Take-Away: There is much discussion these days is over the planning technique of directing an IRA to be paid to a trust on the death of the IRA owner. The benefit of this strategy is to shelter the IRA from creditor claims against the individual beneficiary, which would not be protected if the IRA was made payable directly to the individual beneficiary. As a result, common estate planning lexicon now includes such terms like conduit trust and accumulation trust where irrevocable trusts are named as an IRA beneficiary, and distributions from the IRA are made to the trustee.  But often overlooked is the implication of Michigan’s Uniform Principal and Income Act, which directs how the trustee of the trust is to report distributions from IRAs (and other retirement accounts) to the trust for trust accounting purposes, and which becomes even problematic if the trust is intended to qualify for the federal estate tax marital deduction (to exploit a portability election.) It will get even more complicated with the Uniform Fiduciary Principal and Income Act, if it is ever adopted in Michigan.

Background: We all know the benefits of directing an IRA to be paid to an irrevocable trust on the death of the IRA owner. We also know that required minimum distributions (RMDs) using the oldest trust beneficiary’s life expectancy can be taken from the inherited IRA by the trustee, thus stretching the taxable distributions over potentially a long period of time. The IRS’s rules surrounding see-through trusts can be complex and time sensitive. As such, a lot of time and energy goes into making sure that the trust instrument that the IRA owner names as the IRA’s beneficiary complies with all of these see-through rules [conduit or accumulation]. But not nearly as much time and energy goes into assessing how the trustee will administer the trust that receives the taxable IRA distributions, which is especially important when the goal is to exploit the marital deduction rules.

  • Trust Accounting Income: When the decedent’s trust owns the inherited IRA, periodic distributions from the IRA to the trust must be classified as partly trust income and partly as trust principal for trust accounting purposes. However, trust accounting income is not the same thing as taxable income. Accounting income for fiduciary accounting purposes is determined under the trust instrument and under applicable state law. This, in turn, determines who pays federal and state income taxes on the distributed amount.
  • Disparate Income Tax Rates: An irrevocable trust’s maximum federal income tax rate of 37% applies when the trust accumulates income of $12,500. In contrast, an individual hits the highest 37%  federal income tax bracket when his/her income is at $300,000. To save income taxes, it is obviously much better to expose taxable income to the individual’s income tax rates than an irrevocable trust’s income tax rate.

Impact of Uniform Principal and Income Act: Like many jurisdictions, Michigan has adopted the Uniform Principal and Income Act (UPIA.) The UPIA provides the answer to how a trustee must classify IRA distributions to the trust for trust accounting purposes. Generally, a trust that receives a distribution from a traditional IRA must classify 10% of that distribution as trust income and the remaining 90% of the distribution must be classified as trust principal. [UPIA Section 409.]

  • Example: At his death, the decedent’s traditional IRA held $1.0 million. That IRA generates $40,000 of income in the year of the decedent’s death. The decedent’s trust is named as the IRA beneficiary. The decedent’s trust directs that his daughter, Carlene, the lifetime trust beneficiary, is to receive all income from the trust. The trustee distributes $40,000 to Carlene. But Section 409 requires that only 10% of the distribution, or $4,000,  is to be treated as trust income for fiduciary accounting purposes. Accordingly, due to Section 409, Carlene should only receive $4,000 as taxable income under the trust instrument. The balance of the IRA distribution, $26,000, must be added to trust principal, yet since all distributions from a traditional IRA are taxable, the trust will also be required to pay income taxes at the trust’s rate (37%) on that $26,000 above $12,500,  the net amount of which is then  added to trust principal. This result surprises a lot of trust beneficiaries, since they tend to focus solely on the IRA as taxable income, but they overlook the principles of trust accounting
  • Trust Can Override UPIA: Trust provisions can override Section 409. Example: A trust might require under its terms that: ‘the trustee shall distribute to the trust beneficiary immediately upon receipt all amounts received by the trustee from an IRA and all such receipts shall not be subject to Section 409 of the Uniform Principal and Income Act.’
  • Marital Deduction Exceptions: A few exceptions exist to the 90%/10% allocation rule under Section 409 that is applied if the trust instrument is silent on allocations. Two notable exceptions apply to marital deduction trusts: a QTIP trust [IRC 2056(b)(7)] and general power of appointment marital deduction trust [IRC 2056(b)(5.)]

QTIP Marital Trust: A QTIP election can be made when the trustee of the QTIP Trust is named as beneficiary of the deceased spouse’s IRA, if the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually, so long as no other person has a power to appoint any part of the trust property to anyone other than the surviving spouse. [Revenue Ruling 2002-2.]

Power of Appointment Marital Trust: This marital trust qualifies for the unlimited federal estate tax marital deduction because all income is payable to the survivor for life, and the survivor has a general power of appointment over the trust.

Trustee’s Duty: The trustee must determine the amount of income earned within the IRA, as if the IRA were itself a trust that is subject to the UPIA, withdraw that amount from the IRA and pay that entire amount to the surviving spouse.

  • Unitrust: In 2006 Revenue Ruling 2002-2 was modified. [Revenue Ruling 2006-26.] That new revenue ruling provided possible definitions of income under the laws of the state if the trust is silent on its definition of income. A unitrust percentage between 3% and 5% applied annually to the fair market value of all trust property, including the value of the IRA payable to the trust, is an acceptable definition of income. The other acceptable definition of income that completely avoids the Section 409 allocation requirement is if the trust’s definition of income includes dividends and interest and excludes capital gains. One example provided in this updated Revenue Ruling provides that the trustee must determine each year’s required minimum distribution (RMD) from the IRA. The trustee is then required to withdraw the IRA’s income, or the IRA’s RMD, whichever amount is greater, and distribute that amount to the surviving spouse trust beneficiary which will satisfy the marital deduction rules.

Uniform Fiduciary Income and Principal Act: The Uniform Law Commission is getting ready to update the ‘existing’ UPIA with a new proposal for inherited  IRAs paid to an irrevocable trust. [Not helping matters any, it renumbers ‘old’ Section 409 of the UPIA as Section 408 of the ‘new’ UFIPA.] The proposed Section 408 revises old Section 409’s income allocation provisions. As a result, the ‘old’ 90%/10% allocation will only be applicable in limited circumstances. The ‘new’ Section 408 proposal will require the trustee to determine income of the IRA (which Section 408 refers to as a ‘separate fund’) as if it were a separate trust. If the trustee cannot determine the income in that ‘separate fund’ then income is defined under the Uniform Fiduciary Act as a unitrust amount between 3% and 5%. The unitrust percentage is applied to the value of the ‘separate fund’s’ assets, determined as of the beginning of the trust’s accounting year. If this unitrust method is used by the trustee, then the trust is entitled to a series of periodic payments (equivalent to an annuity) and if the fund’s value cannot be determined, the amount of the annuity payments allocated to income must be determined based on the federal income tax Regulations under IRC 72, assuming a monthly annuity-type of payment. In sum, with the UFIPA, the move is away from a strict 90%/10% allocation to a separate fund approach with a 3% to 5% unitrust allocation of the distributable amount.

Trust Provisions: The trust accounting rules can become a trap for trustees unfamiliar with the Uniform Principal and Income Act. Application of Section 409 can also frustrate the expectations of the settlor who intended their lifetime trust beneficiary to receive all of the income earned by the settlor’s IRA, not realizing that Section 409 prevents the full amount of income from being distributed. If an IRA is to be made payable to an irrevocable trust on the IRA owner’s death, the trust should be designed to opt out of Section 409, if the intent is that the trust’s income beneficiary is to receive all of the RMD taken from the IRA, and not just 10% of the RMD. The best way to avoid the 90%/10% allocation rule of Section 409 is for the trust instrument to provide that the IRA distributions received by the trustee during each accounting period shall be allocated to trust income to the extent, if any, the income earned within the IRS during the trust accounting period or close to  the marital trust ‘safe harbor’ provisions of Revenue Ruling 2002-2.

Conclusion:  How many settlors who intend to set up a conduit trust to receive RMD distributions from their IRA after their deaths understand the implications of the Uniform Principal and Income Act, or the income tax consequences caused by the UPIA? If a conduit trust is intended, the settlor also needs to formally opt out of the application of the UPIA on distributions from the inherited IRA, so that 90% of the distribution is not taxed to the trust at the trust’s 37% income tax rate.