Several weeks ago a couple of individuals indicated  that they wanted to know more about distributions from retirement plans and IRAs to Trusts. Perhaps because it is that time of the year when many of our thoughts turn to taking required minimum distributions before the end of the calendar year or  because Congress is now taking a serious look at repealing stretch IRAs, that I was reminded of that desire for more information. Consequently I thought I would provide an overview of the conduit trust rules. When I find enough courage, or maybe after having consumed a bottle of wine [or two], I will later try to explain the other type of Trust that can accept required minimum distributions over time, known as an accumulation trust.

Conduit Trust: Nowhere does the Tax Code, or the IRS’ Regulations, define a conduit trust. Rather, it is a term that lawyers, accountants, and the IRS in its private letter rulings have all adopted to describe the type of Trust that can qualify as an eligible beneficiary of an IRA or retirement account when the owner dies.

See-Through Trust Requirements: For a Trust to be eligible to be treated as a designated beneficiary of a retirement account or IRA (for simplicity, I will only refer to an IRA account)  called a see-through trust, four separate requirements must be met, two of which are easy, the third is a bit more complicated, and the last awaits more as a trap set by the IRS. The two easy requirements are: (i) the Trust must be valid under state law; and (ii) the Trust is irrevocable, or it will become irrevocable on the death of the IRA owner. The third (iii) requirement is more complicated in that requires that the beneficiaries under the Trust with respect to the IRA must be identifiable within or from the Trust instrument- it sounds easy, but not so much so in practice when lawyers begin to add flexibility to the Trusts that they draft. The last requirement (iv), which often acts as a trap, is that the Trust document, or the trust provisions that pertain to the required minimum distribution to the Trust, must be delivered to the plan administrator, or the IRA custodian, by October 31 of the year which follows the death of the IRA owner. Forget to timely deliver the required documentation to the IRA custodian by that date means that the Trust, while satisfying the other three requirements, will still fail as a see–through trust. In short, in order for a Trust to qualify as the designated beneficiary of an IRA account, it must meet the  see-through trust test. 26 C.F.R. 1.409(a)(9)-4.

Lots of Preliminary Technical Rules First (Sorry!):  Most of these rules you have already heard about before. For example, the required minimum distribution [RMD] from the IRA must start in the year the IRA owner turns 70.5, but that first year’s distribution can be delayed until the following April 1. [But a problem arises if the RMD distribution is delayed;  there will be, in effect, two taxable distributions in that next  calendar year, one for the prior year when the IRA owner turned 70.5, and a second distribution for the April 1 calendar year itself, thus bunching that taxable income into one calendar year, and thus exposing it to a marginally higher income tax bracket.] That April 1 is called the required minimum date. Distributions from the IRA are over the beneficiary’s life expectancy period. That life expectancy period is re-determined annually. 26 U.S. C. 401(a)(9)(D). The IRS’s Uniform Life Table is used to identify the divisor that is used to divide the IRA account balance at the beginning of the calendar year to determine that calendar year’s RMD. [There is a favorable exception if the spouse-beneficiary of the deceased IRA owner is more than 10 years younger; in that case a Joint and Survivor Expectancy Table can be used instead of the Uniform Life Table, which lowers the RMD for the surviving spouse.]

Required Minimum Distribution Rules (RMD’s):

  • Spouse Beneficiary: If the designated beneficiary is the owner’s surviving spouse, the date on which distributions are required to begin may not be earlier than the date that the IRA owner would have turned 70.5. If the IRA owner was under age 70.5 and if the spouse is the sole beneficiary of a Trust that is named as the beneficiary of the owner’s IRA, and if all RMDs must be paid out to the surviving spouse annually, as well as all other distributions from the IRA ( like a QTIP Marital Deduction Trust),  distributions from the IRA do not have to begin until the year in which the IRA owner would have turned age 70.5, not the year following the IRA owner’s death.
  • Non-Spouse Beneficiary: If the IRA owner dies before he attains his required beginning date, the entire account must be distributed within 5 years after the IRA owner’s death, unless the exception described below applies. If the IRA owner dies after attaining his required beginning date, then the remaining portion of his IRA must be distributed to the non-spouse beneficiary at least as rapidly under the method of distributions that was used by the owner as of the date of the IRA owner’s death. Restated, this means the remaining life expectancy of the IRA owner is used for the future distributions, but it is not annually recalculated as it was while the IRA owner was alive.
  • Stretch Exception: Any portion of an IRA’s account that is payable to a designated beneficiary may be distributed over the life of the designated beneficiary or a period that does not extend beyond the life of such beneficiary. The distributions must begin not later than one year after the date of the IRA owner’s death. This is often called the stretch IRA which Congress is now talking about repealing, potentially replaced with a rule that all distributions from the IRA must be taken over a maximum of 5 years from the IRA owner’s death.
  • Trust’s Oldest Beneficiary: If the designated IRA beneficiary is a Trust, the applicable RMD distribution period is based on the life expectancy of the oldest primary beneficiary of the Trust, with distributions starting with the year after the IRA owner’s death.
  • Five Year Payout Rule: If the IRA owner has no designated beneficiary, the IRA distributions must be paid over a period that does not exceed 5 years from the IRA owner’s death.
  • Separate Account Rule: As a general rule, each beneficiary of an IRA can use their own life expectancy to determine their applicable distribution period for their share of the inherited IRA, i.e. a separate account. However, the separate account rule is not available to the beneficiaries of a Trust with respect to IRA distributions that are made to the Trust. 26 C.F.R. 1.401(a)(9)-4. If the goal is to use the separate life expectancies of each trust beneficiary, then the separate shares must be created in the IRA beneficiary designation itself, in which each separate trust share is named (along with its own taxpayer identification number.) An example of such an IRA beneficiary designation would be: “50% of this IRA shall be paid to the George Bush Trust FBO George W. Bush, and 50% of this IRA  shall be paid to the George Bush Trust FBO Jeb Bush.” Simply designating the Trust as the beneficiary, expecting the ‘divide into two shares of equal value’ directive in the Trust instrument itself to allocate the IRA paid to the distinct trust shares will not work. The separate shares must be created in the IRA beneficiary form (a beneficiary level division), not in the Trust instrument (a Trust level division), if the goal is to use each beneficiary’s life expectancy to control his/her separate required minimum distribution amounts. This is where many mistakes are made.

Trust As Designated Beneficiary:

  • See-Through Rule: If a Trust is named as the IRA’s ‘designated beneficiary’, the beneficiaries of the Trust (not the Trust itself) will be treated as the IRA’s ‘designated beneficiaries.’ A Trust can also be the beneficiary of another Trust, so long as  both of the Trusts qualify as see-through trusts.
  • Identifiable Beneficiaries: In order to be considered a ‘designated beneficiary’ an individual must be identifiable as of the date of the IRA owner’s death. If, however, a beneficiary exists at that date who/which if included would cause the Trust to not qualify as a see-through Trust, that beneficiary can be removed prior to the beneficiary finalization date which is September 30 of the year that follows the IRA owner’s death. For example, if the Trust contains a charitable bequest of $10,000 and an IRA is made payable to the Trust which contains that charitable bequest, the charity would not qualify as an individual, which in turn jeopardizes the Trust’s see-through Or, if the IRA owner’s Trust contained a $50,000 gift to his surviving older brother, that $50,000 could be distributed to the brother by September 30 of the following year, and thus the older brother would be ignored as a beneficiary for purposes of calculating the RMD from the IRA paid to the Trust, or if the charitable bequest is satisfied by the Trustee by September 30 of the year following the IRA owner’s death, then the charity will no longer be treated as a trust beneficiary for purposes of determining the Trust’s see-through classification. While a beneficiary does not need to be named in the Trust, e.g. ‘I leave the assets in trust to my issue’, the beneficiaries must nonetheless be able to be identified with certainty by the Trustee at the time of the IRA owner’s death.
  • Trust Protectors: A problem arises if a Trust Protector is given the authority to add beneficiaries to the Trust. A snapshot in time is used to determine the identifiable trust beneficiaries, i.e.  the IRA owner’s death, not when a Trust Protector decides to add trust beneficiaries. A Trust Protector who holds the power to add beneficiaries is problematic when the goal is to establish a see-through
  • Class of Beneficiaries: A beneficiary is treated as being identifiable if it is possible to identify the beneficiary, or member of a class of beneficiaries, with the shortest life expectancy. If a class of beneficiaries is named under the Trust [e.g. ‘ the trustee shall distribute trust income or trust principal  to my descendants’] a class that can expand or contract, that flexibility makes it a challenge for the trustee to identify the trust beneficiary with the shortest life expectancy.
  • Adoptions: If a class of beneficiaries is identified under the Trust which could be expanded by an adoption, that again creates problems when it comes to identifying the beneficiary with the shortest life expectancy. It may be helpful to add a provision to the Trust instrument that creates an exception for older persons who might be adopted after the IRA owner’s death, a provision that,  in effect ‘closes the class’ of potential trust beneficiaries so that the oldest beneficiary can be identified by the Trustee.
  • Powers of Appointment: A further problem exists if a beneficiary is given a power of appointment over the Trust’s assets;  some limitations will need to be placed upon the exercise of the power of appointment over the Trust’s corpus as to the identity of the possible appointees who might receive assets from the Trust when the power of appointment is exercised,  so that the oldest potential trust beneficiary can be identified by the Trustee  determined as of the IRA owner’s death or the beneficiary finalization date. Without that type of limitation a Trust that gives another an unlimited power of appointment will fail to qualify as a see-through trust.
  • Trust Reformations: While a Trust can be reformed through a probate court proceeding, perhaps to eliminate a problematic trust beneficiary, that judicial proceeding will not be binding on the IRS to ascertain if the Trust is a see-through trust for RMD purposes; the IRS’s focus is at the time of the IRA owner’s death, not a subsequent judicial order that attempts a retroactive modification of the Trust instrument. In short, judicial reformation cannot save a defective see-through trust.
  • Estate Expenses: The decedent’s estate is not an individual. Thus a probate estate will not qualify as a beneficiary which otherwise jeopardizes a see-through trust This is why many Trust instruments in their boilerplate provisions direct that the Trustee cannot use retirement benefits that it receives to pay probate administration expenses or the debts of the decedent, as the use of the retirement assets for those purposes would be viewed as an indirect payment of the IRA to the estate, not an individual.

Conduit Trusts (Finally!): As noted earlier, a conduit trust must be a see-through trust.

  • Immediate Payment to Beneficiary: All RMD’s received by the conduit trustee from the IRA must be distributed immediately to the trust beneficiary(s). Any other assets distributed from the IRA to the conduit trustee, including accidental distributions taken from the IRA, i.e. amounts greater than the RMD, must also be immediately paid by the trustee to the beneficiary(s).
  • First Distribution Deadline: A conduit trust must begin payments relatively soon after the IRA owner’s death, i.e. by December 31 of the year that follows the IRA owner’s death. There can be no delays beyond this date. Nor can the Trust start out as an accumulation trust and later convert to a conduit trust.
  • Strictly From the IRA: As a generalization, distributions from other sources to the trust beneficiary(s) other than the IRA cannot be ‘credited’ against the amount that is required to be distributed from the IRA to the conduit Trustee at a later date. Thus, some tracing of the origin of the distributions is involved; only retirement assets can be used to satisfy the conduit distribution of the retirement asset to the beneficiary(s).
  • No Accumulations: No part of any distribution from the IRA to the conduit trust can be accumulated. If any part of the distribution received from the IRA is held for a later distribution by the Trustee, then the Trust is treated as an accumulation trust not a conduit trust.
  • Primary Trust Beneficiary : As noted earlier, the oldest trust beneficiary dictates the RMD from the IRA to the conduit trust. All contingent trust beneficiaries are considered ‘mere potential successors’ and generally they are ignored. The easier type of conduit trust is where there is one primary beneficiary who must receive the RMD that originates from the IRA,  which  passes through the  conduit trust, and then onto that sole trust beneficiary. Anything or anyone can be a successor beneficiary and will be treated as a ‘mere potential successor’ and practically speaking be ignored for RMD purposes. If RMDs are paid out using the primary beneficiary’s life expectancy, hypothetically there will be nothing left in the IRA when the primary beneficiary dies, the IRA being ‘emptied out’ by RMDs over the primary beneficiary’s lifetime. Any remaining IRA assets paid out after the primary beneficiary’s death to a successor beneficiary will not destroy the conduit trust classification.
  • Multiple Trust Beneficiaries: With more than one trust beneficiary, things become a bit more complex. For example, if there are two trust beneficiaries, then during the lifetimes of both beneficiaries no assets can be accumulated for the benefit of any other beneficiary. The applicable distribution period will still be governed by the life expectancy of the oldest of the two trust beneficiaries. The RMD must be distributed by the conduit Trustee, but it does not need to be distributed by the Trustee in fixed percentages to the beneficiaries; the Trustee can be given discretion as to whom or how much is to be distributed among the beneficiaries, just so long as the entire RMD is distributed from the conduit Trust shortly after it is received. If one beneficiary dies, no portion of the RMD can be held in trust for later distribution to that deceased trust beneficiary’s issue or any future beneficiary.

When to Use a Conduit Trust:  (i) The income tax burden that arises from taking RMD’s always passes through the conduit Trust to its beneficiary(s), who often are in a much lower marginal income tax bracket than the Trust, which faces the highest marginal federal income tax bracket with accumulated income in excess of about $10,400 a year. (ii) A conduit Trust tends to be easier for a Trustee to administer; the RMDs flow through the conduit Trust and out to the beneficiary, consequently there will be fewer assets for the conduit Trustee to manage and account for in the future. (iii) All other assets held in the Trust can be controlled by the trustee, either dedicated for specific purposes like distributions for the beneficiary’s health, education or support, or used only in the trustee’s discretion to prevent the beneficiary from depleting the other remaining assets that are held in the Trust. Moreover, the Trust instrument can direct that before the trustee makes a discretionary distribution of other assets to or for the benefit of the trust beneficiary, the Trustee must take into account other resources available to the trust beneficiary, which could include the RMD that was distributed to the beneficiary by the trustee.

When Not to Use a Conduit Trust: (i) Obviously a conduit trust is not a good device to accumulate wealth. By definition, a conduit trust must immediately distribute all RMD’s (and any other accidental or excess distributions from the IRA) to the trust beneficiary(s). If wealth accumulation is the goal, then an accumulation trust becomes a priority. (ii) If a trust is needed to protect beneficiaries who are financially immature or spendthrifts, the required distribution of the RMD to the beneficiary will be inconsistent with the utilization of a trust that it intended to protect the beneficiary.  Along these same lines,  if a trust beneficiary eligible, or is likely to qualify, for means based governmental benefits such as Medicaid or SSI, then a conduit trust could jeopardize that entitlement or the eligibility to receive those governmental benefits.