You can attain inner bliss by mastering the art of drafting the specialized provisions that qualify a trust for stretch-out if designated as a beneficiary of a retirement plan. Here’s how.
“Retirement plan” broadly includes any plan, individual retirement account or Roth IRA subject to minimum required distribution (MRD) rules. “Stretch-out” refers to the ability to take MRDs from a retirement plan after the death of the owner/participant over the life expectancy of a younger individual beneficiary.
If an individual is designated on the death beneficiary designation (DBD), he’ll typically qualify for stretch-out.1 However, if a trust for the same individual is designated on the DBD, the analysis is more complicated. The general rule is that non-individuals (for example, trusts, estates or charities) aren’t eligible for stretch-out.2 However, if a trust that’s been designated as death beneficiary meets certain requirements, the trust’s beneficiaries will be viewed as if they had been designated outright.3 Such a trust is known as a “see-through trust.” Thus, the MRD rules impose two steps of analysis when a trust has been designated:
Step 1: Does the trust qualify as a see-through trust?
Step 2: Who are the see-through trust beneficiaries?
Qualifying as a See-Through Trust
A trust is a see-through trust if it meets the following threshold requirements:4
Valid under state law. The trust is valid under state law or would be but for the fact that there’s no corpus. The final regulations specifically approve the use of testamentary trusts.5
Irrevocable. The trust is irrevocable or will, by its terms, become irrevocable on the participant’s death.
Beneficiaries are identifiable. The beneficiaries with respect to the trust’s interest in the retirement plan are identifiable from the trust instrument. “Identifiable” refers to general requirements that apply to any beneficiary designation.6 Under these requirements, an individual doesn’t necessarily have to be specified by name, so long as he’s identifiable as of the determination date. (Certain post-mortem planning may be allowed up until Sept. 30 of the calendar year following the year of death—known as the “determination date.”)7 In particular, members of a class that’s capable of expansion or contraction will be treated as identifiable if it’s possible to identify the class member with the shortest life expectancy as of the determination date.
Documentation provided to plan administrator. The trustee has timely provided the plan administrator with either:8
• A copy of the trust instrument; or
• A final list of all of the beneficiaries of the trust (including contingent and remainder beneficiaries, with a description of the conditions on their entitlement) as of the determination date, accompanied by the trustee’s certification that, to the best of the trustee’s knowledge, the list is correct and complete and that the other requirements above are satisfied. The trustee must also promise to provide a copy of the trust to the plan administrator on demand.
In the context of post-death MRDs, the deadline forproviding this documentation is Oct. 31 of the calendar year following the year of death (one month after the determination date of Sept. 30).9
WARNING: Failure to meet this deadline disqualfies the trust as a see-through trust!
Drafting a trust to qualify as a see-through trust is straightforward. The tough issues lie ahead with Step 2 because of the way the MRD rules look at trust beneficiaries.
Identifying the Trust Beneficiaries
Because the MRD rules can be metaphysical at times, I suggest the following exercise to attain enlightenment as to how these rules work. Sit cross-legged, and train your inner eye on an imaginary circle, which represents the see-through trust. Imagine that a dot appears inside the circle for each individual who could possibly receive an interest in the retirement plan assets now or in the future. This includes each current beneficiary, remainder beneficiary and contingent or alternate beneficiary. You’re probably seeing lots and lots of dots, but you’re not done. If the trust grants a power of appointment (POA) to anyone, you need to visualize additional dots for each permissible recipient who could possibly receive retirement plan assets under the POA.
As you become one with all of the dots in the circle, you’ll experience the bliss of understanding that MRDs for a see-through trust are determined as if all of the dots had been designated on the DBD, rather than the trust itself. This group of dots represents the pool of see-through trust beneficiaries.
If all of the dots are individuals, the general rule is that the see-through trust’s MRDs will be determined based on the individual beneficiary with the shortest life expectancy.10 If even one dot is a charity or estate, no stretch-out will be allowed. If a dot is another trust, these rules are applied again to the dot trust to determine the beneficiaries of that trust who are counted as being in the circle corresponding to the original see-through trust.
So, what good is a see-through trust if it has to use the life expectancy of the oldest person in the world? Understanding can only come from mastering the exceptions to the general rule—the secrets to “managing the dots.” I know of only three ways:
Conduit trusts. The regulations provide a specific exception to the general rule for conduit trusts. When a trust requires that all distributions passing from a retirement plan to the trust during the primary beneficiary’s lifetime must be passed through to the primary beneficiary, rather than accumulated in the trust, the primary beneficiary of the trust is recognized as the sole see-through trust beneficiary with respect to that retirement plan.11 In other words, the primary beneficiary is the only dot in the circle, and all other dots are disregarded. Although the term “conduit trust” doesn’t appear in the regulations, it’s been universally adopted as a name for this type of trust. The final regulations reason that the alternate takers can be excluded from the pool of see-through trust beneficiaries because the primary beneficiary is entitled to all plan distributions while living.
Mere potential successor (MPS). Another exception under the regulations provides that a successor beneficiary doesn’t need to be counted “merely because the person could become the successor to the interest of one of the employee’s beneficiaries after that beneficiary’s death.”12 The regulations offer the following example:
... if the first beneficiary has a right to all income with respect to an employee’s individual account during that beneficiary’s life and a second beneficiary has a right to the principal but only after the death of the first income beneficiary (any portion of the principal distributed during the life of the first income beneficiary to be held in trust until that first beneficiary’s death), both beneficiaries must be taken into account in determining the beneficiary with the shortest life expectancy and whether only individuals are beneficiaries.13
In other words, a successor beneficiary is an MPS who can be disregarded only if the preceding beneficiary is entitled to all of the income and principal (essentially full distribution). If the preceding beneficiary’s interest is any less than all of the income and principal, then the successor beneficiary’s interest will be more, and the successor beneficiary won’t qualify as an MPS and won’t be disregarded. This is a very narrow rule. The successor beneficiaries under many common trust designs won’t qualify as MPSs under it. In fact, the successor beneficiaries under a conduit trust probably wouldn’t qualify either, but for the specific exception granted to conduit trusts.
Age restriction. In addition to the two exceptions allowed under the regulations, there’s one other way to manage the dots in the circle, which is to draft out everyone who’s too old.
You’ve now attained enlightenment as to the three ways to manage the dots in the circle, and you’re ready to enter the realm of drafting. There are four ways to approach the drafting of a see-through trust. What if it isn’t clear at the time of drafting which type of see-through trust will be best? See “Establishing a Toggle Switch,” p. 49, which explains how to preserve flexibility to choose during the post-mortem period preceding the determination date.
Let’s begin with the conduit trust, which as described above, must direct the trustee to distribute all amounts the trustee receives from a retirement plan to the trust’s primary beneficiary. This description highlights the primary disadvantage of the conduit trust, which is that these distributions must be made, regardless of whether the current beneficiary wants or needs them. This requirement is of particular concern with a very young beneficiary.
However, the actual MRDs for a young beneficiary will be very small, relative to the overall size of the retirement plan. For example, an individual who turns five years old in the year following the plan owner’s death would receive a distribution of 1/78th (approximately 1.25 percent) of his account that year.
The trust instrument may authorize the trustee to make conduit distributions to the minor individual’s custodian acting under applicable state law (for example, the Uniform Transfers to Minors Act (UTMA)). Distributions can also be directed to the legal guardian for the young individual, or the trustee may be given the discretion to do so, effectively allowing the trustee to apply distributions for the individual’s needs.
Will a trust comply with the MRD conduit requirements if it allows the trustee to apply distributions directly in payment of an individual’s needs, without the participation of the individual’s legal guardian? I’m unaware of any guidance on this issue in the MRD rule context, but there’s favorable authority in the context of the marital deduction for estate tax. A marital deduction is allowed under Internal Revenue Code Sections 2056(b)(5) and (7) with respect to certain interests in property passing to a spouse if certain requirements are satisfied, including the requirement that the surviving spouse shall receive the right to all income from the interest for the balance of his life.14 Treasury regulations provide that a trustee’s power to apply income for the benefit of the spouse is a permissible administrative power that won’t disqualify the marital deduction, provided that the overall terms of the instrument are such that the local courts will impose reasonable limitations on the exercise of the powers.15
The funds that actually reach the young beneficiary may be less than the amount of distributions from the retirement plan to the trust, due to the payment of legitimate trust expenses, such as trustee’s fees, tax return preparation or other expenses and, possibly, investment management fees of the retirement plan, to the extent the trustee chooses not to arrange payment of these fees from inside the plan.
Case study. Jane is age 42, divorced, with two daughters, ages 14 and 10, a $600,000 IRA, a $250,000 home and a few other assets. She would prefer to leave her estate to two trusts that protect each child until the child reaches age 35. She would like her children to benefit from stretched-out distributions, but would otherwise like to keep her estate plan as simple as possible. Based on these requirements, she decides to provide conduit trusts for each child.
Drafting considerations. Drafting a good conduit clause requires more time and thought than you might initially expect. Here’s a summary of some of the drafting issues I considered while developing my conduit trust forms. (See “Sample Conduit Subtrust,” on the Trusts & Estates website at http://wealthmanagement.com/archive/sample-conduit-subtrust.)
• Subtrust versus standalone trust. The trusts for the children could be structured as subtrusts under a revocable trust or will or as a dedicated stand-alone trust instrument. The subtrust approach is adequate for many clients, and I recommend this approach for Jane. The stand-alone approach may be worthwhile for certain clients who want the planning that’s been done for retirement assets to stand out in the form of a separate document. This separation may be helpful to fiduciaries, beneficiaries and advisors juggling many different issues during a death administration.
• “Double-duty” trusts. The trusts for the children could be drafted as two different sets of subtrusts, one for retirement plan assets and the other for non-retirement assets or as one set of “double-duty” subtrusts, each holding both retirement and non-retirement assets. One set of double-duty subtrusts will work just fine for Jane. Note that the double-duty subtrusts must coordinate the conduit distribution provisions and those that apply to other trust assets.
• May be confusing to the uninitiated. The conduit clause may be confusing to clients, trust officers or advisors who aren’t familiar with the concept. It can be particularly confusing when the clause is referring in some contexts to distributions from the plan and, in other contexts, to distributions from the trust. I’ve attempted to draft a clause that makes a clear distinction between the beneficiary of the plan versus the beneficiary of the trust (see Section 2.6.2 in “Sample Conduit Subtrust”).
• Need to define stretch-out plan. The conduit distribution provisions should only apply to those retirement plans that will allow stretch-out. Otherwise, if a plan requires a lump sum distribution at the client’s death, the entire plan could be passed out to the beneficiary, regardless of how young he is. Thus, I define the term “stretch-out retirement account” to
effectively exclude from the scope of the conduit clause any plan that can’t pay out over the beneficiary’s life expectancy (or the oldest life of a group of individuals that includes the beneficiary).
• Separate accounts. The language allowing for a group of individuals is intended to apply the conduit provision in a situation when the trust is one of several conduit trusts that, for some reason, don’t qualify for separate account treatment under the MRD rules and must use the life expectancy of the oldest conduit trust beneficiary.
• How to obtain separate account treatment. Separate account treatment isn’t available if the death beneficiary designation simply designates an underlying revocable trust, which means that the oldest child’s life would apply for all of the conduit subtrusts. The preferred approach is to prepare the death beneficiary designation to direct division of the retirement plan into separate accounts that are designated directly to the various subtrusts. For a sample death beneficiary form that could be used for any type of see-through trust (not just conduit trusts), see “Sample Death Beneficiary Designation,” on the Trusts & Estates website at http://www.wealth management.com/deathbeneficiary.
• Chicken and egg. I added a phrase to address the chicken and egg relationship between the sentence that defines “stretch-out retirement account” and the conduit distribution clause (that is, the conduit distribution clause doesn’t apply unless the plan satisfies the definition of “stretch-out retirement account,” and the trust might not satisfy the definition, unless the beneficiary is the only see-through trust beneficiary (see Section 2.6.2 in “Sample Conduit Subtrust”).
• Only applies to primary beneficiaries. Conduit distributions are only required as long as the primary beneficiary is alive. If the conduit provision doesn’t specifically address this issue, unnecessary conduit distributions might be required from a trust that continues beyond the primary beneficiary’s death. Thus, the definitions of “stretch-out retirement account” and “stretch-out retirement beneficiary” are incorporated into the conduit clause in a way to limit the scope of the conduit clause to only the primary beneficiary.
• Designation of trust that subdivides. I chose to define “stretch-out retirement accounts” using the phrase “became part of the trust by reason of the Settlor’s death (or the death of another, depending on the context),” rather than language such as “a trust that was designated,” to clarify that the conduit clause applies even if a revocable trust is designated and immediately subdivides into conduit trusts.
• Early termination. I added the phrase “or earlier termination of his or her trust” to clarify that the conduit clause doesn’t somehow create an obligation that extends beyond the trust termination (see Section 2.6.2 in “Sample Conduit Subtrust”).
• Distributions for benefit of. I’ve chosen to authorize the trustee to distribute conduit amounts outright or to “apply for the benefit of” the primary beneficiary, for reasons discussed above (see Section 2.6.2 in “Sample Conduit Subtrust”). In many trust instruments, additional language may be found in the boilerplate section of the trust providing options to the trustee when a distribution is to be made to a minor or disabled beneficiary. I considered relying only on the boilerplate language, but opted instead to include the “apply for the benefit of” language in the conduit clause to provide the clearest guidance to trust officers and other advisors. The boilerplate should be reviewed in any event to eliminate any contradictory language that might interfere with distribution either outright or for the benefit of the beneficiary (see “Sample Boilerplate Provisions,” on the Trusts & Estates website at http://www.wealthmanagement.com/boilerplate).
• Tax apportionment provisions; payment of taxes and expenses. Tax apportionment provisions in the client’s estate plan should be reviewed carefully. If possible, it’s best to avoid subjecting retirement plan assets to apportionment as the plan may melt down if distributions are needed to pay tax. However, in certain circumstances, a trustee may need to apply plan assets to pay estate or generation-skipping transfer (GST) tax. Any plan assets so applied are likely to generate an income tax at the trust level, as well. Trustee fees and other administration expenses may also need to be paid from plan assets. My conduit distribution clause (see Section 2.6.2 in “Sample Conduit Subtrust”) clarifies that the trustee may pay the portion of these items chargeable to the plan assets and distribute the net remaining to the trust beneficiary. The example in the final regulations doesn’t address these issues, and I’m not aware of any authority that specifically sanctions this approach. However, I believe it would be irresponsible to draft a conduit clause that didn’t address payment of these items. I considered moving the language that addresses these items into the “boilerplate” section of the trust but opted to leave all of the language together to provide the clearest guidance to trust officers and other advisors.
• Clarify trustee’s authority to take plan distributions. Since a conduit clause results in automatic distribution to the trust beneficiary, some mechanism needs to be included to clarify the scope of the trustee’s authority to take plan distributions, to avoid placing what’s effectively a general POA into the hands of a tax-sensitive trustee. Three possible tax-sensitive trustees are addressed: (1) an individual who’s made a disclaimer; (2) an individual subject to a legal obligation to support a beneficiary; and (3) a beneficiary. The authority should be broad enough, however, to allow the trustee to pay expenses or taxes chargeable to the plan assets and to take more than the MRDs if the beneficiary is in need. Also, this clause restricts the trustee’s authority only as long as the conduit provision is in effect. The language used in Jane’s trust should work well for most clients, but others may prefer more restrictive language (for example, the trustee may take only MRDs).
• MRDs in year of participant/owner’s death. The language discussed above that defines a “stretch-out retirement account” as a plan that allows distributions based on the life expectancy of the primary beneficiary needs to be drafted in a way that there’s no confusion if, in the year of the plan owner’s death, a minimum distribution remains to be made that’s calculated using the so-called life expectancy of the deceased plan owner, and not the primary beneficiary.
• Termination during beneficiary’s lifetime and assignment of plan. A conduit trust may provide for a termination while the primary beneficiary is still living. However, on termination, the primary beneficiary must receive complete control over the balance in the retirement plan without any other contingencies. It’s not always easy for a trustee to assign the balance in a retirement plan to the individual primary beneficiary. A conduit trust that provides for a terminating event should allow the trustee the flexibility to keep the trust going after the terminating event, in case there are difficulties assigning the retirement plan interest. Along those lines, it may be advisable to include a POA to ensure the primary beneficiary has dispositive control over a retirement plan interest that must continue in trust.
• Boilerplate provisions. The language in boilerplate provisions (for example, a spendthrift clause) should be reviewed carefully to ensure that there’s no language that would interfere with the distributions required to qualify the trust as a conduit trust under the MRD rules. There are also some helpful provisions to be added to the administrative provisions to support the function of any type of see-through trust (not just conduit trusts). For a more detailed discussion of boilerplate provisions, see “Sample Boilerplate Provisions,” on our website.
Special issues regarding boilerplate provisions may arise if recipients are described using terms such as “spouse” or “issue”:
a. Unnamed spouse. The safest approach is to avoid providing an interest for an individual’s “spouse” with no name or further qualification, because there’s no way of knowing with certainty whom the individual might be married to at the time of determination.
b. Adult adoptions. If interests are provided for a person’s issue or descendants with no further qualification, a similar question arises. Because it’s possible in many jurisdictions to adopt a person of any age, the safest approach is to draft the trust instrument in a way that doesn’t recognize an adoptee who’s older than his adoptive parent.
Gift to Second Tier Beneficiaries
In certain situations, a conduit trust isn’t an option because of the mandatory distributions that would result. The outright gift to second tier beneficiaries approach is an alternative to the conduit trust that may be appropriate when distributions to the current beneficiary must be limited in some way (for example, with a special needs trust or fully discretionary trust).
A trust designed using an outright gift to second tier beneficiaries approach will likely be either a fully discretionary trust or a special needs trust for the benefit of a single current beneficiary for life. At the death of the current beneficiary, the trust will terminate and be distributed free of trust to the remainder beneficiaries (the second tier beneficiaries).
It won’t be possible to exclude any second tier beneficiary from the pool of see-through trust beneficiaries because each has an interest that’s more than that of an MPS under the regulations. (Because the primary beneficiary’s interest in the trust is less than complete ownership of the assets, it follows that the remainder beneficiaries have more of an interest than just an MPS.)
Thus, we must consider the primary beneficiary and the second tier beneficiaries as part of the pool of see-through trust beneficiaries. However, if the third tier or more remote alternate beneficiaries are MPSs under the regulations, we can disregard all of them and limit the pool of see-through trust beneficiaries to a group that’s more manageable for purposes of analysis and drafting.
To exclude the third tier or more remote beneficiaries, it’s essential that the interests that may someday arise for each of the second tier or more remote beneficiaries must pass outright at that time, with no other contingencies. For example, the trust shouldn’t impose even a modest age contingency on any of these beneficiaries (such as an interest is held in trust until age 25).
This requirement highlights the primary disadvantage of the outright gift to second tier beneficiaries approach, which is that assets must pass outright to the second tier or more remote beneficiaries. Not only will the second tier beneficiaries not benefit from any continuing trust, but also, assets could fall into their laps at a young age.
One fact pattern in which this approach may be a good fit is when there are several adult children, one of whom requires a special needs trust. The outright gift to second tier beneficiaries trust is formed only for the special needs trust child, and the other children’s shares either pass outright or are structured as some other type of trust.
Case study. Madeleine has the same facts as Jane, except that Madeleine’s younger daughter, Gwyneth, has unique issues, and Madeleine has decided that Gwyneth’s share needs to be structured as a purely discretionary trust. (Madeleine will provide a conduit trust for her older daughter, Iris, in the manner discussed above.)
Drafting considerations. The need for a purely discretionary trust rules out the use of the conduit approach in this situation. Although Madeleine chose to provide a fully discretionary trust and not a special needs trust for Gwyneth, the outright gift to second tier beneficiaries approach will provide the same outcome under the MRD rules with either a discretionary or a special needs trust.
The following drafting issues assume that Madeleine has directed the remainder of Gwyneth’s trust to pass to Gwyneth’s descendants, if any, and otherwise to Madeleine’s older daughter, Iris or, if Iris isn’t then living, to Iris’ descendants. These interests would pass outright, with no contingencies or age requirements, except that the share for any taker who hasn’t attained age 21 would pass to a custodian under the UTMA.16
On Madeleine’s death, if Gwyneth and at least one of Gwyneth’s descendants are living at the time, the more remote tiers of beneficiaries (for example, Iris or Iris’ descendants) can be disregarded, and the pool of see-through trust beneficiaries will consist of Gwyneth and her descendants then living. However, if there’s no descendant of Gwyneth living on the determination date, then Iris becomes the second tier beneficiary (or if Iris isn’t then living or disclaims, Iris’ then-living descendants become the second tier beneficiaries), and the pool of see-through trust beneficiaries for Gwyneth’s discretionary trust will include Gwyneth and Iris (or Iris’ descendants, as the case may be). If Iris is included, her life expectancy will be the measuring life for determining MRDs for Gwyneth’s trust because Iris is the oldest daughter.
Here’s a short list of drafting issues I considered while developing my forms, which were used to draft “Sample Outright to Second Tier Beneficiary Subtrust,” on the Trusts & Estates website, at http://www.wealthmanagement.com/secondtier:
• POAs. In Madeleine’s situation, there’s no need to provide a POA over the younger daughter’s trust. However, if such a trust were to include a POA, the scope of permissible appointees are probably considered among the pool of see-through trust beneficiaries and would need to be carefully limited to ensure the intended outcome of qualifying the trust for MRDs over the oldest daughter’s life expectancy.
• Trust protector or independent trustee. Madeleine’s situation doesn’t necessarily call for a sophisticated trust that includes trust protectors, independent trustees and the like. However, if any sophisticated devices are included in the trust instrument, they should be reviewed carefully to ensure that any powers that could be used to alter the remainder beneficiaries or the permissible appointees under a POA are carefully limited to ensure the intended outcome of qualifying the trust for MRDs over the oldest daughter’s life expectancy.
• Remainder and contingent beneficiaries. Unlike the conduit trust described above, the drafter must be aware of the ages of the potential individuals who will be named as remainder and contingent beneficiaries and who could potentially be the second tier beneficiaries at the time the trust’s pool of see-through trust beneficiaries is determined. The ultimate success of the strategy will depend on the ages of the primary and second tier beneficiaries at Madeleine’s death (subject to disclaimers or other events, if any, that would be considered at the determination date).
• Alternate heirs. There’s always the possibility that none of the intended second tier beneficiaries will be living at Madeleine’s death. One solution is to include language in the alternate heirs provision that requires outright distribution of retirement plan interests and excludes any person or entity that doesn’t satisfy an age limit. However, this solution is broader than necessary because it only needs to apply if none of the intended second tier beneficiaries are living at Madeleine’s death. Section 2.5.3(b) of the “Sample Outright to Second Tier Beneficiary Subtrust” provides a narrower solution that only applies if needed.
Age Restriction Trust
There’s another alternative that may merit consideration when planning objectives preclude the use of either the conduit or outright gifts to second tier beneficiaries approaches.
Rather than relying on exceptions under the regulations to exclude certain beneficiaries, this approach simply drafts them out by applying age restrictions in the trust document.
Under the age restriction alternative, the trust provides all of the normal POAs and trusts for contingent and remainder beneficiaries but excludes any potential recipient who wouldn’t be recognized as being young enough under the MRD rules (that is, an individual born in a year prior to the target year, a trust that doesn’t qualify to use the life expectancy of an individual born no earlier than the “target year” or a charity, estate or other entity that doesn’t qualify to use a life expectancy).
This structure should, by definition, produce a pool of see-through trust beneficiaries that can’t have any member with a shorter life expectancy than the primary beneficiary. However, this approach must be considered very carefully, because it could produce arbitrary and unexpected results. For example, if three age restriction subtrusts are established for three children who were born a few years apart, the older children will be excluded as alternate beneficiaries under the youngest child’s subtrust. This problem could be avoided by using the oldest child’s age as the target in all three subtrusts, but other arbitrary problems could still occur if any of the remainder and alternate beneficiaries are on the wrong side of the target age.
There’s also some risk that the age restriction approach may not be effective in eliminating all dots who are older than the target age, because it’s, theoretically, possible that the trust could escheat to the state if all of the individuals who could possibly take under the trust predecease the determination date.
Case study. George presents the same facts as Jane, except that he expects that his youngest daughter, Olivia, won’t manage money well, so he wants to provide a discretionary trust for her. He also wants Olivia’s trust to include a POA. George doesn’t want the trusts for his children to mandate outright gifts at the death of a beneficiary. Thus, George will provide an age restriction trust for Olivia and a conduit trust for his oldest daughter, Ashley.
Drafting considerations. Here are some factors to consider:
• Choice of age for age restriction. If an age restriction is applied to Olivia’s trust based on her age, Ashley will be excluded as an heir of Olivia’s trust. This problem can be avoided by using Ashley’s age to set the age restriction. The trade-off is four less years of deferral. Many clients would likely approve this trade-off, and the “Sample Age Restriction Subtrust,” which appears on the Trusts & Estates website at http://www.wealthmanagement.com/agerestriction, is drafted accordingly.
• POAs. Any POA must also reflect the age restriction.
• Stretch-out plans only. The age restriction should be applied only to stretch-out retirement plan assets.
• Account for accumulations. I recommend requiring the trustee to account separately for stretch-out retirement plan assets (including accumulations in the trust from stretch-out retirement plan assets).
• Review all trustee powers. Any powers held by an independent trustee should be drafted carefully and limited to ensure they don’t interfere with the intended MRD outcome.
Last One Standing Approach
There’s one other approach that may be appropriate in certain cases: a trust designed so that it can’t pass to anyone outside a particular class of descendants. In addition, if only one member of the line of descendants is living, the trust terminates and is distributed outright to the sole remaining member of the class with no contingencies or age requirements, so that the successor beneficiaries are MPSs who can be disregarded under the regulations. Thus, the only dots in the circle are the members of the class of descendants, and the qualifying life expectancy for the see-through trust will be that of the oldest member of the class living at the time of determination because any future members of the class can be assumed to be younger. It’s important that the boilerplate provisions don’t recognize an adoptee who’s older than the adoptive parent as a “descendant,” as discussed in “Sample Boilerplate Provisions,” at http://www.wealthmanagement.com/boilerplate.
The last one standing approach has disadvantages that must be considered. Because the trust is limited to the class of descendants, any POA must be limited in the same way, which means that a beneficiary may not appoint in favor of the beneficiary’s spouse or other non-class members. Further, if the last remaining member of the class is very young, the termination of the trusts may result in loss of benefits the trusts are intended to provide, and assets falling into the lap of a young person may do serious damage. If the last remaining member of the class is disabled or has special needs, the consequences could be even worse. Thus, this approach isn’t the best alternative for Madeleine, who has a disabled daughter.
A client with plenty of assets and a large number of descendants may be more willing to tolerate these risks, because there are other assets that may not need to be restricted to stay in the class of descendants, and the probability of the class shrinking to one member may be perceived as being very low.
Case study. Mr. and Mrs. Johnson have four children, 16 grandchildren and two great-grandchildren, with more expected. They own a thriving family business, and many family members participate in the ownership and operation of the business. They would like to create dynasty trusts for their children and more remote descendants. Their assets include large retirement plans.
Drafting considerations. Here are some factors to consider.
• Define class. The Johnsons will have to decide how to define the class of descendants. In some families, the class might be defined with respect to the parents of either or both of Mr. and Mrs. Johnson. However, the Johnsons chose to limit the class to their own descendants, as reflected in the “Sample Last One Standing Subtrust,” which appears on the Trusts & Estates website at http://www.wealthmanagement.com/lastonestanding.
• Separate account treatment. No age restriction language is needed if the Johnsons are content to allow the oldest child’s life expectancy to govern all of the subtrusts. If separate account treatment is desired, however, the Johnsons will need to add an age restriction to each subtrust, which will significantly complicate the drafting. The “Sample Last One Standing Subtrust,” shows that the Johnsons decided against setting these different age restrictions.
• POAs—in general. Any POA needs to limit the class of permissible recipients to members of the class of descendants (further limited by the individual age restrictions if applicable), to minimize the risk of jeopardizing the outcome under the MRD rules.
• POAs—exempt trust. A limited POA with the descendants as permissible recipients will be appropriate for trusts that are exempt by reason of allocation of the GST tax exemption.
• POAs—non-exempt trusts. The document needs to allow for the possibility that “non-exempt” trusts will arise, and this requirement can be problematic due to the interaction of the MRDs rule and transfer tax requirements. A full treatment of this issue is outside the scope of this article, but here’s a short summary of the problem. Even if there are no retirement plan assets, the drafter of any dynastic-style trust needs to decide how to approach non-exempt trusts. Some drafters simply include a general POA (that is, the permissible recipients include one or more of the power holder’s creditors, estate or creditors of the estate). Other drafters limit the general POA in some way (for example, to that portion of the trust that would otherwise be subject to GST tax at the power holder’s death absent the POA). If retirement plan assets will be designated to the trust, stretch-out will be lost because the general POA adds unfavorable dots to the circle with no life expectancy. Possible alternatives to this dilemma include: (1) The Delaware tax trap approach that can cause inclusion if the power holder has the power to appoint to a new trust with a new perpetuities period, and (2) granting the primary beneficiary a right, during his life, to withdraw the entire principal of the trust (or the retirement portion, including accumulations), but only with the consent of a person who isn’t an adverse party within the meaning of IRC Section 2041(b)(1)(C)(ii). One or more non-adverse persons could be designated as independent trustees for purposes of providing (or not providing) this consent. The requirement of consent by a non-adverse party may reduce exposure to creditors in some states.
• Accumulation of exempt trusts. Note that a conduit trust would have been easier to draft (because the POAs don’t interfere with stretch-out), but the required conduit distributions would cause exempt assets to leak out of each exempt trust, which is counter to the multi-generational planning objectives in this case.
• Alternate heirs. The inclusion of alternate heirs may be superfluous because the trust terminates when only one member of the class remains.
Don’t forget that if a marital or bypass trust is to be designated as beneficiary of a retirement plan, it will probably need to be structured in one of the ways described above to preserve stretch-out over the surviving spouse’s life expectancy. There are many trade-offs to be considered, and as a general rule, the value of a retirement plan may be significantly compromised if it passes to a marital or bypass trust compared to a spousal rollover.
Another important consideration, although beyond the scope of this article, is the impact of income tax efficiency. Federal fiduciary income tax is applied at the top bracket on income in excess of roughly $12,000, along with the 3.8 percent Medicare surtax. Many trust beneficiaries will be in lower income tax brackets. Suffice it to say that if any sort of income could be accumulated in a trust, the first choice should be Roth IRA distributions, because they’re not subject to income tax or the Medicare surtax. The next choice should be other retirement plan distributions because they’re not subject to Medicare surtax and, if accumulated, won’t drive up the trust beneficiary’s adjusted gross income, possibly indirectly increasing the beneficiary’s Medicare surtax and overall income tax bracket. For these reasons, the conduit approach may be less attractive than in prior years.
1. Treasury Regulations Section 1.401(a)(9)-4, A-1.
2. Treas. Regs. Section 1.401(a)(9)-4, A-3.
3. Treas. Regs. Section 1.401(a)(9)-4, A-5.
4. Treas. Regs. Section 1.401(a)(9)-4, A-5.
5. Treas. Regs. Section 1.401(a)(9)-5, A-7, Example 2.
6. Treas. Regs. Section 1.401(a)(9)-4, A-1.
7. Treas. Regs. Section 1.401(a)(9)-4, A-4.
8. Treas. Regs. Section 1.401(a)(9)-4, A-6(b).
10. Treas. Regs. Sections 1.401(a)(9)-4, A-5(c) and 1.401(a)(9)-5, A-7(a)(1).
11. Treas. Regs. Section 1.401(a)(9)-5, A-7(c)(3), Example 2.
12. Treas. Regs. Section 1.401(a)(9)-5, A-7(c)(1).
14. Internal Revenue Code Section 2056(b)(5).
15. Treas. Regs. Section 20.2056(b)-5(f)(4).
16. I’ve wondered whether there are negative minimum required distribution (RMD) implications if the custodial account lasts longer than the age of majority (for example, a testamentary Uniform Transfer to Minor’s Act (UTMA) gift under California law can designate an age 25 termination date). I’m not aware of any case or ruling in which the Internal Revenue Service challenged the MRD implications of a UTMA designation, and I observe that UTMA designations to age 21 are commonly used by many practitioners, even when age of minority is younger. However, I suggest avoiding ages older than 21 in a jurisdiction (such as California) that allows an older age to be designated, in the absence of specific guidance on this question.