When a trust is named as the beneficiary of an IRA, it must a qualified “see-through” trust (qualified trust) in order to allow for extended distributions based on the trust beneficiary’s life expectancy. Despite best efforts, some trusts fail to meet the requirements to be a qualified trust; and even experts in the field sometimes make incorrect determinations as to the qualified status of a trust.
Understanding the complexity of the issue and the possible consequences of making an improper determination, a taxpayer (through an authorized representative) submitted a private letter ruling request (PLR) asking the IRS to determine whether a particular trust is qualified. The IRS responded in PLR 201633025.
Beneficiary vs. Designated Beneficiary and The Stretch Option
Before we discuss the PLR, let’s consider how a beneficiary’s distribution options are affected by its ‘designated beneficiary‘ status.
After the death of the IRA owner, the beneficiary can continue maintaining the IRA’s tax-deferred status instead of taking an immediate lump-sum distribution. The period over which the tax deferral can be continued usually depends on whether the beneficiary is a designated beneficiary.
The following is a high level summary of these distribution options for a designated beneficiary vs. a non-designated beneficiary.
Why Certain Trusts Can Be Designated Beneficiaries
An individual can be a beneficiary, and so can a nonperson such as a charity, estate, or trust. However, only an individual can be a designated beneficiary. A trust qualifies to be treated as an individual for beneficiary purposes only if it meets all of the following requirements:
- The trust is a valid trust under state law, or would be but for the fact that there is no corpus.
- The trust is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner.
- The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the IRA owner’s benefit are identifiable.
- The trust documentation is provided to the IRA custodian by October 31 of the calendar year immediately following the calendar year in which the IRA owner died.
The third requirement is the one that many find hard to interpret, and is one of the focal points of this case.
Why the Distinction Matters
So what’s the big deal with the distinction? In most cases, a designated beneficiary has a longer period over which the assets can continue to accumulate in the tax-deferred account, and a longer period over which post-death distributions can be stretched ( than a non-designated beneficiary). This longer period allows more flexibility with tax and estate planning, which can lead to less income taxes being owed on distributions than would be owed by a non-designated beneficiary.
Let’s look at a hypothetical case:
59-year-old John died last year, leaving his IRA to his trust. The IRA has a market value of $1,000,000.
The oldest beneficiary of the trust is 40-year-old Sue. If the trust is qualified, distributions can be stretched over Sue’s life expectancy of 43.6 years. If not, the assets must be fully distributed by December 31 of the 5th year after the calendar year in which John died (see definition: Five Year Rule).
Assuming that no more than the required minimum distribution (RMD) is taken each year and a 5% rate of return, the following is the total accumulated amount and eventual distributions.
- If the trust is a designated beneficiary: Distributions taken over Sue’s life expectancy total over $3.6M.
- If the trust is not a designated beneficiary: Distributions under the five-year rule over total $1.2M.
Note: Calculation results might vary, depending on calculator used, and whether compounding occurs at start or end of compounding period.
Higher income can lead to higher tax rates. Therefore, stretching distributions over 43.6 years provides the opportunity for the income from the distributions to be taxed at lower rates, as the RMD for each year is lower than if the amount had to be distributed within five years.
The PLR: Facts and IRS Response
The following is a summary of the facts of the PLR. Names have been assigned to some of the parties named in the PLR, so as to make it easier to follow.
- John, the IRA owner, died at age 59 leaving three IRAs, all of which had a qualified trust as the sole primary beneficiary.
- The trust was created under John’s will and is valid under State law
- After John’s death, the trustee (of the trust) transferred the three IRAs into an IRA established for the trust.
- A copy of John’s will, containing the terms of trust, was provided to the IRA custodian by the applicable deadline (see Why Certain Trusts Can be Designated Beneficiaries earlier).
The following are the beneficiaries and potential beneficiaries the trust:
- Elaine: John’s daughter
- Favio and Gwen: Elaine’s children
- Helen and Ingrid: John’s siblings
- Various charitable organizations
The trustee of the trust is the Custodian of the Inherited IRA established for the trust.
The Terms of Trust
Under the terms of trust:
- The trustee is to distribute all net income to Elaine
- The trustee also has discretion to make distributions of principal to Elaine or Elaine’s children for health, education, support, or maintenance;
- The trust will terminate when Elaine reaches age 50, at which time the trustee will distribute the remaining income and principal to Elaine.
- If Elaine dies prior to age 50, the trust will terminate and will be distributed to her children, Favio and Gwen.
- If a beneficiary is under age 21 at the time he or she becomes entitled to receive his or her share, the trustee retains possession of the share in trust until the beneficiary attains age 21; if the beneficiary dies before attaining age 21, the beneficiary’s share is paid to the beneficiary’s personal representatives.
- If Elaine and all children are deceased at any time prior to final distribution of the assets from the trust, the trustee must distribute the remaining assets to Helenand Ingrid, John’s siblings
- If Elain, Favio, Gwen, Helen and Ingrid all die before the final distribution of assets from the trust, the trustee must distribute the remaining assets to various charitable organizations.
Since John’s death, beneficiary RMDs – calculated using Elaine’s life expectancy – were distributed.
In the PLR request, the IRS was asked to rule as follows:
- That the beneficiaries of the trust – and not the trust itself – is a designated beneficiary of the IRA, for the purposes of determining the life expectancy that can be used to calculate posted distributions.
- That Elaine’s life expectancy would be used to calculate post-death distributions.
How the IRS Responded
The IRS responded favorably (said yes) to both requests, using the information and representations submitted in the PLR request to determine whether the trust is qualified and which of the beneficiaries have the shortest life expectancy.
For ruling request number 1 – Identifying members of the applicable class
The IRS determined that the trust is a qualified trust, and therefore a designated beneficiary.
Recall that requirements 1, 2 and 4 were confirmed in the PLR request. See the beginning of The PLR: Facts and IRS Response earlier.
Requirement Number 3 is one that many find complex. This is because the trust (and not the beneficiary of the trust) is named on the beneficiary form (as beneficiary). However, putting someone’s name on a beneficiary form is only one of the ways in which someone can be a designated beneficiary.
Another way for an individual to be a designated beneficiary is to ensure that the individual is identifiable under a trust that is named as the beneficiary. According to the RMD regulations- a class of beneficiaries under a trust is identifiable, if the class is capable of expansion or contraction and if it is possible to identify the class member with the shortest life expectancy.
In this case, the class members are Elain, Favio and Gwen (see below), and Elaine is the one with the shortest life expectancy.
For ruling request number 2 – Ignoring the charitable organizations
Remember that, under the terms of the trust, the trustee must distribute the remaining assets to various charitable organizations if Elain, Favio, Gwen, Helen, and Ingrid all died before the final distribution of assets from the trust. On the surface, this might give the appearance that the charitable organizations, which are non-person beneficiaries, would cause the trust to be a non-designated beneficiary. However, that would be the case only if the charitable organizations were in the same beneficiary class as Elaine, Favio, and Glen.
Beneficiaries: Primary & Contingent Class vs. Potential Successor Class
When there are multiple beneficiaries of a trust, the beneficiary with the shortest life expectancy is used for purposes of calculating RMDs. Only a primary or contingent beneficiary is considered when determining which beneficiary has the shortest life expectancy. By definition, a contingent beneficiary is one whose entitlement to the assets after the IRA owner’s death is a “contingent right.” Favio and Glen are the contingent beneficiaries in this case, as their entitlement to the assets as beneficiary is contingent upon Elaine’s death.
While it might seem that the charitable organizations are contingent beneficiaries as well, that is not the case as they fall under an exception to the contingency rule. Under this exception, a party will not be considered a beneficiary merely because that party could becomethe successor to the interest of one of the IRA owner’s beneficiaries after that beneficiary’s death.
In this case, the IRS determined that the charitable organizations fall under that exception, because they could become beneficiaries only if all the other beneficiaries in the other classes died before the assets were fully distributed. As such, the charitable organizations, as well as Helen and Ingrid, are “mere successor beneficiaries” and, as such, Elaine, Favio, and Gwen are the only beneficiaries taken into account for the purposes of determining the applicable distribution period.
- Elaine, because she is entitled to all net income of the trust while she is alive and is entitled to a distribution of the entire trust if she reaches age 50.
- Favio and Gwen, because the trustee has the discretion to make distributions of principal to them during Elaine’s lifetime for their health, education, support, or maintenance, in addition to their contingent interest in the remainder of the trust if Elaine dies before receiving full distribution of the trust at age 50.
Since Elaine is the oldest of the three, hers is the life expectancy that is used.
Getting Professional Help for Trust Designs
While a PLR can give a good idea of the IRS’ interpretation of regulations, it can be relied on only by the individual to whom it is issued and may not be used or cited as precedent. Further, trust designs can be complicated and special rules apply when a trust is the beneficiary of an IRA or other tax-deferred retirement account.
A retirement account owner who is considering naming a trust as beneficiary should engage the assistance of an attorney and/or tax professional who is an expert in the distribution rules that apply to these accounts.