The Internal Revenue Service has demonstrated many times its belief that when nine states adopted the community property system, they did so for the sole purpose of frustrating the transfer tax (and earlier the income tax) system. This same kind of paranoia infects the Service's approach to the use of trusts as beneficiaries of qualified plans and individual retirement accounts.
Beginning in 1987 with the proposed regulations for Internal Revenue Code Section 401(a)9, the IRS in both its regulations and private letter rulings1 has been wary of, if not outright hostile to, the use of trusts. Leading practitioners have repeatedly assured the Service that trusts, which originated in England centuries ago during the Crusades, are a valuable technique for dealing with the transmission of wealth, and were not developed to manipulate the minimum required distribution (MRD) rules. Nonetheless, the IRS and Treasury Department continue to regard trusts with deep suspicion in the context of the MRD rules. This distrust, which the 2001 proposed regulations suggested may have abated, is seen in full force in the final regulations that are effective for distributions after Jan. 1, 2003.2
Although Section 401(a)(9)(E) requires that a designated beneficiary be an individual, the Treasury took the position in the 1987 proposed regulations, the 2001 proposed regulations and the final regulations that a “look-through” rule applies to trust beneficiaries. If a trust is named as a beneficiary, all beneficiaries of that trust are treated as designated beneficiaries to determine the period over which MRDs must be made (if certain formal requirements are met).3
In three companion rulings issued April 25 involving three beneficiaries under the same trust instrument,4 the IRS indicated how it intends to apply the separate-share rules to trusts under Treasury Regulations Sections 1.401(a)(9)-8, A-2 and 401(a)(9)-4, A-5 (e).5
The application of the separate-share rules to individual beneficiaries is different than its application to trust beneficiaries. Dash 8, A-2(a)(2) of the Treasury Regulations6 provides that, if there are separate accounts or separate shares established with different beneficiaries, each account is not aggregated with other accounts (if the separate account is established before Dec. 31 of the year following the year of death of the participant.7 )The regulations at Dash 8, A-3 define a separate account as “separate portions of an employee's benefit reflecting the separate interests of the employee's beneficiaries under the plan as of the date of the employee's death for which separate accounting is maintained.” For example, if a beneficiary designation reads “To A, B and C in equal shares,” the gifts to each of these beneficiaries (assuming that the accounting requirements are met) will result in separate shares so that each beneficiary may use either the five-year rule under Section 1.401(a)(9)(B)(ii) or his own life expectancy under Section 401(a)(9)(B)(iii) to determine the MRD for that beneficiary's separate account.
Logic would therefore dictate that, using the “look-through” rule, the same would apply to separate shares under a trust. Au contraire, said the Service. In its three April rulings, participant A of an IRA died in 2002, before his required beginning date. The beneficiary of his IRA was a revocable management trust created during his lifetime. The terms of the trust required the trustee to divide the trust estate into three equal shares, one for each of A's children. Each share was to constitute a separate trust, to be held and administered as such. The trusts provided that all of the MRDs were to be paid to the beneficiaries (that is to say, a conduit trust). The terms of the trust also provided that separate accounts be maintained in accordance with Proposed Regulations (2001) Section 1.401(a)(9)-1, Q&A H-2(b). The beneficiary designation also noted that the trust was to be divided into three separate trusts, and the trustee could establish separate IRAs in the name of A for the benefit of each beneficiary.8 The revocable management trust was divided before Dec. 31, 2003 so that each beneficiary had a separate trust; the IRA was likewise divided to establish three separate IRAs.
First, the IRS ruled the division into three separate IRAs was valid. That left only the second issue: “[t]hat required distributions from the sub-IRA maintained in the name of Taxpayer A for the benefit of [each of the children] may be paid over the life expectancy of [each such child].” The Service found the MRDs were to span the life expectancy of A's oldest child,9 not the life expectancy of each child for whom a sub-IRA and separate trust were established. Dash 4, A-5(c) provides: “[S]eparate account rules under A-2 of Section 401(a)(9)-8 are not available to beneficiaries of a trust with respect to the trust's interest in the employee's benefit.”
Noting the general rule that MRDs from a trust with multiple beneficiaries are measured by the life expectancy of the eldest beneficiary, the IRS stated the issue is whether that general rule applies “where IRA distributions are made directly to a subtrust created under the terms of a trust.” The IRS, in what can only be called a conclusory analysis, found the subtrusts were created by the trustee of the revocable trust after death pursuant to the terms of the trust. Although there is nothing to preclude the creation of subtrusts, the final regulations do preclude separate-share treatment “where amounts pass through a trust,” as in this case.
So, what should advisors do now when a participant wants to leave his IRA in trust for a number of different children? A did everything generally recommended back then, including providing for the division of the trust both in the trust and in the beneficiary designation.10 Read literally, the prohibition contained in Dash 4, A-5(c) applies to “beneficiaries of a trust.”
Now suppose that, rather than making his living trust the beneficiary, A had established three separate trusts during his life, funding each with a nominal amount, then named the three trusts as beneficiaries of his IRA. Because there are three separate beneficiaries (the trusts) and only one beneficiary of each trust, the prohibition against multiple beneficiaries should not apply. Alternatively, A should have been able to achieve the same result by creating four trusts under one document instead of having his revocable management trust divided on his death.
If A could have obtained the desired result by drafting the document slightly differently, this elevation of form over any semblance of substance is a reductio ad absurdum. The hoops through which someone desiring to use trusts as beneficiaries of qualified retirement benefits must jump are unnecessary. They also demonstrate once again that, despite all the benefits in the final regulations, the Service has learned little about trusts since 1987.
- There are very few published revenue rulings to provide guidance. Instead, the Service uses private letter rulings that are fact-intensive and do not provide general guidance upon which a taxpayer may rely.
- Treas. Regs. Sections 1.401(a)(9)-1 through 1.401(a)(9)-9.
- Treas. Regs. Section 1.401(a)(9)-4, Q&A 5, et seq.
- PLRS 200317041, 200317043 and 200317044. The IRS published two rulings on July 3, PLRs 200329048 and 200327059, gratuitously reiterating that separate shares are not available to a trust with multiple beneficiaries. In neither PLR was the separate-share rule at issue.
- The final regulations, like the proposed regulations issued in 1987 and 2001, are in question-and-answer format.
- References to Dash, A are to the subsections and answers under Treas. Regs. Section 1.401(a)(9).
- Note: This is three months after the date on which the identity of a beneficiary is to be finally determined under Dash 4, A-4(a).
- It is represented by counsel seeking the PLR that all of the requirements for treating the trust as a designated beneficiary in Dash 4, A-5(b) were met.
- See Dash 5, A-7.
- The PLRs indicate that A died in 2002. The final regs were not issued until April of 2002. The proposed regs contained language indicating this situation would have produced the desired results. The final regs reversed that position. A may have died before they were issued, but even if he had not, it's doubtful he would have known of this change in time to have done something about it.
Avin J. Golden, member, Ikard & Golden P.C., Austin, Texas