September 1998 Issue

Protecting the estate from the threat of double taxation

More on Income in Respect of a Decedent

In Brief

Avoiding Both Estate and Income Taxes

Retirement plans, including IRAs, are the preferred vehicles to build nest eggs. However, at death the tax deferral comes home to roost, and the savings can be subject to both estate and income taxes. An article in the September 1997 CPA Journal explored some options to mitigate the effect of this double whammy. The same authors now explore some additional avenues, including the use of--

* charitable entities as beneficiaries

* direct charitable contributions

* QTIP trusts

* life insurance

By Stephen D. Lassar and Mark W. McGorry

ince ERISA was passed in 1974, qualified pension, profit-sharing, and 401(k) plans, in combination with various IRA choices, continue to be the most tax efficient and flexible method of reducing current business and personal taxes. These retirement plans provide the opportunity to shelter income from Federal income tax, and in most cases, FICA, state, and local taxes. The combination of tax deferral and unprecedented increase in value of financial assets in recent years is providing individuals with retirement values large enough that their post-retirement standard of living is easily equal to their pre-retirement lifestyle. Even if financial markets were to experience some temporary setbacks, many will still have retirement accounts that will grow rather than diminish during their lifetime. As a result, at death, they will be leaving to younger generations assets that will not only be subject to significant estate taxes but will also attract income taxes in the hands of beneficiaries. Until recently, there was also an additional 15% estate excise tax that has now been permanently repealed. Even so, the ultimate estate tax shrinkage commonly exceeds 75% or 80% for upper-middle income and high-net-worth taxpayers. However, there are many strategies that can continue the benefits of tax deferral to meet personal and business planning objectives.

The article in the September 1997 CPA Journal detailed some planning areas on the use of IRAs and employer sponsored qualified plans. There are additional strategies that can be used for these two types of post-retirement vehicles.

Use of Charitable Entities as Beneficiaries

One strategy that works equally well for both IRAs and qualified plans is the use of charitable entities as beneficiaries. Some taxpayers like this approach because it helps them meet their personal charitable planning goals with assets in their estate that are usually the most heavily taxed. Others find that under certain circumstances this is the only way to achieve a stretch-out of distributions to continue income tax deferral of these benefits.

For example, the use of charitable remainder trusts as beneficiaries is one way to achieve a stretch-out that offers both income and estate tax benefits. A charitable deduction is allowed to the estate for the present value of that remainder interest because it will ultimately pass to a qualifying charitable organization. The larger the charitable deduction, however, the less benefit heirs will receive. The more significant benefit to heirs often results because the charitable trust is a tax-exempt entity. The entire account death benefit passes income tax free into a charitable trust. Once in the charitable remainder trust, the assets can be reinvested and will continue to grow on a tax- deferred basis. The income beneficiaries of the charitable remainder trust will receive income from the trust under the normal rules that govern taxation of these trusts.

Prior to the Taxpayer Relief Act of 1997, this income stream would usually continue for at least one more generation. In some cases, income beneficiaries would include grandchildren as well. But under the new rules, which generally became effective in July of 1997, the value of the charitable remainder must be at least 10% of the net fair market value of the property being transferred to the charitable trust. Therefore, income payment arrangements that extend over the lives of more than one generation of beneficiaries will not work because the 10% remainder test will not be met. The trust will not qualify as a tax exempt entity. Even lifetime income trusts, whose income beneficiaries are less than age 50 to 55 at the time the trust is funded, are unlikely to meet this 10% charitable deduction requirement. Going forward, the noncharitable income period of choice will probably shift from that of a life annuity to an annuity for a fixed period of years. Under general rules that govern charitable trusts, a trust that is not measured by a beneficiary's life expectancy cannot exceed 20 years.

The Applicable Federal Rate. The maximum annual income distribution from these charitable remainder trusts will need to be determined by reference to the applicable Federal rate (AFR) under IRC section 7520 at the time the trust is created and funded. In general, when dealing with an income interest for a fixed period of years, the lower the AFR, the lower the allowable income distribution can be. For example, at the time of this writing, with the AFR at 7.0%, 10.8% is the maximum annual distribution the income beneficiary could receive under a 20-year charitable remainder unitrust.

Annuity Trusts. Another form of charitable remainder trust is an annuity trust in which the dollar amount of the annual distributions is determined at the time the trust is funded and that dollar amount is fixed for the entire period. As a general rule, the maximum initial annual distribution allowable from an annuity trust will be lower than that allowed from a unitrust. Another difference between an annuity trust and a unitrust is that, while the annuity trust payments will remain constant for the entire income period, the unitrust's payments will rise and fall each year based on increases and decreases in the value of the trust assets as of each annual valuation date.

Effect on Distributions. For the charitable remainder trust to receive IRA or qualified plan death benefits, it must be the beneficiary of the decedent participant's account. This is not always as easy to accomplish as might be expected. An issue to be addressed is the required beginning date (RBD) for distribution from the plan. The RBD for an IRA is April 1 of the year following the calendar year in which the IRA owner reaches age 70 wQ. In the case of a qualified plan, the RBD for those designated as key employees is the same; however, for nonkey employees who continue employment beyond that date, their RBD is postponed until after their actual retirement. Naming a charitable remainder trust as the beneficiary may require larger distributions to participants during the participants' lifetime after the RBD. This means the recognition of taxable income at a faster rate and the dilution of account values at an earlier point in time. Minimum annual distributions are calculated based on the life expectancy of the participant and the named beneficiary. Because a nonnatural person such as a charitable remainder trust is deemed to have a life expectancy of zero, the minimum distribution is calculated solely on the basis of the life expectancy of the participant. This period will always be less than the life expectancy of the participant and another person.

Use of Disclaimer. The most effective way to deal with this issue is to have the charitable remainder trust serve as a contingent beneficiary. Family members who are the intended income beneficiaries of the charitable remainder trust can be named as primary beneficiaries of the IRA or qualified plan. These beneficiaries can disclaim their interest in plan benefits upon the death of the participant and let them pass to the charitable remainder trust. Another advantage to this disclaimer approach is that it allows the intended beneficiary to make a determination of what best suits his or her needs based on circumstances at the time of the participant's death.

Drafting a Trust Document. The exact method for creating the charitable trust needs to be determined in conjunction with the taxpayer's attorney. Some planners might prefer an approach that involves drafting a trust document that remains unfunded until it receives the death benefit distribution. Other practitioners would prefer a testamentary charitable remainder trust under the will that would be named by specific reference in the beneficiary agreement. Regardless of the method chosen, it is important that the trust's income interest to family members be measured from the time of funding and not at the time of drafting or execution of the document that will give rise to the remainder trust. In other words, in the case of a 20-year charitable remainder trust, the income beneficiary's 20-year income interest should be measured from the time the proceeds are deposited to the trust. Since the AFRs that will be applied to the trust cannot be known at the time of drafting, the language of the document should be flexible enough to allow the income beneficiary to receive the greatest income interest permissible (based on the AFR at the time of funding) that will allow the trust to qualify as a charitable trust.

Control. Many high-net-worth families will also want to have a direct say in how the charitable remainder interest will be used. These families would be best advised to consider having the charitable remainder interest pass to either a family foundation, a donor-advised fund, or a supporting organization. This will allow family members the opportunity to direct which charitable organizations will receive the ultimate distributions. Regardless of which arrangement is ultimately used, family members will have the opportunity to meet their charitable gift-giving goals and the prestige accorded to those who make large charitable gifts.

Taxation of Income Beneficiary. The charitable remainder trust approach is most valuable in providing an income tax deferral for the benefit of the income beneficiary. However, there is still an estate tax to be paid on the value of the income interest the beneficiary will receive. For example, if the actuarial value of the remainder interest of the trust that eventually passes to the charity is 20%, the remaining 80% is includable in the decedent's taxable estate. In general, the allocation of the estate tax will be to either the beneficiaries of the charitable remainder trust or to the residuary estate. This would be determined by the tax apportionment provisions in the decedent's will or, if the will is silent on this point, by state law. If the beneficiaries itemize their income tax deductions, they may be able to protect some of their distributions from income taxes through the deduction allowed under IRC section 691(c) for the portion of the estate taxes paid attributable to income included in the value of the estate.

Direct Charitable Contributions

The techniques discussed above deal with strategies that provide an income tax preferred cash flow to a family member for a period of time before the charitable organization benefits. Many high-net-worth individuals would prefer a much more direct charitable bequest. If the cash flow from a charitable remainder trust is not necessary for the financial well-being of family members, the participant might very well choose to leave his or her account balances directly to a charitable organization upon death. This would allow a full charitable deduction for estate tax purposes, and the proceeds would pass free of income taxes directly to the charitable organizations, which could include a family foundation or supporting organization.

IRAs and Qualified Plan Death Benefits in Second or Later Marriages

Many plan participants marry more than once, and have children from those marriages. Distribution of death benefits from their accounts is often a sensitive issue and quite complex, both from a tax and legal point of view.

Non-IRA Plans. ERISA, as amended by the Retirement Equity Act of 1984, provides certain required benefits to the surviving wife of most qualified (non-IRA) pension, profit-sharing, and 401(k) plans. The spouse's interest arises at time of marriage, even as to rights and benefits that accrued to the participant prior to marriage, and are not affected by the typical pre-nuptial agreement. In recent years, however, many family law practitioners have devised a way to deal with these under pre-nuptial agreements. They use the normal negotiation associated with the agreement, and include an enforceable contractual obligation by the new spouse that requires him or her to execute the appropriate documents soon after marriage in accordance with the agreement. However, we frequently see pre-nuptials drafted in the late 1980s or early 1990s that purport to deal with ERISA spousal rights but do not make provisions for the required spousal waivers. In situations like this, planning for disposition of qualified plan assets often requires re-addressing the pre-nuptial agreement as well as documents required under ERISA. The services of legal counsel well-versed in state family law and ERISA will be needed as part of the planning process.

IRAs. Dealing with IRAs is a somewhat less complicated matter because spousal rights associated with qualified plans do not apply to IRAs. This is true even when the IRA is funded totally or partially by a rollover from a qualified plan before or after marriage. Of course, if the qualified plan distribution occurs after marriage, the spouse would have to waive his or her rights under ERISA for a rollover to occur. This event is often what precipitates the discussion of spousal rights under Federal law as well as any pre-nuptial agreement.

Marital Distributions. Because of special tax benefits associated with these particular types of assets when they pass to a surviving spouse, it often makes sense to leave them to the surviving spouse either outright or through use of a QTIP trust. IRA or qualified plan assets that pass in either of these two ways to the surviving spouse will generally qualify for the full estate tax marital deduction so that there will be no estate tax due at the death of the participant's spouse. If the distribution is a direct (nontrusteed) distribution, the surviving spouse will be eligible to create a spousal rollover IRA account. The result will be no income tax at time of rollover. Spouses will be taxed on income only as they receive distributions. Of course, they will then be subject to all of the normal rules governing an IRA of their own, including the 10% pre­age 59 wQ excise tax, as well as the minimum distribution rules that apply at the time the surviving spouse reaches his or her RBD. Another less frequently used option is to maintain the IRA in the name of the decedent. If that option is chosen, the age 59½ and RBD refer to the age of the participant as if he or she had survived.

QTIP Trusts. Although the option of leaving these types of assets to the surviving spouse is attractive from an estate and income tax point of view, it leaves the ultimate disposition of these assets in the hands of the surviving spouse. One vehicle to allow the participant to control the ultimate disposition of these assets is the use of a QTIP trust as beneficiary for either the IRA or qualified plan account.

The account would continue to be maintained in the name of the decedent. Each year it would be required to pay to the QTIP trust the greater of all of the income of the account or the required annual minimum distribution as calculated under IRC section 401(a)(9). The QTIP in turn would then be required to pay this amount to the surviving spouse. This arrangement would continue for the remainder of the surviving spouse's lifetime. At the death of the surviving spouse, the retirement account would pay the balance held in the account to the QTIP. The QTIP would then continue or distribute the proceeds for the benefit of or to the remainder persons of the QTIP. At that point, estate and income taxes would be due and would be calculated under rules in effect at that time. One way to plan to meet the tax bill would be through the use of second-to-die/survivorship life insurance on the lives of the participant and the nonparticipant spouse. It would be most effective if the life insurance were owned outside both insureds' taxable estates, either in an irrevocable life insurance trust or by the issue who are the intended remainder persons of the QTIP.

As noted above, for this QTIP technique to work, the decedent's retirement account must remain open for the rest of the surviving spouse's lifetime. Although not difficult to accomplish with an IRA, it is much more complicated to achieve with an employer-sponsored qualified plan. Although many plans allow for a surviving spouse to be a direct beneficiary for the rest of his or her life, this is usually an option that settles out the decedent's account. In other words, lifetime income is given in exchange for a lump sum and discontinuation of the decedent's interest in the plan. The plan document itself would probably need to be amended to allow this form of distribution to a QTIP trust. As a practical matter, amendments of this nature will usually occur only in the case of a closely held business. Most public company plan trustees would not want to obligate themselves for this type of long-term administrative commitment. Paradoxically, many small businesses will close down after the death of the owner/participant/decedent who is the subject of this planning, and the plan will also terminate and distribute its assets at that time. Using the QTIP approach will be successful if there is a continuation of the business, in particular by children who are remainder persons under the QTIP trust.

Because the IRA is a much more flexible tool for use in this strategy, taxpayers may wish to see if they can qualify for a distribution from their plan to roll over IRAs. This is often allowed even if the individual is still employed and a plan participant. Candidates for this planning are participants past normal or early retirement age under the plan who may be able to take in-service distributions. Spousal waiver of rights under the plan is required for this distribution to occur.

Use of Life Insurance

Although life insurance is not a permissible asset under an IRA account, it can be purchased within a qualified plan. It offers several benefits for the high-net-worth individual who is a plan participant. For example, a plan may allow a participant's directed account to purchase life insurance on the life of another in whom the participant has an insurable interest. This could include insurance on the life of a co-shareholder to assist in funding a "buy-sell" arrangement. The advantage is that it allows the participant to use their pre-tax accumulations to help pay for premiums that are not deductible to themselves or the business. For income tax purposes, the participant would only have to recognize each year the imputed cost of one-year term insurance based on the attained age of the insured co-shareholder. Under the general rules associated with life insurance, the beneficiary will only pay income tax on the portion of the death benefit equal to the cash surrender value. The death benefit in excess of the cash value will be exempt from income tax under IRC section 101(a).

Another possibility is the purchase by a directed account of survivorship insurance on the life of the participant and his or her spouse. Generally, when this approach is used, there needs to be a strategy that would remove the insurance from the plan after the death of one of the two insureds. Even with careful planning, it is possible the insurance could end up in the estate of the last to die if that second death occurs within three years of removing the insurance from the plan.

The IRS has expressed some concern in situations where one of the insureds is not a plan participant. Although there has been no official detailed ruling or regulation about either of the techniques noted above, purchases of these type should be carefully structured to avoid violating any ERISA or IRS rules and regulations. Also, the plan document must allow such purchases, and all plan participants must be able to participate on a nondiscriminatory basis. *

Stephen D. Lassar, JD, LLM, CPA, is senior director of taxation with Saltzer Lassar Piccinnini & Company LLC. Mark W. McGorry, JD, MSFS, CFP, CPC, CLU, ChFC, CMFC, AEP, is with Braunstein, McGorry & Company LLC, an insurance and investment firm offering securities through Nathan and Lewis Securities, Inc.

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