Determining whether IRA distributions to a trust are income or principal.

Trusts have become standard entities used in estate planning. IRAs are often a major asset in taxpayers' estates. The combination of these two facts makes it inevitable that taxpayers will increasingly name trusts as their IRA beneficiaries.

Once a trust is the beneficiary of an IRA and distributions begin, it is necessary to determine, for fiduciary accounting purposes, how much of the distribution is income and how much is principal. The IRA's value as of the date of the IRA owner's death, when the trust becomes the beneficiary, is principal for this purpose. This allocation of the IRA distribution proceeds between income and principal is important in determining how much an income beneficiary receives versus how much a remainderman receives, and also in determining who is responsible for paying the income tax on the distribution.

In the context of a trust, there is a distinction between "accounting income" and "taxable income." Accounting income is determined by the trust instrument or by state law, and quantifies the amount a trustee is required (or allowed) to distribute to income beneficiaries. Taxable income of a trust includes trust receipts subject to income tax. A distribution from an IRA receives different treatment, depending on whether it is accounting income or taxable income. Because the entire distribution is treated as income in respect of a decedent for income tax purposes (in a traditional deductible IRA), the entire distribution will be treated as taxable income. On the other hand, the distribution is likely to consist of both income and principal for trust accounting purposes.

Generally, accounting income is important for ensuring that a trust qualifies for the purposes for which it was established. For instance, in a qualified terminable interest property trust, all income requires distribution, at least annually. Or, in the case of a credit shelter trust, the income often is to be distributed to the spouse. In both these cases, the income referred to is accounting income. It is unlikely that an entire IRA distribution will have to be distributed to the income beneficiaries to meet the terms of these trusts.

How does a trustee determine income and principal? The primary source of guidance is the trust document. Properly drafted, the document can be relied on to allocate receipts between income and principal. Therefore, if a practitioner is involved in the estate planning process and knows that a trust will be named as an IRA beneficiary, he should recommend such provisions.

When a trust document is silent (most common in the real world), the allocation between income and principal must be done pursuant to state law. There are at least two potential ways to make the allocation under these requirements. First (and preferably), the trustee will be able to require the IRA trustee or custodian to use trust accounting principles in determining the source of the distribution. If this is possible, the IRA trustee or custodian can simply inform the trustee of the source of a distribution (i.e., whether it is from income or principal of the IRA) and the trustee can rely on that for his purposes. The IRA trustee or custodian is most likely to be able to perform this function if the IRA is administered at a bank or trust company. Mutual fund and brokerage account IRAs generally do not account separately for income and principal and therefore may not be suitable for an IRA paid to a trust (particularly if the trustee is unwilling to use the default provided in the next paragraph).

If no guidance is available in the trust document and separate accounting for income and principal is not done at the IRA level, the second alternative is to default to other general principles under state law. Most states have adopted provisions to assist a trustee in the allocation of receipts between income and principal. In most cases, this assistance takes the form of the state's adoption of some version of the Uniform Principal and Income Act (UPIA). Each version of the UPIA provides a method of calculating the amount to be considered income when deferred compensation, annuities and similar payments are received. Depending on the version of the UPIA adopted, the calculation can be based on a percentage of the "inventory value" of the IRA, a percentage of the actual distribution received or some other amount specifically provided for by the state's modification to the UPIA. The trustee must be familiar with the particular state's adopted law to properly make the allocation in this case.

In summary, it is often important for a trustee to determine what part of a distribution from an IRA is income or principal. A tax practitioner can be helpful in the planning process by recommending and ensuring that the trust document provides the methodology for the allocation. If the document does not so provide and the trustee looks to the practitioner for help, the practitioner can suggest separate accounting by the IRA trustee or custodian, or can assist in determining the proper allocation pursuant to the applicable state's version of the UPIA.

FROM THOMAS A. BYERS, CPA, CFP, ELLIN & TUCKER, CHARTERED, BALTIMORE, MD