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When Is Retirement; 'Dynasty' Trusts

Natalie Choate answers reader questions about retirement date determination for minimum required distributions and establishing a circle trust.

Natalie Choate, 12/09/2011

The reviews are in for the new edition of Natalie Choate's best-selling book Life and Death Planning for Retirement Benefits (7th ed. 2011): "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "I love the 7th edition!" "It's paid for itself already by answering several questions." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about the new edition of Life and Death Planning for Retirement Benefits, visit www.ataxplan.com.

In my last column, I asked for more questions to be submitted--and I got them! Here are two that came in, one "light" and one "heavy":

Question: My client is a professor at X University. She turned 70½ this year (2011), and her last day of work at XU will be Dec. 31, 2011. She does not have to take minimum required distributions from the XU pension plan until the later of April 1 of the year after the year she turns 70½ (i.e., April 1, 2012) or April 1 of the year after the year she retires. Can we say she is "retiring" in 2012, so as to push her required beginning date back to April 1, 2013? After all, she is working every day right through the end of 2011, so it does seem that the first year she is "retired" is 2012. ... It seems very arbitrary and unfair that she has to take her first required minimum distribution just three months after she retires, whereas if she worked for even one day in January 2012, she wouldn't have to take any distributions until April 2013.

Answer: The usual assumption is that a person who works through 2011 but does not work a single day in 2012 is considered to have retired in 2011. If you want to fight with the IRS and the plan administrator about this, be my guest. And yes it's arbitrary, but any rule based on birth dates and retirement dates will end up having "unfair" results for some people. This has been happening since kindergarten when children born just one day apart might end up in totally different grades because they happened to be born on either side of a cutoff date.

Question: Would the following trust provisions work to establish a "see-through" trust, the beneficiary of which would be the "Designated Beneficiary" for purposes of determining the Applicable Distribution Period for an IRA payable to the trust? I am trying to establish a "circle" trust similar to that discussed in section 6.4.05(B) of the new edition of your book (page 455).

The initial beneficiary would be my daughter Janice. The trust is a lifetime trust for her benefit. The trustee is to use income and principal of the trust as the trustee deems best for Janice's benefit during her lifetime. Though all payments to Janice are discretionary with the independent trustee, there are no other beneficiaries during her lifetime, and the trustee is instructed to consider her health, support, education, and well-being as significant goals of the trust.

Upon Janice's death, whatever is left in the trust will pass to such persons among the class consisting of my progeny as Janice shall appoint by will, provided that she cannot appoint to anyone who is older than she. If she fails to exercise the power, the property will pass to her offspring, or (if she has left no offspring; she has no offspring now living) to my descendants then living who were born after Janice. In either case, the property will be held in life trusts for the individuals on terms similar to the terms of the trust for Janice.

If at any time there is only one descendant of mine living who is either (1) Janice or (2) an individual younger than Janice, the trust will immediately terminate and the trust property will pass outright to such last surviving descendant.

Answer: The law on this question consists of a vague statute and a brief regulation, fleshed out by one or two private letter rulings. Based on this paucity of authority, I cannot offer meaningful reassurance regarding any particular trust. My view is, there are some situations where the statute and regulation clearly support see-through trust status; and in all the other cases "your guess is as good as mine." Your example falls in the latter category.

With regard to a "circle trust," if you have a specified group of living individuals who are the prime (and intended to be the sole, barring unforeseen circumstances) beneficiaries, such as the participant's children, and these beneficiaries are going to get the trust and benefits outright at a certain age that is well within their life expectancy, such as 25, 35, or even 45, then the circle provision (calling for early termination if all but one of the class members dies while there is still money in the trust, with outright distribution to that last surviving class member) meets the letter and spirit of the statute and regulations.

Obviously it shouldn't even be necessary to have such an early termination provision if all the money is to be paid outright to these known named individuals by the time they reach the specified age. In the case of the typical minor's trust, the actuarial likelihood that the minor beneficiaries will reach age 25, 35, or 45 is close to 100%. However, the IRS regulations look for "immediate outright" beneficiaries, and do not recognize "outright upon attaining age 25–45" as equivalent to "outright immediately regardless of age." Until the IRS adopts a more reasonable position on minors' trusts, the circle/early termination device seems to satisfy the IRS's requirement that the taker in default (who takes if the minors die before reaching the specified age) be an individual who is no older than the group members. So that is why the circle trust was invented and that's why it works.

In your example, however, you are not trying to get the retirement benefits to the beneficiary (Janice), while just holding them back until she reaches an appropriate age. You are trying to do the opposite ... you are trying to keep the benefits away from her, except to the extent the trustee deems it advisable to use them for her benefit, and tie the money up forever in trust for your descendants.

The code provision allowing the life expectancy payout is reserved for benefits payable to or for the benefit of the beneficiary whose life expectancy you want to use. That is the opposite of a perpetual trust for descendants. From that perspective, your trust would not qualify.

However, it is also true that the IRS basically invented the minimum distribution rules from whole cloth, ignoring and even contradicting the statute in a number of respects. Also, in private letter rulings, the IRS has blessed things that don't seem consistent with its own regulations and/or the statute. So the next question is whether your proposed trust idea could qualify as a "see through trust" under the IRS' regulation. The following scenarios "test" the trust assuming that your daughter Janice survives you; that you have only one other descendant then living who is younger than Janice (your grandson Ralph); and that Janice does not exercise her power of appointment.

The trust continues in existence during Janice's life, then stays in trust for Ralph's life. But Ralph does not get the property outright immediately on Janice's death, so (under the approach in the IRS's regulation) we have to keep testing until we find someone who gets the property immediately and outright on the death of a prior beneficiary. If Ralph also dies (after Janice), and there are no other younger descendants of yours then living (and the IRS rules are clear we are not entitled to assume that Ralph will have any descendants), who gets the property? Janice is by definition already dead. So the trust would fail under those circumstances and revert to your estate (a nonindividual beneficiary).

The IRS has not considered this type of approach in any published ruling. If they did consider it, they would have to confront the question of whether we are entitled to assume both that Janice survives Ralph and that Ralph survives Janice. Although I do not see how this type of trust could fit with the IRS' regulation, admittedly the IRS has in more than one private letter ruling seemed to ignore the fact that there would be a reversion to the donor's estate if a particular power of appointment is not exercised, so there is no telling but they might be perfectly comfortable with this approach.

Conclusion: The IRS might very well bless your approach if you seek a PLR, but I don't see how it works under the existing regulation or under the statute.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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