SELECTING A DEATH BENEFICIARY FOR QUALIFIED PLAN BENEFITS CREATIVE FUNDING OF CREDIT SHELTER TRUSTS IN THE CONTEXT OF RETIREMENT BENEFITS

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1 SELECTING A DEATH BENEFICIARY FOR QUALIFIED PLAN BENEFITS CREATIVE FUNDING OF CREDIT SHELTER TRUSTS IN THE CONTEXT OF RETIREMENT BENEFITS 2004 Julius H. Giarmarco, Esq. Prepared By: Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C. 101 West Big Beaver Road, Suite 1000 Troy, MI (248) Fax: (248)

2 SELECTING A DEATH BENEFICIARY FOR QUALIFIED PLAN BENEFITS I. GENERALLY. A. Threshold Inquiry Does it Matter? 1. If the qualified plan provides for an accelerated payout period (e.g., a payout within five years or in a lump sum) regardless of who the beneficiary is, then the fact that IRC Sec. 401(a)(9) would permit a longer payout period is irrelevant. 2. If so, get the benefits out of the plan and into an IRA if possible. B. Applicable Table. 1. Uniform Lifetime Table (Exhibit A). a. When participant reaches age 70 1/2, he/she must commence required minimum distributions (RMDs). b. The RMDs must be based on the Uniform Lifetime Table unless the participant s spouse is more than 10 years younger in which case the joint and survivor table is used. c. The participant can take the first RMD in the year he/she attains age 70 1/2, or can take two distributions in the following year (on April 1 st and December 31 st ). 2. Single Life Table (Exhibit B). C. Miscellaneous Issues. a. The beneficiary s life expectancy is determined as of his/her birthday in the calendar year immediately following the calendar year of the participant s death. b. In subsequent calendar years, the applicable distribution period is reduced by one for each calendar year that has elapsed since the calendar year immediately following the participant s death. 1. The participant should include a provision in his/her Will or trust directing and apportioning the payment of estate taxes on IRA and qualified plan benefits. This is particularly important when the IRA or plan beneficiaries are different than the estate or trust beneficiaries. 2. When naming an individual beneficiary of an IRA or qualified plan (i.e., spouse, child, etc.), make sure to name a contingent beneficiary. Otherwise, the default provisions under many plan documents is the participant s estate. See Article VI, A. 1., for the problem of naming the participant s estate as the beneficiary. 1

3 II. SURVIVING SPOUSE. A. Advantages: 1. Spouse can defer required minimum distributions (RMDs) until participant would have reached age 70 ½. Other beneficiaries must take RMDs by the end of the year after the year of the participant s death. 2. Spouse can take RMDs over his/her life expectancy recalculated annually (so RMDs can stretch over spouse s entire lifetime). Other beneficiaries must take RMDs over their life expectancies (on a declining years basis). 3. Only a surviving spouse can roll the benefits over into his/her own IRA. Benefits of a rollover: a. RMDs can be deferred until spouse reaches age 70 ½. b. Spouse can take the RMDs using the Uniform Lifetime Table which permits the spouse to stretch the distributions over his/her lifetime. c. Spouse can name a designated beneficiary for the IRA rollover thereby permitting further income tax deferral over the beneficiary s lifetime. Beneficiary must commence distributions by December 31 st of the year following the spouse s death using the Singe Life Table. d. NOTE: If surviving spouse does not do a rollover, the beneficiaries of the IRA at the spouse s death can only stretch the payments over the spouse s remaining life expectancy. 4. No estate taxes because of unlimited marital deduction. B. Disadvantages: III. QTIP TRUST. A. Advantages: 1. Participant has no control over what surviving spouse does with the retirement benefits. 2. Depending upon the deceased participant s other assets, may result in under-funding the credit shelter trust. 3. Surviving spouse may not be suited to adequately manage the retirement benefits. 1. Qualifies for unlimited marital deduction - provided that the trust document requires the spouse to receive the greater of the RMD or the net income of the plan (if more than the RMD). In Rev. Rul the IRS ruled that the all income requirement is satisfied if the spouse has the right to demand all of the income earned by the IRA. 2

4 2. Participant (not surviving spouse) determines who receives the assets remaining in the QTIP Trust when the surviving spouse dies. Particularly beneficial in second marriages. 3. Protects spouse from his/her inability to properly manage the retirement benefits. B. Disadvantages: 1. RMDs must commence the year after the participant s death (not when spouse reaches age 70 ½ as would be the case with a rollover). 2. RMDs are based on surviving spouse s single life expectancy (cannot use the Uniform Lifetime Table). 3. Cannot flip to the life expectancy of the children or grandchildren when the surviving spouse dies (as would be the case with a rollover). However, distributions can be made over the remaining life expectancy of the spouse. See PLR Possible acceleration of income if a pecuniary (as opposed to fractional) marital deduction formula is used in participant s will or trust. IV. CREDIT SHELTER TRUST. A. Advantages: 1. Shelters participant s estate tax exemption. 2. Participant (not surviving spouse) determines who receives the assets remaining in the credit shelter trust when the surviving spouse dies. 3. Protects spouse from his/her inability to properly manage the retirement benefits. B. Disadvantages: 1. RMDs must commence the year after the participant s death (not when spouse reaches age 70 ½ as would be the case with a rollover). 2. RMDs are based on the surviving spouse s single life expectancy (cannot use the Uniform Lifetime Table). 3. Cannot flip to the life expectancy of the children or grandchildren when the surviving spouse dies (as would be the case with a rollover). However, distributions can be made over the remaining life expectancy of the spouse. See PLR Possible acceleration of income if a pecuniary (as opposed to fractional) marital deduction formula is used in participant s will or trust. 5. Retirement benefits accumulated in the credit shelter trust will be generally taxed at a higher rate than benefits paid to a surviving spouse (unless spouse s annual income is over $319,100 (2004)). 3

5 6. Some of the participant s estate tax exemption is wasted because of the income tax which has to be paid on the retirement benefits. C. Possible Solutions to Disadvantages: 1. Forego the estate tax savings (by underfunding the credit shelter trust) in favor of the income tax savings (by allowing the surviving spouse to do a rollover). Then replace the increase in estate taxes with an ILIT. In such event, the cost of the life insurance will likely be more than offset by the income tax savings. 2. Name spouse as primary beneficiary and credit shelter trust as the contingent beneficiary. When participant dies, if estate tax savings (by funding the credit shelter trust) are greater than the income tax savings (by doing a rollover), then spouse can disclaim all or a portion of the retirement benefits to fill the credit shelter trust. 3. Creative Funding of the Credit Shelter Trust (see pages 7 and 8). V. CHILD OR GRANDCHILD. A. Advantages: 1. Benefits can be paid out over the beneficiary s life expectancy using the Single Life Table. a. However, if estates taxes are due and if the beneficiaries need to use the retirement benefits to pay the estate taxes, a stretch payout is not possible. b. Possible Solution: Use an ILIT to provide beneficiaries with the liquidity to pay estate taxes. In such event, the cost of life insurance will likely be more than offset by the income tax savings. 2. Simplicity. B. Disadvantages: 1. No asset management. Beneficiary can forgo the stretch and withdraw all of the funds immediately. 2. If grandchild or younger generation members are named as beneficiary, must plan for the generation skipping tax. 3. If multiple beneficiaries are named, payout must be based on the oldest beneficiary s life expectancy. However, if separate accounts are established by December 31 of the year following the year of the participant s death, each beneficiary can use his/her own life expectancy. 4

6 VI. TRUST FOR CHILD OR GRANDCHILD. A. Special Rules for Trusts: B. Advantages: 1. If the participant s estate is the beneficiary, this results in having no designated beneficiary. Therefore, the participant s estate should never be the beneficiary of IRA or qualified plan benefits. a. If the participant s estate is the beneficiary, then the benefits must be completely paid by (i) December 31 st of the fifth anniversary year of the participant s death (if the participant died before his required beginning date) - the five-year rule - or (ii) over the participant s remaining single life expectancy (if the participant died after his required beginning date). b. Therefore, the trust agreement must prohibit the use of retirement benefits to pay the participant s estate taxes, administrative expenses and debts. Otherwise, IRS letter rulings suggest that such payments may be treated the same as naming the estate as the beneficiary. c. However, in PLRs and the IRS ruled that where the estate was eliminated as a beneficiary by the September 30 th of the year following the participant s death, only the remaining beneficiaries need be considered to determine who has the shortest life expectancy. 2. Trust must be valid under state law and irrevocable upon the participant/grantor s death. 3. All trust beneficiaries must be identifiable. Otherwise, it s not possible to identify the oldest beneficiary for purposes of determining the shortest payout. a. Therefore, the trust agreement should exclude adult adoptees from the definition of issue. If not, it s possible a child could adopt someone who is older than the oldest beneficiary at the time of the participant s death. b. In addition, if the beneficiary has a power of appointment, the power must be limited so that it cannot be exercised in favor of charity or in favor of anyone who could be older than the powerholder. 4. The trustee must supply to the plan administrator (or in the case of an IRA, the IRA trustee or custodian) by October 31 of the year after the participant s death, either a copy of the trust agreement or certification of certain information spelled out in the regulations. 1. Participant (not beneficiary) determines who receives the assets remaining in the trust when the beneficiary dies. 2. Protects beneficiary from his/her inability to properly manage the retirement benefits. 5

7 C. Disadvantages: VII. CHARITIES. A. Advantages: 1. In order to use the life expectancy of an individual trust beneficiary (or the life expectancy of the oldest member of a group of beneficiaries), a conduit trust must be used. Otherwise, the five-year rule applies if the participant died before his/her required beginning date, or the benefits can be paid over the remaining life expectancy of the participant if the participant died after his/her required beginning date. Features of a conduit trust are: a. The trustee is required to withdraw the applicable RMD and must distribute same as received even if the beneficiary is a spendthrift or substance abuser. The trustee cannot accumulate RMDs in trust. b. Remainder beneficiaries can be disregarded for RMD purposes because they are mere potential successors to the conduit beneficiary s interest. 2. In PLRs , and the IRS ruled that retirement benefits payable to one funding trust (such as the participant s revocable living trust) which then creates separate trusts (such as a separate trust for each child), will not qualify for the separate account rules. a. Thus, the RMD must be based on the life expectancy of the oldest beneficiary. b. Possible solutions: Use one funding trust per beneficiary, but this may be too cumbersome for many clients. Alternatively, it may be possible to qualify for separate account status by naming the separate trusts created in the single funding trust directly in the plan s beneficiary form. 1. Double Win: There are no income or estate taxes due because charities are income taxexempt and because of the unlimited charitable estate tax deduction. One of the best ways to satisfy the participant s charitable intentions. 2. Charity can be the participant s private foundation thereby allowing the participant s heirs to manage the funds. 3. NOTE: If the charity is one of several beneficiaries, the participant is treated as having no designated beneficiary. As such, the five-year rule applies. However, if the charity is paid out before September 30 th of the year following the participant s death, then only the other beneficiaries life expectancies are considered. 4. The charity can also be a testamentary charitable remainder trust. However, the estate tax deduction will be limited to the present value of the remainder interest passing to charity unless the sole non-charitable beneficiary is the participant s spouse (due to the combination of the unlimited marital and charitable deductions. 6

8 B. Disadvantages: 1. Problem: Has the effect of disinheriting the participant s family. 2. Solution: Use an ILIT to replace the wealth passing to charity. The participant can use the plan assets to pay the premiums so that the cost of the life insurance is eventually paid by the designated charity (as opposed to the participant s family). VIII. DRAFTING THE BENEFICIARY FORM. A. Use of Disclaimers. 1. Name a series of beneficiaries who will take if the previous beneficiary dies or disclaims. 2. For example, the participant s spouse could be the primary beneficiary, and then the following contingent beneficiaries (in order): 1) the participant s credit shelter trust; 2) the participant s QTIP Trust; 3) a trust for children; 4) children directly; and 5) charity. B. Drafting Considerations. 1. Make sure the trustee has the power to disclaim benefits either under the instrument or under state law. 2. Make sure the IRA sponsor will accept a custom drafted beneficiary form. 7

9 CREATIVE FUNDING OF CREDIT SHELTER TRUSTS I. PLR A. Facts: B. Ruling: C. Net Result. 1. Husband wishes to create a revocable living trust using a fractional share formula to divide the trust (at his death) into two shares: a marital gift that passes outright to his wife and an amount equal to his estate tax exemption to a credit shelter trust. 2. Husband s living trust also gives his wife a general power of appointment over the trust assets if she predeceases him. The portion subject to the power is equal to the amount of her remaining estate tax exemption, less the value of her taxable estate (excluding the assets subject to the power). 3. Wife plans to execute a Will that exercises the power of appointment in favor of her estate. Her proposed Will goes on to divide her estate (with a fractional formula) into the typical reduced-to-zero marital credit shelter trusts. 1. If Wife predeceases Husband and exercises her general power of appointment, Husband is treated as making a gift to wife of that portion of the trust appointed by Wife. However that gift qualifies for the unlimited gift tax marital deduction. 2. If Wife predeceases Husband, the assets over which she holds the general power of appointment are included in her gross estate. 3. Any assets in Husband s living trust that are appointed to Wife s credit shelter trust (for the benefit of Husband and her descendants) will not constitute a gift from Husband to the other beneficiaries of the credit shelter trust. 4. Any assets appointed from Husband s living trust to Wife s credit shelter trust are not included in husband s estate. 5. Note: the PLR did not address the income tax basis of the assets allocated by Wife from Husband s living trust to her credit shelter trust. Based on PLRs and PLR (both dealing with joint settlor trusts), the IRS is likely to deny a stepped-up basis for assets passing to Husband (under Wife s credit shelter trust) since they were acquired from Husband within one year of Wife s death. IRC Section 1014(e). 1. Assume that Husband has $3 million of assets: a $1.5 million IRA payable to his Wife and $1.5 million of non-ira assets owned by his living trust. Assume further that Wife has no assets in her name alone. 2. If Husband dies first, the non-ira assets can be used to fund his credit shelter trust. 8

10 3. If Wife dies first, however, those same assets can be used to establish her credit shelter trust for Husband and their descendents. 4. Therefore, a single pool of assets can be used to fund the credit shelter trust regardless of which spouse dies first, while still allowing each spouse to control his/her separate property. II. CAUTION IN RELYING ON PLR A. PLRs cannot be cited as precedent. B. Possible Attacks on the IRS Reasoning in PLR There is no doubt that if Wife predeceases Husband he is making a gift of those assets subject to the general power of appointment. a. But can you make a gift to a dead person as the IRS has ruled? If not, the gift is to Wife s estate of which the children are also beneficiaries (via the credit shelter trust). Therefore, the unlimited marital deduction does not apply. Because the estate tax exemption ($1.5 million) exceeds Husband s gift tax exemption ($1 million), the gift may produce a gift tax liability. b. However, if the IRS were to change it s reasoning to worsen the estate tax result, it could mean allowing a full step-up in basis at the first death. The IRS is not likely to want this result. 2. An argument can be made that the credit shelter trust is includible in Husband s gross estate as a transfer with a retained interest. IRC Section a. This is particularly true if Husband is a trustee of Wife s credit shelter trust and/or has a limited testamentary power of appointment over the credit shelter trust s assets. b. This estate tax result is consistent with the result obtained in the lifetime QTIP context, where the IRS has ruled that the secondary life estate reserved by the donor spouse is not included in the donor s spouse s estate at his/her death. 3. An argument can be made that Wife does not have a general power of appointment at all because of Husband s power of revocation and, therefore, the assets subject to the power are not in Wife s estate. See Margrave v Comm r, 618 F. 2d. 34 (1980). 4. Bottom Line: Let s hope the IRS is right on this one. 9

11 EXHIBIT A New Uniform Lifetime Table To determine the Required Minimum Distributions (RMD) from your retirement plan for the current year, divide the market value of your retirement plan on the last day of the previous year by the Applicable Divisor corresponding to the age you will turn this year. The quotient will be your RMD. Age Applicable Divisor Age Applicable Divisor * 3.9 Source: US Treasury Department * The Table ends at age 115+ with an Applicable Divisor of

12 Age EXHIBIT B Single Life Table in S 1.401(a)(9)-9, A-1 Distribution Age Distribution Age Period Period Life Expectancy

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