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

13-Feb-18

See-Through Trusts and Required Minimum Distributions- Limited Power of Appointment Complications

Take-Away: The rules that deal with the distribution of an IRA to an irrevocable trust are already a challenge when identifying the oldest trust beneficiary of the see-through trust. It is even a bigger challenge when the trust beneficiary holds a limited power of appointment over the trust principal.

Background:

  • Identifiable Trust Beneficiaries: We all know of some of the benefits when an inherited IRA is directed to an irrevocable trust that is established to hold assets for the benefit of the IRA owner’s children and grandchildren. The goal is to stretch required minimum distributions from the IRA over the life expectancy of the oldest trust beneficiary. [IRC401(a)(9) and IRC 408(a)(6).] We also know that in order for the irrevocable trust to be classified as a see-through trust for these stretch purposes that the trust beneficiaries must be identifiable among persons who were account beneficiaries (identifying them through the trust)  both on the date of the IRA owner’s death and on September 30th of the following calendar year. [Reg. 1.401(a)(9)-4, Q&A 4.] When a class of beneficiaries are identified in the trust instrument, the members of a class that is capable of expansion or contraction will still be treated as being identifiable if it is possible to identify the class beneficiary with the shortest life expectancy.
  • Powers of Appointment: Powers of appointment are important features of many modern trusts. The power of appointment often serves a non-tax purpose to permit a modification of the trust’s terms based upon a change in the circumstances of beneficiaries with the passage of time. Thus, the presence of a power of appointment in a trust adds flexibility to the trust, as the power can be exercised in a manner different from what the trust instrument would otherwise provide for the distribution of the trust’s assets. Example: Mother creates a trust for her son, giving her son the right to all trust income for life, and upon the son’s death all of the trust assets pass outright to son’s children in shares of equal value. Son is also given a testamentary limited power of appointment to appoint the assets held in the trust to or among his descendants. Sone of son’s children has substance abuse addictions. Son decides to exercise the limited power of appointment on his death and directs his addicted child’s share of the trust residue to continue to be held in trust for the addicted child’s lifetime, as opposed to an outright distribution that the trust instrument otherwise provided. Thus, the power of appointment is exercised to respond to a change in the remainder beneficiary’s circumstances.  A power of appointment can be held by the trustee, a trust beneficiary, or any third-person with no interest whatsoever in the trust (the latter is called a naked power of appointment.)

Who Comprise the Class of Permissible Appointees?: What if the power of appointment, as described in the earlier example, was not limited to the son’s descendants, but instead could be exercised in favor of  the mother’s parents’ descendants, which would include other children of the mother, some of whom might be older than the son, or aunts and uncles of the son, all of whom would be older than the son? When the power of appointment is restricted to individuals, all members of the class of individuals in whose favor the power of appointment may be exercised must be considered in determining the identity of the oldest designated beneficiary for purposes of the required minimum distributions that the trustee must take from the IRA. Any person in whose favor the power of appointment might be exercised is a potential trust beneficiary as of the date of the account owner’s death. The requirement that a designated beneficiary must be both a potential beneficiary as of the IRA owner’s date of date, and also as of the next September 30 of the year following the IRA owner’s death,  will be satisfied so long as the power of appointment is exercisable beginning as of the IRA owner’s death?

Power of Appointment Complications: Mother establishes an irrevocable trust for her son, to which she makes her IRA payable. Suppose the trust instrument provides that a testamentary limited power of appointment is conferred on the mother’s son which may be exercised in favor of the mother’s descendants, but not son, not son’s creditors, not son’s estate, nor the creditor of son’s estate (a limited power of appointment.)  Mother has three living children, of whom son is the youngest child. Son also has two children of his own, who are also descendants of son’s mother. The trust instrument provides that all income is to be paid to the son, and when the son attains age 40 years he possesses the right to withdraw all of the assets held in the trust. If son dies prior to attaining age 40 years, and son does not exercise the limited power of appointment,  the remaining trust assets pass to son’s two children, if living, and if son’s children are not then living, then the trust remainder passes to son’s siblings in shares of equal value.

  • Son dies before reaching age 40 without exercising the testamentary limited power of appointment, but survived by his two siblings. Beginning with the mother’s death, the oldest of the IRA owner’s surviving children (not the son) is the designated beneficiary for purposes of required minimum distributions from the IRA, not the son’s children.
  • If by September 30 of the year following the mother’s death the son irrevocably exercises the power of appointment to take effect on son’s death in favor of son’s descendants, i.e. his children, then the class of IRA beneficiaries to whom the IRA could pass on the date of mother (IRA owner’s) death includes son and his siblings. But because  the limited power of appointment was irrevocably exercised by son on or before September 30 of the following calendar year, the class of beneficiaries to whom the IRA could pass as of that September 30 includes only the son and his descendants, i.e. his children. Thus, the son becomes the oldest beneficiary for purposes of taking required minimum distributions from the inherited IRA. Note that if the son had waited until October 1 in which to irrevocably exercise the limited power of appointment, that would have been too late, and the son’s oldest sibling’s life expectancy would be used for required minimum distribution purposes.

Possible Solutions When a Power of Appointment Leads to an Shorter Life Expectancy:

  • Disclaimer of the Power of Appointment: When a lifetime beneficiary of a trust is given a power of appointment over trust assets in favor of a broadly defined class, which may include persons older than the lifetime beneficiary, a problem exists, as noted earlier. One way to ‘fix’ the problem is for the holder of the power of appointment to disclaim the power to the extent that it applies to the retirement benefits that will be payable to the trust. A power of appointment can be disclaimed under the Estates and Protected Individual Code, which is deemed  to be effective as of the date of death of the IRA owner, when the trust becomes irrevocable. [MCL 700.2908(2)(a).]
  • Drafting the Trust: If the IRA that is made payable to the trust is only one of many different assets to be held in the trust, consider drafting the trust to restrict the beneficiary’s power of appointment to property other than the IRA that is subject to the required minimum distribution rules, expressly excluding the IRA (or any other retirement assets) from the reach of the power of appointment.
  • Grant a General Power of Appointment: As noted in a missive from me a few weeks back [November 2, 2017, IRA Distributions to Trusts], the IRS recently held in a private letter ruling (which cannot be cited for precedence, but it nonetheless remains helpful guidance) that if the lifetime trust beneficiary holds a general power of appointment (not limited) then the identity of possible appointees under the power of appointment will be ignored, since the general power of appointment means that the beneficiary can withdraw the entire asset from the trust, including the IRA, at any time without restriction,  and all of the assets held in the trust subject to the general power of appointment will be taxed in the trust beneficiary’s estate at the time of his or her death.

Conclusion: The IRS has not provided any official guidance with respect to the effect on required minimum distributions over a trust that is subject to the lifetime beneficiary’s limited power of appointment.  Consequently, optional strategies will need to be considered if the settlor of a see-through trust gives to the lifetime trust beneficiary a limited power of appointment over the trust corpus, when the trustee is required to identify the oldest identifiable beneficiary in the class of permissible appointees for purposes of determining the required minimum distribution from the IRA that is payable to the trust.