Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

349

immediately distributes the $1 million it received from the 401(k) plan to Angelina in partial fulfillment of her 50 percent share. The trust has no other income, and makes no other distributions, in Year 1. What is the trust’s DNI deduction for the distribution to Angelina? Step 1: Does the separate share rule apply? The separate share rule applies here because distributions to Jody’s children are made “in substantially the same manner as if separate trusts had been created” for them. Reg. § 1.663(c)-3(a) . If this had been a “spray” trust, with the trustee having discretion to pay income and/or principal of the entire fund to either child at any time (instead of having to give each child an equal amount) the separate share rule would not apply. Step 2: Is the plan distribution corpus? The regulation next requires that we determine whether the 401(k) plan is “corpus” for trust accounting purposes. Assume that it is; see ¶ 6.1.02 . Step 3: Does the trust instrument or state law dictate to which share(s) this plan distribution shall be allocated? If either the trust instrument or state law mandates that the plan distribution be allocated to a particular share, that allocation will be followed for purposes of allocating the resulting DNI among the separate shares. To carry out Step 3, therefore, we must look at the terms of Jody’s particular trust and/or state law: Scenario 1: If Jody’s trust required the trustee to allocate the 401(k) plan proceeds to Angelina’s share, then all the income arising from that plan distribution is allocated to Angelina’s “separate share” and the $1 million cash distribution from the trust carries out $1 million of DNI to Angelina. Reg. § 1.663(c)-5 , Example 9. Under the regulation, a trust instrument’s allocation of an IRD-corpus item to a particular beneficiary’s share is given effect for income tax purposes even if such allocation has no independent economic effect ( i.e., it does not change the amount each beneficiary receives, it affects only the taxability of what each beneficiary receives). In other contexts, the regulations give effect to the allocation of a particular class of income to one beneficiary or another “only to the extent that it has an economic effect independent of the income tax consequences of the allocation.” See Reg. § 1.652(b)-2(b) and Prop. Reg. § 1.643(a)-5(b) , discussed at ¶ 7.4.03 (E). Scenario 2: Alternatively, if Jody’s trust requires that each beneficiary receive an equal share of each asset; or if the trust is silent on that topic but applicable state law requires such pro rata funding of the beneficiaries’ shares; the separate share rule will require that the DNI resulting from the retirement plan distribution be allocated equally to Brad’s and Angelina’s shares. Thus, under Scenario 2, even though the trust distributed $1 million to Angelina, the trust’s income tax deduction is only $500,000, and Angelina includes only that much in her gross income for Year 1. The trust will have taxable income of $500,000 for Year 1. This is the fair result the separate share rule was designed to bring about: Under a trust where the beneficiaries “own” fractional shares, no one beneficiary bears a disproportionate share of income tax just because he happened to receive more distributions in a particular year. Allocation Respected Despite No Economic Effect

IRD, separate shares, and discretionary funding