Among a trustee’s duties, properly allocating receipts between principal and income ranks near the top. Payment from an individual retirement account to a trust illustrates this point. The allocation impacts the amount of the IRA’s income the trustee must count as income of the trust and, per its terms, distribute to a current income beneficiary. Will all, a portion or none of the income earned inside the IRA become income of the trust and then pass down to this beneficiary?
The answer may exist in the trust’s governing instrument. A well-drafted trust includes fiduciary accounting rules to characterize an IRA payment as principal, income or a combination of both. For example, the terms of the trust may allocate an entire payment to income or grant the trustee discretion to make the allocation as income or principal.
What if the trust’s governing instrument omits this guidance? The trustee must then rely on default allocation rules created under state law. Historically, most states have structured their default allocation rules to follow a uniform act periodically published by the National Conference of Commissioners on Uniform State Laws (Uniform Law Commissioners).
Default Allocation Rules
Section 409, created by the 1997 Uniform Principal and Income Act as amended in 2008 (the 1997 Act), contains the default allocation rules for IRA payments. The rules fall into two categories: payments to a marital trust qualifying for the estate tax marital deduction and those to “a trust other than a marital trust” (non-marital trust).
The 1997 Act’s version of Section 409 employs contrasting allocation rules for payments to a marital and non-marital trust, respectively. The rule for a marital trust ensures qualification for the estate tax marital deduction by treating the IRA’s internal income as income of the trust and giving the surviving spouse the right to request a distribution of the account’s internal income.1
IRA payments to a non-marital trust under the 1997 Act, however, receive different treatment. The 1997 Act’s version of Section 409 doesn’t consider the IRA’s internal income the starting point for allocating a payment. Regardless of the actual income earned inside the IRA, Section 409 dictates an allocation of a required payment under federal income tax law of 90% to principal and 10% to income; non-required distributions are 100% principal.2
A major change to the allocation rules for a non-marital trust occurred in July 2018. Section 409 underwent a significant and thoughtful revision as part of the Uniform Fiduciary Income and Principal Act (UFIPA), which the Uniform Law Commissioners approved to replace the 1997 Act.3
Revised Section 409 extends to a non-marital trust the concept that the IRA’s internal income constitutes income of the trust. A “fiduciary,” which under UFIPA includes a trustee, shall base allocation of an IRA payment on the account’s internal income rather than by percentages. The elimination of percentages will create a seismic shift in fiduciary accounting for a non-marital trust.
The percentage rules allocated a fraction of the IRA’s internal income as trust income.4 This result substantially reduced the amount payable to a current income beneficiary entitled to all the trust’s income. The limitation effectively disappears following Section 409’s revision. The change in allocation method under revised Section 409 will apply, “on or after the effective date” a state adopts UFIPA, to existing or future trusts, unless the terms of the trust or UFIPA expressly state otherwise.5 As a result, enactment of revised Section 409 supersedes any allocation provisions for existing and future trusts absent contrary language in the trust’s governing instrument. UFIPA contains no language limiting revised Section 409’s application to existing trusts.
The Mechanics of Revised Section 409
With this background, let’s dig into the operative details of revised Section 409. “Relevant Provisions of Revised Section 409,” p. 45, provides key portions of the new allocation scheme.
Payment from an IRA triggers the allocation process:
Step 1: This step focuses on two methods to determine the IRA’s internal income. While both treat the IRA as a trust, they differ in their approaches.
Method 1. This approach is embodied in Section 409(b)(1) and applies UFIPA’s numerous fiduciary accounting rules to derive the IRA’s internal income. Statements furnished by the IRA administrator identify the account’s receipts and expenses credited to or charged against income. Review of these transactions enables the trustee to determine the IRA’s internal income, the equivalent of the account’s net income.
Banks and trust companies that serve as IRA administrators have statement formats displaying receipts and expenses as principal or income, leading to calculation of an account’s net income. Other administrators may not follow this trust accounting format, but their statements list receipts and expenses accompanied by a description explaining a specific transaction. The trustee must decide whether the description provides enough information to apply UFIPA’s accounting rules to determine the IRA’s internal income. Finally, a third group of administrators may simply list an IRA’s receipts or expenses without any description.
The hierarchy of revised Section 409 favors Method 1 to determine the IRA’s internal income, presumably because it focuses exclusively on receipts and expenses allocable to income. However, Section 409(b)(2) implies that if the trustee can’t glean enough available information to use Method 1, it may switch to Method 2.
Method 2. This method casts the IRA as a unitrust and the IRA’s internal income equals the product of the account’s fair market value (FMV) on a given date, multiplied by between 3% and 5%. The unitrust approach essentially disregards the distinction between principal and income to determine net income. Instead, it reflects the account’s total return (income plus increase/decrease of principal).
Employing Method 2 will require the trustee to obtain the IRA’s FMV as of a specified date shown in “Relevant Provisions of Revised Section 409.” IRA administrators generally provide an account’s FMV on a fixed cycle, including an annual statement.
Step 2: After determining the IRA’s internal income, the trustee proceeds to allocating payment between principal and income. Section 409(c) allocates to trust income the amount received by the trustee equal to the IRA’s internal income during the trust’s accounting period and the balance, the amount exceeding the IRA’s internal income, becomes principal of the trust.
Another portion of revised Section 409 adds one more layer to the allocation decision. In the event the IRA’s internal income for the accounting period exceeds the total of payments received, the trustee under
Section 409(e) may exercise discretion not to withdraw all the account’s internal income.
This decision comes with a catch. If the terms of the trust require distribution of current net income to one or more current income beneficiaries, the trustee must transfer principal to income. The transferred amount equals the excess of the IRA’s internal income earned but not withdrawn during the accounting period.
Possible Administrative Issues
Analysis of revised Section 409’s allocation process raises certain administrative issues:
1. Payment made prior to end of accounting period. Linking the timing of the allocation decision to the trust’s accounting period seems straightforward in theory. For example, the trustee waits until the last day of an accounting period to withdraw a payment. The trustee makes one allocation of the payment to trust income equal to the IRA’s internal income.
What if a trustee receives a payment during a trust’s calendar year accounting period, say Aug. 1, the amount exceeds the IRA’s internal income, but the IRA earns more income after the payment date? According to Section 409(c), the trustee must allocate a payment to trust income “…to the extent of the internal income of the fund [IRA] during the [accounting] period” (emphasis added). This language, effectively, requires a retroactive (second) allocation of the August payment, representing the additional income earned before the end of the accounting period.
2. A balancing act: potential transfer of trust principal to income. As previously discussed, revised Section 409(e) may negatively affect a current income beneficiary’s entitlement to all the IRA’s internal income. Section 409(e) allows a trustee to retain the IRA’s internal income exceeding the amount received during the accounting period rather than withdrawing and paying it to the current income beneficiary. The price for this discretionary decision means a mandatory transfer of principal to income equal to the IRA’s internal income not withdrawn.
This direction has two significant consequences. First, it impacts the remaindermen who otherwise are entitled to the trust’s principal when the trust terminates. Second, keeping a portion of the IRA’s income inside the account defers taxation and grows its value. To the extent the unwithdrawn income remains in the IRA, its retention will shift taxation of income in respect of a decedent (IRD) to the remainder beneficiary. In turn, distribution of trust principal rather than the IRA’s internal income will reduce, in part, a current trust income beneficiary’s tax liability.
A trustee will need to weigh the consequences carefully before exercising discretion to retain the IRA’s income in the account. The commentary to Section 409(e) suggests the trustee apply “general fiduciary standards” written into UFIPA Section 201(a) before exercising discretion. Section 201(b) confirms that “an exercise of discretion under [UFIPA] is presumed to be fair and reasonable to all beneficiaries.”
The following example pulls together the issues just discussed. The IRA owner prior to death named a trust as beneficiary. The trust agreement establishes a postmortem trust for a child and grandchildren. During the child’s life, the trustee must distribute all trust income to her. At the child’s death, the trust terminates with outright distribution of all trust assets to the grandchildren.
Assume these facts regarding the IRA: Its value on Dec. 31 is $1.5 million. For the following calendar year accounting period, the IRA’s internal income is $42,000 determined under Method 1. The federal income tax law’s annual required minimum distribution (RMD) is $55,000. In July, the trustee decides to withdraw $30,000 from the IRA instead of taking the full RMD. At time of payment, the IRA’s internal income is $21,000. The trustee, according to Section 409(c), allocates $21,000 to trust income, $9,000 to principal and distributes $21,000 from trust income to the child.
Between the July payment date and the end of the trust’s accounting period (Dec. 31), the IRA earns an additional $21,000. The trustee withdraws a second payment of $25,000 from the IRA on the last day of the accounting period to satisfy the annual RMD. In addition, the trustee, complying with Section 409(c), reallocates $9,000 from the July payment (previously allocated to principal) to trust income and currently allocates $12,000 from the second payment to trust income. The balance of the second payment, $13,000 ($25,000-$12,000), becomes trust principal. The trustee then distributes $21,000 to the child to account for all the IRA’s internal income earned during the trust’s accounting period.
However, the analysis changes if the trustee relies on Method 2, with a 4% unitrust rate to determine the IRA’s internal income, which is now $60,000 (4% of $1.5 million). The trustee allocates the $30,000 payment received in July entirely to trust income and distributes this amount to the child. On the last day of the trust’s accounting period, the trustee receives $25,000 to fulfill the RMD, allocates the entire amount to trust income and distributes this sum to the child.
The trustee must now deal with the $5,000 of the IRA’s internal income remaining in the account. Exercising discretion granted by Section 409(e), the trustee decides not to withdraw this sum and makes the mandatory transfer of trust principal to income and subsequent distribution to the child. The value of the principal must equal the amount of income retained, but nothing under Section 409(e) prohibits transferring assets in-kind.
3. Accumulated IRA income prior to start of current accounting period. A trustee received an IRA payment during a prior accounting period. Under the terms of the trust, income may be accumulated and distributed at the trustee’s discretion. To ensure compliance with Section 409(c), the trustee will need to segregate any of the IRA’s internal income accumulated during a prior accounting period from the internal income earned during the current accounting period.
The foregoing administrative issues suggest that adherence to the allocation rules of UFIPA’s Section 409 may require tracking the IRA’s internal income earned, allocated and paid to the trust during an accounting period. If needed, the tracking mechanism amounts to a “shadow accounting,” or written statement, documenting the trustee’s treatment of the IRA’s internal income.
Existing State Statutes
In revising Section 409, the Uniform Law Commissioners joined the chorus of states, including Florida, Missouri and Wisconsin, that years ago incorporated into their principal and income acts the concept of treating the IRA’s income as income of the trust.6 A review of these states’ statutes reflects material differences with revised Section 409 and provides further insight.
The first difference involves the method to determine the IRA’s internal income. While revised Section 409 presumes use of Method 1, the comparable provisions under Florida, Missouri and Wisconsin take a different view. The trustee has complete discretion to use Methods 1 or 2. Moreover, each of these states authorizes switching methods during administration.7
A second difference centers on a trustee’s exercise of discretion to retain the portion of the IRA’s internal income exceeding the amount paid to the trust during the accounting period. While revised Section 409(e) compels a transfer of trust principal to income to account for the excess amount otherwise payable to a current income trust beneficiary, none of the named states included this provision in their versions of Section 409.
Duty to Obtain Information
The core concept of revised Section 409, that an IRA’s internal income is income of the trust, obligates the trustee to secure relevant information. This duty includes verifying that the IRA administrator can provide satisfactory accounting information enabling the trustee to use Method 1. Given Section 409’s preference for using Method 1, the trustee should consider documenting the reason for its unavailability before moving to Method 2. Equally important, using Method 2 will create a duty to obtain the IRA’s FMV as of a required date.
The need for this information suggests a bigger picture. Should an IRA owner consider using one entity to serve in both capacities: IRA administrator and trustee of the beneficiary trust? A bank, trust company or investment firm qualified to serve as IRA administrator (trustee or custodian under federal law) may also offer trust services. These institutions may have existing systems and procedures to provide seamless allocation of an IRA payment. However, selection of an IRA administrator and trustee belongs to the IRA owner, who should consult with counsel or a financial advisor.
Trust Terms Override Rules
UFIPA explicitly recognizes that the terms of the trust override Section 409’s default allocation rules.8 The issues created by revised Section 409 should alert the drafter of a trust named as IRA beneficiary to consider inserting specific language addressing allocation of IRA payments. In particular, the drafter may wish to address: the method for determining the IRA’s internal income; the amount the trustee shall distribute to a current income beneficiary entitled to all the trust’s income; and whether the trustee has the authority to retain any portion of the account’s internal income. If the trustee has this authority, will its exercise compel a transfer of principal to income to account for the retained internal income of the IRA?
—The author would like to thank Michael J. Jones, partner in Monterey, Calif.’s Thompson Jones LLP, for his assistance with the article.
Endnotes
1. Uniform Principal and Income Act Section 409(f) (Uniform Law Commission) (amended 2008).
2. Ibid., Section 409(c); for marital trusts, the Internal Revenue Service rejected Internal Revenue Code Section 409(c)’s percentage allocation as it failed to provide the surviving spouse with all the IRA’s internal income, disqualifying the IRA and its beneficiary trust for the marital deduction under the IRC. See Revenue Ruling 2006-26 (May 30, 2006).
3. Uniform Fiduciary Income and Principal Act (UFIPA) (Uniform Law Commission 2018); its full text, including revised Section 409, accompanying commentary and state enactment, can be found at www.uniformlaws.org.
4. Michael J. Jones and Robert K. Kirkland, “Cleaning Up after Formula 409,” Trusts & Estates (June 2018). The article discussed a predecessor version of UFIPA’s Section 409 that would have “render[ed] the 90-10 [percentage] rule applicable only in very limited circumstances.” Ibid., at p. 51.
5. UFIPA, supra note 3 Section 803 (“APPLICATION TO TRUST OR ESTATE. This [act] applies to a trust or estate existing or created on or after [the effective date of this [act]], except as otherwise expressly provided in the terms of the trust or this [act]”).
6. Fla. Stat. Section 738.602; Mo. Rev. Stat. Section 469.437; Wis. Stat. Section 701.1123.
7. Fla. Stat. Section 738.602(2)(b); Mo. Rev. Stat. Section 469.437(2)4; Wis. Stat. Section 701.1123(d)1.
8. UFIPA, supra note 3 Section 201(a)(4) (fiduciary “shall administer the trust or estate in accordance with this [act], except to the extent the terms of the trust provide otherwise or authorize the fiduciary to determine otherwise”).