When a trust is to be the recipient of retirement plan assets and you want it to benefit from stretch-out, you're going to need to qualify that trust as a “see-through trust.”
Steven E. Trytten is a principal in First Foundation, Inc, in Irvine, Calif.
Who says procrastination is bad? If you own an interest in an IRA or retirement plan, you are likely to benefit if you can put off paying income tax as long as possible. In fact, if you play your cards right, you can set up your estate plan to give your heirs the option to keep the procrastination going. This type of arrangement is often called a “stretch-out.”
In tax-speak, a stretch-out is accomplished if the death beneficiary's life expectancy is allowed for the purpose of calculating required minimum distributions (RMDs) after the plan owner's death under Internal Revenue Code Section 401(a)(9) and the regulations thereunder.
The life expectancy of an individual death beneficiary is generally recognized in this way. Charities and estates are never recognized as having a life expectancy. Trusts are not recognized as having a life expectancy, either. But the life expectancy of a beneficiary of a trust may be recognized if, and only if, the trust meets a number of complicated requirements. Such a trust is often called a “see-through trust.”
Many clients designate individuals as primary beneficiaries, and the RMD rules for trusts may not seem applicable. But careful estate planning includes planning for contingent beneficiaries who may be minors, which may require a trust. Some clients must provide trusts due to specific circumstances. Other clients may opt for trusts to provide advantages to heirs that cannot be accomplished with an outright gift, for example, creditor protection or exempt status under the generation-skipping transfer (GST) tax rules. One way or another, if a trust might be designated to receive an interest in a plan, the RMD rules for trusts are required reading.
One of the most widely used approaches to qualifying a trust as a see-through trust is to include a provision in the trust that directs the trustee to distribute to the trust beneficiary any amounts the trustee withdraws from the plan. In other words, plan distributions may not accumulate in the trust, which makes the trust a conduit for directing plan distributions to the individual beneficiary. Such a trust is often called a “conduit trust.”
So, let's review the requirements for a trust to be see-through and examine how a conduit trust is drafted, and when it may be appropriate for planning.
The RMD rules effectively impose two steps of analysis when a trust has been designated as death beneficiary of a retirement plan account: Step one is to determine if the trust qualifies as a see-through. Step two is to determine who are the see-through beneficiary(ies).
Step One — Qualifying as a see-through trust — The term “DB” refers to a “designated beneficiary” within the meaning of the RMD rules (that is to say, a beneficiary who's recognized as having a life expectancy greater than zero). Individuals are generally recognized as DBs under the RMD rules.1 Charities, business entities, estates and trusts are not recognized as DBs.
But if a trust that has been designated as a death beneficiary meets certain requirements, the trust's beneficiaries are viewed as if they'd been designated outright.2 That's why such a trust is sometimes referred to as a see-through trust.
A trust's status as a see-through trust comes into play when determining the RMD requirements after the plan participant's death. Another scenario when this status matters is when a living participant wants to designate a trust for the benefit of a spouse who's more than 10 years younger than the participant, and to calculate lifetime RMDs based on actual joint life expectancies.
A trust is a see-through trust if it meets four threshold requirements:3
- It's valid under state law — The trust is a valid trust under state law, or would be but for the fact that there is no corpus. The final regulations specifically approve the use of testamentary trusts.4
- It's irrevocable — The trust is irrevocable or will, by its terms, become irrevocable upon the participant's death.
- Beneficiaries are identifiable — The beneficiaries of the trust who're beneficiaries with respect to the trust's interest in the participant's plan are “identifiable” from the trust instrument. “Identifiable” refers to general requirements that apply to any beneficiary designation.5 Under these requirements, an individual does not necessarily have to be specified by name so long as he is identifiable as of the date the DB is determined. In particular, members of a class that is capable of expansion or contraction will be treated as being identifiable if it's possible, as of the date the DB is determined, to identify the class member with the shortest life expectancy.
- Documentation is provided to the plan administrator — during the participant's lifetime: It's generally unnecessary to determine whether a trust is a see-through during the participant's lifetime (including the year of participant's death), and thus it is generally not necessary for a trust to satisfy the threshold documentation requirement prior to the participant's death.6 upon the death of participant: To satisfy the documentation requirement in connection with RMDs for years following the year of the participant's death, the trustee must provide the plan administrator with either:7 (a) a copy of the trust instrument as of the participant's date of death; or (b) 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” (Sept. 30 of the calendar year following year of death), 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 are satisfied. The trustee also must promise to provide a copy of the trust to the plan administrator upon demand.
In the context of post-death RMDs, the deadline for providing this documentation is Oct. 31 of the calendar year following the year of death (one month after the determination date of Sept. 30).8
Note that the consequence of failing to meet this deadline is that the trust will not meet the threshold requirements to be a see-through trust in any year of post-death distributions.
Note, too, that a plan will not be disqualified based on inaccurate documentation. In the context of maintaining a plan's qualified status, the regulations provide that a plan has not failed to comply with IRC Section 401(a)(9) if RMDs were too small only because the plan administrator relied on trust documentation.9 (However, the 50 percent excise tax imposed on a beneficiary that fails to take RMDs is calculated based on the actual shortfall, regardless of what the trust documentation may have provided.10)
Also note the regulations clarify that the “plan administrator” of an IRA is the IRA trustee, custodian, or issuer and not the IRA owner.11
So here's my drafting suggestion regarding the documentation requirement: Because the consequence of failing to comply with the documentation requirement is that the trust is precluded from qualifying as a see-through, and there is no known remedial procedure that can be followed if documentation is not submitted by the prescribed due date, I recommend including language in each trust instrument that reminds the trustee of the documentation requirement. (See “Steven E. Trytten's ‘Got Stretch-Out?' Supporting Documents”.)
Step Two — Identifying the see-through trust beneficiaries — If a trust meets the threshold requirements under the first step, it qualifies to have its RMDs calculated as if the “beneficiaries of the trust” (as this term is defined in the Treasury regulations) had been designated outright.12 These materials use the term “see-through trust beneficiary(ies)” to refer to these beneficiaries and the term “see-through trust” to refer to the trust.
Step Two is the determination of the see-through trust beneficiaries. Once these beneficiaries have been determined, the RMD rules can be applied to determine RMDs as if these beneficiaries had been designated outright. The RMDs so determined will, of course, be distributed to the see-through trust to be administered pursuant to its terms.
A quick review of the RMD rules is in order: When a participant dies before the participant's required beginning date (RBD), and assuming no spousal rollover:
- if the entire plan is designated to a DB, the measuring life for post-death RMDs is the DB's single life expectancy;13 or
- if the plan has no DB (for example, the plan was designated to an estate or a charity), no measuring life is allowed and the plan balance must be fully distributed by the end of the fifth calendar year following the year of death.
When a participant dies on or after RBD, and assuming no spousal rollover, the measuring life for post-death RMDs will be:
- if the entire plan is designated to a DB, the greater of the DB's single life expectancy or the participant's remaining life expectancy;14 or
- if the plan has no DB, the participant's remaining life expectancy.
When multiple beneficiaries have been designated in such a way as to create separate accounts for each that are recognized under the regulations,15 post-death RMDs may be determined on a share by share basis, with the likely result that some of the shares will benefit from longer life expectancies. Even if one beneficiary is not a DB, the other beneficiaries who are DBs will still be entitled to take post-death RMDs from their respective shares based on their respective life expectancies.
But if the designation of multiple beneficiaries does not create separate accounts that are recognized under the regulations, then: (1) if one or more of the beneficiaries is not a DB, the post-death RMDs for the entire plan must be determined as if the plan has no DB; or (2) if all of the beneficiaries are DBs, the post-death RMDs for the entire plan must be determined based on the life expectancy of the beneficiary with the shortest life expectancy.
In summary: under the RMD rules, the best outcome is generally obtained by accomplishing separate account treatment for each DB. When separate account treatment is not possible, it is important to keep non-DBs out of the “pool” of beneficiaries, and to generally keep that pool as small as possible to minimize the risk of a DB who is much older than the others. These maxims are particularly important with see-through trusts.
How much is at stake if “separate account” treatment is lost? If the difference in the ages of the various see-through trust beneficiaries is only a few years (for example, the traditional family with all of the children still living) the economic hit is not as much as one might think. But if there is a wide difference in age, the economic cost of losing “separate account” treatment is quite substantial. (See “Steven E. Trytten's ‘Got Stretch-Out?' Supporting Documents” in the online Trusts & Estates Bookstore & Library at www.trustandestates.com.)
See-Through Trust Beneficiaries
Up to this point, the RMD rules for trusts do not seem that difficult. Qualifying a trust as a see-through trust (Step One) is straightforward enough, and complying with the separate account rules is reasonably manageable. But we have not yet addressed the question: “Who are the see-through trust beneficiaries?” This short, simple question is the key to Pandora's box; it leads to a “Deferral in Wonderland” where nothing is as it seems.
The term “beneficiaries of the trust” is not defined in the regulations, although the term is provided in response to a question that uses the phrase “beneficiaries of the trust with respect to the trust's interest in the employee's benefit.” Thus, it is reasonable to conclude that a trust beneficiary whose interest is limited to non-plan assets is disregarded as a see-through trust beneficiary.
Example 1: Paul designates a see-through trust that provides a specific gift of a non-plan asset to George, and directs the balance of the trust to John. George may be disregarded — he is not a see-through trust beneficiary.
That's because any beneficiary entitled to current distribution of plan assets is a see-through trust beneficiary (that is to say, the trustee “shall” or “must” distribute).
Example 2: Paul designates a see-through trust directing that income shall be paid to George as long as he lives, and at George's death the balance shall pass to John. George is then a see-through trust beneficiary.
Example 3: Paul designates a see-through trust directing that trust distributions shall be paid to George if his other resources are not enough to satisfy a certain standard, such as health, education, or support, for as long as he lives. At George's death, the balance shall pass to John. George is a see-through trust beneficiary.
Similarly, any beneficiary who is a permissible recipient of current distributions of plan assets is a see-through trust beneficiary (for example, the trustee “may” distribute).
Example 4: Paul designates a see-through trust that provides the trustee with broad discretion to make or not make distributions to George during George's lifetime, and at George's death the balance shall pass to John. George is a see-through trust beneficiary.
What about John in all these examples? John also is a see-through trust beneficiary. The regulations provide a rule for determining when successor trust beneficiaries are counted in the pool of see-through trust beneficiaries, and when they are not. This rule was changed with the release of final regulations:
Rule under the proposed regulations — The rule under the 1987 and 2001 proposed regulations included all successor beneficiaries in the pool of see-through trust beneficiaries subject to one exception: A successor beneficiary was excluded if his entitlement would arise only if another beneficiary dies before receiving the entire benefit to which that other beneficiary is entitled.16
Rule under the final regulations — The final regulations narrow this exception by providing that a successor beneficiary may not be excluded if he has any right (including a contingent right) to a plan interest “beyond being a mere potential successor” to the interest of another beneficiary upon that other beneficiary's death.17 The examples in the regulations are not very helpful in explaining this provision. Subsequent private letter rulings have shed a little light on the Internal Revenue Service's thinking.18 But the meaning of the “mere potential successor” concept remains far from clear.
Here's my interpretation of how the “mere potential successor” rule would work in connection with a type of trust commonly requested by clients:
Example 5: Paul designates his IRA in two equal shares to two see-through trusts for his two children, Elaine and Linda. Each trust provides for distributions to the child of income and principal as needed for health, education, or support until the child attains 35 years of age, at which time the child's trust terminates. (Upon termination, any remaining IRA interest would be “assigned” to the child without accelerating recognition of income.19) If a child dies before reaching age 35, her trust passes to similar trusts for the child's living descendants or, if none, to a similar trust for the other child (or her descendants) or, if none, free of trust to Paul's heirs at law.
The pool of see-through trust beneficiaries is determined on the date of Paul's death, subject to certain post-mortem planning completed prior to the Sept. 30 determination date following Paul's death.
Each child who is living and has attained age 35 as of Paul's death, and who has not accomplished a qualified disclaimer of her share prior to the determination date, will be the only see-through trust beneficiary of her trust. Any contingent beneficiaries are excluded as “mere potential successors,” because the child is entitled to full distribution of her share of the IRA from the trust with no contingencies.
Who would be a see-through trust beneficiary of Elaine's see-through trust if Elaine has not attained 35 years of age at Paul's death?
My analysis is:
Query: Is Elaine a see-through trust beneficiary of Elaine's see-through trust? Answer: Yes.
Query: If Elaine has living descendants as of the determination date, are they counted as see-through trust beneficiaries of Elaine's see-through trust? Answer: Yes, but … it is not likely to shorten the stretch-out, because the descendants are likely to be younger than Elaine (the only way this would not be true would be if Elaine legally adopted an older person). This discussion assumes that all descendants are younger than their parents or more remote ancestors. We already know that Elaine is not yet 35, so we also know that none of her descendants have attained age 35.
Under the proposed regulations, I thought that Elaine's descendants were not see-through trust beneficiaries, because they were entitled to a portion of the plan only if Elaine died before the entire benefit was distributed to her. I and others interpreted the proposed regulations as allowing an implicit assumption that Elaine would live to a normal life expectancy and therefore would receive the entire benefit.
Under the final regulations, Elaine's descendants are see-through trust beneficiaries, because the interest each might receive if Elaine died would continue in trust until the descendant attains 35 years of age. In other words, there are two contingencies: a survivorship requirement and an age restriction.
Any basis for making the implicit assumption that Elaine will live to life expectancy and receive the entire benefit is clearly absent in the final regulations. Perhaps this type of assumption was not a correct interpretation of the proposed regulations, either, as suggested by a 2002 private letter ruling that includes contingent beneficiaries in the pool of see-through trust beneficiaries even though the primary beneficiaries were to receive full distribution upon reaching age 30.20
Query: Is Linda a see-through trust beneficiary of Elaine's see-through trust? Answer: Yes. The analysis under the final regulations is complicated:
- If Elaine and Linda are both under age 35 at Paul's death, and if Elaine does not have any living descendants as of the determination date, Linda is counted as a see-through trust beneficiary under the final regulations for the same reasons that Elaine's descendants would have been counted (that is to say, Elaine has to die and Linda has to live to age 35). As a result, Linda's older life will govern RMDs on her younger sister's see-through trust even though the designation creates separate accounts.
- If Elaine is under age 35, Linda has attained age 35 as of Paul's death, and Elaine has no descendants, now can Linda can be excluded as a mere potential successor? No, she must be counted as a see-through trust beneficiary. But any contingent beneficiaries who would follow Linda can be excluded, because Linda would receive her interest outright with no other contingencies.
- If Elaine is under age 35, Linda has attained age 35, and Elaine has living descendants, is Linda a see-through trust beneficiary of Elaine's see-through trust? Yes, she must be counted, but any contingent beneficiaries who would follow Linda can be excluded.
Query: Are Linda's descendants see-through trust beneficiaries? Answer: It depends. Under the proposed regulations, I thought that Linda's descendants would not be see-through trust beneficiaries for the reasons I've already enunciated. Under the final regulations, however, it depends on Linda's age at the determination date. If Linda has attained 35 years of age, her descendants can be disregarded under the final regulations because they truly have a “mere survivorship interest.” But if Linda has not attained 35 years of age as of the determination date, then her descendants are see-through trust beneficiaries under the final regulations. Fortunately, they are likely to be younger than either of the children.
Query: Must Paul's heirs at law be counted as see-through trust beneficiaries? Answer: It depends. Under the proposed regulations, I thought that Paul's heirs at law would not have been counted for the reasons already given. Under the final regulations, it depends on whether Linda has attained 35 years of age. If she has, the fact that she would receive her interest outright with no other contingencies allows any contingent beneficiaries after her to be excluded as see-through trust beneficiaries. If Linda has not attained 35 years of age, all of the contingents after her, including Paul's heirs at law, must be included in the pool of see-through trust beneficiaries, which is bad news, because there is a significant chance that the oldest member of the pool will be quite a bit older than the children, resulting in a shorter deferral period.
Why are the rules for trusts so difficult? Based on several informal conversations with Marjorie Hoffman, principal draftsperson of the proposed and final regulations, I understand that the Treasury is very concerned that plan participants will use trusts as vehicles to take undue advantage under the RMD rules. Specifically, the Treasury worries that a younger person's life expectancy will be used to accomplish stretched-out deferral of plan assets that eventually will benefit an older beneficiary. Although I do not share this view, it at least explains why the regulations focus on whether a contingent beneficiary has any interest beyond that of a “mere potential successor.”
It is interesting, however, that by extending special treatment to “conduit trusts” the Treasury is willing to ignore accumulation for the possible benefit of older successor beneficiaries if the accumulation is occurring inside a plan. If the same accumulation occurs outside the plan and in the trust, the older successor beneficiaries will probably be included in the pool of see-through trust beneficiaries.
The IRS has hinted that the participant's estate (which would never be recognized as having a life expectancy) might be viewed as a see-through trust beneficiary if the see-through trust requires or allows plan assets to be applied to satisfy general debts, expenses and tax obligations arising at the participant's death.21 Proactive drafting can go a long way to reduce the risk of this attack, but special care is always advisable when tinkering with general language apportioning debts, expenses and taxes.
The simplest drafting approach would be simply to forbid the trustee from applying plan assets to pay general debts, expenses and tax obligations. But I'm concerned that this approach is too broad and could lead to administrative difficulties and economic distortions among beneficiaries.
That kind of damage is less likely with another simple drafting approach: Limit the trustee's power to apply plan assets to pay general debts, expenses and tax obligations to those that are properly chargeable to the plan assets. One would think that the IRS would recognize the logic that this is not the same as including the estate as a see-through trust beneficiary. But experience tells us that neither the IRS nor the RMD rules can be counted on to produce the most logical result. Still, the IRS has left a clue as to what it would accept in the post-mortem rules that allow certain post-mortem planning to eliminate certain beneficiaries by a determination date of Sept. 30 of the calendar year following the year of death.22
Accordingly, I suggest a more complicated drafting approach that incorporates the post-mortem planning rules by requiring amounts that are properly chargeable to plan assets to be paid prior to the Sept. 30 determination date provided in the regulations. Of course, it may not be possible to determine all such amounts with certainty by the determination date, and the clause will need to provide guidance on how these amounts are to be handled. (See “Steven E. Trytten's ‘Got Stretch-Out?' Supporting Documents” in the online Trusts & Estates Bookstore & Library at www.trustandestates.com.)
Special problems may arise if recipients are described using terms such as “spouse” or “issue.” If a contingent interest is provided for a person's “spouse” with no name or further qualification, there is no way of knowing with certainty who that spouse will be and what his or her age will be at the time the interest vests. Thus, if the contingent interest to “spouse” is not disregarded as a “mere potential successor,” the trust is likely to be treated as not having an identifiable life expectancy.
If interests are provided for a person's issue or descendants with no further qualification, a similar question arises. Because it may be possible in many jurisdictions to adopt a person of any age, this could also cause the trust to be treated as not having an identifiable life expectancy. Two PLRs that addressed trusts providing for a person and then the person's descendants ruled that the trusts qualified to use the person's life expectancy, without raising this question about adoption.23 Nevertheless, the safest approach is to draft the trust instrument in a way that limits the scope of adoptees who are considered to be descendants (assuming this is consistent with the client's dispositive wishes).
If a trust provides a beneficiary with a testamentary power of appointment that could be used to appoint plan assets, are the permissible appointees also see-through trust beneficiaries? The RMD rules are silent, and a number of PLRs have been promulgated with respect to trusts that included powers of appointment without analyzing this issue.
A group of PLRs were issued back in August of 2002 analyzing trusts as IRA beneficiaries under the final regulations.24 These rulings appear favorable, but leave too many questions unanswered to be of much use.
The rulings pertain to the same fact pattern, in which subtrusts were established for a decedent's three children. Each child's subtrust was recognized as having the oldest child's life expectancy under the final regulations, even though it was not a conduit trust. Each child's subtrust provided distributions to the child of income, and of principal subject to an ascertainable standard. Each child's subtrust also provided the child with a testamentary power of appointment that limited the class of permissible appointees to those who are not older than the oldest child.
Based on these facts, the IRS ruled that the oldest see-through trust beneficiary of each subtrust was the decedent's oldest child. The rulings do not identify the takers in default if the power of appointment is not exercised with respect to any of the subtrusts, and do not analyze whether those takers in default should be included in the pool of see-through trust beneficiaries for each subtrust. Also, although the rulings mention the limited class of permissible appointees under the power of appointment in each subtrust, the rulings do not analyze whether the permissible appointees are treated as see-through trust beneficiaries of any of the subtrusts.
I caution that the reasoning in these rulings is incomplete; it is unwise to rely on them.
So what are we to do?
Most commentators who have addressed this issue conclude that the permissible appointees under a power of appointment (testamentary or otherwise) are included among the pool of see-through trust beneficiaries.25 This view is consistent with the Treasury's concern that a trust should not be allowed to take RMDs based on one trust beneficiary's life expectancy if it is possible to accumulate them and ultimately distribute them to another, older trust beneficiary.
Fortunately, a conduit trust is allowed to disregard any see-through trust beneficiaries other than the primary beneficiary who will be receiving conduit distributions. Thus, a testamentary power of appointment may be included in the conduit trust without risk of jeopardizing the conduit trust's ability to use the primary beneficiary's life expectancy for RMD purposes.
If a power of appointment (testamentary or otherwise) is included in a non-conduit trust, the safest course is to assume that all of the permissible appointees under the power of appointment will be included among the pool of see-through trust beneficiaries.
The inclusion of permissible appointees among the pool of see-through trust beneficiaries can cause problems for a non-conduit trust: If the scope of permissible appointees is not limited in some way, the class of permissible appointees either may include a specific recipient with little or no life expectancy, or may be so broad that it's difficult or impossible to determine which recipient has the shortest life expectancy.
One possible solution is to limit the permissible appointees to those who are not older than the “target” see-through trust beneficiary. But that solution could create other problems in interpreting and administering the non-conduit trust, and potentially could distort the economic outcome among the various beneficiaries and recipients. These problems may be partially mitigated if the age limitation is imposed only with respect to “stretch-out retirement assets.”
If an age limitation is to be applied to only “stretch-out retirement assets,” the age limitation must be drafted to apply to both the assets in the stretch-out retirement plan, and any assets that have been distributed from the stretch-out retirement plan and accumulated in the trust. It may be helpful to direct the trustee to account separately for accumulations of stretch-out retirement plan assets.
Some standard clauses granting powers of appointment include charities as permissible appointees. Charities are not recognized under the RMD rules as having a life expectancy, and the non-conduit trust will be treated as having no life expectancy if a charity is included among the see-through trust beneficiaries.
Similarly, if the power of appointment is intended to function as a “general” power of appointment within the meaning of IRC Section 2041 (a common drafting technique with respect to certain marital trusts and trusts that are not anticipated to receive an allocation of GST tax exemption), a standard clause normally will include one or more of the power holder's creditors, estate or creditors of the power holder's estate. If any of these are included among the pool of see-through trust beneficiaries, the non-conduit trust will be treated as having no life expectancy. (Experienced drafters know that it's not impossible to draft a general power of appointment in a non-conduit trust that does not include the power holder's creditors, estate, or creditor's of the estate as permissible appointees, but the drafting techniques involved are beyond the scope of this article.)
This type of problem also can arise if a power of appointment allows an appointment in further trust. The regulations provide that if another trust is a beneficiary of the trust, the other trust's beneficiaries must also be considered in determining the qualification of the trust.26 Thus, the power of appointment should either prohibit appointments in further trust altogether, or should limit permissible trust recipients to trusts that will not jeopardize the primary trust's qualification under the RMD rules (for example, conduit trusts or other trusts that have no life expectancy older than the “target” life expectancy).
As mentioned, a trust must meet certain threshold requirements for the trust to be a see-through trust.27 These requirements must normally be satisfied on the determination date (Sept. 30 of the calendar year following the year of the plan owner's death). Specifically, the trust then must be a valid trust, must be irrevocable, and must provide certain documentation to the plan administrator no later than Oct. 31 of the calendar year following the death of the plan owner.28 Must these requirements be met for purposes of determining the beneficiaries of a trust that is a permissible appointee under a power of appointment? I am not aware of any authority that addresses this question, but doubt that these requirements would apply in such a literal manner. If they did, it would rarely be possible for any trust to be recognized as having a life expectancy if it might someday pass to another trust.
Remember that if the permissible appointees under a power of appointment include a person's “spouse” with no further qualification or a person's issue or descendants with no further age qualification, there could be problems, as I noted earlier.
Some trust instruments authorize a trust protector or independent trustee to modify powers of appointment. Any such power should be limited so that it cannot be used to add permissible appointees to a power of appointment over retirement assets (including accumulations).
The minority view is that permissible appointees are not included in the pool of DB beneficiaries. Although I recommend that practitioners follow the majority view, it could be argued that a power of appointment is better viewed as an enhancement of the interest provided to the see-through trust beneficiary who holds the power of appointment. As such, the power of appointment should not be viewed as creating beneficial interests in the permissible appointees prior to an effective exercise of the power. Therefore, a person should not be considered a see-through trust beneficiary solely because that person is a permissible appointee under a power of appointment. Notice 97-49 supports this conclusion, but in the context of electing small business trusts under IRC Section 1361, stating:29 “The term ‘beneficiary' does not include a person in whose favor a power of appointment could be exercised. Such a person becomes a beneficiary only when the holder of the power of appointment actually exercises the power of appointment in such person's favor.”
If the provisions of a trust are such that the creditors of a beneficiary could attach all or a portion of the trust, must these potential creditors be included in the pool of see-through trust beneficiaries? I am not aware of any authority that has addressed this issue.
The conduit trust distribution approach, which is specifically blessed in the regulations, could lead to attachment by creditors of the amounts that must be distributed under the conduit clause under the laws of many states. One could argue that this potential creditor problem must not be an issue under the RMD rules for trusts because the regulations have specifically approved the conduit trust without any discussion of creditor issues.
But I warn you that the RMD rules were generally written by employee benefits specialists. As a result, these rules fail to adequately address numerous estate-planning concepts. So, it would be wise to draft any trust that is not a conduit trust in a way that will not result in exposing the trust to creditors.
The Conduit Trust
Some sort of special drafting is likely to be needed to qualify a trust as a see-through trust. There are a number of different drafting approaches, each with different advantages and disadvantages, and there is no one drafting approach appropriate for all clients:
One approach is the conduit trust, which I suggest is a good default choice in many cases, because it (1) is less complicated than most of the alternatives; (2) does not limit the drafting of powers of appointment or provisions for remainder beneficiaries; and (3) is a reliable “safe harbor” under the RMD regulations.
Of course, there will be cases in which a conduit trust must be ruled out (for example, a special needs trust that cannot mandate conduit distributions). There also will be clients with more ambitious planning objectives who'll appreciate considering the pros and cons of other alternatives (for example, a dynasty trust).
But for those who choose the conduit trust, there is a certain degree of safety. The regulations specifically provide that when a trust requires all distributions taken from the plan during the primary beneficiary's lifetime to be distributed 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.30 Although the term “conduit trust” does not 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 as “mere potential successors,” because the primary beneficiary is entitled to all plan distributions while living. This interpretation seems inconsistent with the narrow provisions of the “mere potential successor” rule — but I choose not to look a gift horse in the mouth.
Conduit Trust Pros and Cons
When a client is designating a retirement plan interest for an individual heir and considering a conduit trust, be aware that the primary disadvantage of the conduit trust is that plan distributions must be passed to the beneficiary, whether it's in the beneficiary's best interest or not. Fortunately, for younger beneficiaries these distributions are likely to be a very small percentage of the plan balance. It also may be possible to apply the distributions to costs that would otherwise be paid from other sources. This disadvantage seems a small price to pay in return for certainty under the RMD rules.
But decide for yourself. Here, more specifically, are the conduit trust advantages and disadvantages:
Of the various types of trusts that could be drafted to hold a retirement plan interest for the benefit of an individual heir and to accomplish stretch-out minimum distributions over the individual heir's life expectancy, the conduit trust is probably the least complex to draft and most certain to comply with RMD rules.
Multiple conduit trusts may qualify for the separate account rule so long as the death beneficiary designation directs the division of the plan into separate accounts.
The primary disadvantage of the conduit trust is that the amounts of all distributions from the retirement plan (RMDs plus any other distributions) to the trust must be distributed from the trust to the individual, regardless of whether she wants to receive them, subject to possible planning alternatives.
The actual RMDs for a young individual will be very small. 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 (or even less, depending on planning alternatives).
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).
Distributions also can 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 RMD 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 RMD rule context, but there is favorable authority in the context of the marital deduction for estate tax. A marital deduction is allowed under IRC Section 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 her life.31 Treasury regulations provide that a trustee's power to apply income for the benefit of the spouse is a permissible administrative power that will not disqualify the marital deduction, provided that the overall terms of the instrument are such that the local courts will impose reasonable limitations upon the exercise of the powers.32
If a person with an obligation to support the individual beneficiary may be serving as trustee, the trust should be drafted to avoid providing that person with discretionary powers that would cause tax problems. In particular, the trustee's power to take distributions from the retirement plan may need to be limited. (See “Steven F. Trytten's ‘Got Stretch-Out? Supporting Documents” in the online Trusts & Estates Bookstore & Library at www.trustandestates.com.)
The funds that actually reach the young beneficiary may be less than the amounts 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 retirement plan.
Paying the plan's investment management fees from non-retirement assets may or may not provide a better overall financial outcome.
Financial institutions often do not understand trusts or other concepts that deviate from their standard death beneficiary designation form. As a general rule, any time that retirement plans are designated to trusts, allowance should be made for additional paperwork and coordination with the financial institution to get the trust's inherited account set up properly.
A conduit trust may provide for a termination while the primary beneficiary is still living, for example at a specified age. But, upon termination, the primary beneficiary must receive complete control over the balance in the retirement plan without any other contingencies. It is not always easy for a trustee to “assign” the balance in a retirement plan to an 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 power of appointment to ensure the primary beneficiary has dispositive control over a retirement plan interest that must continue in trust.
A trust's interest in a qualified retirement plan may not necessarily be assignable to the trust's beneficiary due to anti-alienation requirements of ERISA and the plan document. IRAs are not subject to these anti-alienation requirements, but some financial institutions resist the notion that a trust can transfer its interest in an IRA to an individual beneficiary without causing a taxable distribution at the time the trust terminates, or at such time as the trustee may choose to distribute the IRA interest. Of course, if one financial institution does not cooperate, the trustee has the power to move the inherited IRA to another financial institution.
Conduit Trust Drafting
Drafting a good conduit clause requires more time and thought than one might initially expect. Here is a sampling of some of the drafting issues I've considered while drafting the forms that can be found online at “Steven F. Trytten's ‘Got Stretch-Out?' Supporting Documents” in the online Trusts & Estates Bookstore & Library at www.trustandestates.com.
Subtrust versus standalone trust — The trusts for children could be structured as subtrusts under a common revocable trust or will, or as a dedicated “stand-alone” trust instrument. The subtrust approach is adequate for many clients. The stand-alone approach may be worthwhile for certain clients who want the planning that has been done for retirement assets to stand out in the form of a separate document. This may be helpful to fiduciaries, beneficiaries and advisors who may be juggling many different issues during a death administration.
“Double-duty” trust — It's possible to draft two different sets of subtrusts, one for retirement plan assets and the other for non-retirement assets, but it's probably not necessary to do so with a conduit trust. One set of “double-duty” subtrusts will work just fine for most clients. Note that the subtrusts must be drafted to include language coordinating the “conduit” distribution provisions and the distribution provisions that apply to other assets.
May be confusing to the uninitiated — The conduit clause may be confusing to clients, trust officers or advisors who are not 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 clear the distinction between the beneficiary of the plan versus the beneficiary of the trust.
Need to define “stretch-out” plan — It's not enough to provide that all plan distributions be distributed to the trust beneficiary. 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 might be. Thus, the term “stretch-out retirement account” is defined to effectively exclude from the scope of the conduit clause any plan that cannot 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 RMD rules and must use the life expectancy of the oldest conduit trust beneficiary.
Chicken and egg — I've added a phrase to address the “chicken and egg” relationship between the sentence that defines “stretch-out retirement account” and the conduit distribution clause (for example, the conduit distribution clause does not 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).
Only applies to primary beneficiaries — Conduit distributions are required only as long as the primary beneficiary is alive. If the conduit provision does not 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 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 does not somehow create an obligation that extends beyond the trust termination.
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. 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 provision 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.
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. But in certain circumstances, a trustee may need to apply plan assets to pay estate or 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 clarifies that the trustee may pay the portion of these items chargeable to the plan assets, and shall distribute the “net” remaining to the trust beneficiary. The example in the final regulations does not address these issues, and I'm not aware of any authority that specifically sanctions this approach. But I believe it would be irresponsible to draft a conduit clause that did not address payment of these items. I've 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. For further discussion of payment of death taxes, including a “pay by Sept. 30” requirement, see “Steven E. Trytten's ‘Got Stretch-Out?' Supporting Documents” in the online Trusts & Estates Bookstore & Library at www.trustandestates.com.
Clarify trustee's authority to take plan distributions — Because 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 is effectively a general power of appointment into the hands of a tax-sensitive trustee. Three possible tax-sensitive trustees are addressed: (1) an individual who has made a disclaimer; (2) an individual subject to a legal obligation to support the beneficiary; and (3) the 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 RMDs 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 my hypothetical trust should work well for most clients, but certain clients may prefer more restrictive language (for example, the trustee may take only minimum distributions).
RMDs in the year of the participant/owner's death — The language I've used 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 is no confusion if, in the year of the plan owner's death, a minimum distribution remains to be made that is calculated using the so-called life expectancy of the deceased plan owner, and not the primary beneficiary.
The IRS has left so many important questions unanswered as to how the RMD rules apply to trusts, that the conduit trust — a structure few, if any, clients would otherwise desire — has become the default approach to drafting see-through trusts because it is less uncertain than any other method. Hopefully, the Service will provide more meaningful guidance in the near future in the form of a published ruling that answers the questions that have made drafting see-through trusts so uncertain.
- Treasury Regulations Section 1.401(a)(9)-4, A 3.
- Treas. Regs. Section 1.401(a)(9)-4, A 5.
- Treas. Regs. Section 1.401(a)(9)-5, A 7, Example 2.
- Treas. Regs. Section 1.401(a)(9)-4, A 1.
- But there is one scenario in which these issues arise and documentation is required. This scenario arises when: (a) the participant's spouse is more than 10 years younger than the participant; (b) the participant has designated a see-through trust for a spouse rather than designating the spouse individually; and (c) the participant seeks to calculate lifetime required minimum distributions (RMDs) based on the actual joint life expectancy of the participant and the spouse, rather than the Uniform Table. When this situation arises, a documentation requirement applies. To satisfy this requirement, the participant must provide the plan administrator with either: (a) a copy of the trust instrument, accompanied by the participant's promise that whenever the trust is amended the participant will provide the plan administrator with a copy of the amendment within a reasonable time; or (b) a list of all of the beneficiaries of the trust (including contingent and remainder beneficiaries with a description of the conditions on their entitlement sufficient to establish that the spouse is the sole beneficiary) for purposes of Internal Revenue Code Section 401(a)(9). The italicized language was added by the final regulations. The list must be accompanied by the participant's certification that, to the best of the participant's knowledge, the list is correct and complete and that the other requirements noted here are satisfied. It also needs to be accompanied by the participant's promise that, whenever the trust is amended the participant will provide the plan administrator with an updated list and, if applicable, an updated certification. The participant also must promise to provide a copy of the trust to the plan administrator upon demand. The regulations do not provide a time deadline for providing this documentation in the context of lifetime RMDs. I recommend that the documentation be submitted prior to the participant's required beginning date or as soon as possible thereafter. It's doubtful that the young spouse's life expectancy in this situation may be considered in any RMD year if the documentation requirement has not been satisfied by the beginning of that year.
- Treas. Regs. Section 1.401(a)(9)-4, A 6(b).
- Treas. Regs. Section 1.401(a)(9)-4, A 6(c)(1).
- Treas. Regs. Section 1.401(a)(9)-4, A 6(c)(2).
- Treas. Regs. Section 1.408-8, A 1(b).
- Treas. Regs. Section 1.401(a)(9)-4, A 5(a).
- Except in the special case when participant dies prior to required beginning date and designates the spouse, and the spouse does not elect a spousal rollover. See Treas. Regs. Section 1.401(a)(9)-3, A 3(b).
- Treas. Regs. Section 1.401(a)(9)-5, A 5(a)(1).
- Treas. Regs. Section 1.401(a)(9)-8, A-2(a)(2).
- 2001 Proposed Treas. Regs. Section 1.405(a)(9)-5, A 7(c).
- Treas. Regs Section 1.401(a)(9)-5, A 7(c).
- Private Letter Rulings 2004-38-044, 2005-22-012 and 2006-10-026.
- IRC Section 691(a)(2).
- PLR 2002-28-025.
- PLR 98-20-021.
- Treas. Regs. Section 1.401(a)(9)-4, A-4(a).
- PLRs 1999-03-050 and 1999-18-065.
- PLRs 2002-35-038 through 041.
- See, for example, Natalie B. Choate, Life and Death Planning for Retirement Benefits, 6th ed. (2006), Ataxplan Publications, Section 6.3.09; or Marcia Chadwick Holt, Estate Planning for Retirement, 1st ed. (2007), Bradford Publishing Company, Section 9.8.
- Treas. Regs. Section 1.401(a)(9)-4, A-5(d).
- Treas. Regs. Section 1.401(a)(9)-4, A 5.
- Treas. Regs. Section 1.401(a)(9)-4, A 6(b).
- 1997-2 C.B. 304.
- Treas. Regs. Section 1.401(a)(9)-5, A 7(c)(3), Example 2.
- IRC Section 2056(b)(5).
- Treas. Regs. Section 20.2056(b)-5(f)(4).
Steven E. Trytten is a partner at Anglin, Flewelling, Rasmussen, Campbell & Trytten LLP in Pasadena, Calif.