Vol. 73, No. 7, July 2000

Funding the Credit Shelter
Trust with IRA Benefits

Paying IRA benefits to a credit shelter trust after the death of the married IRA owner can minimize the income and estate tax on the IRA "pretax" assets after the client's death, helping to preserve more of the estate for the benefit of the surviving spouse.

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.

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