By Patrick L. Emmerling
More for Heirs, Less for the IRS
The recent Revenue Ruling 2000-2 on qualified terminable interest property trusts (QTIPs) is consistent with the Treasury regulations that have governed QTIPs for many years and renders the much-contested Revenue Ruling 89-89 obsolete. The new decision allows greater flexibility in drafting trusts that will qualify for the marital deduction. However, under certain circumstances Revenue Ruling 2000-2 may have adverse gift tax consequences to a surviving spouse. Using specific language in the trust instruments should satisfy the requirements of the new revenue ruling in qualifying an IRA for QTIP treatment.
Individual retirement accounts (IRAs) increasingly constitute a major portion of a taxpayer’s assets. The continuing economic boom is creating a great deal of wealth and more high-net-worth individuals with swelling IRAs. The complex income and estate tax rules for IRAs and qualified plans become even more complicated when the owner wants a present spouse to receive installments from the IRA but wants to direct the balance of the account to children from a prior marriage upon the spouse’s death.
A hypothetical example, John Doe, is in his 60s with two adult children as well as grandchildren. When he divorced his first wife, he retained ownership of his IRA. His second wife has children and grandchildren of her own. His nonretirement assets equal or exceed the applicable exclusion amount, and he intends to use those assets to fund a credit shelter trust.
Doe’s estate planning goals are as follows:
Often, a qualified terminable interest property trust (QTIP) is designated as beneficiary under these or similar circumstances to preserve the estate tax marital deduction and accomplish the nontax estate planning goals.
Logically, an IRA owner should be able to designate a standard QTIP as the beneficiary of the entire death benefit and have it qualify for the marital deduction. However, in Technical Advice Memorandum (TAM) 9220007, the IRS held that an IRA is terminable interest property subject to the nondeductible terminable interest rule of IRC section 2056(b). The IRA agreement in TAM 9220007 did not address the question of when benefits would be paid out; it provided only that it would be consistent with the minimum distribution rules. The IRS determined that the IRA in question failed to qualify as a QTIP because there was no provision requiring the trustee to withdraw all income annually from the IRA. The discretionary power of the trustee to withdraw the income was insufficient.
Although the retirement account described in TAM 9220007 did not qualify for the marital deduction, a few years earlier the IRS had provided a safe harbor approach (Revenue Ruling 89-89, 1989-2 C.B. 231) when designating a QTIP as beneficiary of an IRA or other retirement plan. That ruling gave estate planners a roadmap for qualifying an IRA (or other retirement plan) for the estate tax marital deduction as a QTIP. Since Revenue Ruling 89-89 was issued, many taxpayers and their advisors have followed this approach. Under Revenue Ruling 89-89, the QTIP instrument must satisfy the rules under IRC section 2056(b)(7) and the retirement account itself must comply with those rules as well. Because Revenue Ruling 89-89 required that the IRA’s fiduciary accounting income be distributed to the spouse each year, estate planning attorneys drafted trust instruments and IRA beneficiary designation forms to direct the trustee to withdraw from the IRA the greater of the required minimum distribution or the IRA fiduciary acc ounting income. Attorneys also needed to ensure that any fiduciary accounting income withdrawn from the retirement account would be treated as income for purposes of the QTIP, allowing the QTIP to pass the fiduciary accounting income to the surviving spouse.
While this approach is still valid, the IRS recently allowed an IRA to qualify for QTIP treatment even though the trustee was not required to withdraw the fiduciary accounting income from the IRA (2000-3 I.R.B. 305). The IRS ruled that it is sufficient for the surviving spouse to possess the right to demand that the trustee withdraw the fiduciary accounting income from the IRA and distribute such income to her.
Revenue Ruling 2000-2
The basic facts of the revenue ruling are as follows: John Doe died in 1999 at the age of 55 and was survived by a spouse, Jane Doe, age 50. John had established an IRA as described in IRC section 408(a) prior to death. The IRA invested only in productive assets. John designated the trustee of a testamentary trust as the beneficiary of the entire death benefit payable from the IRA. A copy of the testamentary trust and a list of its beneficiaries were given to the IRA custodian within nine months of John’s death. At the time of his death, the trust was valid and irrevocable under state law. The value of the IRA was included in John’s gross estate pursuant to IRC section 2039.
Pursuant to the terms of the testamentary trust, Jane was entitled to all of the income payable annually and was the only permissable beneficiary of trust principal during her lifetime. John’s children, all of whom were younger than Jane, were the remainder beneficiaries of the testamentary trust. Under the terms of the trust, Jane had the power, exercisable annually, to require the trustee to withdraw from the IRA an amount equal to the income earned in the IRA during the year, effectively distributing the income through the trust to Jane. If Jane did not exercise this power, the trustee would need to withdraw only the minimum required distribution. The IRA agreement contained no prohibition on withdrawing amounts exceeding the annual minimum required distribution.
The holding. The IRS held that the executor may elect to treat the IRA and the testamentary trust as a QTIP so that they qualify for the estate tax marital deduction. The ruling authorized QTIP treatment for the IRA because the surviving spouse could compel the trustee of the testamentary trust to withdraw from the IRA an amount equal to all the income earned in the IRA at least annually and distribute that amount to the spouse. The ruling also requires that a QTIP election be made for both the testamentary trust and the IRA.
The reasoning of Revenue Ruling 2000-2 is not new to QTIP trusts: With respect to nonretirement assets, a marital deduction will be allowed if a trust instrument merely gives the surviving spouse the right to the income. There is no requirement that the income actually be distributed.
This rule is clearly set forth in the Treasury Regulations. For example, Treasury
Regulations section 20.2056-7(d)(2) states—
Entitled for life to all income. The principles of section 20.2056(b)-5(f), relating to whether the spouse is entitled for life to all of the income from the entire interest, or a specific portion of the entire interest, apply in determining whether the surviving spouse is entitled for life to all of the income from the property regardless of whether the interest passing to the spouse is in trust.
Furthermore, Treasury Regulations section 20.2056(b)-5(f)(8) states—
In the case of an interest passing in trust, the terms “entitled for life” and “payable annually or at more frequent intervals,” as used in the conditions set forth in paragraph (a)(1) and (2) of this section, require that under the terms of the trust the income referred to must be currently [at least annually; see paragraph (e) of this section] distributed to the spouse or that she must have such command over the income that it is virtually hers. Thus, the conditions in paragraph (a)(1) and (2) of this section are satisfied in this respect if, under the terms of the trust instrument, the spouse has the right exercisable annually (or more frequently) to require distribution to herself of the trust income, and otherwise the trust income is to be accumulated and added to the corpus.
Based on these regulations, a marital deduction is allowable as long as the surviving spouse is entitled to the income from a trust. There is no requirement that the income be distributed, and no reason for the rule to be different for IRAs and qualified retirement plans. However, Revenue Ruling 89-89 seemed to indicate that there was a difference for IRAs and qualified retirement plans, muddying the water and seemingly creating a marital deduction requirement that applied only to IRAs and qualified plans payable to QTIP trusts. Many commentators criticized Revenue Ruling 89-89 as erroneously implying that the only way to qualify an IRA payable to a trust for the marital deduction was for the IRA agreement to contain language requiring annual distributions of fiduciary accounting income to the surviving spouse. However, with Revenue Ruling 2000-2, the IRS has agreed that at least some rules for determining whether a spouse is entitled to trust income that apply to other forms of property should apply to IRAs and qualified plans as well.
Revenue Ruling 2000-2 also rendered Revenue Ruling 89-89 obsolete. However, this does not mean that the rule set forth in Revenue Ruling 89-89 will no longer work in qualifying an IRA for QTIP treatment: A trust that requires the trustee to withdraw the fiduciary accounting income from the IRA at least annually and distribute it to the surviving spouse will remain eligible for QTIP treatment.
Increased flexibility. Revenue Ruling 2000-2 does, however, allow trusts to be drafted with more flexibility. Under the new ruling, if a spouse does not exercise her power, the trustee is required to withdraw only the minimum required distribution for such year. It cannot be assumed, however, that the surviving spouse will not exercise her right to demand the income. This is especially true in a second marriage where the balance of the trust is intended for children of a prior marriage. Any income in excess of the required minimum distribution may stay within the IRA and thus may achieve greater deferral of income recognition if the minimum required distribution is less than the fiduciary accounting income. The calculation is a function of the applicable life expectancy under the minimum distribution rules and the IRA’s rate of return.
For example, if a spouse’s life expectancy is 25 years and the IRA earns more than 4% in the first year, the required installment for that year ( Qsgth of the value of the account) will be less than the income earned that year. In such a case, the surviving spouse could enable some of the income to remain tax deferred by not distributing it. In most cases, however, the income will not be deferred further, because the minimum required distribution will likely exceed the fiduciary accounting income, especially if the IRA portfolio consists substantially of growth assets.
In some cases, however, the fiduciary accounting income may exceed the minimum required distribution for the first few years, in which case Revenue Ruling 2000-2 will allow for greater deferral of income. Nevertheless, having an IRA payable to a QTIP will result in less income tax deferral than if the benefits were distributed to the surviving spouse and rolled over to her own IRA. A rollover enables the surviving spouse to name a new designated beneficiary and postpone distributions until age 70 Qw, at which time benefits can be withdrawn over the joint life expectancy of the surviving spouse and a younger beneficiary.
Revenue Ruling 2000-2 does not indicate whether, under appropriate circumstances, alternative methods for qualifying a trust for the marital deduction will be acceptable under Treasury Regulations section 20.2056(b)-5. For example, the ruling does not indicate whether the QTIP can give the surviving spouse the right to demand that the trustee distribute to her other assets of the trust equal to the benefit she would have received if the IRA income was distributed to her. This power would be in lieu of the power to compel the trustee to withdraw the income earned on assets held in the IRA.
Under Revenue Ruling 2000-2, an IRA owner who wants to designate a QTIP as a beneficiary may qualify both the QTIP instrument and the IRA for the estate tax marital deduction by complying with the following rules:
Investors and their advisors should review the IRA agreement along with the designated beneficiary form to ensure that the trustee will not be prohibited from withdrawing more than the required minimum distribution from the IRA.
Gift Tax: Lapsing or Nonlapsing Powers
Alhough not discussed in Revenue Ruling 2000-2, the surviving spouse possessed a lapsing power that, if not exercised in a given year, could cause adverse gift tax consequences to the spouse. The power to require a trustee to withdraw income from an IRA that would then be distributed to her pursuant to the terms of the trust is a general power of appointment. (Under IRC section 2514, a general power of appointment is exercisable in favor of the individual possessing the power, the estate, the creditors, or the creditors of the estate.)
Therefore, a lapse of such power would be a release to the extent the amount of the lapse exceeds the five-and-five exception of IRC section 2514(e). Pursuant to IRC section 2514(b), a release of a general power of appointment is a transfer subject to gift tax. The deemed transfer by the surviving spouse would be a completed gift for tax purposes because she would not retain dominion over the corpus of the IRA or the QTIP that remained upon death. Furthermore, the amount of the gift would not be reduced by the income interest retained by the surviving spouse because this deemed transfer probably falls under IRC section 2702, which prohibits a retained interest from reducing the value of a gift unless the retained interest is a qualified interest as defined in that section. Thus, a lapsed power could cause the entire amount of the income not withdrawn in excess of the five-and-five exception to be considered a completed gift by the spouse and subject to gift tax. Furthermore, this gift would not qualify for the gift tax annual exclusion under IRC section 2503(b) because it would be a gift of a future interest.
However, this point is relevant only if a gift tax will be owed as a result of the lapse, which would occur only if the surviving spouse has already used up her unified credit, because the value of the IRA will be included in the surviving spouse’s gross estate pursuant to IRC section 2044. Consequently, the amount of any taxable gift resulting from a lapsed withdrawal power will not be included on line 4 (Adjusted Taxable Gifts) of the surviving spouse’s estate tax return. Therefore, a lapsed withdrawal power has adverse gift tax consequences only to the extent it causes the surviving spouse to actually incur a gift tax. Nevertheless, spouses that have used all of their unified credit might be better off in applying Revenue Ruling 2000-2, either to have the surviving spouse’s power nonlapsing or to have the power lapse to the extent of the five-and-five exception (with the excess being subject to a limited power of appointment).
The new safe harbor approach in designating a QTIP beneficiary of an IRA as set forth in Revenue Ruling 2000-2 allows trusts to be drafted with greater flexibility and, under certain circumstances, will allow for greater deferral of income. Nevertheless, taxpayers and their advisors must take care to avoid possible adverse gift tax consequences to a surviving spouse.
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