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Using IRAs to Fund QTIP Trusts An IRA account may well be the largest asset in a taxpayer's estate; thus, it may be a natural choice for funding a qualified terminable interest property (QTIP) trust. However, such trusts are not for every client, and should be created and funded with care. This article examines important issues in funding a QTIP trust with an IRA, including a recent IRS pronouncement that liberalized some of the rules.
Linda
M. Johnson, Ph.D., CPA Brian
R. Greenstein, Ph.D.
For more information about this article, contact Dr. Johnson at (770) 423-6085 or Linda_Johnson@coles2.kennesaw.edu or Dr. Greenstein at (973) 761-9428 or Greensbr@shu.edu.
Executive Summary
Good estate planning involves not only minimizing estate tax liability, but also ensuring that the taxpayer's nontax objectives are met. A qualified terminal interest property (QTIP) trust is a popular device that allows a taxpayer to provide a surviving spouse with the income from (or use of) property undiminished by estate taxes for life, while ensuring that the former's wishes will be followed after the latter's death. This is accomplished by qualifying the trust property for the estate tax marital deduction, even though a terminable interest exists. Many taxpayers may need to consider funding QTIP trusts with retirement assets. This article analyzes the requirements for effective use of a QTIP election for a trust funded by an IRA, in light of the liberalized distribution requirements set forth in Rev. Rul. 2000-2.1
When to Use a QTIP Trust The decision to use a QTIP trust is a function of the relationships among the taxpayer, his spouse and the intended remainder interest holders. When a taxpayer leaves property outright to a spouse, it becomes the spouse's property to control; thus, the spouse decides the property's next owner. If a taxpayer and spouse have enjoyed a long, happy marriage and have common objects of affection, a QTIP trust may serve little purpose. In fact, a QTIP election may erode the control the surviving spouse has over the children. In such a case, a general power of appointment trust, qualifying under Sec. 2056(b)(5), might be more appropriate, permitting the spouse to appoint property to children according to need, while limiting amounts transferred to less needy or responsible offspring. Sometimes, there are no common objects of affection. If a taxpayer has children from a prior marriage, conflicting testamentary wishes with a spouse or concerns about the spouse remarrying, the desire to ensure an intended distribution of assets may outweigh a QTIP trust's relative inflexibility. QTIP trusts are also useful when there is a significant age disparity between a taxpayer and spouse,2 or when a taxpayer is concerned that the surviving spouse may not be competent to manage or conserve assets. Trusts that qualify for the marital deduction avoid probate at the surviving spouse's death, and defer the payment of estate taxes until that time. Thus, even if the surviving spouse has adequate assets for support, the estate tax deferral allows the estate to grow undiminished, while allowing for the possibility that the estate tax may be reduced or eliminated in the future.
The QTIP Election Because Federal tax law requires that property be taxed at least once every generation, an estate tax marital deduction generally is not allowed for a terminable interest. According to Sec. 2056(b)(1), a "terminable interest" exists if an interest passing to a surviving spouse will terminate or fail on the occurrence (or failure to occur) of an event or contingency. Sec. 2056(b)(7) allows a marital deduction for a terminable interest when a surviving spouse receives a life estate in property for which a QTIP election is made. This provision gives taxpayers the opportunity to both guarantee their nontax wishes and qualify for the marital deduction on property transferred to a surviving spouse.3 Under Sec. 2056(b)(7)(B)(i), an estate tax marital deduction is permitted from the decedent's estate (even though a terminable interest has been transferred), if the following three requirements are met: 1. Property passes from the decedent. 2. The surviving spouse has a qualifying income interest for life in such property. 3. An election is made to treat the property as QTIP. The distributive arrangements specified in the QTIP trust cannot be changed by the surviving spouse. If a QTIP election is made, Sec. 2044 requires the fair market value (FMV) of the QTIP be included in the surviving spouse's estate.4 The "qualifying income interest for life" requirement becomes more complicated when retirement assets, rather than stock or bonds, are used to fund a QTIP trust. When using nonretirement assets as QTIP, the income produced therefrom (e.g., interest and dividends) is distributable to the surviving spouse; the trust corpus is preserved for the remainder interest holders. When using retirement assets such as IRAs, the required minimum distribution (RMD) rules come into play; generally, the RMD differs from the IRA's annual earnings.
RMDs Sec. 401(a)(9)(C)(i) requires a traditional IRA owner to begin receiving RMDs no later than April 1 of the year following the year he turns 701/2,5 or incur a 50% penalty under Sec. 4974(d). Prop. Regs. Sec. 1.408-8, Q&A-6, provides that each RMD equals the IRA balance on December 31 of the previous year, divided by the required distribution period. During an IRA owner's life, the required distribution period depends on the owner's attained age during the distribution year and is determined using the uniform table provided in Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-4(a)(2)(i).6
Effect of IRA Owner's Death The distribution periods found in Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-4(a)(2)(i), apply only to RMDs during an IRA owner's life. Starting with the year following the year of the owner's death, the distribution period used to calculate RMDs is the single life expectancy of the "designated beneficiary," as determined in Regs. Sec. 1.72-9, Table V.7 Although IRA owners can name any individual or entity as an IRA beneficiary, only individuals can be classified as designated beneficiaries.8 However, trust beneficiaries will be treated as designated beneficiaries if the trust meets the requirements in Prop. Regs. Sec. 1.401(a)(9)-4, Q&A-5(b). Thus, when a QTIP trust is an IRA beneficiary, RMDs will be made over the surviving spouse's remaining single life expectancy, starting with the year following the year of the IRA owner's death. By placing IRA assets in a QTIP trust, the IRA owner forgoes significant income tax advantages associated with naming the spouse as the sole beneficiary. If the owner's spouse is the sole IRA beneficiary, after the owner dies, Sec. 408(d)(3)(C)(ii)(II) permits the surviving spouse to elect to treat the IRA as his own.9 This allows the surviving spouse to postpone taking IRA distributions until his required beginning date (RBD); required distributions can then be computed using the distribution period corresponding to the surviving spouse's age.
When an IRA owner dies before reaching his RBD, under Prop. Regs. Sec. 1.401(a)(9)-5,Q&A-5(b), the ac-count balance must be distributed over the life expectancy of the designated beneficiary with the shortest life ex-pectancy, provided distributions begin no later than December 31 of the year after the owner's death. Alternatively, Prop. Regs. Sec. 1.401(a)(9)-3,Q&A-4, states that the IRA may include a provision requiring that the entire balance be distributed within five years of the account owner's death.12 Significant tax deferral advantages are forgone if IRA assets are placed in a QTIP trust and the owner dies prior to his RBD, versus naming the spouse as sole beneficiary. If the spouse is the sole beneficiary, under Prop. Regs. Sec. 1.401(a)(9)-3,Q&A-3(b), he can delay the start of RMDs until December 31 of the year the owner would have turned 701/2. Alternatively, the spouse can treat the IRA as his own and wait until his own RBD (April 1 of the year after the year the spouse turns 701/2) before taking distributions, under Prop. Regs. Sec. 1.408-8, Q&A-5(a). However, if a QTIP trust is the beneficiary, the IRA must be distributed over the spouse's life expectancy.
As the previous two examples illustrate, the primary disadvantage to using retirement assets to fund a QTIP trust is the accelerated distribution period used to compute RMDs. In addition, any portion of the IRA distribution retained by the QTIP trust (i.e., principal) will be taxed at the compressed trust tax rates. Given the preponderance of retirement assets in many estates, taxpayers may decide that the costs associated with placing retirement assets in a QTIP trust outweigh the potential consequences of leaving them outright to a spouse. Should an IRA owner decide that funding a QTIP trust with IRA assets is necessary or desirable, it is essential that the trust be created and administered properly to satisfy the QTIP requirements.
QTIP Requirements As was mentioned, Sec. 2056(b)(7) provides three basic requirements for a QTIP trust. The QTIP election is made by the executor, regardless of whether the QTIP is in the executor's or another person's possession.13 When a QTIP trust is the IRA beneficiary, the income from the IRA flows through the QTIP trust before being distributed to the surviving spouse. Accordingly, the Service has stated in Rev. Ruls. 89-8914 and 2000-2 that an executor must make a valid Sec. 2056(b)(7) election for both the IRA and the QTIP trust. The passing requirement has presented relatively few problems in qualifying property for the marital deduction.15 IRAs and QTIP trusts are treated as having passed from the decedent to the surviving spouse. However, the "qualifying income interest for life" requirement has been the primary issue for concern when IRAs constitute QTIP.
Qualifying Income Interest for Life For property held in trust to qualify for a QTIP election, the surviving spouse must have a qualifying income interest for life. Sec. 2056(b)(7)(B)(ii) provides the following two-prong test: 1. The surviving spouse must be entitled to all the income from the property, payable in annual or more frequent installments. 2. No person may have a power to appoint any part of the property to any person other than the surviving spouse during the surviving spouse's life. Interpretation: The "qualified income interest for life" provision requires that the surviving spouse be entitled to "all" trust income. In Letter Ruling (TAM) 9220007,16 the Service held that a QTIP election was not allowed when a trustee was permitted to delay the start of required distributions from a decedent's IRA to a QTIP trust for a significant period of time. The trustee had three options for receiving payouts from the IRA. Option one provided that if the testator died before his RBD, the trustee could wait up to five years after his death to distribute the full IRA. Options two and three provided that if the spouse was the designated beneficiary and alive at the testator's death, distributions would not begin before the day the testator would have at-tained age 701/2. The testator died at age 68. Under option one, distributions from the IRA could have been delayed for up to five years. Under options two and three, no distributions were required for 21/2 years, when the decedent would have turned 701/2. Because the spouse was not entitled to a distribution of all the income from the trust at least annually, the requirements of Sec. 2056(b)(7)(B)(ii) had not been met and the QTIP deduction was disallowed.
Trust Accounting Income For trust accounting purposes, amounts distributed from an IRA to a QTIP trust must be allocated between income and principal. Section 409(c) of the Uniform Principal and Income Act17 (Act) provides that 10% of the distribution is allocated to income; the remaining 90% is allocated to principal. When the IRS compels a QTIP trust to make a distribution to a surviving spouse in excess of 10% of the total distribution from the IRA, Act Section 409(d) permits the entire amount distributed to the surviving spouse to be allocated to trust income, with the remainder allocated to principal.
Penalty Avoidance Rev. Rul. 89-89 When a trust is funded with an IRA, distributions equal to the RMD must be made to avoid the Sec. 4974(d) 50% excise tax. Given the recent returns earned by some portfolios, the trust earnings may exceed the RMD. In Rev. Rul. 89-89 (which does not specifically address RMDs), the Service held that a trust qualified as a QTIP trust because the IRA had to distribute all income for the year to the trust; the trust had to distribute such income to the beneficiary currently. However, Regs. Sec. 20.2056(b)-5(f) requires only that the income earned from the property (the IRA) be distributed at least annually to the spouse; although Rev. Rul. 89-89 seemed to conflict with this regulation, it remained the Service's position until Rev. Rul. 2000-2.
Rev. Rul. 2000-2 In obsoleting Rev. Rul. 89-89, Rev. Rul. 2002-2 held that, when an IRA's annual earnings exceed the RMD, only the RMD need be distributed to the surviving spouse to meet the "all income for life" requirement, provided that the spouse can compel the trustee to distribute the excess. Rev. Rul. 2000-2 allows spouses to let the excess of the IRA earnings over the RMD remain in the IRA for the benefit of the remainder interest holders. In so doing, the trust (as opposed to the surviving spouse) will pay tax currently on the undistributed income. Gift tax consequences may result, based on the difference between the RMD and the amount earned by the IRA; however, providing the surviving spouse with the right to compel a cumulative distribution of the excess earnings during life will eliminate the potential imposition of gift tax. As a result, any amounts not distributed to the spouse will be included in his estate on death. Moreover, if the spouse's right to compel distributions lapses, Sec. 2514(e) requires that the undistributed excess earnings be treated as a taxable gift from the spouse to the remainder interest holders when the right lapses.
Conclusion Because many estates consist of sizable retirement assets, taxpayers may find it necessary to fund a QTIP trust with them. Tax planners advising clients who are considering placing IRA assets into a QTIP trust will want to keep in mind the following guidelines. First, the trustee should elect to receive annual RMDs using the exception to the five-year rule in Sec. 401(a)(9)(B)(iii). Second, all trust income must be payable annually to the surviving spouse, with no person having the power to appoint trust principal to any person other than the spouse. Third, the trust document must not bar distribution of amounts in excess of the annual RMD under Sec. 408(a)(6). Fourth, the spouse must have the right (exercisable annually) to compel the trustee to distribute an amount equal to the income earned on the assets held by the IRA during the year—even if that amount exceeds the RMD. Finally, to avoid the possibility of a taxable gift in a year in which the surviving spouse takes an RMD less than the actual earnings of the QTIPed IRA, the spouse must have a cumulative right to withdraw these excess amounts. Placing IRAs in QTIP trusts re-duces potential deferral opportunities otherwise available to outright IRA beneficiaries. However, the importance of guaranteeing the former IRA owner's dispositive wishes may often outweigh these potential costs. When IRA assets are placed into a trust for which a QTIP election will be made, it is essential that the passing, election and income-for-life requirements be satisfied. In Rev. Rul. 2000-2, the Service has clarified that only the RMD need be distributed to a surviving spouse to meet the QTIP-income-for-life requirement, if the surviving spouse can compel the trustee to withdraw from the IRA and distribute IRA earnings in excess of the RMD. |
