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

25-Sep-19

Uniform Fiduciary Principal and Income Act- Impact on IRAs Paid to Non-marital Trusts

Take-Away: The Uniform Fiduciary Principal and Income Act, not yet adopted in Michigan, changes the trustee’s treatment of distributions from IRAs and other qualified plans to a trust. It is important to remember that the terms of a trust instrument control the treatment and allocation of a retirement plan distribution to an irrevocable trust. In short, this Uniform Act is only a default rule that applies if the trust instrument is silent on how the trustee should treat the distribution from an IRA to the trust.

Background: If an IRA is paid to a trust, the trustee must allocate the amount of the IRA’s income. Some of the distribution will be treated as income, and per the terms of the trust, will be distributed to the trust’s current income beneficiary. The question is whether some, or all, of the income earned inside the IRA becomes income of the trust, and thus may be required to be distributed to the current income beneficiary. The terms of the trust may allocate an entire payment to trust income, or grant the trustee discretion to make the allocation as either income or principal. As noted in the take-away, the trust instrument can guide the trustee if it contains directions to the trustee on how to treat retirement distributions paid to the trust. It is only when the trust instrument is silent that the Uniform Law will control the trustee’s decision-making.

1997 Uniform Act: Section 409 of the 1997 Uniform Principal and Income Act (amended in 2008) provides the default rule that controls the trustee allocation of distributions from a retirement plan.

  • Marital Trust: Section 409 provides, for a marital deduction trust, that the IRA’s internal income will be treated as income of the trust to which it is distributed, so that with a marital deduction trust, the surviving spouse must have the right to request a distribution of that IRA account’s ‘internal income.’
  • Non-Marital Trust: IRA payments to a non-marital trust, e.g. a conventional credit shelter trust, receive a different treatment under Section 409. If the trust instrument is silent, then Section 409 dictates an allocation of a required payment, e.g. an RMD, of 90% to principal and 10% to income. For a non-required distribution from the IRA to the trust, all of the non-required distribution must be allocated to trust principal.

2018 Uniform Fiduciary Income and Principal Act: This Uniform Act significantly changes Section 409 as it pertains to retirement plan distributions to non-marital trusts. It extends to these trusts the concept that the IRA’s internal income constitutes income of the trust. It also provides (remember, this is a default rule that applies when the trust instrument is silent) that a fiduciary shall base the allocation of an IRA payment on the account’s internal income rather than by percentages [the old 90%-10% split.] This Uniform Act provides that a fiduciary “shall administer the trust or estate in accordance with this [Act] except to the extent the terms of the trust provide otherwise or authorize the fiduciary to determine otherwise.” [Section 201(a)(4).]

This shift, from percentages to ‘actual income’ earned by the IRA account, could have a dramatic impact on fiduciary accountings for a non-marital trust. With the 1997 rule, the trustee allocated a fraction of the IRA’s internal income as trust income. This resulted in a substantially reduced amount payable to a current income beneficiary who is entitled to receive all of the trust’s income. This limitation would disappear with the 2018 Uniform Act’s version of Section 409.

If Michigan adopts this 2018 Act it will trump any allocation provisions for existing trusts, absent contrary language used in the trust instrument.

Determining an IRA’s ‘Internal Income’: Identifying an IRA’s internal income is a bit more challenging than one might expect. It entails a two-step process.

  • Step #1: This first step actually has two options or methods available to the trustee to determine an IRA’s ‘internal income’. Both treat the IRA as a separate trust. The first method relies on statements furnished by the IRA custodian which identify the IRA’s receipts and expenses credited or charged to income. Section 409 seems to favor this first method because it focuses exclusively on receipts and expenses applied to generate the income. [Section 409(b)(1).] If a trustee cannot identify enough information from the custodian’s records to determine the IRA’s ‘internal income’, the trustee may rely on the second method. The second method treats the IRA as a unitrust. The IRA’s ‘internal income’ is presumed to equal between 3% to 5% of the IRA’s fair market value on a specified date. Therefore, the second method effectively disregards the distinction between principal and income to determine the IRA’s ‘net income’ amount and relies on a fraction of the IRA’s current fair market value.
  • Step #2: Once the IRA’s internal ‘net income’ is determined under Step #1, the trustee must then allocate the IRA payment to the trust between trust principal and trust [Section 409(b)(2).] Stating the obvious, the trustee allocates to trust income the amount received by the trustee that is equal to the IRA’s internal ‘net income’ during the trust’s accounting period, and the balance, i.e. the amount exceeding the IRA’s internal ‘net income’, is allocated to trust principal. [Section 409(c).]
  • Step #2 ½:  In the event that the IRA’s internal ‘net income’ for the accounting period exceeds the total of the payments that are received by the trustee, the trustee may exercise discretion not to withdraw all of the IRA’s internal ‘net income’ from the IRA. [Section 409(e).] Yet this discretionary decision available to the trustee comes with a catch. If the terms of the trust require distribution of the trust’s current net income to one or more current trust beneficiaries, the trustee must transfer principal to income. The transferred amount would equal the excess of the IRA’s internal ‘net income’ earned but not withdrawn by the trustee from the IRA during the trust’s accounting period.

Implications for the Trustee: Section 409(e) allows the trustee to retain the IRA’s internal ‘net income’ that exceeds the amount received during the accounting period, rather than withdrawing and paying that income to the current income beneficiary as taxable income. The ‘cost’ of the exercise of that discretion is a mandatory transfer of trust principal to trust income equal to the IRA’s internal ‘net income’ not withdrawn. Thus, the exercise of this discretion by the trustee will impact the trust’s remainder beneficiaries who would otherwise, at a future date, be entitled to the trust’s principal when the trust terminates. Keeping a portion of the IRA’s income inside the IRA will defer taxation and permit the IRA to grow in value. To the extent the unwithdrawn ‘net income’ remains inside the IRA, its retention will shift taxation of that income; it becomes of income in respect of a decedent (IRD) to the trust’s remainder beneficiaries when the trust terminates and that income is distributed to the remainder beneficiaries. Along the same lines, shifting trust principal to trust income will reduce, in part, the current trust income beneficiary’s income tax liability. In sum, this exercise of discretion by the trustee to keep some of the IRA’s ‘net income’ inside the IRA and not distribute it to the current income beneficiary will not make the trust’s remainder beneficiaries happy and could elicit claims of the trustee’s breach of its duty of impartiality.

Example: Assume an IRA owner-settlor names a trust as his IRA beneficiary. The settlor’s trust names his child and grandchildren as the trust beneficiaries. During the child’s lifetime the trustee must distribute all trust income to the child. At the child’s death, the trust will terminate with an outright distribution of all trust assets to the settlor’s grandchildren. Settlor dies. On December 31 of the year of the settlor’s death his IRA has a balance of $1.5 million.

  • In the following calendar year after the settlor’s death, which is the trust’s accounting period, the IRA’s internal income is $42,000 under the first method. Under existing RMD rules [ignoring for the moment the implications of the pending SECURE Act] the RMD from the settlor’s IRA is $55,000 (based on the child’s life expectancy.) On July 1 of the year following the settlor’s death the trustee takes a $30,000 distribution from the IRA- not the full RMD amount. At the time of this distribution, the IRA’s internal income is $21,000. The trustee, per Section 409(c) allocates $21,000 to trust income,$9,000 to trust principal, and distributes $21,000 from trust income to the child. Between the July 1 payment and the end of the calendar year, i.e. the end of the trust’s accounting period, the IRA earns an additional $21,000. The trustee withdraws a second payment of $25,000 from the IRA on December 31 to satisfy the annual RMD for the calendar year of $55,000 total (and avoid the 50% penalty for not taking the full RMD for the year.) The trustee, complying with Section 409(c), reallocates $9,000 from the July 1 payment (previously allocated to principal) to trust income and currently allocates $12,000 from the December 31 payment to trust The balance of the second payment, $13,000 ($25,000 less $12,000 = $13,000) becomes trust principal. The trustee then distributes $21,000 to the child to account for all of the IRA’s internal ‘net income’ earned during the trust’s accounting period.
  • What if the trustee relies on the second method to calculate the IRA’s internal income? Assume that the trustee uses a 4% unitrust rate to determine the IRA’s internal ‘net income’, which is now $60,000 (4% of $1.5 million.) The trustee allocates the $30,000 payment on July 1 entirely to trust income and the trustee distributes this amount to the child. On December 31, the last day of the trust’s accounting period, the trustee receives $25,000 to fulfill the $55,000 RMD for the calendar year, and the trustee allocates the entire amount to trust income and distributes this $25,000 amount to the child. The trustee must now deal with the $5,000 of the IRA’s internal income that remains inside the IRA. Exercising the discretion given to the trustee under Section 409(e), the trustee decides not to withdraw this excess $5,000 and makes the mandatory transfer of trust principal to trust income and distributes that $5,000 amount to the child on December  31. The value of the trust principal distributed to the child must equal the amount of income retained inside the IRA, but nothing under Section 409 prohibits the trustee from transferring assets in-kind to fulfill this obligation.

Conclusion: The main concept behind revised Section 409 is that an IRA’s internal ‘net income’ will be treated as the income of the trust. It requires the trustee to secure relevant information from the IRA custodian, either receipts and expenses used to identify the IRA’s ‘net income’ for the accounting period, or a contemporaneous fair market value of the IRA account’s assets when a distribution is to be taken from the IRA. Due to Section 409’s preference for a trustee to use method #1, the trustee will need to document the reason why it cannot obtain the necessary information from the IRA custodian before it can move on to using method #2 and rely on a fair market value for the IRA account. In light of this need for the trustee to obtain information with regard to the settlor’s IRA from the IRA custodian, that may be a sufficient reason to use the same party to act as both the IRA custodian and also the trustee of the trust to which the IRA is made payable on its owner’s death.