Separate Account Rules Don't Apply When a Trust Is IRA Beneficiary
In Letter Ruling 200538030, the IRS applied the final Regulations regarding minimum required distributions from IRAs, and concluded that the separate account rules of the Regulations cannot be used if the beneficiary of the IRA is a trust. 1
An owner of an IRA was 64 years old at her death and was survived by three children. At the time of her death, the IRA owner had not reached her required beginning date. During her life, the IRA owner executed a trust agreement which provided that upon her death, an irrevocable subtrust was created for the benefit of her children. The trust agreement also provided that upon the IRA owner's death, the trustee was to distribute the remainder of the trust property to the subtrust. The trust agreement specified that the trustee of the subtrust was to divide the property of the subtrust into equal shares and distribute the property to the IRA owner's children.
The trust agreement stated that the trust (not the subtrust) was intended to be the beneficiary of the IRA. The IRA owner executed a beneficiary designation form that designated the trust (not the subtrust) as the beneficiary of the IRA. The laws of the state in which the IRA owner resided provided that an IRA was exempt from the claims of creditors. The IRA owner's estate represented that the trust and the subtrust were valid under state law, and that the IRA administrator had been provided with a copy of the trust agreement and a copy of the beneficiary designation before October 30 of the year following the year of the IRA owner's death.
The estate requested the following two rulings from the IRS: (1) that the IRA may be divided into three IRAs—one for the benefit of the each of the IRA owner's three children, and (2) that minimum required distributions from each of the three IRAs may be determined by using the age and life expectancy of the oldest of the three children.
There have been two sets of Proposed Regulations regarding distributions from IRAs, and these Proposed Regulations culminated in final Regulations being issued in 2002. The Preamble to the final Regulations states that the final Regulations apply to distributions made on or after January 1, 2003. In the private letter ruling, the IRS applied the final Regulations.
When an IRA owner dies and the beneficiary of the IRA is not his or her spouse, distributions from the IRA must commence or continue after the owner's death in specified amounts (referred to as “minimum required distributions”). The minimum required distributions applicable to a “designated beneficiary” of an IRA who is not the spouse of the IRA owner are based on the remaining life expectancy of the designated beneficiary. 2
In order for a beneficiary to be a designated beneficiary, the beneficiary must be an individual. 3 The Regulations permit beneficiaries of a trust to be considered “designated beneficiaries” if: (1) the trust is valid under state law, (2) the trust is irrevocable as of the IRA owner's death, (3) the beneficiaries of the trust are identifiable, and (4) a copy of the trust agreement is provided to the IRA administrator by October 31 of the year following the year in which the IRA owner died. 4 If there is more than one designated beneficiary of an IRA, generally the minimum required distributions are determined using the life expectancy of the oldest beneficiary. 5
When there are multiple designated beneficiaries of an IRA, there is an exception (referred to as the “separate account rule”) to the requirement of using the life expectancy of the oldest designated beneficiary to calculate minimum required distributions. 6 If the requirements of the exception are satisfied, then each of the multiple beneficiaries may use his or her individual life expectancy in calculating his or her minimum required distributions. However, the separate account rule is not available to beneficiaries of a trust, 7 and therefore, each beneficiary of a trust must use the life expectancy of the oldest beneficiary in calculating minimum required distributions.
In Letter Ruling 200538030, the IRS stated that because the laws of the state in which the IRA owner resided prevented the creditors of the estate from reaching the IRA assets, only the IRA owner's three children will be considered for purposes of determining who are the designated beneficiaries of the IRA. The IRS ruled that the trust satisfied the requirements permitting the trust beneficiaries (the IRA owner's three children) to be considered designated beneficiaries of the IRA. The IRS stated that nothing in the Code or the Regulations prohibits the division of an IRA after the death of the owner or prohibits the distribution of an IRA from a trust to the trust beneficiaries. However, the IRS stated that the Regulations prohibit the use of the separate account rule when IRA benefits are payable to a trust. The IRS concluded that because the separate account rule did not apply, each of the trust beneficiaries must use the life expectancy of the oldest beneficiary in calculating the minimum required distributions.
Letter Ruling 200538030 illustrates the IRS's position that designating a trust as a beneficiary prohibits the use of the separate account rule. Therefore, a trust should not be designated as the beneficiary if the ability to use separate accounts is desired. The result in this letter ruling might have been different if the trust agreement had provided that the subtrust was to be divided into separate trusts for the benefit of each of the IRA owner's children and the trustee had distributed the IRA to each of the separate trusts by December 31 of the year following the IRA owner's death. The IRS has previously issued a private letter ruling that would support the use of the separate account rule in this context. 8
It is interesting that this letter ruling does not discuss an alternative to the separate account rule. The Regulations provide that the “designated beneficiaries” of an IRA will be determined based on the beneficiaries who were designated as of the death of the IRA owner who remain beneficiaries as of September 30 of the year following the year of death of the IRA owner. 9 The Regulations state that any person who was a beneficiary as of the death of the IRA owner but is not a beneficiary (because her or her entire interest was distributed or disclaimed) as of September 30 of the year following the year of death of the IRA owner is not taken into account in determining the “designated beneficiaries.” 10
It is the author's opinion that if by September 30 of the year following the year of the IRA owner's death, the trustee of the trust involved in Letter Ruling 200538030 had divided the IRA into three sub-IRAs, and retitled one for each of the three children, then each child should have been able to use his or her individual life expectancy in calculating the minimum required distributions with respect to his or her IRA. This issue was not discussed in the letter ruling nor was a reason given as to why it was not discussed.
1 See also Letter Rulings 200538031, 200538033, and 200538034.
2 Regulation 1.401(a)(9)-5, Q&A-5(c)(1).
3 Regulation 1.401(a)(9)-4.
4 Regulation 1.401(a)(9)-4, Q&A-5.
5 Regulation 1.401(a)(9)-5, Q&A-7(a)(1).
6 Regulation 1.401(a)(9)-8, Q&A-2.
7 Regulation 1.401(a)(9)-4, Q&A-5(c).
8 See Letter Ruling 200234074.
9 Regulation 1.401(a)(9)-4, Q&A-4(a).
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 firstname.lastname@example.org.