At this morning’s TRO meeting Melinda mentioned the benefits of using a Transfer-on-Death (TOD) beneficiary designation for some clients, particularly to name a client’s trust as the designated beneficiary of an investment account.

As I have mentioned in the past, I often encouraged married clients who held separate investment accounts to continue to maintain their separate investment accounts and to name their joint trust as the TOD beneficiary of their individual investment account, in contrast to transferring title to their respective investment accounts into the name of their joint trust. A few reasons warranted this advice:

  • The spouses may have had different investment philosophies, so maintaining separate investment accounts permits them to pursue their respective investment philosophy in contrast to a joint investment account where they arguably would have to mutually agree on what investments to make or to retain;
  • Some spouses held what I called ‘heirloom’ investment assets, e.g. the stock their grandfather gave to them 50 years ago,  which they continue to hold more as a legacy than an income producing investment, or because the tax basis in the gifted securities is so low they do not want to liquidate the investment and incur a sizeable capital gain while they are alive;
  • There will be a 100% basis step-up in the TOD investments on  account owner’s death; the investments then flow directly into the joint trust and avoid probate with its attendant delays and probate court inventory fees;  thereafter, the transferred investments can then be sold by the surviving spouse who continues as the sole trustee of the joint trust, all without any capital gain recognition [although there could be a step-down in income tax basis of the investments, too.]
  • In contrast, had the investment account been held jointly by the spouses, or titled in the name of their joint trust,  there would only be a 50% basis step-up on the death of one spouse, which means that the surviving spouse would incur some capital gains if the investments were subsequently sold by the survivor after the death of their spouse.

Some other observations with regard to TOD registered investments follow. Most are pretty obvious but it probably better to understand the rules than to presume them.

  1. A TOD investment account can be held by 2 or more individuals, but it will be deemed held by them as joint tenants with full rights of survivorship, and not as tenants in common. This means that there would be only a 50% basis step-up on the death of one of the 2 joint-owner spouses. A different income tax basis rule might apply if the joint owners were non-spouses, where the basis step-up rules follow who contributed to the acquisition of the investments. Example: My mother adds my name to her investment account so that it is jointly owned, coupled with a TOD beneficiary designation; since I contributed nothing toward the acquisition of the investments and my name as added solely for my mother’s convenience, there would be a full step-up in the income tax basis on my mother’s death  (or no basis step-up if I died first, since I did not contribute to the acquisition of the investments.) MCL 700.6302
  2. The certificate itself must be formally registered in a beneficiary form. It is not sufficient for another document, e.g. a pour-over will,  which reflects that intent to transfer the security to another individual (or trust) on the account owner’s death. Form trumps intent. MCL 700.6304
  3. The registration can be either TOD or POD (‘pay on death’) so long as these magic words or acronyms are after the account owner’s name and before the name of the designated beneficiary. MCL 700.6305
  4. A fairly obvious point is that so long as the account owner is alive, the named TOD beneficiary has no rights or claim of ownership in the TOD registered securities or account inasmuch as the account owner can always change the beneficiary designation or simply cancel the designation. The beneficiary hold only an expectancy. MCL 700.6306
  5. If more than one beneficiary is named of the TOD investment account, those beneficiaries are deemed to own the investments, after the account owner’s death, as tenants in common, and not as joint tenants with full rights of survivorship. Note that if those surviving beneficiaries then ‘horse-trade’ the TOD investments, there might be in implicit gift if one received investments worth less than the investments they permitted the other beneficiary to retain. There is nothing wrong with ‘horse-trading’ just proceed with caution. MCL 700.6307
  6. If no named beneficiary survives the TOD account holder, then the TOD investments will be distributed to the decedent account owner’s probate estate, where those investments will be subject to the delays of probate and cause a probate court inventory fee to be paid. MCL 700.6307
  7. The transfer of investments via a TOD resignation is treated as non-testamentary. Restated, rather than have to follow the normal rules for the transfer of assets on death by a will, e.g. 2 witnesses, attestation clauses, etc., it is treated like an IRA beneficiary designation,  a contractual agreement that can be specifically enforced by a third-party beneficiary. MCL 700.6309(1)
  8. Just because a TOD registration is used to avoid probate does not mean that the deceased account owner’s creditors are prejudiced. The rights of creditors, including the IRS,  against the named beneficiaries and any other transferees are preserved. In short, the use of a TOD registration will not thwart the rights of the decedent’s creditors to get paid when the account owner dies. In short, a TOD designation avoids probate, but not creditors. MCL 700.6309(2)
  9. While the registering entity, e.g. Greenleaf Trust, is given some protection from claims asserted by the deceased account owner’s estate, creditors, heirs or devisees, that discharge from liability for those claims is dependent upon its good faith reliance on (i) the formal registration of the investments in TOD form; and (ii) information provided to it by a sworn statement from the deceased owner’s personal representative or by the surviving named beneficiary. However, the statutory protection given to Greenleaf Trust for following the TOD beneficiary designation and distributing investments consistent with that beneficiary designation  is limited. The protection does not extend to any re-registration or payment made after Greenleaf Trust receives written notice from a claimant to an interest in the investment that objects to the implementation of a registration in TOD beneficiary form. It is important that no other notice or information available to Greenleaf Trust affects its rights to protection under the statute. In sum, Greenleaf Trust is protected in honoring the TOD beneficiary designation so long as it does not receive a written notice from a third party that challenges the TOD registration. MCL 700.6808(4)
  10. While Greenleaf Trust  is protected under the statute as the registering entity for the registered TOD investments, that statutory protection does not affect the rights of the beneficiaries in disputes among the beneficiaries or with regard to any other person who claims ownership of the security that is transferred or its value or the proceeds if the investments are subsequently liquidated. MCL 700.6308(5)
  11. A TOD or POD beneficiary designation falls within EPIC’s definition of a governing instrument. MCL 700.1104(k). Consequently, as a generalization, if the TOD investment account owner and the designated beneficiary of the TOD investment account are married, and they later divorce, the fact of their divorce (or the annulment of their marriage, but not a legal separation, which is not treated as a divorce) will automatically revoke the beneficiary designation. MCL 700.2807(1)(a).
  12. However, the automatic revocation statute can be circumvented if there exists an express contract that overrides this consequence of a divorce. Example: Spouses in their premarital agreement contractually agree to name the other as a TOD beneficiary, whether or not they later become divorced.
  13. While the general rule is that a divorce automatically eliminates the designation of a former spouse as TOD beneficiary, it would be best to obtain some affidavit from the contingent beneficiary or the deceased owner’s personal representative that no contract exists or court order that “trumps” the automatic revocation of the former-spouse-beneficiary.
  14. Along these same lines, Michigan’s forfeiture of a surviving spouse’s rights statutes [elective rights, intestacy rights, statutory allowances] is conditioned on the surviving spouse having deserted [or was ‘willfully absent from’] the deceased spouse for at least one year prior to the spouse’s death. But that statute that forfeits these statutory rights of a surviving spouse do not apply to a TOD designation of a surviving spouse. In short, if a spouse is named as TOD beneficiary but has deserted the deceased spouse for at least one year prior to their death, they will still be entitled to take the TOD account’s investments. MCL 700.2801(2)(c)

All of these TOD ‘rules’ suggest that it is good practice to annually confirm with the client both the accuracy of the TOD beneficiary designation and to make sure that contingent TOD beneficiaries are named, either in anticipation of divorce, or in anticipation of a qualified disclaimer by the named TOD beneficiary (primary or contingent) for future tax planning purposes.

This need for an annual review of beneficiary designations was recently underscored in an IRS Private Letter Ruling, PLR 201706004. Admittedly a bit off topic, an IRA owner died naming his trust as the only designated beneficiary of his IRA account. Unfortunately, no one could find any proof that a trust actually existed. The decedent’s will left everything to his surviving spouse. The decedent’s estate went to probate court and had the IRA beneficiary designation reformed to name the decedent’s surviving spouse as its beneficiary. While the IRS is normally loathe to abide by a probate court reformation of an IRA beneficiary designation, it approved this beneficiary designation reformation because the surviving spouse would receive all of the IRA under the decedent’s will in any event, thus a surviving spouse IRA rollover was permitted. The point being that while a trust was named as the IRA beneficiary, no one could ever locate a copy of the trust, which meant that the decedent was treated as having died with an IRA but with no designated beneficiary, leading to the ‘default’ IRA beneficiary being the decedent’s estate, and a 5 year required minimum distribution period.