Life and Death Planning for Retirement Benefits

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Chapter 6: Leaving Retirement Benefits in Trust 329
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.
6.5.06 IRD, separate shares, and discretionary funding
Scenario 3: Continuing the Jody Example fro suppose Jody’s trust provides that
“The Trustee shall not be obligated to allocate each asset equally to the two shares, but rather may
allocate different assets to each child’s share, provided that the total amount allocated to each
child’s share is equal.” The trust thus authorizes discretionary pick-and-choose (non-pro rata)
funding.
The trustee has exercised its authority to choose which assets to use to fund each
beneficiary’s share: The trustee, in proper exercise of its discretion, allocated the entire $1 million
401(k) plan distribution to Angelina’s share. Does this enable the trustee to deduct the entire
distribution as DNI?
Probably not. Though other interpretations are possible, the usual interpretation of the
regulation is that, since the trustee could have elected to fund either beneficiary’s share of the trust
with the IRD, the trustee must (in computing its taxable income and DNI) allocate the IRD equally
to the two shares. Under this interpretation, discretionary pick-and-choose funding generally
produces the same result as mandatory pro rata funding (see exceptions below).
If the trustee of a trust that (1) is subject to the separate share rule and (2) permits
discretionary pick-and-choose funding wants the gross income arising from a retirement plan to
be allocated disproportionately, there are two ways to avoid the separate share rule and its
apparently-mandatory pro rata allocation of IRD-corpus, assuming these techniques can be used
consistent with the fiduciary’s obligations to all trust beneficiaries:
Allocation Respected Despite No Economic Effect
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. and Prop. Reg.
discussed a E).