Common Estate Planning Mistakes

I am frequently called upon to review a trust that has been named as beneficiary of retirement benefits and comment on whether it will work for its intended purpose. Here are two of the most common trust drafting mistakes and misconceptions I encounter.

Question: The decedent's IRA is payable to a trust that doesn't even mention the "minimum distribution rules." Does this mean the trust cannot qualify for a life expectancy "stretch" payout and must take a lump sum distribution of the IRA?

Answer: Good news: The trust does not need to mention minimum distributions or retirement benefits.

A little background: In most cases the most favorable form of distribution for an inherited IRA is "annual installments over the life expectancy of the designated beneficiary." This is called the "life expectancy payout method" or the "stretch" payout. Though the life expectancy concept can apply only to an individual, the IRS allows a trust named as beneficiary of a retirement plan to qualify for the stretch payout. The trust must comply with various rules set by the IRS, including a requirement that all beneficiaries of the trust must be individuals. A trust that meets these requirements is called a "see-through trust," and can take distributions over the life expectancy of the oldest trust beneficiary.

The tests for qualifying as a see-through trust can be complicated and sometimes tough to comply with. But the tests depend on the substantive terms of the trust--not whether the trust instrument contains some magic language. A trust that meets the IRS' tests qualifies for the stretch payout even if the instrument never mentions minimum distributions or retirement benefits at all.

When drafting a trust, it is usually considered advisable to mention the retirement benefits and the minimum distribution rules because this shows the grantor's intent and alerts the trustee to the requirements. But the trust may still qualify even if it does not mention those things.

Question: The decedent's IRA was left to a marital deduction trust. The trust provides that the decedent's surviving spouse receives all income of the trust for life. On the spouse's death, the principal passes to the decedent's issue then living. The trust has a provision dealing with "stub income" of the marital trust: Any income the trust receives during the surviving spouse's life that has not yet been distributed to the spouse at the time she dies must be distributed to her estate. Does that provision leaving "stub income" to the surviving spouse's estate destroy qualification of the trust as a see-through trust for minimum distribution purposes?

Answer: Yes, it does.

As explained in the answer to the first question, one of the requirements of attaining "see-through trust" status is that all countable beneficiaries of the trust must be individuals. An estate is not an individual. In your example, the estate is a countable beneficiary of this trust, and therefore the trust has a non-individual beneficiary and "flunks" the see-through trust rules.

Is there any way out of this problem? The surviving spouse should disclaim (on behalf of her estate) any rights to the stub income. That should eliminate the problem of the estate being a potential non-individual beneficiary.

At the drafting stage, here is how to avoid the problem:

The first recommendation is not to provide that stub income is payable to the surviving spouse's estate. Many drafters include this provision under the mistaken impression that the spouse's estate must be entitled to this stub income in order for the trust to qualify for the estate tax marital deduction. But the IRS has issued a regulation specifically saying that this is not required. Paying the stub income to the remainder beneficiaries does not violate the marital deduction rules!

Another suggestion at the drafting stage is to make the trust a "conduit trust," i.e., a trust under which all retirement plan distributions (not just "income" or "minimum required distributions") received by the trust during the life of the "conduit" beneficiary (the spouse in this case) must be distributed to her "forthwith" and cannot be retained (accumulated) in the trust for later distribution to other beneficiaries. Under a conduit trust, the "conduit" beneficiary (in this case the surviving spouse) is considered the "sole" beneficiary of the trust and retirement plan for minimum distribution purposes; all remainder beneficiaries (including the spouse's estate) are disregarded. So payment of "stub" income to the spouse's estate would not upset the see-through trust status.

Resources: For full details on how to make retirement benefits payable to a trust as beneficiary, see Chapter 6 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7^th ed. 2011; http://www.ataxplan.com).

Natalie Choate will be speaking at a location near you if you live in Boston ((3/13/13) or Cambridge (4/19/13), Mass.; South Bend (10/17/13) or Indianapolis (6/21/13), Ind.; Atlanta (11/1/13); San Diego (2/15/13) or San Francisco (4/23-24/13); Chicago (5/13/13); Venice/Sarasota (Jan.8, 2013), Orlando (Jan.17–18, 2013), or Palm Beach Gardens (2/20/13), Fla.; Manchester, N.H. (3/7/13); Overland Park, Kan. (4/26/13); Asheville, N.C. (5/1/13); Columbus, Ohio (5/17/13); or Denver (8/9/13). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.