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

2-Jun-17

QTIP Trusts: IRA Distributions

Warning: What follows is pretty technical.

Take-Away: I am the first to admit that no one gets  excited about reading the Uniform Principal and Income Act (UPAIA). However,  the UPAIA’s rules  are critically important to trustees that must impartially administer irrevocable Trusts for present and future beneficiaries in a low investment income environment.  Understanding those UPAIA rules is especially important when an IRA is made payable to a QTIP Trust which compels the trustee to pay all income to the IRA owner’s surviving spouse.

Context: We are in a period when planning to avoid the federal estate tax has become far less important. Due to the large federal estate tax exemption for each taxpayer, and the portability of the deceased spouse’s unused exemption available to the surviving spouse, the focus has turned to gaining a second basis step-up on the survivor’s death, and how to minimize income taxes. We are also deal more and more with clients who are in second marriages, where the desire is to provide for their surviving spouse, but also the goal to assure that  the decedent’s assets will remain on the surviving spouse’s death to benefit the decedent’s children and grandchildren from their first marriage. As such, it is  common these days to find a decedent creating a QTIP trust for the lifetime benefit of their surviving spouse, and to direct that their 401k or IRA assets be paid to that QTIP trust for the survivor’s lifetime benefit. The QTIP Trust must pay all of its income to the surviving spouse to qualify for the unlimited marital deduction. And all distributions from the IRA or 401k plan to the QTIP are taxable as ordinary income. Yet income tax rules and trust income accounting rules are not necessarily the same, which can lead to confusion.

Background – the UPAIA in Michigan: Michigan adopted the UPAIA in 2004. But it did not adopt an alternate version of that uniform act which gives to the trustee the power to convert an income only trust to a unitrust.  Many other states, like Delaware, have adopted the unitrust conversion option of the UPAIA. Michigan’s version of the UPAIA gives the trustee the power to adjust when the Trust’s investment income is abnormally low. Michigan’s statute provides:

“A fiduciary may adjust between principal and income to the extent the fiduciary considers necessary if the fiduciary invests and manages trust or estate assets as a prudent investor, the terms of the trust or will describe the amount that may or must be distributed to a beneficiary by referring to the trust’s or estate’s income, and the fiduciary determines after applying the provisions in section 103(1) and (2) that the fiduciary is unable to comply with section 103(3).” [MCL 555.504(1)]

Unlike a one-time unitrust conversion power given to the trustee under the UPAIA,  a power to adjust requires the trustee to make an annual decision  with supporting documentation in the trustee’s file to substantiate the trustee’s decision to adjust, as well as how the decision was reached as to the amount of trust principal to be distributed as trust income to the beneficiary. In short, with a power to adjust there is a lot more work for the trustee. Michigan’s statute expressly states that in the exercise of its statutory power to adjust the fiduciary must “consider all factors relevant to the trust or estate and its beneficiaries.” [MCL 555.504(2)]

But if the Trust is intended to satisfy the federal estate tax unlimited marital deduction, the trustee’s power to adjust is limited. “A fiduciary shall not make an adjustment that does 1 or more of the following or under 1 or more of the following circumstances: (a) diminishes the income interest in a trust or estate that requires all of the income to be paid at least annual to a spouse and for which an estate tax or gift tax marital deduction would be allowed in whole or in part, if the fiduciary did not have the power to make the adjustment.” [MCL 555.504(4)(a)]

Recall that the federal estate tax marital deduction is available only when all income is required to be paid by the trustee each year to the surviving spouse trust beneficiary, i.e. it is a requirement for the QTIP election by the trustee or estate fiduciary. [IRC 2056(b)(7)]

QTIP Trusts Subject to the UPAIA: Complications arise when the UPAIA governs the administration of a QTIP Trust.

  • Discretion vs. Require: If a QTIP Trust is  administered and its assets do “not provide the spouse with sufficient income form or use of the trust assets and if the amounts that the trustee transfers from principal to income under section 104 and distributes to the spouse from principal pursuant to the terms of the trust are insufficient to provide the spouse with the beneficial enjoyment required to obtain the marital deduction, the spouse may require the trustee to make property productive of income, convert property within a reasonable time, or exercise the power conferred by section 104(1), i.e. the power to adjust. The trustee may decide which action or combination of actions to take.”  [MCL 555.813] While the trustee possesses the discretion to exercise its power to adjust, i.e. treat some trust principal as trust income to be currently distributed, the surviving spouse can require the trustee to exercise its discretionary power to adjust. The beneficiary requiring the trustee’s exercise of discretion seems to be problematic, if not circular.
  • Ten Percent Allocation to Income Rule: The UPAIA  contains a specific section that is devoted to IRAs that are made payable to Trusts. If no part of the IRA distribution is characterized as interest or dividend income, and if all or part of the distribution is required to be made (i.e. an RMD) , then 10% of the required IRA distribution to the Trust is allocated to the Trust’s income, and the remainder (90% of the IRA distribution) is allocated to the Trust’s principal. A payment is deemed to be required to be made [such as with a marital deduction trust where all income must be paid to the surviving spouse] if the payment is made because the trustee exercises a right of withdrawal. [UPAIA section 409(c).] However, all income must be distributed from the QTIP Trust in order to qualify for the unlimited estate tax marital deduction. [IRC 2057(b)(7)] Yet the UPAIA requires only a 10% allocation of the IRA distribution to trust income when an IRA RMD distribution is taken by the QTIP Trustee (if interest or dividends are not separately reported). Restating the tension, a required minimum distribution from the IRA is tied to the surviving spouse’s life expectancy, not to the amount of income that the IRA generates in a calendar year. Thus,  you have a 100% taxable distribution from the IRA to the QTIP Trust, but the UPAIA directs that only 10% of that taxable distribution is treated as income to be distributed to the surviving spouse to satisfy the QTIP distribution rules.
  • All IRA Income Distributed: The IRS notes that in order for that portion of a Trust that receives IRA distributions to qualify for treatment as a QTIP Trust, and to thus qualify for the unlimited federal estate tax marital deduction- deferring federal estate taxes on the assets held in the Trust until the surviving spouse’s death- all of the IRA’s income must be distributed to the QTIP marital deduction Trust, and then all of that income must then be distributed to the surviving spouse beneficiary. [Rev. Ruling 89-89.]  The mere fact that the surviving spouse, as beneficiary of the QTIP Trust,  possesses the right to require the trustee to withdraw the necessary amount is insufficient to satisfy this all income Consequently, if the RMD taken by the Trustee from the IRA does not correlate to the income generated by the IRA for the calendar year, then the QTIP Trustee must make a larger allocation to income to the extent necessary to qualify for the marital deduction. This requirement is often addressed in a QTIP Trust provision that compels the QTIP Trustee to ‘pay to my surviving spouse the larger of the income generated by the IRA or my surviving spouse’s required minimum distribution for this calendar year”  to assure that all income generated by the IRA is paid out annually to the surviving spouse from the QTIP Trust.
  • RMD-Income Distribution Disconnect: We know that all distributions from an IRA are taxable as ordinary income. Thus, the RMD taken by the QTIP Trustee is taxable; the UPAIA’s 10% allocation rule compels that all income, which means earnings from the assets held in the IRA must be distributed to the surviving spouse who is the lifetime beneficiary of the QTIP Trust. Consequently,  lots of taxable income  comes into the QTIP Trust via the Trustee taking RMD, but arguably only a small portion of that taxable income (10%) is distributed to the surviving spouse, with a corresponding distribution tax deduction available to the QTIP Trust.  All of the taxable RMD to the QTIP Trust that is not distributed to the surviving spouse [90%] will be taxed to the QTIP Trust. Once irrevocable Trusts accumulate taxable income in excess of $10,500 a year, the QTIP Trust will be taxed at the highest marginal federal income tax bracket, i.e. 39.6%. That is a heavy income tax burden faced by the QTIP Trust when the trustee follows the UPAIA’s required 10% allocation to income rule.
  • Two QTIP Elections: In 2006 the IRS confirmed an earlier Revenue Ruling on the taxation of IRAs paid to a QTIP Trust and then went even further to require that the IRA itself, in addition to the QTIP Trust, must elect to qualify for the marital deduction- two QTIP elections, not one. [Rev. Rul. 2006-26.] Restated, when an IRA is payable to a QTIP Trust, the IRS treats the IRA as a separate terminable interest asset that requires its own timely filed QTIP election beside the QTIP Trust’s timely filed QTIP election.
  • IRS Does not Follow  the 10% Rule: In its 2006 Revenue Ruling the IRS also directly criticized the UPAIA’s allocation formula that assigns 10% of an IRA distribution to trust income (10%.) It is easier to simply quote the IRS’ Revenue Ruling:

“This 10 percent allocation to income, standing alone, does not satisfy the requirements of 20.2056(b)(5)(f)(1) and 1.643(b)-1. Because the amount of the required minimum distribution is not based on the total return of the IRA (and therefore the amount allocated to income does not reflect a reasonable appointment of the total return between the income and remainder beneficiaries.) The 10 percent allocation to income also does not represent the income of the IRA under applicable state law without regard to a power to adjust between principal and income.  [A] state [law] version of section 409(d) of the UPAIA requiring an additional allocation to income if necessary to qualify for the marital deduction may not qualify the arrangement under IRC 2056.”

  • New Safe Harbor: Even though UPAIA section 409 provides that receipts would be allocated by the trustee to income to the extent necessary to qualify for the marital deduction, the 2006 Revenue Ruling says that this fiduciary power to allocate or adjust does not satisfy the IRS’s safe harbor for the marital deduction. As a consequence, the UPAIA was  amended  in 2008  to add a new section 409(f) which requires the QTIP Trustee to demand certain distributions of income from the IRA if the surviving spouse requests. If the surviving spouse decides to leave some of the income inside the IRA, in order to accumulate  on an income tax-deferred basis, then the new UPAIA section 409(f) provides that the surviving spouse may require the trustee to distribute other assets from the QTIP Trust equal to that year’s accumulated(undistributed)  income. This 2008 amendment does not appear to have been adopted in Michigan. As a result of the position taken by the IRS and the UPAIA’s response, often you will find that the QTIP Trust will contain a ‘safe-harbor’ savings provision that allows the surviving spouse to direct the trustee to withdraw all of the IRA’s income for the year, even if that income is greater than that survivor’s required minimum distribution for the calendar year.

Conclusion:  With the portability of a deceased spouse’s unused federal estate tax exemption to the surviving spouse, and the growing number of second marriages that prompt the use of a QTIP Trust when one spouse dies, the interplay between the Tax Code’s distribute all income QTIP marital deduction condition to claim the unlimited federal estate tax marital deduction to defer federal estate taxes [or eliminate estate taxes due to portability],  with the UPAIA’s mandatory 90% allocation of each IRA taxable distribution to the QTIP Trust’s principal, overlaid with the trustee’s power to adjust in a low investment income environment, can result in a complex process of elections, calculations, and safe harbor provisions built into a QTIP Trust to ensure that all of the estate tax deferral benefits of the QTIP election are preserved. While deferring federal estate taxes [using a QTIP Trust coupled with a  portability election] and deferring federal income taxes [maintaining an IRA  to exploit the required minimum distribution stretch rule] can work together to achieve tremendous tax savings, navigating the UPAIA’s 10% allocation to income rule presents challenges. The challenge is that the UPAIA is the default rule that applies to determine trust accounting income if the trust instrument is silent on the subject.  Consequently, this is usually why most QTIP Trusts simply direct the Trustee to pay to the surviving spouse, “the larger of the income generated by the IRA or the required minimum distribution for that calendar year, whichever amount is larger” in order to avoid subjecting a large part (90%) of the RMD to the QTIP Trust’s potentially marginal 39.6% federal income tax bracket.

As an aside, the Uniform Law Commission is currently looking at re-writing the UPAIA, so expect the default rules to change, yet again.