How to make direct transfers to the beneficiaries.
When a decedent’s individual retirement account is payable to a trust under an IRA’s beneficiary designation, the day may come for the trust to distribute all of its interest in that IRA to the trust’s beneficiaries. When it does, custodians should routinely allow direct transfers to inherited IRAs set up for the benefit of each trust beneficiary entitled to receive a portion of the trust’s inherited IRA. It’s mystifying that some won’t.
Although trusts are recognized as entities for purposes of the Internal Revenue Code and are treated as U.S. persons,1 the IRC doesn’t fix rights to trust property. Applicable trust law does.
Uniform Trust Code
The Uniform Trust Code (UTC), as adopted by many states, defines “trust instrument” to mean an instrument executed by the settlor that contains a trust’s terms, including any amendments. It further provides that ...“[t]he common law of trusts and principles of equity supplement this [Code], except to the extent modified by this [Code] or another statute of this State.”2
For example, in California, “trust” means “an express trust, private or charitable, with additions thereto, wherever and however created, including a trust created or determined under a judgment or decree under which the trust is to be administered in the manner of an express trust.”3
Trustees must administer trusts solely in the interests of the beneficiaries and owe the beneficiaries a duty of loyalty.4
The UTC defines “beneficiary” to mean a person that either has a present or future beneficial interest in a trust, vested, or that holds a power of appointment over trust property in a capacity other than that of trustee.5
Ownership of property has been described as a collection of rights akin to a bundle of sticks. “A common idiom describes property as a ‘bundle of sticks’—a collection of individual rights which, in certain combinations, constitute property.”6
Beneficiaries
Trustees hold property subject to the terms of a trust to be managed by one or more trustees for the exclusive benefit of the trust’s beneficiaries. Equitable ownership of trust property is always in the trust’s vested beneficiaries, even though property is titled in the name of the trust. Thus, it can’t accurately be said that a trust “owns” property without adding “for the benefit of the trust’s beneficiaries.”
When a trust is named as beneficiary of an IRA, the trustee of that trust must hold and administer the inherited IRA exclusively for the benefit of the trust’s beneficiaries. The trustee is entitled to no part of the trust’s inherited IRA. When the trustee relinquishes control over trust property by transferring property to trust beneficiaries, a change in title occurs. But, the trust’s beneficiaries were, in effect, the inherited IRA’s beneficiaries all along. For that reason, there’s no reason for an IRA custodian to be uncomfortable with direct transfers from the trust’s inherited IRA to inherited IRAs held for the benefit of the trust’s beneficiaries. In that regard, representations made by the trustee should be acceptable.
Procedures
Before making a transfer of inherited IRA assets to inherited IRAs of trust beneficiaries, the trustee may wish to document that the trustee is transferring all beneficial interest in the IRA to the trust’s beneficiaries, specifying the portion transferred to each beneficiary. As a result of that action, the trust beneficiaries become entitled to all future IRA distributions and thus become the persons for whose benefit the inherited IRA is maintained or held.
Before proceeding further, confirm that the IRA custodian will allow the transfers to take place in accordance with the letter of instruction. If the IRA custodian won’t cooperate, consider moving the trust’s inherited IRA to an IRA custodian who’ll cooperate.
Next, each trust beneficiary should establish a separate inherited IRA to receive funds from the trust’s inherited IRA.
Finally, the trustee should make direct trustee-to-trustee transfers to the inherited IRAs of the trust’s beneficiaries. Revenue Ruling 78-406 generally permits trustee-to-trustee IRA transfers, “even if the transfer is at the behest of the IRA owner or beneficiary.” (Emphasis added.) Such transfers are distinguished from rollover contributions. The assets of a transferor IRA are transferred directly to a transferee IRA without the occurrence of any taxable IRA distribution. The transferee IRA is held for the benefit of the same trust beneficiary for whose benefit the trust held the transferor IRA.
There’s no consequent change of beneficial interest in a trust’s inherited IRA when its property is transferred, in a trustee-to-trustee IRA transfer, from the trust’s inherited IRA to one or more new inherited IRAs titled in the name of the decedent for the benefit of the trust beneficiaries in whose favor the fiduciary’s IRA interest terminates. For this reason, such a transfer is entirely within the purview of Rev. Rul. 78-406.
Note that the Internal Revenue Service’s own statements in the instructions to Forms 1099-R and 5498 specifically state that an IRA-to-IRA transfer isn’t a distribution and isn’t reportable to the IRS.
Although Rev. Rul. 78-406 didn’t involve an inherited IRA, the IRS has relied on it in private letter rulings granting direct transfers from trust-held inherited IRAs to inherited IRAs of trust beneficiaries.7 Although PLRs may not be used or cited as precedent, they may be used to establish the reasonable cause from the substantial understatement penalty.8 In addition, the U.S. Supreme Court has said that, “although [taxpayers] are not entitled to rely upon unpublished private rulings which were not issued specifically to them, such rulings do reveal the interpretation put upon the statute by the agency charged with the responsibility of administering the revenue laws.”9
Pecuniary Gifts
If at all possible, avoid funding a trust’s gift of a stated amount, even if that amount results from following a formula stated in the trust instrument that results in funding a gift with a pecuniary amount. The IRS’ position is that doing so will force the trust to realize taxable income from the IRA on transfer to the beneficiary who’s entitled to the gift.10
That position is based on Keenan v. Commissioner, holding that use of property to satisfy a pecuniary gift on death is a sale or exchange for income tax purposes, resulting in realization of capital gains, to the extent of post-death appreciation.11
If the IRS is correct, not only will efforts to continue holding funds in an inherited IRA be thwarted, but also part of the income tax resulting from the pecuniary gift will fall on either the trust or the trust beneficiaries other than the trust beneficiary receiving the pecuniary bequest, or both.
The IRS also takes the position that satisfying a gift pursuant to a formula that’s reducible to a stated amount is a pecuniary gift. For example, a trust saying that, following the death of the trustor, a subtrust will receive the greatest amount that will avoid federal estate taxes translates to a fixed dollar amount. A similar result occurs when a trust providing for a transfer to a trust qualifying for the estate tax marital deduction of the least amount needed to reduce the federal estate tax to zero is funded.
But, unlike the facts in Keenan, the taxable portion of IRAs isn’t capital gains; it’s ordinary income because it’s income in respect of a decedent (IRD). IRC Section 691 governs taxation of IRD. Can Keenan apply to IRD?
It appears Keenan could apply.12 Treasury Regulations Section 1.691(a)-4 generally provides that, when a sale of an item of IRD by the estate or person entitled to receive it occurs, the fair market value of the right, or the amount received on the sale, whichever is greater, is included in the gross income of the seller of the IRD.
Bottom line: Always make direct transfers from the trust’s inherited IRA to each trust beneficiary’s inherited IRA, unless making such a transfer satisfies a pecuniary gift. To reduce the risk of unwanted IRA distributions, provide written instructions to the IRA custodian, including wire transfer instructions.
Duty of Impartiality
For trusts that are named as beneficiaries, what if the trust has several beneficiaries, and there are significant age differences among them? For example, the trustor’s sister, aged 72, is a beneficiary, and the trustor’s child, aged 42, is also a beneficiary. If each beneficiary receives an equal portion of the decedent’s IRA, the trustor’s sister, who’ll have to pay taxes over 15.5 years, will receive less value than the trustor’s children, who’ll have to pay income taxes over 41.7 years. Because the younger beneficiary has the advantage of greater income tax deferral, this isn’t a truly equal division of trust property, possibly raising a question whether the trust is being administered impartially.
—The author gratefully acknowledges the contribution of Natalie B. Choate, of counsel at Nutter, McClennen & Fish in Boston, who reviewed this article and provided her perspectives.
Endnotes
1. Trusts are recognized as taxable entities under Internal Revenue Code Section 641, et seq. IRC Section 7701(a)(1) defines the term “person” to include a trust. Section 7701(a)(30)(E) includes trusts in the term “United States person” for all purposes of the IRC, provided that a court within the United States is able to exercise primary supervision over the administration of the trust, and one or more U.S. persons have the authority to control all substantial decisions of the trust.
2. Uniform Trust Code (UTC) (2010) Section 103(18), (19).
3. California Probate Code Section 82.
4. UTC Section 802.
5. UTC Section 103(3).
6. See Benjamin N. Cardozo, The Paradoxes of Legal Science, at p. 129 (1928) (reprint 2000); see also Dickman v. Commissioner, 465 U.S. 330, 336 (1984). “[O]wnership itself … is only a bundle of rights and privileges invested with a single name.” Steward Machine Co. v. Davis, 301 U.S. 548 (1937).
7. See, for example, Private Letter Rulings 201503024 (Oct. 20, 2014), 201444024 (March 24, 2014), 201430022 (April 30, 2014), 201241017 (Sept. 5, 2012), 201210047 (Dec. 15, 2011), 201208039 (Nov. 17, 2011), 201128036 (April 21, 2011), 201038019 (June 28, 2010), 200945011 (Aug. 4, 2009), 200433019 (2004), 200444033 (2004), 200444034 (2004), 200449040 to 200149042 (2004), 200329048 (2003), 200131033 (2001), 200109051 (2001) and 200013041 (2000). Direct transfers to charitable residuary beneficiaries were also approved in PLRs 200526010 (March 22, 2005), 200652028 (Sept. 13, 2006) and 200826028 (March 27, 2008).
8. See Treasury Regulations Section 1.6662-4(d), defining “Substantial authority” for purposes of claiming an exception to the IRC Section 6662 substantial underpayment penalty.
9. Hanover Bank v. Comm’r, 369 U.S. 672 (1962).
10. Internal Revenue Service Chief Counsel Advice 200644020.
11. Keenan v. Comm’r, 114 F.2d 217 (2d Cir. 1940). See further, Revenue Ruling 66-207 (taxable sale or exchange event occurs, where estate’s assets are applied at their appreciated value in satisfaction of a pecuniary legacy).
12. For a contrary view, see Natalie B. Choate, Life and Death Planning For Retirement Benefits, Ataxplan publications, Chap. 6.