See-Through Trusts – The Search for ‘Countable’ Beneficiaries, Part One, the Disregard Rules

Take-Away: The Proposed Regulations under the SECURE Act contain roughly 10 separate ‘rules’ to identify when an individual named in a trust is disregarded for purposes of determining the identity of all trust beneficiaries, which in turn controls the required minimum distribution that the trustee must take when a retirement account is made payable to the trust on the account owner’s death.

Background: There are a lot of good reasons to name a trust as the beneficiary of an individual’s IRA or qualified plan account. Sadly, the rules associated with naming a trust as the designated beneficiary of a retirement account have been vague and difficult to navigate, e.g. the mere potential successor beneficiary of an accumulation see-through rust. Fortunately, the SECURE Act’s Proposed Regulations provide a series of somewhat helpful disregard rules that can be followed to determine which beneficiaries of an irrevocable trust need to be counted to determine the applicable distribution period (the applicable denominator) for the trust’s required minimum distributions (RMDs.)

Before the new rules under the Proposed Regulations are summarized when some trust beneficiaries can be disregarded, a quick review of some basic retirement plan distribution principles and concepts is helpful:

Designated Beneficiary: A beneficiary must be an individual in order to be a designated beneficiary of the retirement account. [IRC 401(a)(9)(E)(i).]

Eligible Designated Beneficiaries: Under the SECURE Act, the life expectancy of these beneficiaries [ i.e., the surviving spouse, a minor child of the decedent, a disabled or chronically ill beneficiary, or a beneficiary who is less than 10 years younger than the decedent] also matter in determining the distribution period of the retirement account that is payable to the decedent’s trust.

See-Through Trust: Since a trust is not an individual, the Regulations contain a rule that the trust as named beneficiary will be ignored and its beneficiaries will be treated as if they were directly named on the retirement account beneficiary designation form. Accordingly, if all of the trust beneficiaries are individuals the decedent will be treated as having named a designated beneficiary, even though a trust is actually named as the beneficiary. [See below for the requirements of a see-through trust.]

Countable Beneficiaries: If a nonindividual is a potential beneficiary of a trust, the trust will lose its status as a designated beneficiary, unless that trust beneficiary is somehow disregarded under other rules. The ages of the countable beneficiaries of the trust matter. The life expectancy of the oldest countable trust beneficiary will be the applicable distribution period (or the applicable denominator) in some cases.

Conduit See-Through Trust: A conduit trust is a see-through trust that provides with respect to the deceased account owner’s interest in the retirement account that ‘all distribution from such retirement account will, upon receipt by the trustee, be paid directly to, or for the benefit of, specified beneficiaries.’ [Proposed Regulations 1.401(a)(9)-4(f)(1)(ii)(A).]

Beneficiary Finalization Date: This is a fixed date, September 30 of the year that follows the retirement account owner’s death. All trust beneficiaries must be determined, or identified, by this date. This date should not be confused with another date that is required for a trust to qualify as a see-through trust, the October 31 delivery date. See below.]

Mere Potential Successor Beneficiaries: The challenge is that almost every trust has a long chain of potential beneficiaries who could inherit the trust’s assets if some prior beneficiary dies before a specific age, a beneficiary dies without issue, some specified event occurs,  or one trust beneficiary dies before another trust beneficiary. Under prior Regulations, certain contingent or successor beneficiaries were disregarded, when seeking to identify all of the trust’s countable beneficiaries. However, the confusing test in the prior Regulations provided no definition of mere potential beneficiaries, and only one example was given which was not very enlightening. Hence, a lot of anxiety existed as to identifying the oldest beneficiary who life expectancy controlled the RMDs from the retirement account payable to the trust.

SECURE Act Proposed Regulations: The new Regulations provide much more guidance on what beneficiaries, and when beneficiaries of a trust, will be disregarded in identifying the trust’s countable beneficiaries. [Proposed Regulation 1.401(a)(9)-4(f).] Practically speaking, these Proposed Regulations divide a trust’s beneficiaries into two (2) categories. In the first category, the trust beneficiaries are always counted. Some, but maybe not all, trust beneficiaries in the second category may be disregarded in identifying which trust beneficiaries must be counted. What follows are the steps that need to be taken to identify who are the counted trust beneficiaries that will determine the distribution period of the retirement account that is paid to the trust. Part 2 will provide examples of how these disregard rules are applied.

Step 1- Is the Trust a See-Through Trust?: If the trust instrument does not pass this first step, then an entirely different set of mandatory distribution rules apply that are not related to the life expectancy of one of the trust beneficiaries. Recall that the rules used to determine if a trust is a see-through trust, i.e. the trust is ignored and its beneficiaries are treated as the designated beneficiaries,  include: (i) the trust is irrevocable on the account owner’s death; (ii) the trust can only have individuals as its beneficiaries; (iii) all of trust beneficiaries must be identified, and thus counted, by September 30 of the year that follows the account owner’s year of death; and (iv) a copy of the trust or its relevant provisions identifying beneficiaries, must be provided (delivered) to the account custodian or plan administrator by the end of October of the year that follows the account owner’s death (the delivery date.)

Step 2- Who are the Potential Beneficiaries of the Trust?: Some trust beneficiaries are disregarded under what are informally described as seven (7) disregard rules. The first three (3) of these disregard rules will apply to every irrevocable trust that is named as the beneficiary of the decedent’s retirement account:

• Disregard any individuals who predeceased the account owner;

(b) Disregard any individuals who are not born yet;

(c) Disregard potential appointees under a power of appointment that is granted under the trust instrument, unless and until that power is actually exercised; however,  include all ‘takers-in-default’ of the non-exercise of the power of appointment in the list of potential trust beneficiaries.

The next four (4) disregard rules  may apply, depending on whether some events occur after the account owner’s death, but prior to September 30 of the year that follows the account owner’s death.

(d) Disregard any beneficiary who disclaims his/her interest in the benefits of the trust by means of a qualified disclaimer before the September 30 deadline;

(e) Disregard any beneficiary who, by virtue of a distribution prior to the September 30 deadline, has no further interest in the benefits of the trust;

(f) Disregard any beneficiary who is removed prior to the September 30 deadline by means of a trust reformation  or trust decanting permissible under state law; and

(g) Add any beneficiary who is added to the group of trust beneficiaries by means of a trust reformation or trust decanting as permissible under state law.

Step 3- Divide the Trust Beneficiaries into the Two Categories: The list of potential trust beneficiaries is divided into the first category, i.e. those beneficiaries who must or might receive benefits as a result of the account owner’s death, and the second category, those trust beneficiaries who may receive benefits from the trust not distributed to the first category beneficiaries, but who cannot receive benefits after the account owner’s death until someone else has  died.

Step 4- Three More Disregard Rules that Must Be Applied: The group of potential trust beneficiaries is further culled with three more disregard rules: (i) the conduit trust rule; (ii) the age 31 rule; and (iii) the second-choice-second category beneficiary rule.

(h) Disregard any second category trust beneficiary under a conduit trust [Proposed Regulation 1.401(a)(9)-4(f)(ii)(A), (3)(i)(B), Example (1)(B).]

(i)  Disregard any second category trust beneficiary who will inherit only if a first category trust beneficiary who would have inherited the property outright at a certain age (age 31 or younger, or by the end of year after the account owner’s death, if later) dies before reaching that age (or the year’s-end.) [Proposed Regulation 1.401(a)(9)-4(f)(3)(ii)(B).]; and

(j) Disregard any second category trust beneficiary who will inherit only if some other second category trust beneficiary who was supposed to inherit outright on the death of the first category trust  beneficiary fails to survive such first category trust beneficiary. [Note, this is the most recent iteration of the mere potential successor rule.]

Thus, there are plenty of disregard rules to follow in the task of identifying the group of countable beneficiaries of a see-through trust. Fortunately, there are several examples in the Proposed Regulations that help to understand how these disregard rules are implemented by trustees. Part 2 of this discussion of the see-through trust and the Proposed Regulation’s  disregard rules is a series of examples that might help to explain how those rules will be applied by trustees.