Estate planning with pensions.

This item illustrates how a well-meaning client created a potential problem for his heirs, and proposes a way to solve the problem after the damage is done.

Good estate planning often calls for the use of a revocable trust that becomes irrevocable at death. However, in most cases, the planner recommends that the trust not be named as a beneficiary of either the decedent's share of a pension plan or IRA accounts; unless the trust qualifies as a "look-through" trust, the heirs will be required to receive and be taxed on the entire pension benefits within a five-year timeframe; see Sec. 401(a)(9)(B)(ii) and (iii).

In this case, the decedent was attempting to apportion his estate among his second wife, his two natural children and a stepchild. The estate's major asset was a defined-benefit pension plan. The decedent died within six months of the time he changed the beneficiary designations on his pension accounts, without realizing the complications these changes would later cause.

Facts

The decedent, age 62, was not receiving benefits from his pension plan or IRA accounts prior to his death on Dec. 31, 2003. He named Iris revocable trust as the primary beneficiary of the plan and accounts in June 2003. The secondary beneficiary was listed as "none." His spouse consented to a waiver on the same date. The decedent's revocable trust permitted the trustee (his spouse) to use trust assets to pay funeral and administrative expenses of the estate, as well as inheritance and similar taxes. The decedent's trust became irrevocable at his death. The trust beneficiaries were his spouse (55%), daughter (15%), son (15%) and stepdaughter (15%).

Issues

The issues were as follows:

1. Will the trust meet the definition for determining a designated beneficiary of a qualifying trust (specifically, a look-through trust), under Regs. Sec. 1.401(a)(9)-4, Q&A-5 and, thus, qualify to make distributions to all beneficiaries over the life of the eldest beneficiary (i.e., the surviving spouse)?

2. If the trust is a qualifying trust, can separate accounts be set up fur each of the beneficiaries and their own lives used to calculate the required distributions, rather than the spouse's life?

3. Do the trust and pension plan need to take any action?

Discussion

The trust appeared to meet the strict definition of a qualifying trust, specified in Regs. Sec. 1.401(a)(9)-4, Q&A-5; thus, distributions could be made based on the spouse's life. However, there was a problem.

The fact that the trust could pay estate administration expenses, funeral expenses and/or debts and taxes of the decedent made the estate an "unnamed" trust beneficiary. Because an estate has no life expectancy, the IRS has ruled that there can be no designated beneficiary for purposes of Regs. Sec. 1.401(a)(9)-4, Q&A-5. The regulations are clear: as long as there is one trust beneficiary that does not qualify, the trust itself will not qualify. Thus, even though the trust appeared to meet the regulation, the benefits would still have to be paid out within five years of Dec. 31, 2003, because the estate was an unnamed beneficiary.

However, the IRS recently issued three letter rulings (Letter Rulings 200432027-200432029) that allowed a trust that had paid estate administration expenses and inheritance taxes to qualify. All three rulings are the same; there were three rulings because there were three trust beneficiaries.

The crux of each ruling is that a trust can qualify as long as there is not a nonqualified beneficiary as of September 30 of the year following the year of the decedent's death. In the three rulings cited above, the trust paid all known estate expenses and taxes to the decedent's personal representative before the September 30 deadline.

The IRS ruled that "the only remaining beneficiaries of the trust" as of the required documentation date were the three adult children. Thus, the trust was a qualifying trust.

In the rulings, the IRS also held that even though the trust could be divided into three separate accounts, the eldest beneficiary's life expectancy still had to be used to calculate the lifetime payout period for the distributions.

The spouse will automatically qualify for favorable options not available to the other beneficiaries (such as a rollover to her own IRA account).

Recommendations/Timing

The estate planner should:

1. Decide if a payout period longer than five years is desirable for the beneficiaries. It appears it would not be possible to lengthen the five-year period merely by purchasing annuities, if the trust does not otherwise qualify under the regulation.

2. If a longer payout period is desired, determine whether or not it would be feasible to calculate and pay the expenses of the estate and the projected estate taxes before September 30. If it is possible, pay all such expenses before that date.

3. Provide the pension plan administrator with a final list of all trust beneficiaries as of September 30, along with a copy of the trust no later than October 31.

4. If it is feasible for the trust to eliminate the estate as an unnamed beneficiary by paying expenses as discussed above, make the first distribution to the beneficiary (the trust) before December 31, based on the surviving spouse's life expectancy. If, instead, the required payout will he more than five years, payments do not have to begin before the end of the year following death, but it might be advisable for them to begin then, anyway.

5. Consider submitting a ruling request if the lifetime payout method is used, to ensure the desired outcome, because letter rulings are not precedent and ensure the results only for the requesting taxpayer.

EILEEN LAMSE, CPA, HAMMEL & COMPANY P.C., TUCSON, AZ