Hot Topics and Recent developments in The IRA/Qualified Plan Distribution arena
From the Sublime to the Ridiculous

Marital Deduction Issues
Spousal Rollovers
Community Property
The Separate Account Rule At Death
Disclaimers
Trusts As Beneficiaries, Etc.

1999 and 2000 (so far) have been fertile years for IRS rulings and pronouncements in the area of IRA and qualified plan minimum required distribution (MRD) rules. The purpose of this article is to acquaint the reader with a number of the rulings and pronouncements, some of them informal and unofficial, and occasionally really weird.

The source for much of what we think we know in this area has been gleaned from two ALI-ABA Programs, Estate Planning for Distributions from Qualified Plans and IRAs (1999/Q284; 2000/VLR997), held in May of 1999 and 2000, in which Marjorie Hoffman (herein “MH”), Senior Technician Reviewer, Employee Benefits and Exempt Organizations Branch - Internal Revenue Service, and principal author of the proposed regulations under §401(a)(9), gave her personal opinions of what the rules are. In 2000, Marjorie Hoffman was joined by her colleague at the IRS, George Masnik (herein “GM”), Chief, Branch 4, Office of the Assistant Chief Counsel, responsible for the development and issuance of rulings, both public and private, in the estate, gift, and GSTT areas.

In order to keep this article as brief as possible, I am going to assume that the reader is familiar with the basic minimum required distribution (MRD) rules. Those rules need to be mastered before the practitioner should even dream of injecting into the equation the subject of trusts, disclaimers and community property. An introduction to the general distribution rules can be found in my article “The Minimum Distribution Rules Affecting IRAs and Qualified Plans in a Nutshell, A Guide for the Perplexed.” This article, and my 900 page treatise, Estate Planning for Distributions From Qualified Plans and IRAs, can be found on my website: http://www.trustsandestates.net/ (go to the “Guides and Articles” page). The subject of trusts as beneficiaries is treated in excruciating detail, far beyond the treatment given in this paper, in Article VIII, “Excise Taxes on Distributions.”

ARTICLE 1
MARITAL DEDUCTION ISSUES
Revenue Ruling 2000-2 [1]

1.1 If A QTIP Trust Is The Beneficiary Of An IRA Or Qualified Plan (QP), Must All Of The Income From The Plan Or IRA Be Distributed To The QTIP Trust In Order To Qualify The Plan Or IRA For The Estate Tax Marital Deduction, Or Is It Sufficient That The Surviving Spouse Has The Right To Demand Distribution? The latter.

The answer is that it is sufficient that the surviving spouse has the right to demand distribution. There never was any doubt that this is the law with respect to other forms of property, because, under the IRC, the spouse need only be “entitled” to the income, and further, Treas. Reg. §20.2056-7(d)(2) explicitly provides—

(2) Entitled for life to all income. The principles of 20.2056(b)-5(f), relating to whether the spouse is entitled for life to all of the income from the entire interest, or a specific portion of the entire interest, apply in determining whether the surviving spouse is entitled for life to all of the income from the property regardless of whether the interest passing to the spouse is in trust.[2]

And, Treas. Reg. §20.2056(b)-5(f)(8) explicit provides—

(8) In the case of an interest passing in trust, the terms “entitled for life” and “payable annually or at more frequent intervals,” as used in the conditions set forth in paragraph (a)(1) and (2) of this section, require that under the terms of the trust the income referred to must be currently (at least annually; see paragraph (e) of this section) distributable to the spouse or that she must have such command over the income that it is virtually hers. Thus, the conditions in paragraph (a)(1) and (2) of this section are satisfied in this respect if, under the terms of the trust instrument, the spouse has the right exercisable annually (or more frequently) to require distribution to herself of the trust income, and otherwise the trust income is to be accumulated and added to corpus. . . [3]

Rev. Rul. 2000-2[4] now tells us that the regulation just quoted does indeed apply to IRAs and QPs, as in the case of any other asset; and, more importantly, that it applies where the beneficiary of the IRA or QP is a QTIP trust, provided that the trustee acts as a conduit for any income from the IRA or QP that the spouse demands be distributed to the trust, and provided the trust is required to distribute that income to the spouse. This ruling will come as no surprise to sedulous readers of ACTEC Notes, since the subject has previously been addressed in depth in an article that anticipated the holding of Rev. Rul. 2000-2 and which expressed no doubt that Treas. Reg. §20.2056(b)-5(f)(8) applies to a Spouse’s beneficial interest in an IRA and to a QP or IRA named as beneficiary.[5] It is nevertheless reassuring to have a Revenue Ruling on point.

Specifically, Rev. Rul. 2000-2 addressed the following question:

May an executor elect under section 2056(b)(7) of the Internal Revenue Code to treat an individual retirement account (IRA) and a trust as qualified terminable interest property (QTIP) if the trustee of the trust is the named beneficiary of decedent's IRA and 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 to distribute that amount to the spouse?[6]

The following facts were recited in the Ruling:

A died in 1999 at the age of 55, survived by spouse, B, who was 50 years old. Prior to death, A established an IRA described in section 408(a). The IRA is invested only in productive assets. A named the trustee of a testamentary trust established under A's will as the beneficiary of all amounts payable from the IRA after A's death. A copy of the testamentary trust and a list of the trust beneficiaries were provided to the custodian of A's IRA within nine months after A's death. As of the date of A's death, the testamentary trust was irrevocable and was a valid trust under the laws of the state of A's domicile. The IRA was includible in A's gross estate under section 2039.

Under the terms of the testamentary trust, all trust income is payable annually to B, and no one has the power to appoint trust principal to any person other than B. A's children, who are all younger than B, are the sole remainder beneficiaries of the trust. No other person has a beneficial interest in the trust. Under the terms of the trust, B has the power, exercisable annually, to compel the trustee to withdraw from the IRA an amount equal to the income earned on the assets held by the IRA during the year and to distribute that amount through the trust to B. The IRA document contains no prohibition on withdrawal from the IRA of amounts in excess of the annual minimum required distributions under section 408(a)(6). [The life expectancy exception under the look-through rule for trusts was elected, and distributions were begun in the year following death.]

* * * *

Under the terms of the testamentary trust,[7] B is given the power, exercisable annually, to compel the trustee to withdraw from the IRA an amount equal to all the income earned on the assets held in the IRA and pay that amount to B. If B exercises this power, the trustee must withdraw from the IRA the greater of the amount of income earned on the IRA assets during the year or the annual minimum required distribution. Nothing in the IRA instrument prohibits the trustee from withdrawing such amount from the IRA. If B does not exercise this power, the trustee must withdraw from the IRA only the annual minimum required distribution.[8] [Emphasis added.]

The precise holding was—

An executor may elect under section 2056(b)(7) to treat an IRA and a trust as QTIP when the trustee of the trust is the named beneficiary of the decedent's 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 to distribute that amount to the spouse, and no person has a power to appoint any part of the trust property to any person other than the spouse.[9]

Rev. Rul. 2000-2 gave the death knell to Revenue Ruling 89-89[10] by declaring it obsolete. We are all familiar with the fact that Revenue Ruling 89-89 approved a cumbrous process whereby the IRA was required to distribute all of its fiduciary accounting income (computed how?) to the QTIP trust, and the trust, in turn, would distribute the income to the spouse. Despite being rendered technically obsolete, 89-89 is still a valid approach,[11] but it has the disadvantage of requiring income in excess of the minimum required distribution (MRD) to be distributed and taxed earlier than 401(a)(9) would otherwise require. How big a disadvantage this is depends on the nature of the investment. If capital growth constitutes most of the increase in the IRA each year, and fiduciary accounting income (computed how?) is minimal (say, 3.82%[12]), then the MRD is usually going to exceed fiduciary accounting income anyway —but not always.

One advantage that the 2000-2 approach has over 89-89 is that the burden of determining fiduciary accounting income, while still there, is not so pressing. If the spouse does not make an issue out of it, then the fact that all of the true fiduciary accounting income was not distributed is not quite so critical as it might have been under 89-89.

Rev. Rul. 2000-2 is explicit that “[b]ecause the trust is a conduit for payments equal to income from the IRA to B, A's executor needs to make the QTIP election under section 2056(b)(7) for both the IRA and the testamentary trust.”[13] This is consistent with the odd notion, articulated in some of the private letter rulings, that a trusteed IRA (or QP or custodial IRA?) is itself a trust, and as such cannot be an asset of another trust, and that a 2056(b)(7)(B)(v) election must therefore be made for both the IRA interest and for the QTIP trust itself.

It seems to me that a more appropriate (if slightly less technical) approach would be simply to treat the QTIP trust as owning “the right to receive” distributions from the IRA or QP (which is undoubtedly true), and treating this “distribution right” as a property interest and asset of the QTIP trust (also undoubtedly true), the same as if the QTIP owned the right to receive insurance commissions or a royalty interest. (Query, is a separate election required for other wasting assets?) I fail to see why it is the least bit relevant where the distributions (the right to receive which is owned by the QTIP trust) come from.

Treating the right to the distributions simply as a part of the corpus of the QTIP trust has the added benefit of meaning that the trustee of the QTIP trust can credit the income account with any income from the IRA (determined under applicable state law), and can distribute an equivalent amount from the QTIP trust rather than from the IRA, in those cases where the spouse needs the money and where the income exceeds the MRD. This alternative will likely result in less income taxes being owed than if the income is forced to be disgorged by the IRA. I believe that such an alternative to 2000-2 is viable, but why rely on it exclusively when Rev. Rul. 2000-2 gives us a ready alternative? I believe that it is possible to combine both approaches.[14]

As is pointed out later in this article, a proposed regulation has no more weight in court than that of a brief filed by the Commissioner.[15] A Revenue Ruling is no different, but, like a proposed regulation, a Revenue Ruling can be used by the taxpayer as a shield against the IRS, even if it cannot be used by the IRS as a sword. Revenue Ruling 89-89 was utterly useless, in my opinion, because under the facts given, there was absolutely no way that the arrangement did not qualify for the marital deduction, and so the ruling was of zero benefit to the taxpayer. Nevertheless, the ruling was used by most of us as a roadmap for qualifying IRA/QTIP trust combinations for the marital deduction. As a roadmap, 89-89 was very poor indeed, even after considering the cartographer. Now, eleven years later, we have a new, much improved map, one that I predict will entirely supplant the 89-89 approach.

Possible Pitfalls. In 2000-2, it is not clear whether the failure of the spouse to take a distribution during the year would result in the lapse of the right to the income. A lapse in this situation is, however, expressly sanctioned by Treas. Reg. §20.2056(b)-5(f)(8) and Rev. Rul. 2000-2. Moreover, if the intent is to dissuade the spouse from taking a distribution which the spouse doesn’t need, thereby incurring an income tax earlier than otherwise, consider making the withdrawal right explicitly non-lapsing. That way the spouse will not be as likely to take a distribution which the spouse does not presently need, but which the spouse might want to take later. Moreover, there are tax advantages to making the right non-lapsing.

If the right actually lapses, what are the transfer tax consequences, if any? The estate tax consequences are nil, since the QTIP will be included in the estate in any event. Are there any gift tax consequences? There might be if the gift were complete. Is a gift of a remainder interest complete if the donor retains the right to the income, and there is no power over the remainder retained? Possibly.

Recall that the whole basis for the common law GRIT[16] as an estate planning tool was that when a grantor transferred property to a trust, retaining the right to the income, there was a completed gift of the remainder even though an income interest was retained. However, since the present value of the remainder was much less than the future value of the remainder (and, much more importantly, the income was expected to be less than the applicable federal rate), the GRIT had definite transfer tax savings features. And what was the Congressional response to the common law GRIT? §2702, which makes matters considerably worse. If it applies, §2702 would presumably operate to provide that if the spouse eschewed the right to say, $50,000, then upon the lapse there would be a gift, a gift not just of the value of the remainder interest in the $50,000, but of the $50,000 itself. This is certainly how §2702 would operate in the case of a common law GRIT.

Are the 5&5 rules helpful?

Probably not in the case of a common law GRIT because §2036 applies to actual transfers, and there is no 5&5 exception for actual transfers. The exercise or release of a power of appointment is only “deemed” to be a transfer. It is not a real transfer. That is why the Treasury needs §§2041 and 2514, because §§2036 and 2501 were thought to be insufficient. (If you think about it, you will realize that if §2036 applied to lapsed powers, then Crummey Trusts would be ineffective.) In the case of the lapse of a QTIP income right, however, I believe that §2514 would ameliorate the situation somewhat, to the extent the lapse was within the 5&5 harbor. Further, as is the case in any transaction under §2702, the taxpayer is only penalized if a gift tax is incurred (after application of the applicable exclusion), either immediately or in the future. If a gift tax is incurred, the estate tax adjustments are helpful, but never fully ameliorate the loss of the time value use of the money used to pay the tax. IRC §2514(e) provides:

(e) Lapse of power

The lapse of a power of appointment created after October 21, 1942, during the life of the individual possessing the power shall be considered a release of such power. The rule of the preceding sentence shall apply with respect to the lapse of powers during any calendar year only to the extent that the property which could have been appointed by exercise of such lapsed powers exceeds in value the greater of the following amounts:

(1) $5,000, or

(2) 5 percent of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied.

Can the right to the income be satisfied out of corpus? I would argue yes; but, if not, then the 5% figure is 5% of the income, and that won’t help.

Can the gift issue be avoided by giving the spouse a nongeneral power of appointment? Presumably yes, but then giving the beneficiary of a trust a power of appointment over IRA or QP proceeds creates other problems, discussed latter on in this paper.

What about §2519? If applicable, §2519 could be a huge problem. According to the Ruling[17] under discussion, “B has a qualifying income interest for life in the IRA and the testamentary trust for purposes of sections 2519 and 2044.”[18] §2519 provides:

“Any disposition of all or part of a qualifying income interest for life in any property to which this section applies shall be treated as a transfer of all interests in such property other than the qualifying income interest.”

Is a lapse with a retained income right a “disposition”? Perhaps not. Recall the tortured nomenclature of §§2041 and 2514, where a release is taxed as a transfer and a lapse is treated as a release, unless within the 5&5 exception. Transfers, releases and lapses, I know, but “dispositions”? Treas. Reg. §25.2519-1 provides that a disposition of any part of the income interest is treated as a transfer of the value of the remainder interest in QTIP property. Is the reverse true? Is a transfer of a part of the income interest a disposition of that interest? Arguably, yes, but the real question is whether a transfer of income that has already accrued is a disposition of a part of the income interest for purposes of §2519, taking the purposes of the statute into account.

The regulation is helpful in otherwise elucidating how the statute operates in practice, but it does not define the term “disposition.” I think that once the income has actually accrued, any subsequent transfer of that income is not a disposition of the income interest (presumably the right to receive income in the future), but is, at worst, a disposition/transfer of the income itself, after the functional equivalent of receipt. This is because the right to the income matured prior to the lapse. To illustrate, if one were asked to value the income interest as of the date of lapse,

ARTICLE 1 MARITAL DEDUCTION ISSUES Revenue Ruling 2000-2[1]

ARTICLE 1
MARITAL DEDUCTION ISSUES
Revenue Ruling 2000-2 [1]