Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

A definition of “income” provided by the governing instrument or by applicable state law will be accepted for tax purposes if it “provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year ....” See § 643(b) and Regs. § 1.643(b)-1 , § 20.2056(b)-5(f)(1) . The IRS found that the UPIA 1997’s 10 percent rule (see “C” above) of determining income “does not satisfy the marital deduction income requirements of § 20.2056(b)-5(f)(1) and § 1.643(b)-1 , because the amount of the ... RMD] is not based on the total return of the IRA (and therefore the amount allocated to income does not reflect a reasonable apportionment of the total return between the income and remainder beneficiaries).” Rev. Rul. 2006-26, 2006-22 I.R.B. 939; emphasis added. The IRS then explained what it views as the “income” of a retirement plan that the surviving spouse must be entitled to when such plan is payable to a marital deduction trust: either the plan’s internal investment income (“trust-within-a-trust” concept; see ¶ 6.1.03 (C)) or an acceptable ( i.e., 3%–5%) annual “unitrust” percentage amount (see ¶ 6.1.04 ). Because of problems with the 10 percent rule, the American College of Trust & Estate Counsel (ACTEC), through its Employee Benefits Committee, and other interested groups are seeking to have the UPIA amended to eliminate it. A number of states have modified § 409 so that retirement plan distributions received by the trust are accounted for using a unitrust or trust-within- a-trust approach rather than the 10 percent rule. Unfortunately, most states’ approaches still do not satisfy the IRS’s definition, because their rules account only for distributions the trustee receives from the retirement plan, not for the investment results “inside” the retirement plan. Some other states have not adopted the 1997 UPIA at all. The bottom line is that every drafter and trustee must check the applicable state law regarding its definition of “income” with respect to retirement benefits payable to the trust. There are three ways to avoid the problems discussed in ¶ 6.1.02 : draft a totally discretionary trust (see “A” below); define income as it applies to retirement plan benefits (see “B” and “C”); or use the “unitrust” approach (see ¶ 6.1.04 ). For a marital deduction trust, use “C” or the “unitrust” approach; do not use “A.” This ¶ 6.1.03 gives an overview of this subject; it does not provide sufficient detail to enable the drafter to prepare a trust instrument without studying the applicable state law and IRS standards set forth in regulations under § 643 and in Rev. Rul. 2006-26. Also, this discussion deals with planning approaches; the trustee of a trust that is already operative needs to comply with the terms of the instrument and applicable state law to determine the trust’s income, and does not have the option to simply adopt whatever method is appealing. A. Draft so the definition of “income” doesn’t matter. The trust accounting question may be unimportant in a totally discretionary trust. For example, if the trust provides that the trustee shall pay to the life beneficiary “such amounts of the income and/or principal of the trust as the trustee deems advisable in its discretion from time to time,” it will make no difference whether the internal income of (or a distribution from) a particular retirement plan is treated as income or principal for trust accounting purposes. The beneficiaries’ substantive rights do not depend on whether a particular asset or receipt is classified as income or principal. Trust accounting: Drafting solutions