See-Through Trusts- The Search for ‘Countable’ Beneficiaries, Part Two, Examples of the Disregard Rules

Take-Away: Identifying the trust beneficiaries who must be counted  to determine the correct required minimum distribution (RMD) from a retirement account made payable to a trust is a real challenge. Some examples might help to explain when a trust beneficiary can be disregarded, and when trust beneficiaries (and their life expectancies) must be counted.

Caveat: I apologize in advance for the length and complexity of this missive. Perhaps we have the IRS or Congress to blame for its required length.

Background: Part one covered the several disregard rules under the SECURE Act’s Proposed Regulations that must be followed to identify the countable beneficiaries of a see-through trust that is named as the beneficiary of a deceased’s retirement account. Those disregard rules will not be repeated here. What follows is the application of the disregard rules under what is might be described as a fairly basic estate plan, with some variations among the examples to demonstrate how a disregard rule applies, or not.

Cautions: Keep in mind the following precautions.

First, the disregard rules only apply to the trust instrument, and not to the decedent’s beneficiary designation form that is used with regard to the retirement account.

Second, the Proposed Regulations make it clear that if the decedent’s trust could be liable for the expenses incurred in the administration or distribution of the deceased account owner’s estate at death, the decedent’s estate will be treated as a beneficiary of the trust. Since the decedent’s estate is a non-individual, in order to qualify as a see-through trust,  the decedent’s trust instrument must specify that retirement benefits payable to the trust cannot be used to pay claims against the decedent’s estate, estate administrative expenses, or expenses that are incurred by the estate in the distribution of estate assets.

Basic Trust Distribution Pattern: Joe’s trust instrument provides for the following distribution of its assets: Upon my death, pay income to my wife Jill for her life, and upon Jill’s death distribution the trust principal shall be distributed to my issue then living by right of representation, or if no issue of mine is then living, then to the American Red Cross. Joe is surviving by his wife Jill. They have three children: Abe, Ben, and Clara, and four grandchildren- Don, Evan, Fran, and Gloria. The potential beneficiaries of Joe’s Trust include: Jill, Joe’s three children, his four grandchildren, and the American Red Cross. Under this basic scenario, none of the potential beneficiaries of Joe’s Trust will be disregarded under the first seven (7) disregard rules. Now for the variations on this basic theme.

Example 1- Disregard Predeceased Beneficiary: Joe’s Trust instrument provides- Upon my death, pay to my brother John the amount of $5,000.00 cash, and then pay to my wife Jill for her life,……[see Basic Trust Distribution Pattern above for balance of Joe’s Trust’s distribution provisions.] John died before Joe. John is disregarded as a potential beneficiary of Joe’s Trust because John died before Joe. However, if John survived Joe, but John then died before September 30 of the year that follows Joe’s death,  John’s death would not eliminate him as a ‘listable’ potential trust beneficiary because John’s estate would possibly take John’s share of Joe’s retirement account that is payable to the Trust.

Example 2- Disregard Individuals Who Do Not Yet Exist: Joe’s Trust instrument provides- Upon my death the trustee shall pay trust income or trust principal to or for the benefit of such persons as the trustee shall select from the then living members of a class that consists of my wife Jill, and my issue living at the time of such payment for their health, education, support and welfare in such amounts as the trustee deems advisable in the trustee’s sole discretion. If at any time there is no issue of mine living, and my wife Jill has died, this Trust shall terminate and its corpus shall be distributed to the American Red Cross. Joe is survived by Jill, their 3 children, and their 4 grandchildren. All of them, along with the American Red Cross are potential trust beneficiaries. While Joe’s Trust is intended to benefit his present and future issue in perpetuity, Joe’s  ‘issue’ will not be counted, since they do not exist yet. Therefore, the trustee of Joe’s Trust only looks at the individuals who are actually living when Joe dies as potential beneficiaries.

Example 3- Disregard Potential Appointees: Joe’s Trust instrument provides – The trustee of this Trust shall pay all income to my wife Jill for life, and upon Jill’s death the trustee shall distribute the trust principal to such charities or individuals as my wife Jill may appoint by her Last Will, or in default of such appointment, the trustee shall pay the trust principal to my issue then living by right of representation, or if no issue of mine is then living, to the American Red Cross. Joe is survived by Jill, their 3 children, and their 4 grandchildren. Jill, the 3 children and the 4 grandchildren are the potential  beneficiaries of Joe’s Trust. The potential appointees under Jill’s power of appointment are disregarded, unless and until Jill actually exercises her power of appointment. Since Jill’s power of appointment cannot occur until her death, because the power can only be exercised under Jill’s Last Will,  which cannot be effective until Jill’s death, Jill’s power of appointment is ignored (for now.)

Example 4- Disregard Disclaimant: Joe’s Trust instrument provides – On my death, the trustee shall pay to my brother John the amount of $5,000 and then the trustee shall pay all income to my wife Jill for life, and on the death of Jill, the trustee shall distribute the principal of this Trust to my issue then living by right of representation, or if none of my issue are then living, to the American Red Cross. Joe is survived by John, Jill, his 3 children, his 4 grandchildren. John disclaims the $5,000 bequest by means of a qualified disclaimer that is made by him  before September 30 of the year that follows Joe’s death. The Trust’s potential beneficiaries are  then Jill, their 3 children, and their 4 grandchildren. Note that if John’s disclaimer had not been a qualified disclaimer, e.g. it was made more than 9 months after Joe’s death, John would not then be disregarded as a potential beneficiary of Joe’s Trust. [Proposed Regulation 1.401(a)(9)-4(c)(3)(ii).]

Example 5- Disregard Individual with No Further Interest: Joe’s Trust instrument provides –Upon my death the trustee shall  pay to the American Red Cross the amount of $10,000, and then the trustee shall pay all income from this Trust to my wife Jill for her life, and on Jill’s death the trustee shall distribute the trust principal to my issue then living by right of representation, or if no issue of mine is then living, the residue of this Trust shall be paid by the trustee to the Smithsonian Institute. Joe is survived by Jill, their 3 children and their 4 grandchildren. The $10,000 pecuniary bequest is paid to the American Red Cross prior to September 30 of the year following Joe’s death. The payment of the pecuniary bequest to the American Red Cross thus eliminates the American Red Cross as a potential  beneficiary of Joe’s Trust. The potential beneficiaries of Joe’s Trust include Jill, their 3 children, their 4 grandchildren, and the Smithsonian Institute.

Example 6- Disregard Individual Removed by Reformation or Decanting: Joe’s Trust instrument provides –Upon my death, the trustee shall use trust income and/or trust principal for the health, education, care and support of my three children Abe, Ben and Clara. In addition, the trustee may in its discretion pay trust income and/or trust principal to or for the benefit of my Uncle Don if the trustee determines in its sole discretion that such amounts are not required for the care and support of my three children and that Uncle Don’s other financial resources are not sufficient for his health, care and support. When there is no child of my then living who is under the age of 25 years, this Trust shall terminate and all remaining trust income and principal shall by distributed by the trustee outright to my then living children in shares of equal value. All of Joe’s children [Abe, Ben and Clara] are now under the age 21, and thus they are ‘eligible designated beneficiaries.’ Joe’s Uncle Don is age 83, but he is neither disabled nor chronically ill, but he too is an ‘eligible designated beneficiary’ since Uncle Don is less than ten years younger than Joe. Uncle Don lives on his own, and he has more than enough financial resources to provide for his future needs for the rest of his life. Naming Uncle Don as a trust beneficiary makes him the oldest trust beneficiary, with a life expectancy of 9.3 years. Removing Uncle Don as a trust beneficiary would mean Joe’s IRA could be distributed to the Trust over the life expectancy of Joe’s oldest child (currently age 10), for the next 21 years until the oldest trust beneficiary, Abe, is age 31. No one told Uncle Don of his ability to disclaim his interest in the Trust until 12 months after Joe’s death. The trustee initiates a trust reformation proceeding before September 30 of the year following Joe’s death, in order to reform the Trust to remove Uncle Don as a discretionary trust beneficiary with respect to Joe’s IRA that is made payable to the Trust. The reformation of Joe’s Trust, retroactive to the date of Joe’s death, is granted by the local probate court, on ‘mistake of law’ grounds (caused by the recent SECURE Act’s change in distribution rules.) Uncle Don is not treated as a potential beneficiary of Joe’s Trust as it relates to Joe’s IRA that is made payable to the Trust.

Example 7- Add Beneficiary Through Reformation, Decanting, or Power of Appointment: Joe’s Trust instrument provides- Upon my death, the trustee shall pay trust income in equal shares to my brother John’s children, i.e. my nephews, Ron, Asa, and Bill, or the surviving members of that class, as long as they live, and thereafter the trustee shall distribute the trust principal to their then living issue per stirpes. Overlooked in the trust provision was Joe’s other nephew through John, Brad, was not included in the Trust. After Joe’s death, his Trust is reformed consistent with state law to correct the scrivener’s error to add Brad as one of the intended nephews to the list of potential trust beneficiaries. The reformation of Joe’s Trust is completed before September 30 of the year that follows Joe’s death. Brad is thus added to the list of potential trust beneficiaries. [Aside: The Proposed Regulations make no allowance for a post-death reformation of Joe’s IRA beneficiary designation- only Joe’s Trust reformation will be respected by the IRS.]

Example 8- Second Category Beneficiary: Joe’s Trust instrument provides- Upon my death the trustee shall pay all income to my wife Jill for her life, and upon her death, the trustee shall distribute trust principal to my son Abe if he is then living, otherwise the trust estate shall be distributed to the American Red Cross. Both Jill and Abe survive Joe. Jill is a first category trust beneficiary because she receives benefits from the Trust on Joe’s death; Jill does not have to wait until someone dies in order to receive benefits from Joe’s Trust. Abe is a second category trust beneficiary because Abe has to wait until someone else, his mother Jill, dies before he receives anything from Joe’s Trust. Note that the American Red Cross is also a second category trust beneficiary even though the charity will not receive anything unless both Jill and Abe die. [Note that there is no such thing as a ‘third’ trust beneficiary category under the Proposed Regulations.]

Example 9- First Category Beneficiary: Joe’s Trust instrument provides- Upon my death the trustee shall pay all income to my wife Jill until her death or remarriage. Upon my wife Jill’s death or remarriage, the trustee shall distribute the trust principal to my son Abe if he is then living, otherwise if my son is not then living the trust estate shall be distributed by the trustee to the American Red Cross. Both Jill and Abe survive Joe. Jill is a first category trust beneficiary because she receives benefits from the Trust upon Joe’s death; Jill does not have to wait until someone else dies in order to benefit from Joe’s Trust. Abe is also a first category beneficiary because he may receive benefits without having to wait until Jill’s death; Abe will receive benefits from Joe’s Trust if Jill remarries, as her remarriage forfeits her beneficial interest in Joe’s Trust. The American Red Cross is a second category trust beneficiary since that charity cannot receive benefits from Joe’s Trust merely because Joe dies, but it may receive some of the benefits from Joe’s Trust not distributed to Jill after she dies (if she does not remarry.)

Example 10- Conduit Trust: Joe’s Trust instrument provides- Every time the trustee takes a distribution from my IRA that is made payable to this Trust, the trustee shall promptly distribute such distribution to my wife Jill, or apply that IRA distribution for her benefit. On Jill’s death any amounts remaining in the IRA shall be paid to the American Red Cross. Jill is a first category trust beneficiary. The American Red Cross is a second category trust beneficiary and the charity is disregarded, i.e. it is not treated as a countable trust beneficiary because Joe’s Trust is a conduit trust.

Example 11- Age 31 Rule: Joe’s Trust instrument provides- The trustee shall use trust income and trust principal for the benefit of my nephew Ted, for his health, education and support, until Ted attains the age of 30 years, at which time this Trust shall terminate and its corpus shall be distributed outright to Ted, if he is then living. In the event that Ted dies prior to attaining the age of 30 years, this Trust shall terminate and its corpus shall as soon as practicable be distributed by the trustee to the American Red Cross. Ted is a first category trust beneficiary. The American Red Cross is a second category trust beneficiary. The American Red Cross is disregarded because it will receive funds from Joe’s Trust only if the first category trust beneficiary, Ted, who would inherit the trust funds outright upon reaching age 31 (or any younger age) dies before reaching that prescribed age. Although the age 31 rule is the same age as the final year of distribution to a minor child of the deceased account owner, i.e. an ‘eligible designated beneficiary’, 10 years after attaining majority, this age 31 rule applies to any first category trust beneficiary who is set to receive an outright distribution from the trust at or before that age, even if such trust beneficiary is not a minor child of the account owner.

Example 12- The Mere Potential Successor Rule: Joe’s Trust instrument provides- The trustee shall pay income to my wife Jill for her lifetime, and on Jill’s death, the trustee shall distribute the trust principal to my issue if then living by right of representation, and if none of my issue are then living, to the American Red Cross. Joe is survived by Jill, their 3 children and their 4 grandchildren. Accordingly, the potential  trust beneficiaries of Joe’s Trust include: Jill, their 3 children Abe, Ben and Clara, and their 4 children, (Joe’s grandchildren) and the American Red Cross. The first category trust beneficiaries is only Jill. The second category of trust beneficiaries consists of the 3 children, the 4 grandchildren, and the American Red Cross, since they must all wait until not only Joe’s, but also Jill’s deaths, before they might inherit anything. However, the American Red Cross is disregarded as a potential trust beneficiary because it is a second category trust beneficiary that will not receive anything from Joe’s Trust until another second category trust beneficiary, i.e. Joe’s issue, fail to survive Jill. When Jill (the first category trust beneficiary) dies, Joe’s living issue will inherit the trust corpus outright. The American Red Cross will not receive anything from Joe’s Trust if any other second  category trust beneficiary survives Jill. Consequently, the American Red Cross only receives something from Joe’s Trust if the none of the “first choice, second category, trust beneficiaries” do not survive Jill.

Pulling This All Together: Applying the various disregard rules should lead to the ability to identify the countable beneficiaries of an irrevocable trust and from them, the correct required minimum distribution period that the trustee must follow with regard to distributions from a retirement account to the decedent’s trust. To summarize-

1. If any of the Trust’s countable beneficiaries is a nonindividual, e.g. the account owner’s estate or a charity, the Trust is a non-designated beneficiary, which means that it is not a see-through Trust. In that event, the distribution period from the IRA is the 5-year rule if the account owner died prior to his/her required beginning date (RBD, age 72), or if death is later than his/her RBD, then the account owner’s ghost life expectancy.
2. If the Trust is a conduit trust, the distribution period for the IRA to the Trust is exactly the same as it would have been for the conduit  trust beneficiaries if they were named directly as the designated beneficiaries of the decedent’s retirement account,  i.e. the SECURE Act’s 10-year distribution rule for a ‘regular’ designated beneficiary, or a life expectancy payout (with the life expectancy redetermined annually) in the case of a conduit trust  created for the account owner’s surviving spouse.
3. If the Trust falls within the definition of an applicable multi-beneficiary trust (AMBT) the distribution period to the Trust is the life expectancy of the oldest countable disabled or chronically ill individual of the AMBT. [Proposed Regulation 1.401(a)(9)-5(d)(1)(ii).] All retirement funds must be distributed no later than the 10^th anniversary of the death of the last disabled or chronically ill trust beneficiary. [Proposed Regulation 1.401(a)(9)-5(f)(2)(iii.)]
4. If a countable trust beneficiary is a minor child of the account owner, the distribution period  to the Trust is the life expectancy of the oldest countable trust beneficiary who may, or may not, be a minor child who is an ‘eligible designated beneficiary’, with 100% distribution of the retirement account required to occur no later than 10 years after the oldest countable minor child ‘eligible designated beneficiary’ attains age 21, or dies earlier. [Proposed Regulation 1.401(a)(9)-5(f)(1)(i), (2)(ii)(A).]
5. If all countable beneficiaries of the Trust are ‘eligible designated beneficiaries ‘(but none is a minor child of the account owner, e.g. grandchildren of the account owner, making them ‘non-eligible designated beneficiaries’) the distribution period is the life expectancy of the oldest countable trust beneficiary with 100% distribution of the retirement account required to occur no later than 10 years after the death of the last countable beneficiary. [Proposed Regulation 1.401(a)(9)-5(d)(ii), (2).] If, however, the account owner died prior to his/her required beginning date (RBD), the 10-year distribution may apply in some cases. [Proposed Regulation 1.401(a)(9)-3(c)(5)(iii).] If the account owner died after his/her required beginning date (RBD), and he/she was younger than the oldest countable trust beneficiary, the account owner’s ghost life expectancy will be used to determine required minimum distributions prior to the final payout year. [Proposed Regulation 1.401(a)(9)-2(a)(4).]
6. If none of the situations described above apply,  then the SECURE Act’s 10-year distribution rules applies and all retirement funds must be distributed no later than the year that contains the 10^th anniversary of the account owner’s death. If the account owner died after his/her required beginning date (RBD), annual distributions will be required to be taken by the trustee from the retirement account in years 1-9 based on the life expectancy of the oldest countable designated trust beneficiary. [Proposed Regulation 1.401(a)(9)-5(d)(1)(i), 5(e)(1), (2).]

Conclusion: If you read this far, congratulations! There are many rules that must be followed when dealing with retirement plan distributions. When a trust is named as the beneficiary of the decedent’s retirement account, even more rules have to be followed if the 5-year distribution rule is to be avoided. If you counted correctly, arguably there are 10 disregard rules that have to be applied in order to identify the correct life expectancy that must be used to calculate RMDs taken from the decedent’s retirement account by the trustee. These, sad to say, are the rules that we must now begin to apply when an IRA or qualified plan account is made payable to the decedent’s irrevocable trust.