Funding the Credit Shelter Trust with IRA Benefits

by John A. Herbers

etirement benefits, IRAs, tax-deferred annuities, and other assets that have built-in ordinary income tax have become significant parts of many clients' estates. These assets often represent a disproportionately large part of the client's estate and pose a significant tax planning problem both to the client and to the client's advisors. This article addresses one technique to minimize the income and estate tax on these "pretax" assets after the client's death.

This article describes the technique of paying IRA¹ benefits to a "credit shelter" trust after the death of the IRA owner. The "credit shelter" trust is the typical estate planning device used by many married couples to receive assets of up to the estate tax exemption amount, or unified credit equivalent, at the death of the first spouse. The credit shelter trust shelters a part of the deceased client's estate from estate tax - the sheltered part typically equals the estate tax exemption amount. The exemption amount is $675,000 for taxpayers dying in 2000, and is scheduled to increase to $1 million for taxpayers dying in 2006 and later years. The credit shelter trust typically is built into the client's living revocable trust or will, supports the surviving spouse during his or her lifetime, and then distributes to the client's children or grandchildren at the second spouse's death. The credit shelter trust thus allows a married couple to use the estate tax exemptions that are available to both husband and wife, while preserving the couple's entire estate for the benefit of the surviving spouse during his or her life.

Minimum Distribution Rules

A significant difficulty that arises with paying IRA benefits to credit shelter trusts is continuing the IRA's income tax deferral after the IRA owner turns age 70-1/2.² Under the "minimum distribution" rules of Internal Revenue Code section 401(a)(9), an IRA must begin making "minimum required distributions" when the owner attains age 70-1/2. These minimum required distributions then must continue during the IRA owner's lifetime, and also must continue after the IRA owner's death.

Many IRA owners take only the minimum required distributions from their IRAs during their lifetime in order to continue the income tax deferral on the IRA and on its earnings. Likewise, many IRA owners structure distributions from the IRA after their death to continue the income tax deferral. The installment method of making required minimum distributions can continue after the IRA owner's death, provided that the owner has named a "designated beneficiary" to receive the IRA.

If for some reason the IRA owner does not name an eligible "designated beneficiary," then during the IRA owner's lifetime, minimum required distributions must be taken using a single life expectancy rather than a joint and survivor life expectancy factor, and so distributions will be accelerated. Likewise, if there is no "designated beneficiary," then after the IRA owner's death the IRA must be distributed over five years.³ If the IRA owner had lived past his or her required beginning date, however, and did not have an eligible designated beneficiary, then the IRA must be distributed by the end of the year following the IRA owner's death.⁴

In most cases, a "designated beneficiary" is an individual, because the minimum distributions are calculated based in whole or in part on the life expectancy of the "designated beneficiary." Entities that do not have life expectancies typically cannot be "designated beneficiaries."⁵ Thus, for example, estates, corporations, and partnerships cannot be eligible as "designated beneficiaries." Under the general rule, a trust is not a "designated beneficiary" because a trust does not have a life expectancy. The Treasury Department's Proposed Regulations, however, allow an exception to this general rule.

Trust as Beneficiary. The Treasury Department originally issued Proposed Regulations in 1987⁶ that describe the circumstances under which a trust could be a "designated beneficiary." Under the initial proposed regulations (which have yet to be finalized), a trust could be treated as a "designated beneficiary" provided it met four tests, one of which was that the trust be in existence and irrevocable as of the IRA owner's "required beginning date."⁷ The requirement that the trust be in existence and irrevocable posed a problem for many clients who wished to use either a testamentary trust or a living revocable trust as recipient of the IRA funds after their deaths.

Accordingly, in December 1997, the Treasury Department amended the 1987 Proposed Regulations to incorporate a more liberal rule for allowing trusts to qualify as "designated beneficiaries."⁸ Under the modified proposed regulations, a living revocable trust that will become irrevocable upon the IRA owner's death can be treated as a "designated beneficiary." All of the other requirements under the old proposed regulations still must be met as of the IRA owner's required beginning date. However, the 1997 amendments added the additional requirement that specified information, or a copy of the trust document together with a required statement, be provided to the plan administrator on or before the required beginning date.

With proper planning, the IRA owner can name a revocable trust as beneficiary of the IRA, and then use a joint and survivor life expectancy factor during his or her lifetime to measure minimum required distributions. Also, after the IRA owner's death the IRA can then be paid to the owner's revocable trust in installments, rather than a lump sum. The longest permissible period for the required distributions would be based upon the life expectancy of the oldest trust beneficiary and would not be limited to a maximum five-year payout.⁹ In the typical credit shelter trust situation, the oldest trust beneficiary will be the surviving spouse. Thus, in many cases, it should be possible to pay an IRA into a credit shelter trust over the life expectancy of the surviving spouse, thus permitting installment payments after the IRA owner's death of five, 10, or 15 or more years, depending upon the age of the surviving spouse.

With proper planning, paying the IRA to the credit shelter trust can be used to satisfy four primary estate planning goals:

1. make the funds in the IRA available to the surviving spouse during his or her life;
2. pass the IRA funds that are not consumed by the spouse during his or her lifetime to the children or other remainder beneficiaries after the surviving spouse's death;
3. fully use each spouse's estate tax exemption and so double up on the amount that passes estate tax-free to the children; and
4. obtain at least some income tax deferral on the IRA over the lives of both the owner and surviving spouse.

Income Tax Planning

For the client who is considering paying an IRA to a credit shelter trust, the income tax on the IRA is a significant planning issue that must be addressed. The IRA represents taxable income as ordinary income, and so will create an income tax liability to the credit shelter trust upon distribution from the IRA into the trust. The income tax brackets that apply to trusts are quite compressed compared to the income tax brackets that apply to individuals. In 2000, a trust reaches the highest income tax bracket of 39.6 percent on its taxable income above $8,650.¹⁰

Trust Accounting Rules

The distributions from the IRA into the credit shelter trust almost certainly will, at least in part, represent trust corpus under the trust income and principal accounting rules of Wisconsin Statutes section 701.20.¹¹ Trust principal typically is not distributable automatically to the surviving spouse; thus, the taxable income that the IRA distribution creates will not automatically flow out to the spouse. If the IRA's taxable income is taxable to the trust, then it is likely that it will be taxed at some of the highest income tax brackets. "Trapping" taxable income inside trusts thus can create an overall higher tax to apply to the IRA distributions, compared to the result if the distributions can somehow be taxable to a beneficiary, rather than to the trust.

The most typical way to cause a trust's income to be taxable to a beneficiary is to distribute the income to the beneficiary, because typically the distributed income qualifies for the "distribution deduction" under Internal Revenue Code sections  651 and 661. These Tax Code sections apply to trusts that are "simple" and "complex," respectively, and would allow the income tax liability on income that a trust receives and then disburses, to be paid by the recipient of the funds rather than by the trust.

But even if the amount of the IRA distribution that the Trustee receives is in fact distributed to the spouse, there is an open question as to whether those distributions will qualify for the income tax "distribution deduction." The distribution deduction rules of Tax Code sections 651 and 661 refer in part to "income" as that term is defined for trust accounting purposes. If a trust has an item of taxable income that represents principal under the trust accounting rules, distributing this item of "accounting principal/taxable income" will not automatically qualify for the distribution deduction under Tax Code sections 651 and 661.

Both of these Tax Code sections refer to state law definitions of "income," and the trust accounting principal and income rules of section 701.20 of the Wisconsin Statutes are unclear at best as they relate to IRA distributions. Section 701.20 does not specifically address IRA distributions. Subsection 701.20(11) relates to "rights to receive periodic payments under a contract or plan for deferred compensation or for the benefit of one or more of the employees of an employer," and then points to subsection (2)(a)3 to determine income and principal. Subsection 701.20(2)(a)3 defines income and principal as "what is reasonable and equitable in view of the respective interests of the beneficiaries."¹²

Example. Assume a credit shelter trust is funded in part with an IRA that is valued at $500,000 as of the owner's death. The surviving spouse has a 12.5-year life expectancy. The IRA's investments generate $25,000 of interest and dividends during the next year, and the required minimum distribution is $40,000. How much of the $40,000 required distribution represents income, and how much represents principal? At least three answers appear reasonable:

1. The first answer is that the full $40,000 represents principal because the IRA must be distributed over the 12.5-year life expectancy of the surviving spouse, and $40,000 represents the first year's installment payout ($500,000 ÷ 12.5 = $40,000). This first approach uses a "first in, first out" (or FIFO) accounting methodology of tracking distributions.
2. The second answer is that the first $25,000 of the distribution represents income, and the balance of $15,000 represents principal. The theory here is that the IRA's investments generated $25,000 of "income" as determined under the normal trust accounting rules, and so the first $25,000 distributed from the IRA represents this interest and dividend income. This second approach uses a "last in, first out" (or LIFO) accounting methodology of tracking distributions.
3. The third answer is that the distribution somehow annuitizes the $500,000 beginning balance over the spouse's 12.5-year life expectancy, and so part of the $40,000 represents accounting income and part represents accounting principal. The relative proportions of income and principal would depend upon the interest rate assumption used in annuitizing the beginning balance. This third approach uses an annuity methodology of tracking distributions.

The problem is that, absent specific guidance in the governing trust instrument, the trustee and family are probably left to the Wisconsin Statutes' "reasonable and equitable" rule for trust accounting of the IRA distribution under sections 701.20(11) and (2)(a)3 and the trust may not obtain a distribution deduction for trust principal even if it is distributed. Rather than relying on reason and equity to define "income" and "principal," the trust document should address the issue of what constitutes "income" for trust accounting purposes in order to allow a distribution deduction for this amount, and thus obtain the best income tax treatment for the IRA distributions.

Planning Alternatives

At least three planning options are available to the drafter in addressing the income tax liability associated with the IRA funds that are payable to the credit shelter trust:

1) The governing document can allow or permit the distribution of the principal portion of the IRA distributions to the spouse. If the trust's principal must be paid to the spouse, then the taxable income on this "accounting principal/taxable income" will almost certainly also flow out of the trust to the spouse, and by passing out the taxable income to the spouse, the spouse's tax brackets will apply to the IRA distribution. The spouse's tax brackets will almost certainly be lower than the trust's brackets and so overall income tax can be saved.

However, this first approach of forcing the entire IRA distribution out of the trust to the spouse defeats one of the primary tax planning goals of using the credit shelter trust in the first place. A primary use of a credit shelter trust is to allow the assets in the credit shelter trust to remain in the trust and avoid estate tax in the surviving spouse's estate. If funds pass out of the credit shelter trust to the spouse to save income taxes, then the estate tax purpose of the trust is defeated because these funds are returned into the spouse's estate for estate tax purposes.

2) As a second alternative, the credit shelter trust can be structured to allow or require the trustee to distribute funds to the children or other beneficiaries, and then to treat the distributions as having been made out of the IRA funds that are principal for trust accounting purposes, but that are also taxable income for income tax purposes. Again, by forcing the "accounting principal/taxable income" out of the trust to beneficiaries, the trust will not have to pay income tax on the IRA at its brackets, and almost certainly income tax will be saved because the children's tax brackets will be lower than the trust's brackets. However, this approach of forcing the entire IRA distribution out of the trust to the children or grandchildren defeats the second important planning goal of using the credit shelter trust: to maintain the couple's assets for the benefit of the surviving spouse. Passing funds out of the credit shelter trust to the children or grandchildren merely to save income taxes defeats this second purpose of using the credit shelter trust because it removes assets from the trust and so makes those assets unavailable for the spouse.

3) A third approach is to cause the credit shelter trust to be taxed as a "grantor" trust on the IRA distributions that represent accounting principal/taxable income. The surviving spouse or other trust beneficiary can be given the authority to withdraw the accounting principal/taxable income, and then he or she will be taxable on that income whether or not the withdrawal power is exercised.¹³ Thus, causing the credit shelter trust to be a "grantor trust" as to the accounting principal/taxable income avoids the trust being taxed on these funds, and also avoids forcing the funds to be distributed out of the trust to the spouse, the children, or other beneficiaries.

Giving the spouse or other beneficiary the power to withdraw the principal portion of the IRA distribution solves the income tax problem, but could create a gift or an estate tax problem. If a person has the power to withdraw assets from a trust but fails to exercise that power, then the failure to exercise the withdrawal right could be a "lapse" of a withdrawal right. Lapses of withdrawal rights can be treated as taxable gifts by the person who held the power. Lapses of withdrawal rights also can result in estate tax on the "lapsed" property in the estate of the powerholder after his or her death.¹⁴

The two most typical methods of dealing with the tax issues involved with a possible "lapse" of a withdrawal right are to give the powerholder (here, the spouse) a limited power of appointment over the credit shelter trust, or to limit the withdrawal power to the greater of $5,000 or 5 percent of the trust (a "5 x 5" power).¹⁵ Giving the spouse a limited power of appointment over the accounting principal/taxable income that he or she does not withdraw avoids a gift tax on the "lapse," but permits the spouse to redirect the lapsed amounts after his or her death. Giving the spouse the "5 x 5" power avoids both the gift and estate tax problem on the lapsed amounts that fall within the "5 x 5" power and does not risk the spouse's redirection of the funds in the credit shelter trust after his or her death.

Conclusion

There are many practical difficulties to be addressed when planning to use an IRA to fund a credit shelter trust. These practical difficulties accentuate the dilemma that the client faces when funding a credit shelter trust with an IRA. The dilemma requires the client (and the client's planners) to choose between avoiding estate tax by fully using both spouses' estate tax exemptions, versus deferring income tax on the IRA for the longest permissible period. The practical difficulties of distributing an IRA to a credit shelter trust can be overcome with careful planning. Married clients can have the benefits of using both spouses' estate tax exemptions, while postponing to a certain degree the inevitable income tax on the IRA funds.

The planner must walk carefully through the minefield laid by the IRS when using IRA assets to fund the credit shelter trust. A cautious planner can successfully maneuver his or her client past these traps and achieve most, if not all, of the client's planning goals.

Endnotes

¹ For ease of discussion, as used in this article, "IRAs" include all qualified retirement plans, tax sheltered annuities, and IRAs.

² A second problem must be addressed for participants who still have balances in their qualified retirement plans. These qualified retirement plans typically are subject to the Retirement Equity Act of 1984 (REA), and the REA requires a spousal consent to designation of retirement plan balances to beneficiaries other than the spouse. Thus, for participants who wish to designate a credit shelter trust as beneficiary of a qualified retirement plan, a starting point is obtaining a spousal waiver of the REA's requirements.

³ I.R.C. § 401(a)(9)(B)(ii).

⁴ I.R.C. § 401(a)(9)(B)(i).

⁵ Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A D-2A.

⁶ Prop. Treas. Reg. § 1.401(a)(9)-1. Generally, taxpayers may rely on proposed regulations pending the issuance of final regulations.

⁷ The "required beginning date" is April 1 of the year following the year in which the IRA owner or qualified retirement plan participant attains age 70-1/2.

The remaining three tests to qualify a trust as a "designated beneficiary" are: 1) the trust be in existence and valid (or would be valid but for lack of corpus); 2) all trust beneficiaries must be identifiable; and 3) a copy of the trust document must be provided to the plan administrator. See Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A D-5 (prior to amendment Dec. 31, 1997).

⁸ Prop. Treas. Reg. § 1.401(a)(9)-1, Q&A D-5 through D-7.

⁹ I.R.C. § 401(a)(9)(B)(iii).

¹⁰ Rev. Proc. 99-42, 1999-46 I.R.B. 568 (Nov. 15, 1999).

¹¹ See Wis. Stat. §§ 701.20(11), 701.20(2)(a)3.

¹² Wis. Stat. § 701.20(2)(a)3.

¹³ I.R.C. § 678(a)(1).

¹⁴ I.R.C. §§ 2514, 2041.

¹⁵ See I.R.C. § 2041(b)(2).

Wisconsin Lawyer