes. Perhaps the most important reminder from the article is that if a trust is designated beneficiary, either a Section 678 trust or a QSST trust, that classification will mitigate, to some extent, the high income taxes otherwise imposed on accumulated trust income. An S corporation could be named as the IRA beneficiary, but then you are probably faced with a 5-year payout obligation. While a Section 678 trust or BDOT may be best from an income tax perspective, it carries with it creditor protection and governmental benefit concerns, not to mention probably a bewildered client.