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Using IRAs to fund QTIP trusts.

EXECUTIVE SUMMARY

* If a taxpayer and spouse have enjoyed a long, happy marriage and have common objects of affection, a QTIP trust may serve little purpose.

* The "qualifying income interest for life" requirement becomes more complicated when retirement assets, rather than stock or bonds, are used to fund a QTIP trust.

* Rev. Rul. 2000-2 allows spouses to let the excess of IRA earnings over the RMD remain in the IRA for the benefit of the remainder interest holders.

An IRA account may well be the largest asset in a taxpayer's estate; thus, it may be a natural choice for funding a qualified terminable interest property (QTIP) trust. However, such trusts are not for every client, and should be created and funded with care. This article examines important issues in funding a QTIP trust with an IRA, including a recent IRS pronouncement that liberalized some of the rules.

Good estate planning involves not only minimizing estate tax liability, but also ensuring that the taxpayer's nontax objectives are met. A qualified terminal interest property (QTIP) trust is a popular device that allows a taxpayer to provide a surviving spouse with the income from (or use of) property undiminished by estate taxes for life, while ensuring that the former's wishes will be followed after the latter's death. This is accomplished by qualifying the trust property for the estate tax marital deduction, even though a terminable interest exists. Many taxpayers may need to consider funding QTIP trusts with retirement assets. This article analyzes the requirements for effective use of a QTIP election for a trust funded by an IRA, in light of the liberalized distribution requirements set forth in Rev. Rul. 2000-2.(1)

When to Use a QTIP Trust

The decision to use a QTIP trust is a function of the relationships among the taxpayer, his spouse and the intended remainder interest holders. When a taxpayer leaves property outright to a spouse, it becomes the spouse's property to control; thus, the spouse decides the property's next owner. If a taxpayer and spouse have enjoyed a long, happy marriage and have common objects of affection, a QTIP trust may serve little purpose. In fact, a QTIP election may erode the control the surviving spouse has over the children. In such a case, a general power of appointment trust, qualifying under Sec. 2056(b)(5), might be more appropriate, permitting the spouse to appoint property to children according to need, while limiting amounts transferred to less needy or responsible offspring.

Sometimes, there are no common objects of affection. If a taxpayer has children from a prior marriage, conflicting testamentary wishes with a spouse or concerns about the spouse remarrying, the desire to ensure an intended distribution of assets may outweigh a QTIP trust's relative inflexibility. QTIP trusts are also useful when there is a significant age disparity between a taxpayer and spouse,(2) or when a taxpayer is concerned that the surviving spouse may not be competent to manage or conserve assets. Trusts that qualify for the marital deduction avoid probate at the surviving spouse's death, and defer the payment of estate taxes until that time. Thus, even if the surviving spouse has adequate assets for support, the estate tax deferral allows the estate to grow undiminished, while allowing for the possibility that the estate tax may be reduced of eliminated in the future.

The QTIP Election

Because Federal tax law requires that property be taxed at least once every generation, an estate tax marital deduction generally is not allowed for a terminable interest. According to Sec. 2056(b)(1), a "terminable interest" exists if an interest passing to a surviving spouse will terminate or fail on the occurrence (or failure to occur) of an event or contingency. Sec. 2056(b)(7) allows a marital deduction for a terminable interest when a surviving spouse receives a life estate in property for which a QTIP election is made.

This provision gives taxpayers the opportunity to both guarantee their nontax wishes and qualify for the marital deduction on property transferred to a surviving spouse.(3) Under Sec. 2056(b)(7)(B)(i), an estate tax marital deduction is permitted from the decedent's estate (even though a terminable interest has been transferred), if the following three requirements are met:

1. Property passes from the decedent.

2. The surviving spouse has a qualifying income interest for life in such property.

3. An election is made to treat the property as QTIP.

The distributive arrangements specified in the QTIP trust cannot be changed by the surviving spouse. If a QTIP election is made, Sec. 2044 requires the fair market value (FMV) of the QTIP be included in the surviving spouse's estate.(4)

The "qualifying income interest for life" requirement becomes more complicated when retirement assets, rather than stock or bonds, are used to fund a QTIP trust. When using nonretirement assets as QTIP, the income produced therefrom (e.g., interest and dividends) is distributable to the surviving spouse; the trust corpus is preserved for the remainder interest holders. When using retirement assets such as IRAs, the required minimum distribution (RMD) rules come into play; generally, the RMD differs from the IRA's annual earnings.

RMDs

Sec. 401(a)(9)(C)(i) requires a traditional IRA owner to begin receiving RMDs no later than April 1 of the year following the year he turns 70 1/2,(5) or incur a 50% penalty under Sec. 4974(d). Prop. Kegs. Sec. 1.408-8, Q&A-6, provides that each RMD equals the IRA balance on December 31 of the previous year, divided by the required distribution period. During an IRA owner's life, the required distribution period depends on the owner's attained age during the distribution year and is determined using the uniform table provided in Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-4(a)(2)(i).(6)

Example 1: J turned 70 1/2 on Aug. 5, 1998 and began receiving IRA distributions on April 1, 1999. J computes his 2001 RMD by dividing his IRA balance as of Dec. 31, 2000 by 23.5. His 2002 RMD will be his IRA balance as of Dec. 31, 2001, divided by 22.7. The divisors (23.5 and 22.7) represent the respective distribution periods for ages 73 and 74, J's age as of Dec. 31, 2001 and Dec. 31, 2002, and are found in a table in Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-4(a).

Effect of IRA Owner's Death

The distribution periods found in Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-4(a)(2)(i), apply only to RMDs during an IRA owner's life. Starting with the year following the year of the owner's death, the distribution period used to calculate RMDs is the single life expectancy of the "designated beneficiary," as determined in Regs. Sec. 1.72-9, Table V.(7) Although IRA owners can name any individual or entity as an IRA beneficiary, only individuals can be classified as designated beneficiaries.(8) However, trust beneficiaries will be treated as designated beneficiaries if the trust meets the requirements in Prop. Regs. Sec. 1.401(a)(9)-4, Q&A-5(b). Thus, when a QTIP trust is an IRA beneficiary, RMDs will be made over the surviving spouse's remaining single life expectancy, starting with the year following the year of the IRA owner's death.

By placing IRA assets in a QTIP trust, the IRA owner forgoes significant income tax advantages associated with naming the spouse as the sole beneficiary. If the owner's spouse is the sole IRA beneficiary, after the owner dies, Sec. 408(d)(3)(C)(ii)(II) permits the surviving spouse to elect to treat the IRA as his own.(9) This allows the surviving spouse to postpone taking IRA distributions until his required beginning date (RBD); required distributions can then be computed using the distribution period corresponding to the surviving spouse's age.

Example 2: T named a QTIP trust as his IRA beneficiary. On his RBD, T began receiving RMDs in accordance with the Sec. 401 distribution rules. T died in 2001. Beginning in 2002, the trust will take RMDs using the remainder of T's surviving spouse's single life.(10) After the surviving spouse dies, the QTIP assets will pass to the remainder interest holders T designated in the QTIP trust document. The remainder interest holders will be required to continue taking RMDs over the surviving spouse's remaining life expectancy.(11)

Example 3: The facts are the same as in Example 2, except that T named his spouse as the sole IRA beneficiary, without a QTIP trust. When T dies, his surviving spouse can elect to treat T's IRA as her own and wait until her RBD (or until December 31 of the following year, if her RBD has passed) to begin receiving RMDs. This allows the surviving spouse to prolong the IRA distribution period and gives her power to name the next IRA beneficiary.

When an IRA owner dies before reaching his RBD, under Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-5(b), the account balance must be distributed over the life expectancy of the designated beneficiary with the shortest life expectancy, provided distributions begin no later than December 31 of the year after the owner's death. Alternatively, Prop. Regs. Sec. 1.401(a)(9)-3, Q&A-4, states that the IRA may include a provision requiring that the entire balance be distributed within five years of the account owner's death.(12)

Significant tax deferral advantages are forgone if IRA assets are placed in a QTIP trust and the owner dies prior to his RBD, versus naming the spouse as sole beneficiary. If the spouse is the sole beneficiary, under Prop. Regs. Sec. 1.401(a) 9)-3, Q&A-3(b), he can delay the start of RMDs until December 31 of the year the owner would have turned 70 1/2. Alternatively, the spouse can treat the IRA as his own and wait until his own RBD (April 1 of the year after the year the spouse turns 70 1/2) before taking distributions, under Prop. Regs, Sec. 1.408-8, Q&A-5(a). However, if a QTIP trust is the beneficiary, the IRA must be distributed over the spouse's life expectancy.

Example 4: R, an IRA owner, died on April 12, 2001. A QTIP trust is his IRA beneficiary. R would have turned 70 1/2 in 2005. R's wife, M, will turn 70 1/2 in 2009. Unless the IRA specifies that the five-year rule applies, the QTIP trust must begin taking distributions over M's single life expectancy, beginning no later than Dec. 31, 2002.

Example 5: The facts are the same as in Example 4, except that M is the sole IRA beneficiary. M could opt to take RMDs over her life expectancy beginning no later than Dec. 31, 2005 (i.e., the year R would have turned 70 1/2). Alternatively, M could elect to treat R's IRA as her own and wait until April 1, 2010 (her RBD) to begin RMDs. This allows M to significantly prolong the IRA distribution period and to control the naming of the next IRA beneficiary.

As the previous two examples illustrate, the primary disadvantage to using retirement assets to fund a QTIP trust is the accelerated distribution period used to compute RMDs. In addition, any portion of the IRA distribution retained by the QTIP trust (i.e., principal) will be taxed at the compressed trust tax rates.

Given the preponderance of retirement assets in many estates, taxpayers may decide that the costs associated with placing retirement assets in a QTIP trust outweigh the potential consequences of leaving them outright to a spouse. Should an IRA owner decide that funding a QTIP trust with IRA assets is necessary or desirable, it is essential that the trust be created and administered properly to satisfy the QTIP requirements.

QTIP Requirements

As was mentioned, Sec. 2056(b)(7) provides three basic requirements for a QTIP trust. The QTIP election is made by the executor, regardless of whether the QTIP is in the executor's or another person's possession.13 When a QTIP trust is the IRA beneficiary, the income from the IRA flows through the QTIP trust before being distributed to the surviving spouse. Accordingly, the Service has stated in Rev. Ruls. 89-89(14) and 2000-2 that an executor must make a valid Sec. 2056(b)(7) election for both the IRA and the QTIP trust.

The passing requirement has presented relatively few problems in qualifying property for the marital deduction.(15) IRAs and QTIP trusts are treated as having passed from the decedent to the surviving spouse. However, the "qualifying income interest for life" requirement has been the primary issue for concern when IRAs constitute QTIP.

Qualifying Income Interest for Life

For property held in trust to qualify for a QTIP election, the surviving spouse must have a qualifying income interest for life. Sec. 2056(b)(7)(B)(ii) provides the following two-prong test:

1. The surviving spouse must be entitled to all the income from the property, payable in annual or more frequent installments.

2. No person may have a power to appoint any part of the property to any person other than the surviving spouse during the surviving spouse's life.

Interpretation: The "qualified income interest for life" provision requires that the surviving spouse be entitled to "all" trust income. In Letter Ruling (TAM) 9220007,(16) the Service held that a QTIP election was not allowed when a trustee was permitted to delay the start of required distributions from a decedent's IRA to a QTIP trust for a significant period of time. The trustee had three options for receiving payouts from the IRA. Option one provided that if the testator died before his RBD, the trustee could wait up to five years after his death to distribute the full IRA. Options two and three provided that if the spouse was the designated beneficiary and alive at the testator's death, distributions would not begin before the day the testator would have attained age 70 1/2. The testator died at age 68. Under option one, distributions from the IRA could have been delayed for up to five years. Under options two and three, no distributions were required for 2 1/2 years, when the decedent would have turned 70 1/2. Because the spouse was not entitled to a distribution of all the income from the trust at least annually, the requirements of Sec. 2056(b)(7)(B)(ii) had not been met and the QTIP deduction was disallowed.

Trust Accounting Income

For trust accounting purposes, amounts distributed from an IRA to a QTIP trust must be allocated between income and principal. Section 409(c) of the Uniform Principal and Income Act(17) (Act) provides that 10% of the distribution is allocated to income; the remaining 90% is allocated to principal. When the IRS compels a QTIP trust to make a distribution to a surviving spouse in excess of 10% of the total distribution from the IRA, Act Section 409(d) permits the entire amount distributed to the surviving spouse to be allocated to trust income, with the remainder allocated to principal.

Example 6: An IRA has an RMD of $120,000, payable to a QTIP trust. For trust accounting purposes, Act Section 409(c) allocates $12,000 to trust income and $108,000 to trust corpus. However, if the IRS requires that the entire $120,000 be distributed to the surviving spouse's QTIP trust, for trust accounting purposes the entire $120,000 distribution is treated as income; zero is allocated to corpus.

Penalty Avoidance

Rev. Rul. 89-89

When a trust is funded with an IRA, distributions equal to the RMD must be made to avoid the Sec. 4974(d) 50% excise tax. Given the recent returns earned by some portfolios, the trust earnings may exceed the RMD. In Rev. Rul. 89-89 (which does not specifically address RMDs), the Service held that a trust qualified as a QTIP trust because the IRA had to distribute all income for the year to the trust; the trust had to distribute such income to the beneficiary currently. However, Regs. Sec. 20.2056(b)-5(f) requires only that the income earned from the property (the IRA) be distributed at least annually to the spouse; although Rev. Rul. 89-89 seemed to conflict with this regulation, it remained the Service's position until Rev. Rul. 2000-2.

Rev. Rul. 2000-2

In obsoleting Rev. Rul. 89-89, Rev. Rul. 2002-2 held that, when an IRA's annual earnings exceed the RMD, only the RMD need be distributed to the surviving spouse to meet the "all income for life" requirement, provided that the spouse can compel the trustee to distribute the excess. Rev. Rul. 2000-2 allows spouses to let the excess of the IRA earnings over the RMD remain in the IRA for the benefit of the remainder interest holders. In so doing, the trust (as opposed to the surviving spouse) will pay tax currently on the undistributed income. Gift tax consequences may result, based on the difference between the RMD and the amount earned by the IRA; however, providing the surviving spouse with the right to compel a cumulative distribution of the excess earnings during life will eliminate the potential imposition of gift tax. As a result, any amounts not distributed to the spouse will be included in his estate on death. Moreover, if the spouse's right to compel distributions lapses, Sec. 2514(e) requires that the undistributed excess earnings be treated as a taxable gift from the spouse to the remainder interest holders when the right lapses.

Example 7: An IRA owner dies in 2001, after his RBD; his IRA beneficiary is a QTIP trust. On Dec. 31, 2001, the IRA balance was $1,200,000. In 2002, the surviving spouse's single life expectancy was 10 years and the IRA produced $130,000 of income (interest and dividends). For 2002, the RMD is $120,000 ($1,200,000/10). The required distribution from the QTIP trust is the lesser of (1) the $130,000 income produced by the IRA or (2) the $120,000 RMD. To avoid the Sec. 4974(d) 50% excise tax, the surviving spouse is required to take distributions totaling only $120,000; the QTIP trust will be treated as having satisfied the "all income for life" requirement on the distribution of $120,000, if the surviving spouse has the right to compel the trustee to distribute the additional $10,000 of earnings. If the $10,000 is not distributed to the surviving spouse, that amount will be treated as a gift to the remainder interest holders, unless the surviving spouse has a cumulative right to compel the distribution at any time prior to their death.

Example 8: The facts are the same as in Example 7, except that during 2002, the IRA produced only $100,000 of income. The required distribution from the QTIP trust to the surviving spouse is the lesser of (1) the $100,000 income earned by the IRA or (2) the $120,000 RMD. The QTIP trust is required to take distributions totaling $120,000 from the IRA to avoid the 50% excise tax, but is required to distribute only $100,000 to the surviving spouse.

Conclusion

Because many estates consist of sizable retirement assets, taxpayers may find it necessary to fund a QTIP trust with them. Tax planners advising clients who are considering placing IRA assets into a QTIP trust will want to keep in mind the following guidelines.

First, the trustee should elect to receive annual RMDs using the exception to the five-year rule in Sec. 401(a)(9)(B)(iii) . Second, all trust income must be payable annually to the surviving spouse, with no person having the power to appoint trust principal to any person other than the spouse. Third, the trust document must not bar distribution of amounts in excess of the annual RMD under Sec. 408(a)(6). Fourth, the spouse must have the right (exercisable annually) to compel the trustee to distribute an amount equal to the income earned on the assets held by the IRA during the year--even if that amount exceeds the RMD. Finally, to avoid the possibility of a taxable gift in a year in which the surviving spouse takes an RMD less than the actual earnings of the QTIPed IRA, the spouse must have a cumulative right to withdraw these excess amounts.

Placing IRAs in QTIP trusts reduces potential deferral opportunities otherwise available to outright IRA beneficiaries. However, the importance of guaranteeing the former IRA owner's dispositive wishes may often outweigh these potential costs. When IRA assets are placed into a trust for which a QTIP election will be made, it is essential that the passing, election and income-for-life requirements be satisfied. In Rev. Rul. 2000-2, the Service has clarified that only the RMD need be distributed to a surviving spouse to meet the QTIP-income-for-life requirement, if the surviving spouse can compel the trustee to withdraw from the IRA and distribute IRA earnings in excess of the RMD.

(1) Rev. Rul. 2000-2, IRB 2000-3, 305, obsoleting Rev. Rul. 89-89, 1989-2 CB 231.

(2) When there is a significant age disparity between spouses and the taxpayer has children from a prior marriage, the children may predecease the spouse. If this occurs, the children would derive no benefit from a QTIP trust; although the QTIP trust provided the taxpayer control over the assets, his grandchildren (not his children) may ultimately receive the QTIP. This may raise generation-skipping transfer tax issues, which are beyond the scope of this article.

(3) Sec. 2523(f) provides a similar provision for an inter vivos transfer of property.

(4) Although the surviving spouse can enjoy undiminished use of the property or income, the inclusion of the FMV in his estate can create a potential tax liability. To remedy this inequity, Sec. 2207A(a)(1) provides a right of recovery for the marginal estate tax liability imposed by the inclusion of these assets in the surviving spouse's estate. Surviving spouses may waive this right to recovery in their wills. Similarly, Sec. 2207A(b) provides a right of recovery for gift taxes imposed by lifetime transfers; compare Sec. 2207B, which provides a right of recovery for taxes imposed due to inclusion caused by a power of appointment.

(5) Each subsequent RMD must be paid by December 31 of the distribution year.

(6) The IRS issued proposed regulations (REG-130477-00, REG-130481-00, 1/17/01) that govern mandatory distributions from IRAs and other retirement plans. The rules replace the 1987 proposed regulations (EE-113-82, 7/27/87) and are effective for distributions starting in 2002. However, IRA owners can elect to use the new rules to compute their 2001 RMDs. Because the new rules provide distribution periods at least as generous as under the former proposed regulations, for purposes of this article it is assumed that an IRA owner will elect to use the new roles when computing 2001 RMDs.

(7) See Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-5(a). The designated beneficiary is determined as of December 31 of the year after the year of the owner's death. When there is more than one designated beneficiary on this date, the single life expectancy of the beneficiary with the shortest life expectancy is used, according to Prop. Regs. Sec. 1.401(a)(9)-4, Q&A-4(a) and -5, Q&A-7(a). If there is no designated beneficiary (e.g., the beneficiary (or one of the co-beneficiaries) is the owner's estate or a charity), RMDs are required to be made over the remainder of the IRA owner's single life expectancy, under Prop. Regs. Sec. 1.401(a)(9)-4, Q&A-3.

(8) According to Prop. Regs. Sec. 1.401(a)(9)-4, Q&A-3(a), the beneficiary under the account is the designated beneficiary if no beneficiary is named.

(9) Prop. Regs. Sec. 1.408-8, Q&A-5, provides that, for the surviving spouse to elect to treat the owner's IRA as his own, he must be the sole IRA beneficiary and have unlimited right to withdraw amounts. These conditions are not met if a trust is named IRA beneficiary, even if the spouse is the sole trust beneficiary.

(10) For RMDs made during the surviving spouse's life, Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(2) and -6, provide that the distribution period is determined under Regs. Sec. 1.72-9, Table V, using the surviving spouse's actual age as of December 31 of the distribution year.

(11) According to Prop. Regs. Sec. 1.401(a)(9)-5, Q&A-5(c)(2), for years after the year of the spouse's death, the spouse's remaining life expectancy is calculated using his age as of the birthday of the year of death. For each subsequent year, the distribution period is reduced by one for each year that has elapsed since the year immediately following the year of death.

(12) If there is no designated beneficiary as of December 31 of the year following the year of the owner's death, distributions must be made in accordance with the five-year role, under Prop. Regs. Sec. 1.401-(a)(9)-4, Q&A-3(b). To prevent a spouse from using the five-year rule, an IRA owner can put a provision in the trust agreement prohibiting use of the rule.

(13) If no executor is appointed, qualified and acting within the U.S., Regs. Sec. 20.2056(b)-7(b)(3) allows the election to be made by any person in actual or constructive possession of the property (e.g., the trustee of an inter vivos trust included in the beneficiary's estate). The election is made on the last estate tax return fried on or before the due date (including extensions).

(14) Rev. Rul. 89-89, note 1 supra.

(15) Sec. 2056(c) provides that property will be treated as having passed from the decedent if such interest: (1) is bequeathed or devised to such person by the decedent; (2) is inherited by such person from the decedent; (3) is the dower or curtesy interest (or statutory interest in lieu thereof) of such person as the surviving spouse of the decedent; (4) has been transferred to such person by the decedent at any time; (5) was at the time of the decedent's death, held by such person and the decedent (or by them and any other person) in joint ownership with right of survivorship; (6) can be appointed by the decedent (either alone or in conjunction with any person) and if the decedent appoints or has appointed such interest to such person or if such person takes such interest in default on the release or nonexercise of such power; or (7) consists of proceeds of life insurance on the decedent receivable by such person.

(16) IRS Letter Ruling 9220007 (1/27/91).

(17) Uniform Principal and Income Act (1997), drafted by the National Conference of Commissioners on Uniform State Tax Laws. The Act and its predecessors (the Uniform Principal and Income Acts of 1931 and 1962) were formally adopted by 41 state legislatures.

For more information about this article, contact Dr. Johnson at (770) 423-6085 or Linda_Johnson@coles2.kennesaw.edu or Dr. Greenstein at (973) 761-9428 or Greensbr@shu.edu.

Linda M. Johnson, Ph.D., CPA Associate Professor of Accounting Michael J. Coles College of Business Kennesaw State University Kennesaw, GA

Brian R. Greenstein, Ph.D. Director, Graduate Tax Program W. Paul Stillman School of Business Seton Hall University South Orange, NJ
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Title Annotation:qualifying income interest for life; minimizing estate tax liability
Author:Greenstein, Brian R.
Publication:The Tax Adviser
Geographic Code:1USA
Date:May 1, 2001
Words:4602
Previous Article:Illinois DOR amends income tax regulations.
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