QTIPing an IRA.

Rev. Rul. 2000-2 liberalizes the rules for designating a qualified terminable interest property (QTIP) trust as the beneficiary of an individual retirement account (IRA) set forth in Rev. Rul. 89-89. Designating an IRA beneficiary is often an important part of an estate plan. The account owner may designate a QTIP trust as the beneficiary of an IRA so that he can control the disposition of the IRA after death. This is often done if the account owner has children from a prior marriage and wishes to provide for the current spouse while controlling the disposition of the asset after the spouse's death. Designating the spouse as the beneficiary may allow for a longer deferral of distributions and resulting taxes; however, the account owner's interest in controlling the disposition of the account may outweigh the potential tax deferral.

The account will qualify for the estate tax marital deduction on the death of the plan owner if Sec. 2056(b)(7) requirements are satisfied, including the requirement that the surviving spouse be entitled to all the income from the property annually. When designating a QTIP trust as an IRA beneficial, the interaction of the Sec. 401(a)(9) minimum distribution rules and Sec. 2056(b)(7) QTIP requirements create technical questions. Does the IRA have to distribute all of the income earned during the year, in addition to any required distributions of corpus, to the trustee of the QTIP trust?

Example: P set up a QTIP trust that includes an IRA with an account balance of $100,000 as of December 31 of the prior year. The account is being paid out over a 25-year life expectancy in accordance with the Sec. 401(a)(9) minimum distribution rules. The minimum required distribution is $4,000, and the income of the IRA is $6,000. The income earned by the QTIP trust on its other assets is $1,000. How much must be distributed from the IRA for the year to the QTIP trust?

In Rev. Rul. 89-89, the IRS held that an IRA is treated as QTIP if the principal balance payable at the date of death is payable in annual installments to a testamentary QTIP trust over the surviving spouse's life expectancy. The income on the undistributed assets in the IRA is paid annually to the QTIP trust, and the QTIP trust distributes the income received from the IRA, along with any other QTIP trust income. In the example, the IRA must distribute $10,000 (income of $6,000 and required principal installment of $4,000), and the QTIP trustee must distribute $7,000 (IRA income of $6,000 and other income of $1,000) to the surviving spouse to comply with Rev. Rul. 89-89. The $4,000 IRA principal distribution is treated by most states as corpus of the QTIP trust and does not have to be distributed; however, the distribution will be taxed at the trust's compressed income tax rates.

Designating a QTIP trust as the beneficiary results in an acceleration of the income tax on an IRA asset, because the distribution is in excess of the Sec. 401(a)(9) minimum distribution rules. In the example, if the spouse were the beneficiary of the IRA, the distribution would have been $4,000, not $10,000.

Commentators have suggested alternate approaches to allow the IRA to distribute only the required minimum amount. One suggestion was to give the surviving spouse the power to require the distribution of the IRA income. This approach is now permitted by Rev. Rul. 2000-2.

Rev. Rul. 2000-2 modifies Rev. Rul. 89-89 by allowing an IRA and a QTIP trust to qualify under Sec. 2056(b)(7) if, under the terms of the testamentary QTIP trust, the surviving spouse has the "power, exercisable annually, to compel the trustee to withdraw from the IRA an amount equal to all the income earned on the assets held by the IRA" and to pay that amount to the surviving spouse. Thus, in the example, if the spouse is given the power to require the withdrawal of income but elects not to, the IRA need only distribute the minimum of $4,000, which will be treated as corpus of the QTIP trust, and the trust will be required to distribute only $1,000, representing the income earned by it on other assets. This alternative allows the surviving spouse and remainder beneficiaries to maximize the deferral of distributions from the IRA and the resulting income tax. However, the deceased account holder will not be able to control the income subject to the power of the surviving spouse.

Rev. Rul. 2000-2 requires only that the surviving spouse have the power exercisable annually to withdraw the income. If the withdrawal right lapses during the surviving spouse's life without being exercised, the surviving spouse will have made a taxable girl to the remainder interest holder subject to Sec. 2514(e).

Advisers should consider preparing QTIP trust instruments that allow the surviving spouse to compel the QTIP trustee to withdraw annually from the IRA all of the income earned on the IRA assets. Additionally, the adviser should also prepare the IRA beneficiary designation to allow the trustee to withdraw the required amount.

FROM PAUL G. SAVOTH, J.D., CPA, LL.M., ASSOCIATE PROFESSOR, MONMOUTH UNIVERSITY, SHREWSBURY, NJ (NOT ASSOCIATED WITH KPMG LLP)