Breaking the silence of the Treasury regulations.
In the August 2017 issue of Trusts & Estates, Emily Kembell artfully framed the moment when an estate-planning attorney’s heart may skip a beat. The client wants a revocable trust drafted that will also serve as the beneficiary of a traditional individual retirement account.1 The engagement has lurking danger.
Step 1, describing the beneficiaries’ interests following the IRA owner’s death, presents no challenges. The trust’s terms include mandatory income and discretionary principal distributions to a beneficiary for life (lifetime beneficiary). At this beneficiary’s death, two other individuals (primary remaindermen) share a right to complete distribution of the trust’s assets. But, the outright distribution comes with a condition. The primary remaindermen must reach a specified age: If underage at the lifetime beneficiary’s death, the interest stays in a separate trust until the primary remaindermen attain the specified age. Step 2 occurs if a primary remainderman dies prematurely: The client names an individual and a favorite charity (secondary remaindermen) to take outright distribution in equal shares. In addition, the trust’s governing instrument authorizes the trustee to accumulate IRA distributions and protects the beneficiaries against creditors.
Step 2 may bring the anxiety. The trust’s terms will earn the drafter a journey through the final Treasury regulations (the regulations) governing required distributions from the IRA.2 Among other issues, the regulations interact to create the IRA’s payout period, known as the “applicable distribution period” (ADP). The longer the ADP, the more income tax the trustee can potentially defer when withdrawing the annual required minimum distribution (RMD).
A Regulatory Swamp?
If the goal is to ensure a long ADP, the drafter will plunge headlong into a specific set of regulations to assess whether the trust’s terms can achieve this goal. Initially, they spell out the procedural requirements the governing instrument and trustee must satisfy to treat the beneficiaries as if the account owner had named them directly.3 Then, the regulations turn to the “big issue,” filtering the multiple beneficiaries named in the governing instrument to capture the ones creating the ADP.
Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(A-7) acts as the filter and initially traps all the trust’s beneficiaries. If the trust only has individuals, known as “designated beneficiaries,” the oldest beneficiary’s life expectancy will create the ADP.4 However, a non-individual beneficiary, such as an estate or charity, will disqualify use of an individual beneficiary’s life expectancy even if the trust has one or more individual beneficiaries.5 This structure will likely reduce the ADP, accelerating payment of income tax.
A beneficiary with a contingent interest further complicates the filter’s operation. The regulation states that a beneficiary’s “contingent right” under the trust’s terms factors into the ADP’s determination.6 But, a different part of the regulation, specifically, Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(c)(1), suggests that another contingency will exclude certain beneficiaries from consideration.
The regulation’s text doesn’t explain the facts creating this contingency. Instead, it uses the term “mere potential successor” to identify an excluded beneficiary. The regulation and an accompanying example involving a trust that may accumulate IRA distributions only name an individual with a lifetime right to the trust’s income and primary remaindermen who take outright distribution at the trust’s termination. They’re the only beneficiaries the trustee must consider in determining the ADP.7 The regulation dodges the effect of a primary remainderman dying before taking outright distribution and a secondary remainderman succeeding to this interest.
If this sounds like entering a regulatory swamp, you’ve been warned. Since the effective date of the regulations (Jan. 1, 2003), the Internal Revenue Service hasn’t issued any authoritative guidance to clarify the meaning of a “mere potential successor.” The only insight comes from IRS private letter rulings, which can’t be cited as precedent.8 Analysis of several PLRs has concluded that the trustee must search for and count a secondary remainderman when a primary remainderman survives creation of the trust, but could predecease the lifetime beneficiary without satisfying the condition for outright distribution.9
Another PLR, obtained by my former employer, Wells Fargo Bank, casts doubt whether the trustee must consider a secondary remainderman. In the PLR, the IRS disregarded several secondary remaindermen as “mere potential successors” even though the beneficiaries entitled to outright distribution hadn’t satisfied the required conditions at the IRA owner’s death.10
The PLR states that the IRA owner died at age 59 survived by a child, two grandchildren and two siblings. His testamentary trust provides the child with a lifetime right to the trust’s net income. The child and grandchildren may also request discretionary distributions of principal during the child’s lifetime.
The governing instrument then lists the conditions for outright distribution of the trust’s assets. The child must reach age 50. If not, then the grandchildren take outright distribution unless any are under age 21. In that event, the trust still terminates with a grandchild’s share to be held in a separate trust.
If a grandchild dies before turning 21, the trust share passes to the estate. If all grandchildren predecease the child, who then dies before reaching 50, the IRA owner’s siblings take outright distribution. Finally, if the siblings are deceased, several charities step up as the outright beneficiaries.
The trustee sought the PLR to continue relying on the child’s lengthy life expectancy to calculate the annual RMD and avoid an alternative scenario with potentially devastating tax consequences. As the IRA owner died before the required beginning date,11 another regulation would require complete distribution within five years after the IRA owner’s death (the so-called “5-year rule”).12 The IRS would reach this result by deeming the child, obviously under 50, to have died immediately after the IRA owner, followed one minute later by the grandchildren who were under age 21. Their estates then take outright and immediate distribution of the trust’s assets, including accumulated and future IRA payments.13
After reciting the applicable regulations, the IRS found that the only beneficiaries the trustee must consider for purposes of measuring the ADP are the child and grandchildren.14 The IRS excluded the other beneficiaries as “mere potential successors.”
Kembell’s article succinctly diagnosed the PLR’s problem:
It’s understandable and unsurprising that the [child and grandchildren] must be considered. What’s less clear is why the IRS deemed the [grandchildren’s estates] siblings and charities as ‘mere successor beneficiaries within the meaning of the regulations.’15
The comment highlighting the PLR’s lack of clarity calls out the regulations’ silence. But, the IRS left a clue. The phrase “within the meaning of the regulations” suggests the IRS may have relied on another source to break the regulations’ silence and explain the operation of the mere potential successor rule.
The source, ironically, lies within Treasury Decision (TD) 8987, a document that published the regulations in 2002.16 The TD’s preamble, according to the IRS Internal Revenue Manual, “explains the rule.”17 Reviewing its explanation should uncover a regulation’s “meaning.”
As shown in “Comparing Provisions,” p. 32, the text in the preamble’s “Explanation of Provisions” describes the conditions creating a “mere potential successor.” “Comparing Provisions” also includes a side-by-side comparison of the language of the applicable regulation and the TD’s preamble. The italicized language in the preamble doesn’t appear in Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(c)(1), which mentions but doesn’t explain who’s a “mere potential successor.”18 The preamble does so by creating an “exception from the multiple beneficiary rules for death contingencies” that otherwise count to measure the ADP.
The exception effectively creates a contingency that excludes beneficiaries falling under the mere potential successor rule. The preamble’s text sets its parameters. If a primary remainderman survives creation of the trust at the IRA owner’s death but should die before receiving outright distribution of its assets, the successor to this interest isn’t a beneficiary for purposes of measuring the ADP. Another commentator believes the IRS configured the regulation to avoid speculation whether a primary remainderman will live to take outright distribution and eliminate the need to consider default beneficiaries.19
In everyday practice, a well-drafted trust includes secondary remaindermen. The TD’s preamble recognizes this omission from the applicable regulation and fills the gap by excluding them from consideration.20
Significance of Preamble
Unlike a PLR, a TD has universal application. The Internal Revenue Manual states a TD “is cited as legal authority and is binding on all taxpayers and the IRS, unless invalidated.”21 To my knowledge, the IRS hasn’t invalidated this part of the preamble to TD 8987.
“Comparing Provisions” includes the complete text of the Internal Revenue Manual’s comment on a TD’s authority.
Applying TD’s Language
At the IRA owner’s death, the TD’s preamble effectively lays out a three-part approach to analyze which beneficiaries the trustee must include to determine the ADP:
• Identify the beneficiaries who survived the IRA owner.
• Focus on any conditions linked to a beneficial interest.
• Segregate the beneficiaries who could only take an interest if another beneficiary should die before satisfying condition(s) to receive the interest.
Now, let’s apply this analysis to the hypothetical trust discussed in the article’s opening paragraphs. Assume all the named beneficiaries will survive the IRA owner. The TD’s preamble considers the secondary remaindermen (an individual and charity) as “mere potential successors.” According to the preamble, they “could [only] be entitled to a portion of the [IRA, including accumulated IRA distributions held in trust] by becoming the successor to the interest of [another beneficiary] after that beneficiary’s death.”22 The trustee takes the remaining individuals, lifetime beneficiary and primary remainderman into consideration to measure the ADP.
Further Insight Into IRS Thinking
In the PLR, the IRS touched on the role of state property law in reaching its conclusion.
This ruling expresses no opinion on the property rights of the parties under state law, and only provides a ruling on the impact of federal tax law on the specific facts presented.
A reasonable inference is that the IRS will look to the trust’s terms and ignore state law classifications of the beneficiaries’ interests to determine the ADP. Under state common and statutory law, a remainderman may have an unconditional (vested) right to complete distribution of the trust’s assets on the lifetime beneficiary’s death or a contingent right requiring satisfaction of one or more conditions.23
Equally important, the preamble’s language confirms an implicit element of the regulations. The IRS has effectively created its own definition of contingencies a trustee must consider for purposes of determining the ADP. An includible contingency exists when the trust’s terms conditionally or unconditionally delay a primary remainderman’s access to the trust’s principal until the lifetime beneficiary’s death.24 By contrast, an excludable contingency arises if a primary remainderman’s successor has no independent beneficial interest in the trust and takes solely due to the primary remainderman’s death. In the PLR, the IRS treated the grandchildren as primary remaindermen even though their interest in outright distribution depended completely on the child’s untimely death. The IRS most likely deemed the grandchildren’s interest to be independent of the child’s to be consistent with the regulations.
PLR is an “Outlier”
The PLR’s exclusion of the secondary remaindermen has drawn criticism. The universally respected commentator, Natalie B. Choate, called it an “outlier that may represent a change of IRS policy or may just be an IRS mistake.”25 The basis for the criticism is the IRS “ignored” the IRA owner’s siblings in determining the ADP if the child and grandchildren died before reaching the respective ages for outright distribution.26
Viewed through the lens of the TD’s preamble, the PLR doesn’t reflect a change of policy. The status of the grandchildren’s estates, the siblings and charities as “mere potential successors” adheres to the preamble’s language. These beneficiaries have no independent beneficial interest in the trust’s assets.
The IRS, however, did make a mistake by not integrating the preamble’s text into the regulation to define the term “mere potential successor.” The IRS could achieve this goal by issuing new binding guidance with examples that track the text of the TD’s preamble and highlight the beneficiaries who are “mere potential successors.”
The probability of the IRS issuing this guidance long after the regulations’ release is low.27 Nonetheless, the preamble’s text on which all practitioners may rely offers the opportunity to preserve a lengthy ADP even if the secondary remaindermen include an individual much older than the primary remainderman or an entity like a charity. The alternative solution, seeking an expensive PLR to obtain this result, may now have less appeal.
Preamble Provides Explanation
The final regulations governing required distributions from retirement plans, including IRAs, left a deafening silence when a trust is the beneficiary. The regulations didn’t explain the effect on the ADP if a trust’s primary remainderman dies before the date when this beneficiary takes outright distribution of the trust’s assets, including accumulated and future IRA distributions and, under the trust’s terms, a secondary remainderman becomes entitled to this interest.
The preamble to the TD that released the regulations supplies the missing explanation. A secondary remainderman has no significance in determining the ADP.
Trusts with dispositive terms that follow the preamble will enable trustees to cite its binding authority on the IRS. This result should calm the drafter’s mind in preparing the trust’s governing instrument.
Endnotes
1. Emily Kembell, “Designating Beneficiaries for Retirement Plans,” Trusts & Estates (August 2017).
2. Treasury Regulations Section 1.408-8, Q&A-1 (an individual retirement account is subject to the required minimum distribution rules in Treas. Regs. Section 1.401(a)(9)-1 through Section 1.401(a)(9)-9 for qualified retirement plans).
3. Treas. Regs. Section 1.401(a)(9)-4, Q&A-5.
4. Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(a)(1).
5. Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(a)(2) and Section 1.401(a)(9)-4, Q&A-3.
6. Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(b).
7. Treas. Regs. Section 1.401((a)(9)-5, Q&A-7(c)(1) (flush language); Treas. Regs. Section 1.401((a)(9)-5, Q&A-7(c)(3) Example One; the regulations also include a second example in which the trustee must distribute all IRA distributions to the lifetime beneficiary. As the trust can’t accumulate IRA distributions, it simply acts as a conduit, making a primary remainderman a “mere potential successor.” See Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(c)(3), Example Two. Further discussion of the conduit trust exception to the mere potential successor rule is beyond the scope of this article.
8. Internal Revenue Code Section 6110(k)(3) (private letter rulings may not be cited or used as precedent); the PLRs are: 200438044 (June 22, 2004), 200522012 (Feb. 14, 2005) and 20060026 (Dec. 13, 2005).
9. Natalie B. Choate, Life and Death Planning for Retirement Benefits (7th ed. 2011) (Life and Death), at pp. 441-442; Natalie B. Choate, “IRA Mistakes and How to Fix Them: the 203 Best and Worst Planning Ideas for Your Client’s Retirement Benefits” (“IRA Mistakes”), 34th Annual Advanced Estate Planning Institute of the Cincinnati Bar Association (March 24, 2017), at p. 107.
10. PLR 201633025 (May 18, 2016). For a detailed discussion of this PLR, see David S. Sennett and Brandon A.S. Ross, “‘Mere Potential Successor’ Can Cause IRA Payout Confusion,” Estate Planning (November 2017), at pp. 9-17.
11. Treas. Regs. Section 1.408-8, Q&A-3 (April 1 of the calendar year following the calendar year in which the IRA owner attains 70).
12. Treas. Regs. Section 1.401(a)(9)-3, Q&A-2 (the IRA must be distributed by Dec. 31 following the fifth anniversary of the IRA owner’s death).
13. This analysis is based on the so-called “snapshot rule.” See Choate, Life and Death, supra, note 9, at p. 440. For an example applying the snapshot rule, see Natalie B. Choate, “Making Retirement Benefits Payable to Trusts,” 39 Annual UCLA/CEB Estate Planning Institute (April 2017), at pp. 43-46.
14. The Internal Revenue Service rationale: the child is “taken into account” as she receives the trust’s net income and “is entitled to a distribution of the entire trust if she attains age 50”; the grandchildren “are also taken into account as the trustee may make discretionary distributions of principal to them during the child’s life in addition to their contingent interest in the remainder of the Trust if the child dies before receiving full distribution of the Trust at age 50.”
15. Kembell, supra, note 1, at p. 49.
16. Treasury Decision (TD) 8987.
17. Internal Revenue Manual (Manual) Part 32.1.1.2.5 (2018).
18. Interestingly, Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(c)(1) as written in the 2001 proposed Treasury regulations included verbatim the first italicized sentence. The IRS moved this text from the final version of this regulation to the TD’s preamble.
19. See Gair Bennett Petrie, Price on Contemporary Estate Planning (2015 ed.), at p. 13,017 (“regulation did not speculate as to who would be default beneficiaries” (if remaindermen failed to survive the lifetime beneficiary)).
20. The trustee’s submission requesting the PLR didn’t refer to or cite the preamble to TD 8987.
21. Manual, supra note 17.
22. Supra note 16.
23. Sheldon F. Kurtz, Moynihan’s Introduction to the Law of Real Property (5th ed. 2011), at p. 159.
24. Treas. Regs. Section 1.401(a)(9)-5, Q&A-7(c)(3)(iii).
25. Choate, “IRA Mistakes,” supra note 9, at p. 109.
26. The PLR’s description of the siblings’ interest isn’t clear. The PLR states that if a grandchild dies before reaching 21, “[this] beneficiary’s share is paid to the beneficiary’s personal representative.” The actual terms of the trust give the siblings outright distribution if the grandchildren predecease the child who then fails to turn 50 or if the child and grandchildren don’t survive the IRA owner. The trustee in its PLR request offered the former scenario as an alternative ruling. The oldest sibling’s life expectancy would determine the applicable distribution period in the event the IRS rejected continued reliance on the child’s life expectancy. The IRS didn’t accept this alternative.
27. The American College of Estate and Trust Counsel has repeatedly asked the IRS to publish authoritative guidance to explain the “mere potential successor rule.” See Kembell, supra note 1, at p. 48.