Taxpayers commonly name trusts as beneficiaries of their individual retirement accounts. If the trust is properly drafted, it will qualify as a designated beneficiary under Internal Revenue Code Section 401(a)(9), making it possible to stretch payouts over the life expectancy of the oldest trust beneficiary to maximize tax deferral. If the trust isn't properly drafted, however, the IRA will have no designated beneficiary and will have to be paid out over the decedent's ghost life expectancy or within five years after the decedent's death.
Historically, it was relatively easy to fix a trust that failed to qualify as a designated beneficiary because of a drafting error. This could be accomplished through (1) disclaimers by unwanted trust beneficiaries, (2) payouts to unwanted trust beneficiaries, or (3) post-mortem trust reformations. Recently issued Private Letter Ruling 201021038 reminds planners that the Internal Revenue Service will no longer permit post-mortem reformations.1 The PLR highlights the importance of careful drafting.
Importance of Stretch Out
For many, retirement assets represent a substantial portion of their wealth. The benefits afforded by allowing assets to grow in a tax-deferred environment can give rise to tremendous wealth accumulation during the owner's life and, if structured properly, to tremendous wealth accumulation for the owner's family after the owner's death.
The stretch IRA concept contemplates planning so that the beneficiaries can inherit the balance in a retirement plan intact. This strategy's key advantage is that it allows the beneficiaries to keep the retirement plan in a tax-deferred environment for as long as the law allows. If properly executed, this strategy can create substantial wealth transfer opportunities for a plan owner's family. Consider for example, a $500,000 IRA under four scenarios, ranging from immediate liquidation of the entire IRA to stretching distributions over the youngest beneficiary's life expectancy. Let's assume an 8 percent growth rate, a 35 percent federal income tax rate, a 50 percent turnover on growth and a 15 percent federal capital gains rate. (See “The Power of the Stretch Out,” p. 27.) A look at the four scenarios shows that by properly structuring the IRA over the course of 35 years, an additional after-tax amount of over $2 million could have been passed to the beneficiaries. (In 2045, the IRA payable to a 15-year old non-spousal beneficiary is worth $6,005,531 versus $3,665,503 if an immediate distribution is made.) Thus, properly structuring beneficiary designations offers a tremendous opportunity for those clients who have had the foresight to accumulate wealth in a tax-deferred vehicle.
The law allows a taxpayer to contribute pre-tax dollars to an IRA, which may continue to grow tax-deferred. Upon distribution of IRA assets, the distribution will be taxed as ordinary income of the recipient. Congress intended that IRAs be used as retirement rather than as general wealth accumulation vehicles. Thus, it created rules that require certain amounts of the IRA to be distributed after the IRA owner reaches a specified age.
The date by which a taxpayer must begin forced distributions is known as the required beginning date (RBD). This is generally defined as April 1 of the year following the calendar year in which a taxpayer reaches age 70½.2 The failure to take a required minimum distribution (RMD) will result in a 50 percent penalty on the amount that should have been distributed.
For post-death RMDs, it must be possible to identify an age to calculate a life expectancy factor. A beneficiary is the person, persons or entity that will receive the remaining balance in the IRA or qualified retirement plan (QRP) upon the IRA owner's death. However, for IRAs and QRPs, it's critical that the beneficiaries qualify under the law as a designated beneficiary. Only individuals and certain types of trusts qualify as a designated beneficiary. Estates and charities don't. The failure to have a designated beneficiary will result in either of the following:
If the IRA owner dies before his RBD, the IRA must be distributed no later than Dec. 31 of the fifth anniversary year of his death, or
If the IRA owner dies after his RBD, the IRA must be distributed based upon his life expectancy in the year of death. The life expectancy is reduced by one for each succeeding year after the year of death. Thus, it's critical that a qualified designated beneficiary be named.
RMDs to the beneficiaries who inherit the benefits are based on the life expectancies of those beneficiaries. The designated beneficiary is determined based on the beneficiaries designated as of Sept. 30 of the calendar year following the calendar year of the IRA owner's death. Any person who was a beneficiary as of the date of the IRA owner's death, but isn't a beneficiary as of that later date (for example, because the person disclaims entitlement to the benefit to which the person is entitled before that date), isn't taken into account in determining the designated beneficiary for purposes of determining the distribution period for RMDs after the owner's death.
Trust as Beneficiary
For a trust to be considered a designated beneficiary under the IRC Section 401(a)(9) regulations governing RMDs from IRAs, the following requirements must be met:3
- The trust is a valid trust under state law, or would be but for the fact that there's no corpus.
- The trust is irrevocable or will, by its terms, become irrevocable upon the IRA owner's death.
- The beneficiaries of the trust who are beneficiaries with respect to the trust's interest in the IRA owner's benefit are identifiable from the trust instrument within the meaning of Treasury Regulations Section 1.401(a)(9)-4, A-1.
- The documentation described in Treas. Regs. Section 1.401(a)(9)-4, Q&A 6 has been provided to the plan administrator (this requirement can be satisfied by providing a copy of the trust to the plan administrator by Oct. 31 of the year following the year of the owner's death).
If these requirements are satisfied, the beneficiaries of the trust (and not the trust itself) will be treated as having been designated as beneficiaries for purposes of determining the distribution period. Accordingly, the life expectancy of the oldest trust beneficiary can be used to determine RMDs.4 If the trust doesn't meet the above requirements, the owner is considered to have no designated beneficiary and the retirement plan must be distributed in five years if the plan owner died before his RBD or over the plan owner's remaining life expectancy if he died on or after his RBD. This can lead to a tremendous loss of tax-deferred growth. Requirements 1, 2 and 4 are easily met. Most trusts fail to qualify as designated beneficiaries because of the third requirement. While at first blush it may appear simple to identify the beneficiaries of a trust, the analysis isn't that straightforward. One must look at all potential beneficiaries of a trust to determine (1) if such beneficiaries can be identified by Sept. 30 of the year following the year of death, and (2) if such beneficiaries are all individuals with an ascertainable life expectancy. When drafting a trust, one should examine all possible scenarios that could exist at a person's death. A complete discussion of how to properly draft a trust to qualify as a designated beneficiary, however, is beyond the scope of this article.
Disclaimer and Payout
To determine the beneficiaries, look at the beneficiaries named as of the date of the IRA owner's death who remain beneficiaries as of Sept. 30 of the calendar year following the calendar year of the IRA owner's death. Consequently, any person who was a beneficiary as of the date of the IRA owner's death, but isn't a beneficiary as of that Sept. 30, isn't taken into account in determining the oldest trust beneficiary. This creates an important post-mortem planning opportunity for lengthening the payout period for an IRA.
Treas. Regs. Section 1.401(a)(9)-4, Q&A 4 explicitly provides two methods for eliminating unwanted beneficiaries. It states that if a person receives the entire benefit the person is entitled to before Sept. 30 of the year following the IRA owner's date of death or makes a qualified disclaimer before that date, such person isn't taken into account in determining the IRA's designated beneficiary.
Example of disclaimer — The beneficiaries of Harold's IRA are his sister Maude (age 75) and his son Mark (age 35). Within nine months after Harold dies, Maude makes a qualified disclaimer of her interest in the IRA. As a result, Maude is no longer the designated beneficiary and the IRA is payable over Mark's life expectancy instead of hers.5
Example of payout — Juanita creates a trust providing an outright bequest of $10,000 to the Salvation Army, with the remainder to her issue. Generally, the bequest to the Salvation Army would taint the entire trust from qualifying as a designated beneficiary because it doesn't have a measurable life expectancy. However, if the $10,000 bequest is satisfied by Sept. 30 of the year following the year of Juanita's death, the Salvation Army can be disregarded for RMD purposes and the IRA will be payable over the life expectancy of the oldest heir.6
These disclaimer and payout provisions are useful in the post-mortem planning stage to eliminate undesirable, non-individual, beneficiaries or to utilize the life expectancy of a much younger beneficiary.
Reformation of Trust Instrument
In the past, a third method used to eliminate beneficiaries after the IRA owner's death was reformation of the trust instrument. PLRs had previously established the ability to reform beneficiary designations, trusts and wills. In PLRs 200616039-41,7 the decedent opened an IRA with Company 1. The IRA agreement designated the decedent's wife as the primary beneficiary and his daughters as contingent beneficiaries of the IRA. Subsequently, the decedent transferred all of the assets from Company 1 IRA to an IRA established with Company 2. Under the Company 2 agreement, the wife was designated as the primary beneficiary of the Company 2 IRA. However, the agreement didn't designate any contingent beneficiaries.
The decedent died after his RBD. His wife died shortly thereafter. The decedent's will provided, in relevant part, that in the event the wife didn't survive the decedent or if the wife died within 60 days of decedent, the rest, residue and remainder of the decedent's estate was to pass to the decedent's two daughters. Within nine months of the decedent's death, one daughter, in her capacity as personal representative of the wife's estate, disclaimed each and every interest that the wife or her estate had in the Company 2 IRA. The probate court subsequently entered an order reforming the beneficiary designation of the Company 2 IRA. The reformed beneficiary designation listed the daughters as the contingent beneficiaries of the Company 2 IRA (as was the case with the Company 1 IRA). The IRS ruled that the daughters' life expectancies could be used to determine the RMDs from the IRA. Note that although the disclaimer eliminated the unwanted beneficiary (the wife), the reformation was needed to add a new beneficiary after the decedent's date of death.
Similarly, the IRS has repeatedly respected state court orders reforming trusts to qualify the trusts as designated beneficiaries under Treas. Regs. Section 401(a)(9). In those rulings, the IRS followed the court orders in determining the applicable life expectancy for RMDs. In PLR 200608032,8 for example, the trust, which was the beneficiary of an IRA, was amended to disallow, after Sept. 30 of the year following the year of the decedent's death, a distribution of any portion of the IRA to or for the benefit of the decedent's estate, any charity or any non-individual beneficiary. In addition, per the amended trust, after Sept. 30 of the year following the year of the decedent's death, the IRA wasn't to be used for payment of the decedent's debts, taxes, expenses of administration or other claims against the decedent's estate, or for the payment of transfer taxes due on account of the decedent's death.
We've also submitted several PLR requests that successfully asked for designated beneficiary status of a trust that was reformed after the death of an IRA owner.9 This reformation was performed at the state court level to modify the trust so it met the requirements of Treas. Regs. Section 1.401(a)(9)-4, Q&A 5 to have a trust qualify as a designated beneficiary.
In more recent years, however, the IRS has indicated that it will not respect state court actions in determining the designated beneficiary of a retirement plan. In PLR 200742026,10 which we submitted, the IRS refused to recognize a post-mortem reformation of an IRA beneficiary designation form to determine the measuring life for calculating post-death RMDs. This reversed the holding in PLRs 200616039-41, discussed above. PLR 200742026 mirrored that of PLRs 200616039-41 in that all involved a taxpayer who unintentionally omitted a contingent beneficiary in his beneficiary designation form when his IRA was transferred to a new custodian. All involved the death of the primary beneficiary. In each instance, the state court reformed the beneficiary designation form to reflect the prior/intended beneficiary. In the end, however, the IRS refused to follow the state court order as it related to federal tax law, stating that:
the statute and applicable regulations clearly describe the method to determine the designated beneficiary and provide a specific mechanism to achieve a post-required beginning date payout period longer than the IRA owner's remaining life expectancy — the IRA owner merely has to ensure that at least one individual is designated as beneficiary under the IRA as of his date of death. In this case, no living person was named, as either primary or contingent beneficiary, on that date. Accordingly, under the foregoing rules, Taxpayer A must be treated as having no designated beneficiary as of his death under section 401(a)(9).
State Court Reformation
If unwanted beneficiaries can be eliminated through qualified disclaimers or timely payoffs, nothing further needs to be done. The IRS will respect the beneficiary changes and the payout period will be extended. If the elimination of unwanted beneficiaries is accomplished through a state court reformation, however, there are two additional issues:
- Whether the IRS must respect the state court reformation for federal tax purposes; and
- Whether the reformation has retroactive effect for federal tax purposes.
Respecting the reformation
Under the U.S. Supreme Court's decision in Commissioner v. Estate of Bosch,11 federal courts and the IRS are bound by decisions of a state's highest court on state property law issues but need only give “proper regard” to state trial court decisions like trust reformations. If a state's highest court has not ruled on an issue, the IRS can make its own determination of how that court would rule on the question. Thus, if the IRS doesn't believe that a reformation is consistent with state law as enunciated by the state's highest court, it may refuse to respect the reformation for federal tax purposes.
In Sinopoulo v. Jones, the U.S. Court of Appeals for the Tenth Circuit affirmed the Tax Court's decision that changes to the legal effects of a transaction through state court reformation of a document generally don't have retroactive effect for federal tax purposes and can't change the tax consequences of a completed transaction, and six other Circuits subsequently agreed.12 While the IRS must respect a state court order that's binding on the taxpayer before a taxable event occurs, it's not bound by a reformation that occurs after the IRS has acquired a right to tax revenue.13 In the latter case, the changes effected by the reformation relate back to the date of the instrument for the parties to the instrument, but are effective only from the date of reformation for third parties that previously acquired rights under the instrument (for example, the IRS).14
There are two exceptions to the retroactive effect rule. First, the rule applies only where a reformation alters or amends a trust, but not where it merely interprets, construes, clarifies or determines the legal effect of the original trust instrument under state law. The latter type of reformation can change federal tax consequences even if rendered after a tax liability has been determined because it merely states what the trust provided from the beginning, rather than changing it after the fact.15 The other exception is for reformations specifically authorized under the IRC. The most important example is IRC Section 2055(e)(3), which allows the parties to reform a charitable remainder trust to qualify for the charitable deduction.
Note that the IRS didn't address the Bosch or retroactive tax effect issues in either the favorable PLRs discussed above (200616039-41 and 200608032) or in the unfavorable ruling (200742026).
IRS Denies Retroactive Effect
In PLR 201021038, the IRS ruled that it wouldn't respect the retroactive reformation of a trust for purposes of Section 401(a)(9) and the related regulations. It didn't raise the Bosch issue, evidently being satisfied that the reformation was consistent with state law, but invoked the American Nurseryman16 line of cases to deny retroactive effect to the reformation, evidently believing that this provided a stronger rationale than the one stated in PLR 200742026.
In PLR 201021038, the IRA owner died after executing a trust that was named beneficiary of the IRA. The trust's beneficiaries were given a power to appoint to charities and older unidentifiable individuals. Inclusion of the charities as possible recipients of IRA funds prevented the IRA from having a designated beneficiary. The trustees subsequently asked the state court to modify the trust to comply with certain requirements under Treas. Regs. Section 1.401(a)(9). The state court granted the trustees' petition and the trust was modified to, among other things, exclude charities and older beneficiaries as potential beneficiaries under the trust. This reformation was presumably done before Sept. 30 of the year following the year of the IRA owner's death and was retroactive ab initio.
The IRS stated that while it will look to local law to determine the nature of the interests provided under a trust document, it's not bound to give effect to a local court order that modifies the dispositive provisions of a document after a taxpayer has acquired rights to tax revenues under its terms. Citing American Nurseryman, it stated that courts have generally disregarded the retroactive effect of state court decrees for federal tax purposes and that allowing otherwise would create considerable opportunity for “collusive” state court actions having the sole purpose of reducing federal tax liabilities. Furthermore, the IRS was concerned that federal tax liabilities would remain unsettled for years after their assessment if state courts and private persons were empowered to retroactively affect the tax consequences of completed transactions and completed tax years.17
Neither of the exceptions to the retroactive effect rule applied. The interpretation or construction exception was inapplicable because the terms of the trust had clearly been changed rather than merely interpreted and there was no IRC Section like 2055(e)(3) specifically authorizing a reformation. Thus, the reformation didn't have to be given retroactive effect and was treated as changing the beneficiaries between the date of death and the following Sept. 30.
Treas. Regs. Section 1.401(a)(9)-4, Q&A 4 provides that to be a designated beneficiary, an individual must be a beneficiary as of the date of the IRA owner's death. Therefore, the IRS stated, beneficiaries could be added between the date of death and the following Sept. 30, but new beneficiaries couldn't be created. The IRA had no designated beneficiary on the date of death because of the charity's inclusion, so the effect of the reformation was to impermissibly create a new beneficiary after the date of death. Accordingly, the designated beneficiary of the IRA had to be determined under the trust terms as they existed at the time of the IRA owner's death. The adverse ruling means the trust wasn't treated as a designated beneficiary trust and that the trust beneficiary's life expectancy couldn't be used for determining RMDs.
Message and Moral
The ruling's truly important message is that the IRS will not respect retroactive trust reformations for purposes of treating a trust as a qualified designated beneficiary. This means that in most cases, the drafter must either get the trust right the first time or reform it prior to the IRA owner's death. While it may be possible to fix a problem through a disclaimer or payoff, these remedies often aren't available.
The ruling's moral is that counsel and other advisors must exercise great care when drafting trusts that are meant to be named as beneficiary of a retirement account. Given the difficulty of drafting an accumulation trust that qualifies as a designated beneficiary, it may be advisable to first draft the trust as a conduit trust (that is, any and all IRA distributions must be paid outright to the trust beneficiary) and give the trust protector a one-time option to switch the trust to an accumulation trust after the death of the IRA owner but before Sept. 30 of the year following the year of death. This technique was approved in PLR 200537044. It's also a good idea to review trusts while IRA owners are still alive to avoid the American Nurseryman issue.
In any event, we can no longer rely on post-mortem relief through state court reformations to rectify drafting errors in creating a qualified designated beneficiary. Because of the tremendous amount of tax-deferred growth that could be lost, it's critical that we (1) know if a trust is named as a beneficiary of any of our client's retirement accounts, and (2) ensure that any trusts named as beneficiary qualify as designated beneficiaries.
Tax Policy Implications
First, there are many important reasons to name a trust as an IRA beneficiary, including (1) spendthrift protection, (2) creditor protection, (3) special needs, (4) investment management, (5) estate planning, and (6) dead hand control, but it's very difficult to draft an IRA trust properly. Perhaps there should be a special IRC provision like Section 2055(e)(3) permitting trust reformations between the date of death and the following Sept. 30 to correct beneficiary designation errors.
In addition, commentators have noted that the rationales advanced under PLR 201021038 for not permitting reformations to have retroactive effect (possibility of collusive action and lack of finality) are open to serious criticism. First, while some reformations may be collusive, many are not. Why not treat collusion as an evidentiary problem to be dealt with on a case-by-case basis as the Ninth Circuit did in Flitcroft v. Comm'r?18 Second, while allowing reformations indefinitely would be undesirable, permitting reformations only until the following Sept. 30 would do little to delay finality.19
Private Letter Ruling 201021038 (May 28, 2010).
Internal Revenue Code Section 401(a)(9)(C)(i)(I). Note that in the case of a qualified plan, the qualified plan participant who owns 5 percent or less of the entity under which the qualified plan operates doesn't reach his required beginning date until such time as he retires. See IRC Sections 401(a)(9)(C)(i)(II) and (ii).
Treasury Regulations Section 1.401(a)(9)-4, Q&A 5(b).
Treas. Regs. Section 1.401(a)(9)-4, Q&A 5(a).
See, for example, PLRs 200444033 (Oct. 29, 2004), 200521033 (May 27, 2005) and 200616039 (April 21, 2006).
See, for example, PLR 200608032 (Nov. 30, 2005).
PLRs 200616039-41 (April 21, 2006).
PLR 200608032 (Feb. 24, 2006).
PLRs 200235038 (June 4, 2002) and 200620026 (May 19, 2006).
PLR 200742026 (Oct. 19, 2007).
Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).
Sinopoulo v. Jones, 154 F.2d 648 (10th Cir. 1946); American Nurseryman Publishing Company v. Comm'r, 75 T.C. 271, 276-277 (1980), aff'd without published opinion, 673 F.2d 1333 (7th Cir. 1982); Estate of Hill v. Comm'r, 64 T.C. 867 (1975), aff'd without published opinion, 568 F.2d 1365 (5th Cir. 1978); Emerson Institute v. United States, 356 F.2d 824 (D.C. Cir. 1966), cert. denied, 385 U.S. 822 (1966); Piel v. Comm'r, 340 F.2d 887 (2d Cir. 1965); M.T. Straight Trust v. Comm'r, 245 F.2d 327 (8th Cir. 1957); Eisenberg v. Comm'r, 161 F.2d 506 (3d Cir. 1947), cert. denied, 332 U.S. 767 (1947). The Ninth Circuit, however did reach the opposite conclusion in Flitcroft v. Comm'r, 328 F.2d 449 (9th Cir. 1964).
Revenue Ruling 73-142, 1973-1 CB 405.
Sinopoulo v. Jones, supra note 12.
Blair v. Comm'r, 300 U.S. 5 (1937); Kelly's Trust v. Comm'r, 168 F.2d 198 (2d Cir. 1948); LeBeau v. Comm'r, TCM 1980-201).
American Nurseryman Publishing Company v. Comm'r, supra, note 12.
Courts have given the following policy reasons for refusing to give retroactive effect to reformations for federal tax purposes: (1) The possibility of collusive state court actions; (2) the Internal Revenue Service can't be bound by a state court order when it wasn't a party to the action; (3) a retroactivity rule would undermine the value of finality and leave tax liabilities unsettled for long periods of time; and (4) obtaining a reformation is often a decision made in hindsight to save on taxes.
The recent case of Breakiron v. Gudonis, Civil Action No. 09-10427-RWZ, U.S. District Court, D. Mass. (Aug. 10, 2010), suggests that where some of these negative policy factors are absent, taxpayers may prevail. The case involved a beneficiary who had obtained a local court order rescinding a disclaimer. Because the IRS was a party to the action, the taxpayer didn't seek the disclaimer to gain a tax benefit and there was no collusion, the court held that reformation of the disclaimers was conclusive for federal tax purposes. The facts in PLR 201021038 were less favorable because the IRS wasn't a party to the reformation and the purpose of obtaining the reformation was to gain greater tax deferral.
Flitcroft v. Comm'r, supra note 12.
See David Hasen, “Unwinding Unwinding,” Emory Law Journal (2008) at p. 871.
Robert S. Keebler, far left, is a partner and chair of the financial and estate planning team and Michelle L. Ward is a senior consultant, both in the Appleton, Wis., office of Virchow Krause & Company, LLP. Peter Melcher is a senior manager at the firm and is based in its Milwaukee office
The Power of the Stretch Out
|Year||Immediate Designated Distribution||IRA Payable to Non-Qualified Beneficiary (5-year rule)||IRA Payable to 40-year-old Non-Spousal Beneficiary||IRA Payable to 15-year-old Non-Spousal Beneficiary|
Assumptions: $500,000 IRA, 8% growth rate, 35% federal income tax rate, 50% turnover on growth, 15% federal capital gains rate
— Robert S. Keebler, Michelle L. Ward & Peter Melcher