Preserving the Designated Beneficiary If a Trust Is Named as Beneficiary of a Qualified Plan or IRA

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1 Preserving the Designated Beneficiary If a Trust Is Named as Beneficiary of a Qualified Plan or IRA Virginia F. Coleman All section references are to the Internal Revenue Code ( IRC ) unless otherwise indicated. IRA refers to individual retirement account; QTIP, to qualified terminable interest property; RBD, to required beginning date; and Service, to the Internal Revenue Service. A. Who Is a Trust Beneficiary for Purposes of Section 401(A)(9)? 1. In 1987, regulations were first proposed under section 401(a)(9) which stated that if a trust was named as beneficiary of a plan or IRA and certain conditions were satisfied, a look-through rule would apply to determine whether there was a designated beneficiary and if so the identity of the designated beneficiary. 52 Fed. Treas. Reg. 28,070 (July 27, 1987). These regulations were substantially revised in 1997(62 Fed. Treas. Reg. 67,780), and have been carried forward largely unchanged in the 2001 proposed regulations, issued January 17, 2001 (66 Fed. Treas. Reg. 3928), and now in the 2002 final regulations (67 Fed. Treas. Reg. 18,988 (April 17, 2002). Virginia F. Coleman is a partner in the Boston office of Ropes & Gray. She is a fellow of the American College of Trust and Estate Counsel, a member and past chairperson of its Employee Benefits Committee, and a member of its Estate and Gift Tax and International Estate Planning committees. She is also an academician of the International Academy of Estate and Trust Law and a member of The American Law Institute. Acomplete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call CLE-NEWS and ask for Customer Service. Have the order number of the course materials SH019 handy. 5

2 6 ALI-ABA Estate Planning Course Materials Journal October 2003 a. The identity of the designated beneficiary remains crucial to the payout period for post-mortem minimum distributions, although in most instances, under the 2002 regulations, it will be irrelevant to the determination of minimum distributions during life. b. After the participant reaches his required beginning date, when at a minimum post-mortem distributions may be made over his life expectancy, if his primary real beneficiary is his spouse (or other individual) of roughly the same age, it will be of little or no consequence even with respect to post mortem distributions if a trust for the spouse or other individual is named as beneficiary and gives rise to no designated beneficiary. In either case the payout period (participant s nonrecomputed remaining life expectancy or spouse s (or other individual s) recomputed (or nonrecomputed) remaining life expectancy) will be much the same. c. If the real beneficiary is of a younger generation (child or grandchild), the existence or not of a designated beneficiary if a trust for child or grandchild is named as beneficiary will make a major difference in the distribution period for post-mortem distributions. In addition, regardless of the identity of the real beneficiary, if death occurs before the required beginning date, it is necessary to have a designated beneficiary to avoid the fiveyear rule. 2. If the conditions for application of the look through rule, which are discussed at Section J below, are satisfied at the relevant time(s), the beneficiaries of the trust who are beneficiaries with respect to the trust s interest in the employee s benefit will be treated as the employee s designated beneficiaries. Treas. Reg (a)(9)-4, A-5 (2002). Prop. Treas. Reg (a)(9)-4, A-5 (2001). Prop. Treas. Reg (a)(9)-1, D-5(a) (1997). Assuming there are multiple beneficiaries, absent separate accounts the payout period will be determined in accordance with the life expectancy of the beneficiary with the shortest life expectancy. Treas. Reg (a)(9)-4, A-5(c), 1.401(a)(9)-5, A-7 (2002). Prop. Treas. Reg (a)(9)-4, A-5(c), 1.401(a)(9)-5, A-7 (2001). Prop Reg (a)(9)-1, E-5(a)(1) (1987). 3. Guidance from the Service on who would be treated as the beneficiaries of a trust if the look-through rule was applicable (Current beneficiaries only? Remaindermen? Contingent remaindermen? Remote contingent remain-

3 Preserving the Designated Beneficiary 7 dermen? Permissible appointees?) has been scant. The 2002 regulations contain the most extensive treatment of this subject to date, but unfortunately leave unclear just what the result is in all but one situation: the so-called conduit trust. a. A conduit trust as used in this outline is a trust under which all benefits paid to the trust are paid out currently to one or more beneficiaries rather than retained to any extent by the trust for future distribution, and which either: i. Lasts for the life of the oldest current beneficiary; or ii. Terminates in favor of the oldest current beneficiary when he or she reaches a certain age. b. In the case of such a trust, the only beneficiar(ies) which are taken into account for purposes of determining the designated beneficiary are the current beneficiar(ies). The theory is evidently that in these circumstances, unless the oldest beneficiary dies prematurely, the plan or IRA will be fully distributed to that beneficiary (or other current beneficiaries, who by definition will be younger). c. The emphasis on life expectancy in this rationale, combined with numerous conversations with personnel at the Service over the years, had led this author to believe that an assumption that all beneficiaries would live out their life expectancies was a key underpinning also of the analysis for the non-conduit trust. Recent developments, however, have led her to think otherwise. B. When Must You Look to Future Beneficiaries? 1. The issue in brief is under what circumstances must you look beyond the current beneficiary(ies) of a trust to beneficiaries with a future interest in determining the designated beneficiary. a. On this point, Treas. Reg (a)(9)-5, A-7(b) and (c) (2002) provides as follows: (b) Contingent beneficiary. Except as provided in paragraph (c)(1) of this A-7, if a beneficiary s entitlement to an employee s benefit after the employee s death is a contingent right, such contingent beneficiary is nevertheless considered to be a beneficiary for

4 8 ALI-ABA Estate Planning Course Materials Journal October 2003 purposes of determining whether a person other than an individual is designated as a beneficiary (resulting in the employee being treated as having no designated beneficiary under the rules of A-3 of 1.401(a)(9)-4) and which designated beneficiary has the shortest life expectancy under paragraph (a) of this A-7. Successor beneficiary (1) A person will not be considered a beneficiary for purposes of determining who is the beneficiary with the shortest life expectancy under paragraph (a) of this A-7, or whether a person who is not an individual is a beneficiary, merely because the person could become the successor to the interest of one of the employee s beneficiaries after that beneficiary s death. However, the preceding sentence does not apply to a person who has any right (including a contingent right) to an employee s benefit beyond being a mere potential successor to the interest of one of the employee s beneficiaries upon that beneficiary s death. Thus, for example, if the first beneficiary has a right to all income with respect to an employee s individual account during that beneficiary s life and a second beneficiary has a right to the principal but only after the death of the first income beneficiary (any portion of the principal distributed during the life of the first income beneficiary to be held in trust until that first beneficiary s death), both beneficiaries must be taken into account in determining the beneficiary with the shortest life expectancy and whether only individuals are beneficiaries. 2. If you interpret this literally, it would appear that in every non-conduit trust virtually all beneficiaries, down to the most contingent of contingent beneficiaries, would have to be considered, since there could always be an unusual order of death. a. Example: Trust to spouse for life, remainder to issue per stirpes; in default of issue to charity. At the applicable date there are five children living and 10 grandchildren. Nonetheless, charity is taken into account so there is no designated beneficiary. b. Example: Trust for minor child to age 21. If the child dies before age 21 the trust is distributable to charity. It appears there would be no designated beneficiary because the child could die before age 21, in which case the charity would take. 3. The only non-conduit trust example in the 2002 regulations, which is similar to an example in the 2001 proposed regulations, is not helpful on this point. a. The example involves a trust under which income is payable to B, and A s children, who are all younger than B, are the sole remainder beneficiaries of the Trust P. No other person has a beneficial interest in Trust P. In this circumstance B and the children are all taken into account, and B is

5 Preserving the Designated Beneficiary 9 the designated beneficiary. Treas. Reg (a)(9)-5, A-7(c)(3), Ex. 1 (2002). But the facts as stated assume away the hard part. The children and B cannot be the sole persons with any beneficial interest in the trust. Even if the trust in fact did not provide for issue of a deceased child, or otherwise provide at all for who would take if the children all predeceased B, A or his estate would have a reversionary interest. Thus either the example is postulating a trust which cannot exist it is hoped not or is saying that B and the children are the sole beneficiaries of the trust for purposes of determining the designated beneficiary. In other words, you need not look beyond the children to contingent remaindermen. b. There are two ways you can reach this conclusion. The first, which we shall call the life expectancy rule, is by assuming that all the beneficiaries alive on the applicable date live out their life expectancies and treating as contingent beneficiaries only those who would take in that eventuality. The second, which we shall call the snapshot rule, is by treating as contingent beneficiaries only those who would take if the trust were to terminate on the applicable date. In the above example both rules would give rise to the same result. However, for what it s worth, the fact that the regulation stipulates that the children were all younger than B suggests that the drafters were thinking in terms of the life expectancy rule rather than the snapshot rule, inasmuch as the ages of the children would have been irrelevant under the snapshot rule. i. Marjorie Hoffman, the primary drafter of the regulations has indicated informally that this issue was simply not thought about. In other words, there was not a conscious decision that the contingent remaindermen were not relevant to the inquiry, even though the result reached can only be rationalized on this basis. 4. Prior history is of limited utility in this area, since the Service s thinking has obviously been evolving. For what it is worth, however, the Service has given ample notice previously that remaindermen would be taken into account in a nonconduit trust.

ALI-ABA Course of Study. Estate and Distribution Planning With Qualified Plans & IRAs

ALI-ABA Course of Study. Estate and Distribution Planning With Qualified Plans & IRAs 1 ALI-ABA Course of Study Estate and Distribution Planning With Qualified Plans & IRAs Encore Presentation with Live Q & A November 10, 2008 Live Video Webcast Preserving the "Designated Beneficiary" If