Robert B. Wolf is a principal of Tener, Van Kirk, Wolf & Moore, P.C., Pittsburgh, PA. He is a former Chair of the Probate and Trust Law Section Council of the Allegheny County Bar Association, a fellow in the American College of Trust and Estate Counsel (ACTEC), and has been listed in the book The Best Lawyers in America since 1993.

Bob is the "Godfather" of the TRU (Total Return UniTrust) and has written and spoken extensively on the subject of the design of this new generation of trust vehicle. His many articles, "Defeating the Duty to Disappoint Equally-The Total Return Trust, and "Total Return Trusts - Can Your Clients Afford Anything Less" constitute the seminal work in computer modeling and verifying the value of the TRU.  You can find no less than 7 of his articles, sample documents, and state-by-state research on TRUs (together with articles on TRUs and the UPIA by other authorities) on LISI's sister site, http://www.leimberg.com under FREE RESOURCES. 

Bob alerts LISI members to a breakthrough Revenue Ruling.  (Later this week, we'll be providing LISI members with even more on this most important development in a special report by Virginia Coleman.)

EXECUTIVE SUMMARY:

Revenue Ruling 2006-26 clarifies and expands upon the rules for qualified terminable interest elections where an interest in an IRA or other Defined Contribution Plan is payable to a trust seeking qualification for a QTIP marital deduction status. The Ruling sets out the requirements for such qualification in three situations addressing the requirement for "income" distributions in the context of states which (1) have adopted the power to adjust and Section 409(c) and 409(d) of the Uniform Principal and Income Act, (2) in states that have a unitrust definition of income, and (3) in states with neither the UPIA with the power to adjust nor a unitrust definition.

The Revenue Ruling holds that the provisions of Section 409(c) which provides that 10% of the required distributions from an IRA or other retirement account shall be considered income, and 409(d) which directs the trustee to distribute such additional amounts needed to qualify for the marital deduction, are not sufficient to satisfy the "income" requirements of the marital deduction, but that a direction to pay the "income" from the IRA to the trust and ultimately to the surviving spouse will overcome that deficiency.

Rev. Rul. 2006-26 also holds that a unitrust definition of income for the IRA and the trust, or both, will satisfy the marital deduction "income" requirements if supported by applicable state statute under 1.643(b)(1). It provides that applicable state law can apply a unitrust definition to the IRA and a traditional income definition to the trust, or vice versa, without harm to the marital deduction, as each interest, the IRA and the trust, must qualify and be elected for QTIP treatment separately, as stated in Rev. Ruling 89-89.

FACTS:

A dies in 2004 at age 68 survived by his spouse, B, the life beneficiary of a testamentary marital trust which is the beneficiary of A's IRA.

B has the right to insist that the assets in the trust be invested so as to be reasonably productive, and there is no prohibition against the trustee requesting more than the minimum required distribution from the IRA.

As in Rev. Ruling 2000-2, 2000-1 C.B. 305, B has the right to require that the trustee withdraw all of the income from the IRA, and the trust then requires that the income be distributed to B. Any portion of the MRD that exceeds the income from the IRA is reinvested in the trust.

At B's death, the trust passes to A's children. There are no other beneficiaries (including contingent beneficiaries) to the trust.

The Ruling discusses the marital deduction qualification of the trust in the context of state law:

In a state with the Uniform Principal and Income Act, including Section 104 with the power to adjust and Section 409(c) and 409(d) defining what portion of a distribution from  an IRA or other retirement account is considered to be "income;"

In a state with a 4% unitrust definition of income for the IRA and for the trust either by the governing instrument or by consent of the parties; and

In a state with a traditional definition of income and no power to adjust, no section 409(c) and 409(d) provisions defining what portion of a distribution from  an IRA or other qualified plan is "income," and no unitrust definition of income.

RULINGS

The Uniform Principal and Income Act (UPIA) Section 409(c) provision labeling 10% of the required distribution to be "income" and the rest of the distribution to be "principal" does not, in itself, satisfy the marital deduction requirements. Nor does the "savings" provision in 409(d) necessarily save it.

But a requirement in the trust that the surviving spouse has the right to make the trustee demand and withdraw all the "income" of the IRA using the power to adjust to determine a reasonable apportionment of the total return from the IRA will allow the IRA to qualify for the marital deduction.

A 4% unitrust definition of income under state law for the IRA, or  the Trust, or both will qualify in all events for the marital deduction as granting the surviving spouse a qualifying income interest for life.

A traditional definition of income for both the IRA and the trust will also qualify in all events for the marital deduction.

Under the facts of the ruling, since the MRDs may be larger than the "income" to be distributed to the surviving spouse, the surviving spouse is not the only beneficiary of the IRA during her lifetime, and thus the MRD's begin the year after death, rather than the year on which the deceased participant would have attained the age of 70 ½.

The life expectancies of the surviving spouse and the remaindermen have to be taken into account, and the shortest life expectancy would be the one used. 

The life expectancy of the surviving spouse without recalculation would be used for the duration of the trust, both during the surviving spouse's lifetime and thereafter.

COMMENT

THE BAD NEWS:  STRANGE RESULTS WHEN UPIA AND IRAs MIX

The Uniform Principal and Income Act provides in 409(c) that where the distribution from an IRA (or other qualified plan) is not earmarked as dividends or interest or otherwise defined to be "income" by the payor, that only 10% of the mandatory distributions shall be considered to be income.

In the context of the required minimum distribution regulations under Section 401(a)(9), this rule produces some very strange results. If the sole beneficiary of the trust is considered to be the surviving spouse of the participant, there might be no required distribution at all until the deceased participant would have reached 70 ½. This means there would be no "income" at all, until then.  

And where there is a required distribution, the amount that is required is entirely dependent upon the age of the beneficiary, and not the "return," in any sense of the word, from the underlying investment assets in that retirement account.

EXAMPLE:

A 20 year old beneficiary has a life expectancy of 63 years. The required distribution would be 1.58% of the IRA balance as of the end of the prior year.

Under the UPIA Rule, this would mean that .158% ($158 on $100,000) would be considered to be "income" from the IRA.

A 63 year old, on the other hand, would have a life expectancy of 22.7 years, and a required distribution of 4.4%, of which 10%, or .44% ($440 on $100,000) would be considered to be income.

As Natalie Choate succinctly put it in her 2004 article in Trusts and Estates,

"[t]he amount of a required distribution from a retirement plan,

under the rules of IRC Section 401(a)(9),

has nothing to do with any traditional concept of income or principal of the plan."[1]

This is a significant problem, because under the Final Regulations, in order for an amount to be treated as "income" it must either be income under traditional notions of income or principal, or, if supported by state statute, a non-traditional notion such as the unitrust or the power to adjust may be available if the approach is considered to be a reasonable apportionment of total return.

THE GOOD NEWS: SPOUSE'S RIGHT TO FORCE WITHDRAWAL QUALIFIES FOR MARITAL

The good news is that the Service looked at the application of the power to adjust first with reference to the trustee's duty to fairly allocate the total return from the trust and in the IRA, and since the facts provided that spouse B had the right to force the trustee to withdraw the IRA "income", so allocated (really, so "adjusted"), it should qualify for the marital deduction.

WARNING:  

There were cautionary words for the 10% rule of 409(c) and (d):

Depending upon the terms of Trust, the impact of State X's version of sections 409(c) and (d) of the UPIA may have to be considered. State X's version of section 409(c) of the UPIA provides in effect that a required minimum distribution from the IRA under Code section 408(a)(6) is to be allocated 10 percent to income and 90 percent to principal.

This 10 percent allocation to income, standing alone, does not satisfy the requirements of §§ 20.2056(b)-5(f)(1) and 1.643(b)-1, because the amount of the required minimum distribution is not based on the total return of the IRA (and therefore the amount allocated to income does not reflect a reasonable apportionment of the total return between the income and remainder beneficiaries).

The 10 percent allocation to income also does not represent the income of the IRA under applicable state law without regard to a power to adjust between principal and income. State X's version of section 409(d) of the UPIA, requiring an additional allocation to income if necessary to qualify for the marital deduction, may not qualify the arrangement under § 2056. Cf. Rev. Rul. 75-440, 1975-2 C.B. 372, using a savings clause to determine testator's intent in a situation where the will is ambiguous, but citing Rev. Rul. 65-144, 1965-1 C.B. 422, for the position that savings clauses are ineffective to reform an instrument for federal transfer tax purposes.

KEY TO MARITAL IS REQUIREMENT THAT "INCOME," MODIFIED AS NEEDED BY THE POWER TO ADJUST BE DISTRIBUTED OR GIVEN TO SURVIVING SPOUSE:

So to qualify for the marital deduction, the trustee must be required to distribute or the surviving spouse must be given the right to require the "income" to be paid out to her annually, while the power to adjust is applied as needed to allocate the total return from the trust fairly and impartially..

In a state with a unitrust definition of income, the Ruling held that a 4% distribution from the IRA, or a right in the surviving spouse to require that the amount be withdrawn and then distributed by the trustee to B, will qualify for the marital deduction for QTIP purposes. We can mix and match the definitions -  if state law allows -  as between the marital trust and the IRA, because their qualification and election are separate from one another:

The result would be the same if State Y had enacted both the statutory unitrust regime and a version of section 104(a) of the UPIA and the income of Trust is determined under section 104(a) of the UPIA as enacted by State Y, and the income of the IRA is determined under the statutory unitrust regime (or vice versa). Under these circumstances, Trust income and IRA income are each determined under state statutory provisions applicable to Trust that satisfy the requirements of § 20.2056(b)-5(f)(1) and § 1.643(b)-1. Therefore B has a qualifying income interest for life in both the IRA and Trust.

USE OF POWER TO ADJUST RESPECTED:

So the Service has answered some important questions that were left hanging in the Final Regulations promulgated on December 30, 2004. The use of the power to adjust or the unitrust definition of income, if supported by state statute, will be respected in the context of an IRA and qualification for QTIP treatment under Section 2056(b)(7).

But the IRS also said that the definitions under those state laws do not have to be identical for the IRA and the trust to which it is directed to distribute, since the qualification for and election of QTIP treatment for the IRA and the trust are separate, which has been the Service's position since the promulgation of Rev. Ruling 89-89.

This is particularly good news for anyone with a state law similar to that of Pennsylvania, (20 PA.C.S.§8149(c)) which already opted to look to the "income" inside the IRA to define what part of the IRA distribution was "income."

CONSERVATIVE PLANNING:

To be sure to qualify an IRA for the marital deduction where it is payable to a QTIP trust, it may be wise to use a belt and suspenders approach with provisions mandating the payout of "income" from the IRA in both the IRA beneficiary designation and also in the trust itself. The Ruling does not require it, but it may be wise to nail down the "income" distribution in the IRA itself, making doubly sure that the "income" you want is the "income" you get.

Many IRAs claim to adopt the law of a particular state to govern the IRA. One would hope that a Pennsylvanian with a Fidelity IRA (which references the law of Massachusetts) would be able to use the unitrust definition of income allowed under Pennsylvania law.  Hence it might be wise to require the payout of the "net income" from the IRA (under traditional definition of income or unitrust definition of income) or the MRD, whichever is greater, in the beneficiary designation as well as the trust, to be doubly sure[RBW1].

While the approach of just giving the spouse the power to require a distribution of the "income" may sound appealing, there are a number of other potential issues associated with this option that may make it less attractive than it sounds. For example:

Does the power that is unexercised make the trust partially and cumulatively a grantor trust?

Might the lapse of the right be a deemed addition to the trust if the QTIP trust were GST Exempt and "income" were over 5%?  

FLEXIBILITY THOUGH MIXING AND MATCHING:

But the ability to treat the IRA and the rest of the QTIP trust using different state law definitions of income should be extremely helpful. For example, if the QTIP marital trust is a unitrust paying out 4% of the value of the marital trust (possibly to include the value of the IRA as well), but if the IRA is governed by the traditional definition of "income", the IRA could well pay out just dividends at 2% or less while the overall QTIP distribution provisions can be more generous, thus taking advantage of using the trust that will be taxable in the surviving spouse's estate, while not accelerating unduly the distributions from the IRA, with the income tax that comes with it!

PROSPECTIVE EFFECT

The Ruling states that it will not be "adversely applied" to taxpayers for taxable years beginning before May 30, 2006 with reference to trusts administered pursuant to state law granting the trustee the power to adjust between principal and income or authorizing a unitrust payment in satisfaction of the income interest of the surviving spouse. Presumably, this means that while the Ruling deals with the marital deduction, which has its effect on the date of death, that the administration of the trust thereafter, if inconsistent with the Ruling, will not be used against the taxpayer until the year after the rules were published. 

CONCLUSION

Revenue Ruling 2006-26 provides some much needed guidance on QTIP qualification in the context of IRAs and other retirement accounts, taking into account the fact that 45 states now have total return statutes with either the power to adjust or a power to convert to a unitrust.

The Ruling welcomes both powers and the unitrust definition of income, as applied separately to the trust and the IRA, while eschewing the 10% of MRD rule contained in 409(c) as irrelevant.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!