PENSION DISTRIBUTION PLANNING AND QUALIFIED DOMESTIC TRUSTS

By Lawrence M. Lipoff, CPA, CEBS, Principal, Lipoff and Company, CPA, PC

Significant professional literature currently exists regarding the advantages of a qualified pension plan or IRA participant naming a spouse as "designated beneficiary." However, much less literature exists regarding the effects of naming a noncitizen spouse as designated beneficiary.

In addition to qualifying for the IRC section 2056 estate tax marital deduction, there are significant advantages available when a citizen spouse is named as designated beneficiary. These include the following: 1) recalculation of a designated beneficiary's life expectancy is only allowed if the designated beneficiary is one's spouse per [IRC section 401(a)(9)(D)], 2) a designated beneficiary's life expectancy is established based upon being no more than 10 years younger than the participant during the participant's lifetime unless the designated beneficiary is the taxpayer's spouse [Prop. Treas. Reg. 1.401(a)(9)-2, Q&A 7(a)], 3) a surviving spouse can, if permitted by the plan, roll the decedent's qualified pension plan balance into the surviving spouse's own individual retirement account or treat the decedent's qualified pension plan or individual retirement account as the surviving spouse's own [IRC section 402(c)(9) and Prop. Treas. Reg. section 1.408-8, Q&A A-4], and establish a different designated beneficiary, 4) a surviving spouse can elect to defer (and perhaps with distribution planning, avoid) the 15% excise tax on excess accumulations of IRC section 4980A(d)(5), 5) a surviving spouse can delay required minimum distributions should the participant die prior to the participant's required beginning date, i.e., rather than the usual five-year rule or the exception to the five-year rule per [IRC section 401(a)(9)(iii and iv) and Prop. Reg. Section 1.401(a)(9)-1, Q&A C-3], and 6) if the plan provides, a surviving spouse can change the participant's designated beneficiary if the participant dies prior to his required beginning date [Prop. Reg. Section 1.401(a)(9)-1, Q&A E-5(f)].

Should the participant wish that the surviving spouse receive income for life rather than the plan in total, a technique that can be used is to name a qualified terminable interest property (QTIP) trust as the plan's beneficiary. In addition to the participant, the participant's spouse's life expectancy would be used to determine IRC section 401(a)(9) minimum required distributions.

However, by choosing a QTIP as the plan's beneficiary, a surviving spouse will seemingly lose the ability to make the Sec. 4980A(d)(5) election (described above) as well as the right to delay distributions until the later of (1) December 31 of the calendar year following the participant's death or (2) December 31 of the calendar year in which the participant would have reached age 701*2.

Choosing a QTIP trust will require that consideration be given as to whether the "greater than" or the "double distribution" option for the QTIP will be used. The double distribution method loses more income tax deferral possibilities when the qualified pension plan or IRA internal income exceeds the IRC section 401(a)(9) minimum distribution requirement.

The "greater than" method (consistent with PLR 9317025) for distribution to a QTIP would say that the amount to be distributed would be the greater of (1) the IRC section 401(a)(9) minimum required distribution (calculated taking into account the participant and spouse's life expectancy, with the term certain method required for the spouse) or (2) all of the net income of the plan for the year paid to an irrevocable QTIP trust that was created during the qualified pension plan or IRA owner's life. The "double distribution" method (as delineated in Revenue Ruling 89-89) requires (1) equal annual installments of the account balance over the spouse's life expectancy plus (2) the annual income earned on the undistributed portion of the account balance to be paid to a testamentary QTIP trust.

After an IRC section 2056(b)(7) irrevocable election was to be made, PLR 9416016 allowed QTIP trust language contained in the trust's governing instrument to allow the qualified pension plan or IRA to qualify for the participant's estate tax marital deduction. Also, a safer approach may be to place this language in the beneficiary designation.

Irrespective of whether the marital deduction is available through an outright transfer of the account balance to the surviving spouse or through a QTIP trust, the marital deduction is really just a tax deferral device. The estate tax will be paid eventually by the surviving spouse's estate, albeit with right for reimbursement by the QTIP remaindermen out of the QTIP trust, at the surviving spouse's estate's marginal tax rate.

Enter the Noncitizen Spouse

When a noncitizen spouse is made a designated beneficiary, IRC section 2056(d)(1) provides that no marital deduction would be available unless a qualified domestic trust (QDOT) is used. A QDOT may be created by the decedent (during life or by will), surviving spouse, or decedent's executor.

Other than an IRC section 2056A(b)(3)(B) distribution on account of hardship, when distributions of QDOT "principal" would be made to the surviving noncitizen spouse, estate taxes would be due based upon the participant's estate tax marginal bracket; when the surviving spouse dies, the remaining QDOT principal would be subject to estate tax at the original participant's estate tax marginal tax bracket. If a QDOT was not established, then the original participant's estate would have to pay tax with the estate tax return.

Two recent private letter rulings have provided an indication of the IRS's view, albeit limited from precedent setting under IRC section 6110(j)(3), regarding qualified pension plan or IRA distributions and noncitizen spouse designated beneficiaries with QDOTs in place.

PLR 9544038 addressed a situation where a QTIP-QDOT was to be established as a participant's qualified pension plan or IRA beneficiary. If the participant were to die prior to the participant's required beginning date, annual distributions were to be made based upon the greater of 1) all income generated or deemed generated by the qualified pension plan or IRA, 2) an amount based upon the ages of the surviving spouse and the eldest contingent beneficiary within Reg. 1.72-9 tables, 3) the required minimum distribution under IRC section 408(a)(6), or its successors, or 4) the required minimum distribution under IRC section 401(a)(9), or its successors. If after the participant's required beginning date the participant were to die, annual distributions were to be made based upon the greater of 1) all income generated or deemed generated by the qualified pension plan or IRA, 2) the current method of distributions being made at the participant's death, 3) the required minimum distribution under IRC section 408(a)(6), or its successors, or 4) the required minimum distribution under IRC section 401(a)(9), or its successors.

For trust accounting purposes, the trustee of the QTIP-QDOT would allocate to income the portion of distributions from the qualified pension plan or IRA equal to the greater of (1) the amount earned by the plan less the corpus allocation delineated under Treas. Reg. section 20.2056A-4(c)(4) and (2) the income calculated under the principal and income act of the state under whose laws the QTIP was established.

In summary, PLR 9544038 allowed a QTIP-QDOT to be established as a participant's qualified pension plan or IRA beneficiary. However, some of the aforementioned benefits available when a surviving spouse is the beneficiary of a qualified pension plan or IRA, irrespective of IRC section 2056 and 2056A for citizen and noncitizen spouses, respectively, would still be available.

PLR 9623063 allowed a surviving noncitizen spouse to rollover the decedent participant's qualified pension plan balance into an IRA. This would enable the surviving spouse to have the aforementioned advantages of a surviving spouse, e.g., establish new designated beneficiaries and therefore a new required minimum distribution schedule.

Regarding a marital estate tax deduction or deferral, the surviving spouse interest was to be created by having the IRA subject to a QDOT. The initial IRA balance would be the QDOT's original trust property. As delineated in PLR 9623063, as income is earned inside the IRA, any amounts distributed would be considered income to the QDOT for purposes of IRC section 2056A(b)(3)(A) and income not distributed would be added to principal. Definition of income would comply with IRC section 2056A(c)(2) and Reg. section 20.2056A-5(c)(2), which corresponds to Sec. 643(b), except that income would not include capital gains and would not include any other item that would be allocated to corpus under applicable local law irrespective of governing instrument provisions.

Not in the case discussed in PLR 9623063 is what would happen if in year one, income exceeded distributions and in year two, distributions exceeded income. Would income not distributed in year one and added to principal come out first as income in year two rather than as principal subject to IRC section 2056A(b)(1)(A)? Similarly, upon the death of the surviving spouse in year two, would the excess income be disregarded in determining imposition of IRC section 2056A(b)(1)(B)?

Presumably, the answer to both questions is that once trust earnings are considered principal, the earnings will always be considered principal. Therefore, income in excess of distributions in year one will not be restated as income in year two when distributions exceed income. Should the surviving spouse die in year two, the income in excess of distributions will be disregarded in calculating the imposition of IRC section 2056A(b)(1)(B).

Considering both private letter rulings, other than meeting the technical requirements of a QDOT and having estate taxation based upon the marginal estate tax rate of the predeceased spouse, the key point is that naming a noncitizen spouse as designated beneficiary directly or through a QTIP trust appears to have similar rules as naming a citizen spouse regarding minimum distribution requirements.

Reg. section 20.2056A-5(c)(1) defines a hardship distribution which is exempt from QDOT tax as being "in response to an immediate and substantial financial need relating to the spouse's health, maintenance, education or support of the health, maintenance, education or support of any person that the surviving spouse is legally obligated to support." Furthermore, "closely held business interests, real estate, and tangible personality are not considered sources that are reasonably available to the surviving spouse." Significantly, distribution planning might contemplate use of the hardship provision even if the surviving spouse has significant assets in addition to a qualified pension plan or IRA balance.

Regarding IRC section 2056A(b)(3)(A)'s exemption from QDOT tax for distributions of trust accounting income to the surviving spouse, the previous regulation's paragraph (c)(2) provides that "except as provided in this paragraph (c)(2) or in administrative guidance published by the IRS, income does not include items constituting income in respect of a decedent (IRD) under IRC section 691. However, in cases where a QDOT is designated by the decedent beneficiary of a pension or profit sharing plan described in IRC section 401(a) or an individual retirement account or annuity described in IRC section 408, the proceeds of which are payable to the QDOT in the form of an annuity, any payments received by the QDOT may be allocated between income and corpus using the method prescribed under Reg. section 20.2056A(4)(c) for determining the corpus and income portion for an annuity payment."

Of particular consequence is the wording, "QDOT is designated by the decedent beneficiary of a pension or profit sharing plan." A reasonable question would arise whether the decedent's executor or the surviving spouse would establish the QDOT. Would this exemption from tax apply? Although the effect would be the same, it is quite possible that the answer would be no. If so, planning opportunities under the two private letter rulings might not be available.

Reg. Section 20.2056A-5(c)(3)(iv) provides an exemption from tax for distributions and dispositions that "reimburse the surviving spouse for any tax imposed on the spouse under Subtitle A of the Internal Revenue Code on any item of income of the QDOT to which the surviving spouse is not entitled under the terms of the trust ... and income taxes paid by the spouse (either by actual payment or through withholding) with respect to amounts received in a lump sum distribution from a qualified plan if the lump sum distribution is assigned by the surviving spouse to a QDOT." Interestingly, the language is, "if the lump sum distribution is assigned by the surviving spouse to a QDOT."

Reg. section 20.2056A-5(c)(3)(iv) would be applicable where an item would be considered fiduciary accounting income within the qualified pension plan or IRA and corpus within a QDOT established as in PLR 9544038. Perhaps that would happen where the qualified pension plan and the QDOT were established in separate jurisdictions with differing principal and income rules. Another application would be where the surviving noncitizen spouse would do a rollover as in PLR 9623063. *

Editors:
Marco Svagna, CPA
Lopez Edwards Frank & Company LLP

Lawrence Foster, CPA
KPMG Peat Marwick LLP

Contributing Editors:
Richard H. Sonet, CPA
Marks Shron & Company LLP

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Eric Kramer,JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

James McEvoy, CPA
Chase Manhattan Bank