Take-Away: Naming a trustee as the beneficiary of an IRA can be an effective way to exploit the required minimum distribution rules [RMDs] while protecting the IRA assets from the claims of the trust beneficiary’s creditors or to forestall an individual beneficiary’s temptation to take a lump sum distribution from an inherited IRA. But the rules that authorize a trustee to be treated as an IRA beneficiary and exploit the stretch IRA rules are horrifically complex and not well understood. Which may explain why most trusts to which an IRA is payable are structured as a conduit trust and not an accumulation trust.

Comment: It was suggested after my October 6 presentation on IRA distribution rules that I spend some time addressing the benefits (and grief) associated with naming the trustee of an irrevocable trust as the beneficiary of an IRA. This is a response to that request. Note that these same rules generally apply to distributions from  qualified plans, e.g. a 401(k) account,  as well as IRAs, but for simplicity purposes I will only refer to an IRA that names the trustee of a trust as its primary beneficiary.

Caution #1: You might want to have a bottle of 5 Hour Energy close at hand before reading what follows.

Caution #2: As you know from my previous missives, Congress is seriously looking at ending the stretch IRA opportunity, possibly reducing the time in which to ‘empty’ a decedent’s IRA without penalty from the beneficiary’s life expectancy down to a maximum of 5 years. If that change in RMD distribution rules comes to pass as part of tax reform or simplicity, presumably there will be far fewer IRAs that will be made payable to an irrevocable trust on the IRA owner’s death if the favorable stretch IRA disappears.

Background: Key points or concepts follow:

  • ADP: If the IRA beneficiary is an individual, that individual is permitted to withdraw/deplete the IRA  using their life expectancy to calculate their required minimum distributions (RMDs) from the IRA. This draw-down period tied to the beneficiary’s life expectancy is called the applicable distribution period (ADP.) In the press the long duration in which to take taxable distributions from the inherited IRA is usually referred to as a stretch IRA.
  • 5 Year Payout: If the IRA owner dies prior to age 70 ½, normally the IRA must be ‘emptied’ through distributions over a period of no more than 5 years. If an individual is named as the IRA beneficiary, the beneficiary my stretch required distributions from the IRA over the individual’s life expectancy. If the beneficiary is not an individual, then the delayed payout is normally no more than 5 years. Thus, if a trust is named as beneficiary of the IRA, the entire IRA balance normally must be withdrawn by the trustee within 5 years of the owner’s death. IRC 401(a)(9)(B)(ii). But there is an exception.
  • Designated Beneficiary Exception: The Tax Code provides an exception to the five-year payout rule when a ‘non-individual’ trust (or more accurately the trustee of the trust)  is named as a designated beneficiary. If a trustee is named as the beneficiary of the IRA the trust may qualify as a designated beneficiary and use an individual trust beneficiary’s life expectancy for required distributions from the IRA. The oldest trust beneficiary’s life expectancy is used to establish the ADP. But the exception applies only so long as four conditions are met. These are often called the ‘see through rules’ where the trustee (or the trust) as the named primary beneficiary is essentially ignored and the trust is ‘seen through’ with the focus on the trust’s individual beneficiaries.
  • ‘See-Through Rules’-Four Conditions: If a trustee is named as the beneficiary of the IRA the trust may qualify to use an individual trust beneficiary’s life expectancy for required minimum distributions from the IRA, but only so long as all four conditions are met. Three of the four conditions are fairly easy to meet, the fourth is the cause of a lot of confusion. The four conditions are: (i) the trust is valid under state law, or would be even if unfunded (easy); (ii) the trust is irrevocable or will become irrevocable under its terms (easy); (iii) the trust beneficiaries who have an entitlement to the trust’s interest in the IRA are identifiable within the meaning of the tax Regulations (not easy, despite how it sounds); and (iv) by October 31 of the calendar year that follows the IRA owner’s death, the trustee must provide to the IRA sponsor or custodian a final list of all trust beneficiaries as of the prior September 30 (after the year of the owner’s death) or a copy of the ‘actual trust document’ that the IRA owner named as the IRA beneficiary on his/her death is furnished to the custodian (easy as it is a ministerial task of the trustee, so long as the trustee does not blow the October 31 due date). It is the identifiable beneficiary condition that  causes the trustee’s head to spin.
  • Basic Distribution Rule: If the trust instrument has only individuals named as its beneficiaries, they are In that situation,  the trustee must use the oldest identified individual trust beneficiary’s life expectancy at the owner’s death to determine the ADP for the IRA. Treas. Reg. 1.401(a)(9)-5. Note that the determination of the pool of trust beneficiaries is delayed until September 30 of the year following the year of the IRA owner’s death; this delay is intended to give the trustee time to ‘cash out’ older beneficiaries so that they are not part of the pool of eligible trust beneficiaries when the age of the oldest is identified for ADP purposes. Example: I create a trust that says, “pay to my 97 year old mother $200,000 at my death and the balance of my estate is to continue to be held in trust for the benefit of my children.” My mother is the oldest individual beneficiary of the trust at the time of my death and I suspect that her life expectancy is under 3 years. Thus, if the trustee can cash my mother out of the trust by September 30, [or my children encourage her to disclaim her interest in my trust] she does not need to be counted by the trustee for ADP purposes.
  • Non-Individual Beneficiaries: If a trust instrument has multiple beneficiaries and at least one beneficiary is a non-individual, e.g. an estate, a trust, a charity, a corporation, etc., then the determination of the ADP for the IRA becomes much more difficult. A non-individual can never qualify as a designated beneficiary and the non-individual beneficiary’s existence in the line of succession of beneficiaries in the trust usually eliminates the use of an individual’s life expectancy for the ADP from the IRA, forcing the trustee to empty the IRA taking taxable distributions over a period of no longer than 5 years. Treas. Reg. 1.401(a)(9)-4. Accordingly, finding a non-individual beneficiary in the trust is a kind of a bad thing if stretch IRA is a planning objective behind naming the trustee as the IRA’s primary beneficiary.
  • ‘Class’ Analysis by the Trustee: Consequently the trustee must determine the potential for a non-individual beneficiary to succeed to a beneficial interest in the trust. If that potential exists then “Houston, we have a problem.”  In making this determination the trustee will divide trust beneficiaries into two classes based upon the conditions of their entitlement to receive distributions from the trust. The first class includes beneficiaries with a current entitlement to trust distributions ,e.g. discretionary distributions of trust income or trust principal. The second class includes those beneficiaries who in the future will possess a right to receive trust principal upon the trust’s termination, e.g. remainder trust beneficiaries. This analysis by the trustee tends is generally a process of elimination. It is the second class of trust beneficiaries, i.e. contingent remainder beneficiaries, where there is often a lot of ‘what if..?’ planning going on where the non-individual beneficiaries tend to lurk and cause all the problems. Most trusts try to anticipate a named beneficiary not surviving to an age of distribution, and address that contingency by naming alternate beneficiaries. The problem surfaces if those alternate beneficiaries are older than the current beneficiaries or worse yet, a charity is named as the ultimate, contingent, trust beneficiary.
  • Contingent Beneficiaries: Generally the IRS Regulations that a trustee looks to for guidance in the search for non-individual beneficiaries of the trust presume that all contingent beneficiaries of a trust will be counted in identifying members of the ADP class of beneficiaries. But then, per the Regulations,  some beneficiaries will be not be treated as contingent beneficiaries if they fall into a category that the Regulations call mere potential successors. Reg. 1.401(a)(9)-5, A-7(c)(1). Having an exception is always helpful, but using a phrase like mere potential successors is not helpful at all when seeking guidance to avoid a 50% penalty for failing to take a required minimum distribution from an IRA.
  • Mere Potential Beneficiary: Sadly only a highly simplistic example is given by the IRS in the Regulations, to wit: Beneficiary #1 is entitled to all the income from the trust for life. On Beneficiary #1’s death, the trust calls for outright distributions of all trust assets to Beneficiary #2 and Beneficiary #3. The current beneficiary [Beneficiary #1] and the remainder beneficiaries [Beneficiary #2 and Beneficiary #3] all will count in determining the ADP for the IRA payable to the trust. That’s the example, that’s it! The IRS’s example does not identify any other beneficiaries as successors in interest who would be deemed mere potential successors. So we are left guessing as to when a continent beneficiary who is named in a trust would be classified as a ‘mere potential successor’ as opposed to a contingent beneficiary who the Regulations tell us must be counted by the trustee to determine the ADP for the IRA.

Example: Assume that I create an irrevocable trust for my daughter on my death. I name the trustee of this trust as the sole designated beneficiary of my IRA. The trust instrument directs that the trustee may pay to my daughter all income from the trust or it may accumulate the income in the trust. The trust then goes on to say that when my daughter attains age 50 years she is then entitled to withdraw the entire trust balance. The trust also then engages in ‘what if..?’ distribution planning which often comprises a large part of most trusts. The trust instrument goes on to state that if my daughter does not survive until attaining age 50 then the trust estate is divided into separate shares of equal value, creating one share for each of my daughter’s two children, and if one of those children is under the age of 21 at the time of their mother’s death, their trust share will be held back from them until they attain the age of 21 years. The ‘what if..?’ planning continues under the trust instrument with the provision that if my grandchild  does not survive my daughter or dies before attaining age 21 years, the trust share created for that predeceased grandchild then passes to my living (older) siblings, if any, and if there are no living siblings of mine at that time, then the deceased grandchild’s share is to then be distributed to the American Cancer Society. This sounds like a fairly classic type of trust distribution arrangement dealing with several ‘what if..? contingencies, ultimately naming a charity if no one who I wanted to benefit survives. But reflect on this hypothetical trust distribution arrangement: (i) a trust is a non-individual, so that if my daughter does not survive until age 50 and her child is then under the age of 21 years [causing the ‘hold-back’ trust] does the presence of that ‘hold back’ trust cause there to be a non-individual contingent beneficiary? (ii) what if neither my daughter, nor one of her two children, nor my siblings are living at the time of my death, which means that the American Cancer Society [a non-individual contingent beneficiary] ultimately might receive a portion of the trust’s assets- will that charitable gift cause the ADP for the IRA to be reduced to 5 years since it is a non-individual, even though I still have one living grandchild? (iii) are my older siblings counted if both my daughter and/or her child ‘might’ not survive to their ages of distribution?

The Big Question: When is a contingent beneficiary a mere potential successor in the trust for ADP determination purposes? Alternatively,  when must a non-individual be counted in determining the ADP for the IRA? The IRS has not given much guidance on answering these questions. In general,  the position of the IRS seems to be that the unrestricted right to receive accumulated IRA distributions in the future will amount to a countable contingency for those trust remainder beneficiaries who are living at the IRA owner’s death. Turning back to the prior example, my grandchildren living at the time of my death would gain unrestricted access to the trust assets should their mother fail to attain age 50 years for the outright distribution from the trust to her. Thus my grandchildren would be contingent beneficiaries who must be ‘counted’ by the trustee for the ADP. Turning to the ‘hold back’ trusts for a minor grandchild [or a grandchild’s estate if the share was not redirected on my grandchild’s death to my then living (older) siblings] is yet another beneficiary of the trust But the ‘hold back’ trust only receives the trust assets by virtue of a living remainder beneficiary- my grandchild- not yet being age 21 years. In this instance the ‘hold back’ trust for my grandchild will probably be considered a mere potential successor beneficiary of the trust. The grandchildren’s contingent interest in the trust upon their mother’s premature death (prior to age 50) elevates them beyond being a mere potential successor and thus includes them in determining the ADP. My conclusion that the grandchild’s ‘hold back trust’ can be ignored and not counted is not supported by any specific examples provided by the IRS, but it was a position the IRS took in a 2016 Private Letter Ruling, which cannot be relied upon as precedent. PLR 201633025. As such,  many trustees are left to guess at how to distinguish a contingent beneficiary (who is countable in the trustee’s ADP analysis) and a contingent beneficiary who is viewed as only a mere potential successor (who/what can thus be ignored by the trustee in counting the beneficiaries for ADP purposes.) Head spinning yet?

Proposed Snapshot Analysis: Noted retirement planning expert Natalie Choate seems to have identified the best way for a trustee to decipher the mere potential successor definition when it seeks to implement the IRA distribution rule for ADP purposes. When a trust has multiple beneficiaries, Ms. Choate’s suggested method is for the trustee to:

  • search for the first beneficiary  who would take all of the trust’s assets outright and  immediately upon the trust’s termination, following a predecessor beneficiary’s death. This beneficiary’s identity  then determine the group of trust beneficiaries (those beneficiaries who enjoy the trust before this one beneficiary can be identified) whose life expectancies will be used  to determine the ADP for IRA distributions.
  • At the same time, this approach then eliminates any succeeding beneficiaries, after this identified beneficiary, from the ADP, even if they are ‘contingent beneficiaries’ as they will only be viewed as mere potential successors.
  • If there are any restrictions of limitations on a beneficiary’s entitlement to an outright and immediate distribution from the trust, the presence of those restrictions or limitations will require the trustee to continue to search for the successor interest in the trust who holds this unrestricted right to the outright and immediate access to all of the trust’s assets.
  • In summary,  when the first beneficiary who can claim the entire trust estate as a matter of right is identified, the ADP class is that beneficiary and all prior trust beneficiaries. All contingent trust beneficiaries who appear in the trust after this one beneficiary who was entitled to the entire trust is estate, can be ignored as mere potential successors.
  • Choate, Life & Death Planning for Retirement Benefits, Section 6.3.07, pages 439-440, (Ataxplan Publications, 7th 2011).

(On your second bottle of 5 Hour Energy yet?)

Conduit Trust Alternative: For those of faint heart who simply are too uncomfortable implementing the above rules (assuming that they can even understand the rules) for what is often called an accumulation trust that receives and accumulates distributions from IRAs for future distribution, most estate planners opt for an alternative called the conduit trust. The same 4 conditions necessary for a see through trust  apply to a conduit trust. A conduit trust effectively preserves the use of an individual trust beneficiary’s life expectancy, even when the trust has non-individual beneficiaries. The terms of the conduit trust must require the trustee to distribute all retirement plan and IRA distributions to the individual trust beneficiaries, i.e. no accumulation of income originating from retirement plan benefits paid to the trust. The conduit trust guarantees that the trust will not accumulate plan or IRA distributions to which a non-individual beneficiary may gain access. While the oldest trust beneficiary’s life expectancy continues to govern the RMD’s from the IRA [if there are no ‘separate shares’ to which the IRA is paid for each beneficiary- remember, separate shares must be created in the IRA beneficiary designation, not the trust instrument, for each trust beneficiary’s life expectancy to govern his/her trust share’s portion of the IRA paid to the trust.] Thus, with a conduit trust, the trustee will not have to worry about the presence non-individual identifiable beneficiaries in the trust.

Conclusion: Most IRAs are made payable to a conduit trust so the trustee does not have to grapple with distinguishing contingent beneficiaries from mere potential successors in the trust for ADP purposes for the IRA. If confronted with an accumulation trust the trustee will have to spend time to assure itself that it has fully identified all the present and contingent beneficiaries, and that it is certain who the oldest of those beneficiaries is, for purposes of determining the IRA’s ADP, also decide along the away who are only mere potential successors in that trust. When in doubt, follow Ms. Choate’s snapshot analysis and the trustee will probably keep out of harm’s way and avoid the 50% IRS penalty imposed when failing to take a required minimum distribution from an IRA.