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

4-Sep-18

Retirement Benefits Paid to a Trust

Take-Away: Accounting income is not the same thing as taxable income. This becomes clear with reference to Section 409 of the Uniform Principal and Income Act (UPIA). Generally an irrevocable trust that receives a distribution from an IRA or other qualified retirement plan must classify 10% of that distribution as trust accounting income; the remaining 90% of the distribution is classified as trust principal. The National Conference of Commissioners on Uniform Laws proposed earlier this year a change in the Section 409 formula which will require a trustee to determine income of the retirement plan account (which it calls a separate fund) as if it were a separate trust.

Background: For a trust using Michigan law, the UPIA is the default rule, which applies if the trust instrument does not opt out of the application of the UPIA to the trust and how its trustee accounts for income. Accordingly, many trusts may be subject to Section 409 of the UPIA, which can lead to a few surprises for both the trustee and the trust beneficiary.

  • Example: Mom dies this year leaving an IRA valued at $1.0 million, which IRA is payable to Mom’s trust. The IRA earns income of $30,000 during 2018. Mom’s trust directs that all income earned on trust property is to be paid to Mom’s son, Steve. The trustee withdraws  the $30,000 planning to pay the IRA’s income to Steve. But Section 409 requires that only $3,000 of the $30,000 distribution (10%) is treated as trust income for fiduciary accounting purposes. In short, because of Section 409, Steve will receive only $3,000. The remaining $27,000, which is not available to be distributed by the trustee to Steve will be subject to income taxes at the trust income rates on that amount. There are few exceptions to this 90%/10% allocation rule under the UPIA.
  • Opt Out: As noted, a trust instrument can opt out of Section 409 with regard to IRAs, qualified plan accounts, pensions or annuities that are paid directly to the owner’s trust on death.
  • Marital Trust Exception to the 90%/10% Rule: Payments to either of two types of trust arrangements that qualify for the estate tax marital deduction will cause all of the retirement plan income to be classified as trust income by the trustee instead of applying the 90%/10% rule of Section 409: (i) a trust to which a QTIP election has been made; and (ii) a trust that qualified for the federal estate tax marital deduction because the surviving spouse is entitled to receive all income from the trust and the surviving spouse also holds a general power of appointment over the trust’s assets. In these limited circumstances the trustee must determine the amount of income earned within the IRA or qualified plan account as if the IRA/retirement account was itself a trust subject to the UPIA, withdraw that amount from the IRA/retirement account, and distribute that entire amount to the surviving spouse.
  • All Income: These special rules with regard to a marital deduction trusts are intended to comply with Revenue Ruling 2000-2 (Jan.18, 2000). That Revenue Ruling held that a QTIP election that is made with respect to a deceased spouse’s IRA (not just the trust to which the IRA was made payable) may be made when the trustee of the QTIP Trust is named the beneficiary of the IRA, the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA/retirement assets at least annually, and no person has a power to appoint any part of the trust property to any person other than to the surviving spouse.
  • All Income or RMD: In  Revenue  Ruling  2006-26 (May 30. 2006) the Service addressed the possible definitions of income in a marital trust when the state’s trust laws are silent with regard to the definition of income, in part addressing a marital trust that was structured as a unitrust. In an example provided under this Revenue Ruling the Service gives an example where the trustee must determine each year’s required minimum distribution (RMD) amount from the IRA. The trustee was required under the trust instrument to withdraw the greater of the IRA’s income for the year, or the IRA’s RMD, and distribute that amount to the surviving spouse, in order to comply with the marital deduction rules.

Proposed UPIA Update: The National Commissioners on Uniform Laws are taking a second look at Section 409. Making life a bit more confusing, they propose to renumber Section 409 as Section 408. The upshot of this proposed change is to limit the use of the 90%/10% allocation rule to only a few circumstances.

  • Unitrust: If the IRA income cannot be determined, then it will be defined under Section 408 as a unitrust amount between 3% and 5%. The unitrust amount will be applied to the value of the separate fund’s assets, determining at the beginning of the trust’s accounting year.
  • Treat as an Annuity: If the unitrust method is used, the trust is entitled to a series of periodic payments, like an annuity, and if the separate 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 which relates to annuities. The interest rate used to determine the unitrust amount is the  IRC 7520 is based on monthly payments. The UPIA assumes a monthly unitrust payment which may not always be the case with a trust that directs payments.
  • Power to Adjust: If the trust is a marital deduction trust, and all of the separate fund’s income cannot be accessed by the trustee, the trustee must to the extent requested by the surviving spouse, reclassify trust principal as income and distribute that amount to the surviving spouse.
  • 10% Rule: Only when the value of the retirement account cannot be determined is the 10% of the amount received classified by the trustee as income with the balance classified as principal.

Planning Thoughts:

  • Opt Out of the UPIA: As noted earlier, the UPIA provides the default rule when a trust is silent with regard to describing trust income that is subject to distribution. The subject of what is trust income and what is trust principal is probably not high on the topics that a drafting attorney covers with his or her client. Hopefully, as more folks become alert to Section 409 they will begin to have conversations with clients when the topic of making an IRA or retirement account is made payable to an irrevocable trust on the death of the account owner. Consider a trust beneficiary who is age 30 when the IRA owner dies and makes his/her IRA payable to a trust for the beneficiary. The RMD for the 30 year old trust beneficiary is 1.9% of the IRA- is 10% of that RMD amount what the settlor wants distributed to the beneficiary when the trustee is directed to pay ‘all income’ to the beneficiary?
  • Define What is “Income” in the Trust: Perhaps more trust instruments should be drafted to opt out of Section 409, and adopt the language of the ‘new’ proposed separate fund concept identified in proposed Section 408 of UPIA. Or use a trust income definition formula that provides that all IRA distributions received by the trustee during each accounting period will be allocated to trust income to the extent of the income earned within the IRA during that trust accounting period. Or the trust instrument could say that an amount shall be paid to a trust beneficiary from trust principal equal to the amount, if any, by which income earned within the IRA exceeds the amount of all IRA distributions received by the trustee in any accounting year.