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IRA Payable to QTIP Trust: Marital Deduction Requirements

Estate Planning Journal

In Revenue Ruling 2006-26 1 the IRS discussed the interrelationship between several provisions of the Uniform Principal and Income Act (“UPIA”) and the marital deduction requirements when a QTIP trust is designated as the beneficiary of an IRA. Rev. Rul. 2006-26 modifies and supersedes Rev. Rul. 2000-2. 2

 

Facts

The facts presented in Rev. Rul. 2006-26 were as follows: The decedent died at age 68, survived by his spouse. The decedent's will established a marital trust, and the decedent had designated the trust as the beneficiary of his IRA.

The terms of the trust provided that during the spouse's lifetime, all income of the trust was payable annually to the spouse, and that no person had the power to appoint any part of the trust principal to any person other than the spouse. The terms of the trust permitted the spouse to require the trustee to invest the principal of the trust, including the IRA, in assets productive of a reasonable amount of income. The terms of the trust also provided that the spouse had the power, exercisable annually, to compel the trustee to withdraw from the IRA an amount equal to all the income of the IRA for the year and to distribute that income to the spouse.

The trust provided that if the spouse exercised the power to compel a withdrawal from the IRA, the trustee was obligated to withdraw from the IRA the greater of all the income of the IRA or the required minimum distribution and to distribute to the spouse at least the income of the IRA and to add to the principal of the trust the excess of the required minimum distribution over the income of the IRA. If the spouse did not exercise the power to compel a withdrawal from the IRA for a particular year, then the trustee was required to withdraw from the IRA only the required minimum distribution. The trustee separately determined the income of the trust (excluding the income of the IRA and excluding any IRA distribution made to the trust) and the income of the IRA.

The IRA documents did not prohibit the withdrawal from the IRA of amounts in excess of the required minimum distribution. The executor of the decedent's estate elected to treat both the IRA and the trust as qualified terminable interest property (“QTIP”).

After setting forth these facts, the IRS, in Rev. Rul. 2006-26, presented three situations involving various provisions of UPIA. The issue in each of these three situations was whether the IRA and the trust qualified for the marital deduction.

Situation 1 involved a state whose statutes contained a provision similar to that in section 104(a) of UPIA. This section permits a trustee to allocate the aggregate investment return of a trust between income and principal if three requirements are satisfied: (1) the trust assets are invested under a prudent investor standard imposed by statute, judicial decision, or the terms of the trust; (2) the amount to be distributed to a beneficiary is described by reference to the trust's income; and (3) the trust cannot be administered impartially after applying the state's statutory rules regarding the allocation of receipts and disbursements to income and principal. The purpose of UPIA section 104 is to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio's total return in the form of traditional trust accounting income such as interest, dividends, and rents.

In Situation 1, the state's statutes also contained a provision similar to that found in sections 409(c) and 409(d) of UPIA. UPIA section 409 addresses payments from a private or commercial annuity, an IRA, and a pension, profit-sharing, stock bonus, or stock-ownership plan. UPIA section 409(c) provides that to the extent a payment is required to be made under any of these plans (either under federal income tax rules or under the terms of the plan), 10% of the amount received by the trust is allocated to income and the balance is allocated to principal. If payment under any of these plans is not required to be made, then a payment received is allocated entirely to principal. UPIA section 409(d) provides that if—in order to obtain an estate tax marital deduction for a trust—a trustee must allocate more of a payment to income, the trustee is required to allocate to income the additional amount necessary to obtain the marital deduction.

In Situation 1, the trustee allocated the total return of the assets held in the trust (excluding the IRA) between income and principal in a manner that fulfilled the trustee's duty of impartiality between the income and remainder beneficiaries. The amount allocated to income was distributed to the spouse as the income beneficiary of the trust. The trustee made a similar allocation with respect to the total return of the assets of the IRA. If the spouse exercised the withdrawal power, the trustee was required to withdraw from the IRA the greater of the amount allocated to income or the required minimum distribution, and to distribute to the spouse the amount allocated to income of the IRA.

Situation 2 involved a state whose statutes provided that if the trust instrument specifically provides, or the interested parties consent, the “income of the trust” means a unitrust amount of 4% of the fair market value (“FMV”) of the trust assets valued annually. The trustee annually determines an amount equal to 4% of the FMV of the IRA assets and an amount equal to 4% of the FMV of the trust's assets, exclusive of the IRA. In accordance with the terms of trust, the trustee distributes an amount equal to 4% of the trust assets, exclusive of the IRA, to the spouse. In addition, if the spouse exercises the withdrawal power, the trustee withdraws from the IRA the greater of the required minimum distribution or an amount equal to 4% of the value of the IRA assets, and distributes to the spouse at least an amount equal to 4% of the value of the IRA assets.

Situation 3 involved a state that has not enacted UPIA. Thus, the trustee applies either the common law or statutory rules of the state regarding the allocation of receipts and disbursements to income and principal, and has no power to adjust between income and principal. Applying the common law or statutory rules, the income of the trust (exclusive of the IRA) is determined separately from the income of the IRA. If the spouse exercises the withdrawal power, the trustee withdraws from the IRA the greater of the income of the IRA or the required minimum distribution and distributes to the spouse at least the income of the IRA.

Analysis

“Qualified terminable interest property” is defined as property passing from the decedent, in which the surviving spouse has a qualifying income interest for life, and with respect to which the decedent's executor makes a QTIP election on the decedent's estate tax return. 3 A surviving spouse has a “qualifying income interest for life” if the surviving spouse is entitled to all the income from the property, payable annually, or at more frequent intervals. 4 Hence, in order to qualify property for a marital deduction, two requirements must be satisfied: (1) the spouse must be entitled to all the income from the property, and (2) such income must be payable annually and for the life of the spouse.

Addressing the first requirement, Reg. 20.2056(b)-5(f)(1) provides that with respect to property transferred to a trust, a surviving spouse is considered to be entitled to all the income from such property if the spouse is entitled to trust income that is determined under applicable local law that provides for a reasonable apportionment of the total return of the trust between the income and remainder beneficiaries, and that satisfies the requirements of Reg. 1.643(b)-1. Under Reg. 1.643(b)-1, applicable local law will be respected if it provides for a reasonable apportionment of the total return of the trust between the income and remainder beneficiaries. Reg. 1.643(b)-1 provides that a state statute that defines income as a unitrust amount or that permits the trustee to make adjustments between income and principal to fulfill the trustee's duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust.

With respect to the second requirement, Reg. 20.2056(b)-5(f)(8) specifies that a spouse will be considered entitled for life to all the income from the trust payable annually if the spouse has the right exercisable annually (or at more frequent intervals) to require distribution to the spouse of the trust income.

In Rev. Rul. 2000-2, the IRS ruled that if a retirement plan benefit is payable to a marital trust, then both the retirement plan benefit and the trust must meet the marital deduction requirements. This conclusion is based on the position of the IRS that an IRA is in essence a trust and therefore the marital deduction requirements must be satisfied separately by both the IRA and the marital trust.

Situation 1. The IRS found that under the facts of Situation 1 of Rev. Rul. 2006-26, the spouse had a qualifying income interest for life in the trust and the IRA. The IRS ruled that an allocation in accordance with UPIA section 104(a) of the total return of the assets held directly by the trust (exclusive of the IRA) and the total return of the IRA constituted a reasonable apportionment between the income and remainder beneficiaries. Consequently, the trust and the IRA satisfied the requirement of Regs. 20.2056(b)-5(f)(1) and 1.643(b)-1. In addition, the IRS stated that the trust and the IRA met the requirement of Reg. 20.2056(b)-5(f)(8) that the surviving spouse be entitled for life to all the income from the trust, payable annually, because pursuant to the terms of the trust, the spouse had the right to access all the IRA income, and the income of the trust was payable to the spouse annually.

The IRS further held that the 10% allocation-to-income rule of UPIA section 409(c) did not satisfy the requirements of Regs. 20.2056(b)-5(f)(1) and 1.643(b)-1 because the amount allocated to income was not based on the total return of the IRA, and therefore the amount allocated to income did not reflect a reasonable apportionment of the total return of the IRA between the income and remainder beneficiaries. Moreover, the IRS found that the 10% allocation rule did not represent the income of the IRA that would be determined under state law without regard to the power of the trustee to adjust between principal and income pursuant to UPIA section 104(a).

The IRS also implied, based on Rev. Rul. 65-144, 5 that UPIA section 409(d), requiring an additional allocation to income if necessary to qualify for the marital deduction, may not qualify the IRA for the marital deduction. In Rev. Rul. 65-144, the IRS ruled that savings clauses are ineffective to reform an instrument for federal transfer tax purposes.

Situation 2. The IRS found that under the facts of Situation 2, the spouse had a qualifying income interest for life in the trust and the IRA. The IRS concluded that a state statute that defines income as a unitrust amount is a reasonable apportionment of the total return of a trust and therefore met the requirements of Regs. 20.2056(b)-5(f)(1) and 1.643(b)-1. The IRS also held that the trust and the IRA satisfied the requirement of Reg. 20.2056(b)-5(f)(8) that the surviving spouse be entitled for life to all the income from the trust, payable annually, because pursuant to the terms of the trust, the spouse had the right to access all the IRA income, and the income of the trust was payable to the spouse annually.

Furthermore, the IRS held that the result would have been the same if the state had enacted both the statutory unitrust regime and UPIA section 104(a) and the income of the trust is determined under UPIA section 104(a), and the income of the IRA was determined under the statutory unitrust regime (or vice versa). Under these circumstances, trust income and IRA income would each be determined under state statutory provisions that satisfy the requirements of Regs. 20.2056(b)-5(f)(1) and 1.643(b)-1, and accordingly, the spouse has a qualifying income interest for life in the trust and the IRA.

Situation 3. In Situation 3, the IRS held that the spouse had a qualifying income interest for life in the trust and the IRA under Section 2056(b)(7)(B)(ii) because the spouse received the income of the trust (excluding the IRA) at least annually and the spouse had the power unilaterally to access all the income of the IRA determined under Reg. 20.2056(b)-5(f)(1). The IRS ruled that the result would have been the same if the state had enacted UPIA section 10(a), but the trustee had decided to make no adjustments pursuant to that provision.

The IRS noted that the holdings in Situations 1, 2, and 3 of Rev. Rul. 2006-26 would have been the same if the terms of the trust had directed the trustee annually to withdraw all the income from the IRA and to distribute to the spouse at least the income of the IRA (instead of granting the spouse the power, exercisable annually, to compel the trustee to do so). The IRS also observed that the holdings of the Ruling applied not only to IRAs but also to other qualified retirement plans described in IRC Section 4974(c) that are defined contribution plans. Finally, the IRS said that the holdings of the Ruling will not be applied adversely to taxpayers for taxable years beginning prior to May 30, 2006, if the trust was administered pursuant to a state statute granting the trustee a power to adjust between income and principal or authorizing a unitrust payment in satisfaction of the income interest of the surviving spouse.

Comments

The IRS's conclusions contained in this Ruling are easier to understand if it is remembered that the IRS views an IRA as a trust, and therefore if an IRA is payable to a marital trust, not only must the trust satisfy the requirements for the marital deduction but the IRA must also satisfy those requirements. This Ruling is important because it sets forth the position of the IRS regarding what constitutes income of an IRA in states that have adopted UPIA.

The determination of the amount of income is crucially important if the beneficiary of an IRA is a marital trust. In light of the critical importance of the spouse having the power to compel the trustee to withdraw the income of the IRA, estate planning documents should be reviewed to make sure such a provision is included for those clients who have designated a marital trust as the beneficiary of an IRA or other qualified retirement plan.

1 2006-22 IRB 939.

2 2000-1 CB 305. See Madden and Hayes, “Current Tax Developments: IRS Rules on QTIP IRA and Conduit Trust,” 27 ETPL 171 (May 2000).

3 Section 2056(b)(7)(B)(i).

4 Section 2056(b)(7)(B)(ii).

5 1965-1 CB 422.

Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or fsbaldino@lerchearly.com.

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