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The UPIA’s treatment of retirement benefits should be reformed.
After the death of (1) a participant in an employer-sponsored tax-qualified retirement plan that’s a defined contribution plan, or (2) an individual who accumulates an individual retirement account, the benefits from those plans/accounts are payable to a beneficiary. In most cases, the beneficiary is designated by the plan participant or IRA owner. When a trust is named as beneficiary, the trustee of the trust so named will frequently establish an inherited IRA, then effectuate a direct, trustee-to-trustee transfer of the decedent’s plan benefits to the inherited IRA.
Some retirement benefits are payable in cash and securities that may be transferred to the receiving trust’s inherited IRA, while others pay in the form of an annuity.
Some IRAs, including inherited IRAs, are trusteed IRAs, operated by a bank or trust company; others are custodial accounts maintained by an investment firm.
Trust Accountings
When a trust owns an inherited IRA, periodic distributions from that IRA to the trust must be classified partly as trust income and partly as trust principal for trust accounting purposes.
Keep in mind that accounting income isn’t the same thing as taxable income. If it were, all IRA distributions would be “income” in many cases (conversely, Roth IRA distributions would never be “income”). Rather, accounting income for fiduciary accounting purposes is determined under the trust instrument and applicable state law. This, in turn, determines who pays federal (and, if applicable, state) income taxes on the distributed amount. Bear in mind that the top trust federal income tax rate of 37 percent applies at a mere $12,500—far less than for individuals (ranging between $300,000 and $600,000, depending on filing status).
In jurisdictions that have adopted legislation based on the present Uniform Principal and Income Act (UPIA), the answer to classification as trust income versus principal lies in state laws adopting UPIA Section 409 (Section 409). Generally, a trust that receives a distribution from an IRA must classify 10 percent of that distribution as trust accounting income. The remaining 90 percent is classified as trust principal.
For example, say a decedent’s IRA valued at $1 million is payable to a trust, and the IRA earns $30,000 of income during 2018. The trust provides that all income earned on trust property is payable to the decedent’s daughter, Jolene. The trustee withdraws $30,000 to pay the IRA’s income to Jolene. But, Section 409 requires that only $3,000 of the $30,000 distribution (10 percent) is treated as trust income for fiduciary accounting purposes. Because of Section 409, Jolene will receive only $3,000. Not only is the remaining $27,000 not available to distribute to the income beneficiary, but also the trust will be required to pay income taxes at trust income rates on that amount.
Here’s a true story about how that rule can come as a surprise to trustees. A trust was named as beneficiary of the deceased settlor’s IRA and Roth IRA, as well as an annuity contract. The trust provided that all income was to be paid to the settlor’s son. Discretionary distributions could also be made for the son’s health, education, maintenance and welfare. The son was also granted a limited power of appointment (POA) on his death in favor of the settlor’s descendants. Based on the son’s age, required minimum distributions (RMDs) could be paid to the trust over 36 years. Application of California’s version of Section 409 meant that the son wasn’t going to get the income earned within the IRAs. He was only going to receive 10 percent of each year’s distribution. In any year when the trustee must withdraw more than the RMD to comply with California’s rule that “income” is 10 percent of the IRA’s value, substantial value of tax deferral would be lost, and income taxes would be paid earlier than if RMDs were adhered to.
There are few exceptions to the 90/10 rule. Characterization by the payer will be respected. But, characterization by the payer is rare—we’ve never seen an occurrence of that.
Payments to either of two types of trust arrangements qualifying for the estate tax marital deduction will cause the IRA’s income to be classified as trust income of the receiving trustee instead of applying the 90/10 rule: (1) a trust with respect to which a federal estate tax qualified terminable interest property (QTIP) election has been made;1 and (2) a trust qualifying for the estate tax marital deduction because all income is payable to the surviving spouse for life, and the surviving spouse has a general POA over the trust.2 In those marital deduction cases only, the trustee must determine the amount of income earned within the IRA as if the IRA were itself a trust subject to the UPIA, withdraw that amount from the retirement account and distribute that entire amount to the surviving spouse.
The UPIA’s approach to preserving the marital deduction when an IRA is payable to a QTIP trust was crafted to comport with Revenue Ruling 2000-2, holding that a QTIP election with respect to a decedent’s IRA may be made when the trustee of the QTIP trust is the named beneficiary of the IRA, the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually and no person has a power to appoint any part of the trust property to any person other than the spouse.3
Trust provisions can override Section 409. For example, a trust might require under its terms that the trustee shall distribute to the trust beneficiary immediately on receipt all amounts received by the trust from a private or commercial annuity, an IRA or a pension, profit sharing or stock bonus plan and that such receipts shall not be subject to Section 409.
Rev. Rul. 2006-26
Rev. Rul. 2006-26 provides possible definitions of “income” under the trust laws of “state X” that apply if the trust is silent. Rev. Rul. 2000-2 was modified and, as modified, was superseded.
A unitrust percentage between 3 percent and 5 percent applied annually to the fair market value of all trust property, including the value of the IRA payable to the trust, is an acceptable definition. The other acceptable definition of income is a traditional one of income that, by its terms, completely avoids provisions comparable to Sections 104(a) and 409(c) and (d) of the UPIA (adopted in California Probate Code Section 16361). Under that definition, income includes dividends and interest and excludes capital gains.
Another example included in the revenue ruling illustrates an acceptable income definition, when a trust that grants a surviving spouse the right to demand withdrawal of all trust income is named as death beneficiary of an IRA, including income earned on property held in the IRA. Under the terms of the trust, the trustee must determine the interest income and dividends realized within the retirement fund. In addition, the trustee was granted the power to allocate the total return of both IRA and non-IRA assets held directly in the trust between income and principal in a manner that fulfills the trustee’s duty of impartiality between the income and remainder beneficiaries. The allocation of the total return of the IRA and the total return of the trust in that manner constituted a reasonable apportionment of the total return on the investments in both the IRA and the trust between the income and remainder beneficiaries under both estate tax marital deduction requirements and trust income tax requirements.
The trust in the example also provides that the trustee must determine each year’s RMD. The trustee was required to withdraw IRA income or the IRA’s RMDs, whichever was greater, and distribute that amount to the surviving spouse.
Proposed UPIA Update
In 2018, the National Conference Of Commissioners On Uniform State Laws published, in draft form for discussion only, the Uniform Fiduciary Income And Principal Act [Formerly Revised Uniform Principal And Income Act]. Former Section 409 has been renumbered Section 408. Proposed Section 408 revised former Section 409’s income allocation provisions, rendering the 90/10 rule applicable only in very limited circumstances. The proposal will generally require trustees to determine income of the retirement plan account (referred to as a “separate fund”) as if it were a separate trust.
If income can’t be determined, it’s then defined as a unitrust amount between 3 percent and 5 percent. The unitrust percentage is applied to the value of the separate fund’s assets, determined as of the beginning of the trust’s accounting year. If the unitrust method is used, the trust is entitled to a series of periodic payments (an annuity), and if the fund’s value can’t be determined, the amount of annuity payments allocated to income must be determined based on the federal income tax regulations under Internal Revenue Code Section 72, relating to annuities. The interest rate determined under IRC Section 7520 based on monthly payments must be used for this purpose. Note that the UPIA assumes a monthly unitrust payment. Not all unitrusts pay monthly; some pay quarterly, semi-annually or annually.
Furthermore, when a trust is either under a QTIP election or qualifies for the marital deduction because it’s an IRC Section 2056(b)(5) POA trust paying the spouse all income for life, and all of the separate fund’s income can’t be accessed by the trustee, the trustee must, to the extent requested by the surviving spouse, reclassify trust principal as income and distribute that amount to the surviving spouse.
Only when the value of the account can’t be determined is 10 percent of the amount received classified as income, with the remaining balance classified as principal.
Planning
The 90/10 rule isn’t something one who’s unfamiliar with trust law can be expected to understand intuitively. It becomes a trap, a cruel joke on both settlors and their intended beneficiaries. The settlor might instead want a family member to receive income earned within the IRA, yet not understand that the 90/10 rule could defeat accomplishment of that intent.
Drafting attorneys should, when trusts are being designed, helpfully explain to their clients how this rule operates after death. Likewise, following the settlor’s death, the successor trustee will need coaching.
Intention regarding income isn’t the only consideration. RMDs from inherited IRAs and Roth IRAs regulate the value of income tax deferral. In some cases, the year’s RMD could be less than the IRA’s income. For a beneficiary age 52 or under, the percent that must be withdrawn is less than 3 percent. For a 30-year-old, it’s less than 1.9 percent.
Trusts may be crafted to avoid the 90/10 rule. One possible method is for the trust instrument to provide that IRA distributions received by the trust during each accounting period shall be allocated to trust income to the extent of income earned within the IRA during that trust’s accounting period (similar to marital deduction trust drafting).
A further trust provision could say that an amount shall be paid to trust beneficiaries from trust principal equal to the amount, if any, by which income earned within the IRA exceeds the amount of all IRA distributions received in any accounting year. A trust that includes such a provision could define income specifically to include any amount received by the IRA that would be classified as income if realized directly in the hands of the trustee.
Not all tax-favored retirement benefits come in the form of an account. Retirement annuities payable from an employer-sponsored plan or from an individual retirement annuity might be payable to a trust. Treasury Regulations Section 1.72-6 provides a method for classifying a portion of annuity payments, based on the concept that each payment represents a return of the investment in the contract (principal) versus income. Also, IRAs may invest a portion of assets in a qualified longevity annuity contract. Qualified longevity annuity contracts may include a return of premium feature that guarantees that, if the annuitant dies before receiving payments at least equal to the total premiums paid under the contract, an additional payment is made to ensure that the total payments received are at least equal to the total premiums paid under the contract. That return of premium payment is likely principal and should be so classified under UPIA.
Many of our clients reflexively suggest that their trust be named as beneficiary of their qualified retirement plan or IRA benefits. We must make sure that they’re advised of the consequent trust principal and income allocations required under state law, as well as the resulting income tax consequences. If, after careful consideration, the trust will be named as beneficiary, consider drafting the trust to avoid application of the UPIA.
Endnotes
1. Internal Revenue Code Section 2056(b)(7).
2. IRC Section 2056(b)(5).
3. Revenue Ruling 2000-2 (Jan. 18, 2000); Rev. Rul. 2006-26 (May 30, 2006).