James H. Beauchamp
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USING ERISA CONTRIBUTIONS TO FUND THE BY-PASS TRUST

Distributions from ERISA Funds and non-Roth IRA’S have always been a challenge in estate planning. Before December 30,1997, when the IRS released Prop. Reg. §1.401(a)(9)-1 (reproduced below; this regulation has been recently amended as part of a comprehensive overhaul of the 1987 proposed regulation, which deal with IRAs; the January 12, 2001 proposed regulation has not changed the verbiage of the 1997 version), there were several risks in naming a trust as the beneficiary of the IRA. First, there was a serious question as to whether a trust qualified as a “designated beneficiary”. The general rule is that designated beneficiaries must be living persons. A “trust” is not a living person, and accordingly, would not qualify as being a “designated beneficiary”. In addition, the effective income tax rates for trusts is much higher than those paid by individuals. This year, for example, the marginal tax rate for trusts earning taxable income in excess of $8,650 is 39.6%. Contrasting that tax rate with a married couple filing jointly, the couple will not enter the 39.6% arena unless their taxable income exceeds $288,350. Thus, even if a trust could qualify as a “designated beneficiary”, the trust would have to pay income taxes of 39.6% for income received in excess of $8,650 (this benchmark would apply to most IRAs).

All of those fears were allayed when the Treasury Department amended the proposed regulations under §1.404(a)(9)-1, and the sun broke through the clouds. The purpose of this month’s article is to give a thumbnail sketch of what happened – but for purposes of this article, all ERISA contributions will be referred to as IRAs (note, however, that the planning tools described in this article are not available for all ERISA contributions; each case will have to be dealt with separately, depending on the terms of the §401(k) plan, the §403(b) plan, and so forth). In addition, this article does not cover Roth IRAs – we are only dealing with conventional IRAs.

First, the definitions. As you may or may not know, IRA distributions made at death are not made to “death beneficiaries”. The IRS refers to the recipients as “designated beneficiaries”. Suppose a trust were named as a “designated beneficiary” of the IRA. What are the income tax consequences of such a designation?

Under the proposed regulation, the IRS conceded that trusts are merely conduits, and the trustee will not have to pay income taxes using the accelerated trust tax tables. In the answer given to question D-5 of the proposed regulation, the Treasury Department made the following statement: “(The) trust itself may not be the designated beneficiary (of an IRA) even through the trust is named as a beneficiary. However, (if) the requirements (below) are met, distributions made to the trust will be treated as (being) paid to the beneficiaries of the trust . . . “. This sentence is very important, because the IRS is, in effect, permitting the trust to be "taxed" as a partnership, i.e., the trust pays no income tax at all. The income tax on the IRA distribution is to be paid by the trust beneficiaries at their respective income tax rates.

Because it sounds so good to say it, let me say it again: this provision of the proposed regulation acknowledges that trusts are conduits, through which income may flow to the beneficiaries, and the trust is not taxed using the trust income tax tables – the income will be taxed using the tax tables of the individual beneficiaries. In order to qualify for this tax treatment, however, the following conditions must be met:

(1) The trust must be a valid trust under state law, or would be but for the fact there is no corpus.

(2) The trust must be revocable by will, or by its terms, becomes irrevocable upon the death of the owner of the IRA.

(3) The beneficiaries of the trust must be identifiable from the trust instrument.

(4) Documentation relating to the above items 1-3 must be provided to the IRA plan administrator. The trustee can identify the beneficiaries of the trust even after death of the Settlor of the trust – such designation must, however, be made nine months after death. In lieu of making such an identification, the plan administrator can be given a copy of the trust.

With this proposed amendment now in place, we now have enhanced estate planning opportunities. Let me give you an example of what I am talking about, using Dick and Jane Smith as a hypothetical case study. Dick is a retired oil company executive, and has rolled his §401(k) plan into an IRA, now worth 1.8 million dollars. The remainder of Dick and Jane’s assets consists of their $400,000 home and some personal effects. Since Dick cannot transfer his IRA to his wife, at least before his death, his wife is in an awkward situation, because her assets are less than the unified credit equivalent, viz., $675,000.

Even though Dick and Jane have established an A-B tax credit sheltered trust, they cannot take full advantage of the By-Pass Trust provisions, which will save estate taxes only if $675,000 of Dick’s assets are shifted to the By-Pass Trust upon his death. As things now stand, when Dick dies, Jane will inherit all of his IRA, which will not be taxed for estate tax purposes (it qualifies for the marital deduction). The remainder of Dick’s assets, which are half of the $400,000 joint assets, or $200,000, will be placed in the tax credit trust (i.e., the By-Pass trust). Thus, the A-Trust (the marital deduction trust) now owns Dick’s IRA, i.e., 1.8 million and half of their joint assets (the $200,000 attributable to Jane). In summary, when Jane dies, she owns 2.0 million in assets, which will be taxed for estate tax purposes (the federal estate taxes are $780,800, less the unified credit of $220,550, or a net tax bill of $560,250). The By-Pass trust, which owns $200,000 in assets, is not taxed again on her death.

Stated differently, what is missing in the equation is a complete funding of the By-Pass trust on Dick’s death. Had the By-Pass trust been completely funded, the estate taxes saved would equal $213,750.

After the Treasury Department released its amendment to the proposed regulation, Dick and Jane can amend the IRA designated beneficiary, and name the Trustee of the Dick and Jane Smith Trust as the beneficiary. If that were done, and upon Dick’s death, the trustee can allocate enough of the IRA funds to the B-Trust, thereby using the entire Unified Credit. In our example, the sum of $675,000 of IRA funds can be allocated to the B-Trust. The balance of Dick’s estate will be treated as marital deduction property. Through the combined "deductions" available to Jane (the marital deduction and the unified credit), there will be no estate taxes on Dick's death. Furthermore, when Jane dies, there will be no additional estate tax on the B-trust, since it was “taxed” at Dick’s death (Jane will, however, receive distributions from the B-Trust, during her lifetime). At her death, Jane's heirs will be paying estate taxes on an estate of $1,525,000 (note: the B-Trust, consisting of $675,000 in assets, is not part of her taxable estate); the heirs will be entitled to use the unified credit of $220,550 against the tax of $567,050, which reduces the federal estate tax to $346,500. Using this traditional A-B trust scenario, we will save $213,750 in federal estate taxes.

Assume, for a minute, that Dick is deceased, and Jane has survived him. The question now becomes, how is the trustee of the By-Pass Trust going to distribute the IRA? Since the IRA has been allocated to the B-Trust, which is irrevocable (it is not a marital deduction trust), and since withdrawals from IRAs are taxable for income tax purposes, how is it to be distributed to Jane? Presumably the trustee of the Credit Sheltered Trust would not distribute all of the IRA funds at once, because of the increased income taxes that must be paid by the beneficiary (a lump sum distribution to Jane of all of the $675,000 would be subject to a 39.6% marginal tax rate). So there must be some planning on how the IRA is to be paid to Jane, through the By-Pass trust.

If Dick died before reaching the required beginning date (age 70 ½), then payments from the IRA could be made over the life span of the oldest beneficiary named under the Credit Sheltered Trust. In the above example, since Jane is the life tenant of Trust B, distributions are based on her life expectancy.

But suppose Dick had reached age 70 ½, his required beginning date, and was taking distributions under his IRA. If that happened, the trustee would distribute the remainder of the IRA, using whatever distribution period Dick had elected. If he had elected the fixed method, then distributions would be based on his remaining life. If he had elected distributions under a joint life, then distributions would continue to be made on that basis.

Because the surviving spouse, in this case Jane, might need some income options on her own behalf, I still believe it advisable to name Jane as the primary beneficiary of the IRA. She is entitled to disclaim her ownership interest in the IRA, in favor of the By-Pass trust; thus, if she disclaimed enough of the IRA’s to fund the B-trust, then she will have received though the back door what she would have received through the front – with the benefit that the Tax-Sheltered Trust is now fully funded, and substantial estate taxes will be saved by the heirs of the Smith trust.

In summary, the purpose of this article is to set forth, perhaps in an over-simplified presentation, changes in how trusts are taxed. These issues are very complex, for both income tax purposes and for estate tax purposes – to use some of these ideas requires preparation and signing of fairly complicated IRA beneficiary designation forms (ironically, several investment and brokerage firms have not yet approved the use of these forms). Though there will be a downside in expenses (finding someone to assist in preparing the beneficiary designation forms), there is an upside, because of what can now be done. Using the recent proposed Treasury regulation, persons such as Dick, who is top heavy in his IRA holdings, will be able to do normal estate planning, namely, using part of his own assets (the IRA’s) to fund the By-Pass Tax Sheltered Trust.

© 2000 James H. Beauchamp

Prop. Reg. §1.401(a)(9)-1

PAR.2. Section 1.401 (a)(9)-1 as proposed to be added at 52 FR 28075, July 27, 1987, is amended by

1. Revising Q&A D-5.

2. Revising Q&A D-6.

3. Adding Q&A D-7.

The additions and revisions read as follows:

* * * * * * * *

D. Determination of the Designated Beneficiary

* * * * * * * *

D-5. Q. If a trust is named as a beneficiary of an employee, will the beneficiaries of the trust with respect to the trust’s interest in the employee’s benefit be treated as having been designated as beneficiaries of the employee under the plan for purposes of determining the distribution period under section 401(a)(9)(A)(ii)?

A. (a) Pursuant to D-2A of this section, only an individual may be a designated beneficiary for purposes of determining the distribution period under section 401(a)(9)(A)(ii). Consequently, a trust itself may not be the designated beneficiary even though the trust is named as a beneficiary. However, if the requirements of paragraph (b) of this D-5 are met, distributions made to the trust will be treated as paid to the beneficiaries of the trust with respect to the trust’s interest in the employee’s benefit, and the beneficiaries of the trust will be treated as having been designated as beneficiaries of the employee under the plan for purposes of determining the distribution period under section 401(a)(9)(A)(ii). If, as of any date on or after the employee’s required beginning date, a trust is named as beneficiary of the employee and the requirements in paragraph (b) of this D-5 are not met, the employee will be treated as not having a designated beneficiary under the plan for purposes of section 401(a)(9)(A)(ii). Consequently, for calendar years beginning after that date, distribution must be made over the employee’s life (or over the period which would have been the employee’s remaining life expectancy determined as if no beneficiary had been designated as of the employee’s required beginning date).

(b) The requirements of this paragraph (b) are met if, as of the later of the date on which the trust is named as a beneficiary of the employee, or the employee’s required beginning date, and as of all subsequent periods during which the trust is named as beneficiary, the following requirements are met:

(1) The trust is a valid trust under state law, or would be but for the fact that there is no corpus.

(2) The trust is irrevocable or will, by its terms, become irrevocable upon the death of the employee.

(3) The beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit are identifiable from the trust instrument within the meaning of D-2 of this section.

(4) The documentation described in D-7 of this section has been provided to the plan administrator.

(c) In the case of payments to a trust having more than one beneficiary, see E-5 of this section for the rules for determining the designated beneficiary whose life expectancy will be used to determine the distribution period. If the beneficiary of the trust named as beneficiary is another trust, the beneficiaries of the other trust will be treated as having been designated as beneficiaries of the employee under the plan for purposes of determining the distribution period under section 401 (a)(9)(A)(ii), provided that the requirements of paragraph (b) of this D-5 are satisfied with respect to such other trust in addition to the trust named as beneficiary.

D-6. Q. If a trust is named as a beneficiary of an employee, will the beneficiaries of the trust with respect to the trust’s interest in the employee’s benefit be treated as designated beneficiaries under the plan with respect to the employee for purposes of determining the distribution period under section 401(a)(9)(B)(iii) or (iv):?

A. (a) If a trust is named as a beneficiary of an employee and the requirements of paragraph (b) of D-5 of this section are satisfied as of the date of the employee’s death or, in the case of the documentation described in D-7 of this section, by the end of the ninth month beginning after the employee’s date of death, then distributions to the trust for purposes of section 401(a)(9) will be treated as being paid to the appropriate beneficiary of the trust with respect to the trust’s interest in the employee’s benefit, and all beneficiaries of the trust with respect to the trust’s interest in the employee’s benefit will be treated as designated beneficiaries of the employee under the plan for purposes of determining the distribution period under section 401 (a)(9)(B)(iii) and (iv). If the beneficiary of the trust named as beneficiary is another trust, the beneficiaries of the other trust will be treated as having been designated as beneficiaries of the employee under the plan for purposes of determining the distribution period under section 401(a)(9)(B)(iii) and (iv), provided that the requirements of paragraph (b) of D-5 of this section are satisfied with respect to such other trusts in addition to the trust named as beneficiary. If a trust is named as a beneficiary of an employee and if the requirements of paragraph (b) of D-5 of this section are not satisfied as of the dates specified in the first sentence of this paragraph, the employee will be treated as not having a designated beneficiary under the plan. Consequently, distribution must be made in accordance with the five-year rule in section 401(a)(9)(B)(ii).

(b) The rules of D-5 of this section and this D-6 also apply for purposes of applying the provisions of section 401(a)(9)(B)(iv)(II) if a trust is named as a beneficiary of the employee’s surviving spouse. In the case of payments to a trust having more than one beneficiary, see E-5 of this section for the rules for determining the designated beneficiary whose life expectancy will be used to determine the distribution period.

D-7. Q. If a trust is named as a beneficiary of an employee, what documentation must be provided to the plan administrator so that the beneficiaries of the trust who are beneficiaries with respect to the trust’s interest in the employee’s benefit are identifiable to the plan administrator?

A. (a) Required distributions commencing before death. In order to satisfy the requirement of paragraph (b)(4) of D-5 of this section for distributions required under section 401(a)(9) to commence before the death of an employee, the employee must comply with either paragraph (a)(1) or (2) of this D-7:

(1) The employee provides to the plan administrator a copy of the trust instrument and agrees that if the trust instrument is amended at any time in the future, the employee will, within a reasonable time, provide to the plan administrator a copy of each such amendment.

(2) The employee—

(i) Provides to the plan administrator a list of all of the beneficiaries of the trust (including contingent and remainderman beneficiaries with a description of the conditions on their entitlement);

(ii) Certifies that, to the best of the employee’s knowledge, this list is correct and complete and that the requirements of paragraphs (b)(1), (2), and (3) of D-5 of this section are satisfied;

(iii) Agrees to provide corrected certifications to the extent that an amendment changes any information previously certified; and

(iv) Agrees to provide a copy of the trust instrument to the plan administrator upon demand.

(b) Required distributions after death. In order to satisfy the documentation requirement of this D-7 for required distributions after death, by the end of the ninth month beginning after the death of the employee, the trustee of the trust must either –

(1) Provide the plan administrator with a final list of all of the beneficiaries of the trust (including contingent and remainderman beneficiaries with a description of the conditions on their entitlement) as of the date of death; certify that , to the best of the trustee’s knowledge, this list is correct and complete and that the requirements of paragraph (b)(1), (2), and (3) of D-5 of this section are satisfied as of the date of death; and agree to provide a copy of the trust instrument to the plan administrator upon demand; or

(2) Provide the plan administrator with a copy of the actual trust document for the trust that is named as a beneficiary of the employee under the plan as of the employee’s date of death.

(c) Relief for discrepancy between trust instrument and employee certifications or earlier trust instruments. (1) if required distributions are determined based on the information provided to the plan administrator in certifications or trust instruments described in paragraph (a) (1), (a)(2) or (b) of this D-7, a plan will not fail to satisfy section 401(a)(9) merely because the actual terms of the trust instrument are inconsistent with the information in those certifications or trust instruments previously provided to the plan administrator, but only if the plan administrator reasonably relied on the information provided and the minimum required distributions for calendar years after the calendar year in which the discrepancy is discovered are determined based on the actual terms of the trust instrument. For purposes of determining whether the plan satisfied section 401(a)(9) for calendar years after the calendar year in which the discrepancy is discovered, if the actual beneficiaries under the trust instrument are different from the beneficiaries previously certified or listed in the trust instrument previously provided to the plan administrator, or the trust instrument specifying the actual beneficiaries does not satisfy the other requirements of paragraph (b) of D-5 of this section, the minimum required distribution will be determined by treating the beneficiaries of the employee as having been changed in the calendar year in which the discrepancy was discovered to conform to the corrected information and by applying change in beneficiary provisions of E-5 of this section.

(2) For purposes of determining the amount of the excise tax under section 4974, the minimum required distribution is determined for any year based on the actual terms of the trust in effect during the year.

 

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