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George F. Bearup, J.D. Senior Legal Trust Advisor

19-Oct-20

Is an IRA a Trust?

Take-Away: There seems to be some confusion if an IRA is a trust, or not a trust, depending upon the source of ‘law’ that is referred to. If an IRA is a trust, then its custodian has fiduciary duties to the IRA owner and the IRA beneficiaries.

Background: Probably most individuals who establish an IRA probably were not aware that they had established a trust. Their intent in creating an IRA is either to save for their retirement, or save current income taxes, neither of which has anything to do with an intent to establish a trust. However, that seems to be the case, although you would never suspect it when reading Michigan’s Trust Code.

Michigan Law: The Estates and Protected Individuals Code (EPIC) provides an extensive definition of a trust:

“Trust includes, but it not limited to, an express trust, private or charitable, with additions to the trust, wherever and however created. Trust includes, but I not limited to, a trust created or determined by judgment or decree under which the trust is to be administered in the manner of an express trust. Trust does not include a constructive trust or a resulting trust, conservatorship, personal representative, custodial arrangement under the Michigan uniform transfers to minors act, business trust providing for a certificate to be issued to a beneficiary, common trust fund, voting trust, security  arrangement, liquidation trust, or a trust for the primary purpose of paying debts, dividends, interest,  salaries, wages, profits, pensions, or employee benefits of any kind, or another arrangement under which a person is a nominee or escrowee for another.” [MCL 700.1107(n).]

The Reporter’s Comments to this expansive definition of a trust adds some ambiguity when it notes that the an individual retirement trust (IRT) sponsored by some financial institutions  ‘using a trust rather than a custodial account’ is believed by some to be a trust. The Reporter goes on to note: “Whether an IRT is a trust for purposes of EPIC and, most important, for purposes of the Michigan Trust Code, is not entirely clear. However, analysis of the language used in Section 1107(n) suggests that the term trust  encompasses an IRT, and therefore, that the Michigan Trust Code applies to IRT’s. As important, anecdotal evidence suggests that institutions that offer IRTs, and their clients that select them, do so specifically because of a desire to benefit from the advantages trusts offer for structuring ownership of property. It therefore makes sense that IRT’s would be within the definition of trust for purposes of EPIC generally and the MTC in particular.

From the definition of trust provided by EPIC, and the Reporter’s Comments, a fair conclusion is that an individual retirement trust (IRT) may be a trust, but a custodial account IRA is not a trust under EPIC’s definition of trust as used in the Michigan Trust Code.

Federal Law: The Internal Revenue Code gives a different take on if a custodial IRA is a trust. IRC 408(a) provides, in part:

  • Individual Retirement Account: For purposes of this section, the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries, but only if the written governing instrument creating the trust meets the following requirements….

Treasury Regulations reinforce the conclusion that an IRA is to be treated as a trust. The Regulations provide that an IRA must be a trust or a custodial account. [Treasury Regulation 1.408-2(a).] Consistent with IRC 408 the Regulations note that any such custodial account ‘shall be treated as a trust.’ Final IRS Regulations have the force of law. Accordingly, from a federal perspective, an IRA is always a trust, although it may be labeled a custodial account. [Treasury Regulation 1.408-2(d).]

While this distinction between state and federal law sounds a bit nit-picky, it is important to remember that an IRA exists only under federal tax law, and it exists only as a trust. Nothing in the definition of an IRA depends on state law (in contrast, for example, to a charitable remainder trust which must satisfy the requirements of applicable state law as to the creation of a trust. [IRC 664.]) In short, an IRA exists independent of state law, or what Michigan law chooses to classify as a trust. Thus, a logical conclusion is that a custodial IRA is still a trust which is the sole source of law for its existence.

What’s the Big Deal?

  • Charities: A small matter is that a charity cannot own an IRA, according to the plain reading of IRC 408. Consequently, when an individual dies naming a charity as the designated beneficiary of the decedent’s IRA, and the IRA custodian demands that the charity establish an inherited IRA in order to receive the transferred inherited funds, that violates the law; to ‘own’ an IRA is to ‘establish’ an IRA, and a charity cannot establish an IRA. Because the charity cannot open and hold an IRA, by forcing it to establish an ‘inherited’ IRA in order to receive the inherited funds is not technically an IRA, albeit owned by a tax exempt entity, which means the IRA custodian is forcing a taxable distribution. Restated, the IRA custodian’s position causes the IRA to have its own tax status, and that tax status is taxable because the Tax Code is silent on conferring on the ‘non-IRA’ tax-exempt status if held in the name of a charity. In addition, if the charity-beneficiary is required to create an inherited IRA in order to receive the decedent’s IRA account, that means that the charity becomes a customer of the IRA custodian, which in turn exposes the charity to the know-your-customer required disclosure provisions of Section 326 of the Patriot Act.
  • Fiduciary Duties: A trustee is subject to a state’s fiduciary duties, while a mere custodian is not subject to fiduciary duties. This distinction could have a bearing on remedies for any delays the designated IRA beneficiary might experience if the IRA custodian takes a long time to make a distribution from the IRA either to an inherited IRA or outright to the designated beneficiary if the custodian is subject to fiduciary duties, including the duty to expeditiously administer the IRA, aka trust. [MCL 700.7801.]

Conclusion: Did you know that when you opened an IRA you were actually creating a trust, subjecting the IRA custodian to fiduciary duties in its management and its distribution?