Coordinating Income and Estate Planning for IRAs and Qualified Plans

1. Coordinating Income and Estate Planning for IRAs and Qualified Plans Presented by: Robert S. Keebler, CPA, MST 1400 Lombardi Ave., Ste 200 P.O. Box 11997 Green Bay, WI 54307-1997 Ph: (920) 490-5626 Fax: (920) 499-1050 E-mail: rkeebler@virchowkrause.com

2. Why Retirement Distribution Planning is Important Potential tax exposure to IRA without planning

3. IRAs Payable to Trusts

4. IRAs Payable to Trusts How an IRA is Payable to a Trust IRA Beneficiary Designation Form Trust IRA distributions over the life expectancy of the oldest beneficiary Spouse Children

5. IRAs Payable to Trusts Benefits of Using a Trust • Spendthrift protection • Creditor protection • Divorce protection • Special needs • Investment management • Estate planning • “Dead-hand” control

6. IRAs Payable to Trusts Disadvantages of Using a Trust • Trust tax rates • Legal and trustee fees • Income tax returns • Greater complexity

7. IRAs Payable to Trusts Other Considerations • Older or unidentifiable contingent beneficiary • Estate as contingent beneficiary • Powers of appointment • Failure of beneficiaries clause • Failure to provide trust document to custodian by October 31 of year following year of death • Making lump sum distribution to trust

8. IRAs Payable to Trusts Four Requirements of All IRA Trusts • Trust is valid under state law • Trust is irrevocable upon death of owner • Beneficiaries of the trust are identifiable from the trust instrument • Documentation requirement is satisfied

9. IRAs Payable to Trusts Types of IRA Trusts • Accumulation Trusts • Conduit Trusts

10. IRAs Payable to Trusts Conduit Trusts A trust in which all distributions from the IRA are immediately distributed to the trust beneficiary/beneficiaries

11. IRAs Payable to Trusts Conduit Trusts – Example #1 Trust IRA Discretionary Distributions, but no less than total withdrawals from IRA Mother is not “countable” for determining applicable life expectancy Child – age 30 Entire Trust outright upon Grandchildren reaching age 30 Child – age 30 If Grandchildren die before reaching age 40 Mother Age 80

12. IRAs Payable to Trusts Conduit Trusts – Example #2 All distributionsfrom IRA Trust IRA Child #1 At Child #1’s death To Red Cross

13. IRAs Payable to Trusts Accumulation Trusts A trust in which distributions from the IRA are allowed to accumulate within the trust

14. IRAs Payable to Trusts Accumulation Trusts The key issue in analyzing an accumulation trust is to determine which beneficiaries are “countable.” All beneficiaries are countable unless such beneficiary is deemed to be a “mere potential successor” beneficiary.

15. IRAs Payable to Trusts Accumulation Trusts – Example #1 Trust IRA Discretionary Distributions Child – age 30 Mother is “countable” for determining applicable life expectancy Entire Trust outright upon Grandchildren reaching age 30 Child – age 30 If Grandchildren die before reaching age 40 Mother Age 80

16. IRAs Payable to Trusts Accumulation Trusts – Example #2 Trust IRA Discretionary Distributions Accumulation Trust Sister measuring life for determining required minimum distributions Grandchildren Entire Trust outright upon Grandchildren reaching age 30 Grandchildren If Grandchildren die before reaching age 30 Sister Age 67

17. IRAs Payable to Trusts Separate Shares • In proper circumstances, the IRS allows the division of the IRA into separate shares per beneficiary • In the case of an individual beneficiary, this must be determined by December 31 of the year following the year of death • Separate shares established when divided • No separate shares available for estates • Disclaimer rule • Death by September 30

18. IRAs Payable to Trusts Separate Shares Payable to single trust No separate shares identified in the beneficiary designation form IRA paid over oldest life expectancy

19. IRAs Payable to Trusts Separate Shares IRA payable to multiple sub-trusts Each trust named in beneficiary designation form IRA paid trust beneficiary’s life expectancy

20. IRAs Payable to Trusts Separate Shares – PLR 200537044 • Ruling 1: Each Beneficiary’s Trust Share Qualified for Maximum Stretch-out. • Upon the death of the Settlor, the IRA stand-alone trust creates separate shares for each beneficiary (in this case, separate shares for 9 beneficiaries), each trust share “treated effective ab initio to the date of the Decedent’s death” and each share functioned as a “separate and distinct trust” for the beneficiary. • The beneficiary designation form named each separate share as a primary beneficiary of the IRA. • Before the December 31st deadline, the IRA was divided into separate accounts for each share. • Held: Separate account treatment permitted; MRD of the IRA for each separate trust share measured by the lifetime of its sole beneficiary for whom the share was created.

21. IRAs Payable to Trusts Separate Shares – PLR 200537044 • Ruling 2: Allowance of One-Time “Toggle” Between Accumulation and Conduit Trust. • Each separate share in the IRA stand-alone trust had language structuring the separate share as a conduit trust. • The trust provided for an independent 3rd party, as “trust protector” to transform each sub-trust to an accumulation trust in the protector’s sole discretion by voiding the conduit provisions ab initio. • Trust Protector had the authority to limit the initial trust beneficiary ab initio. • After Participant’s date of death, Trust Protector exercised “toggle” and converted one share to an accumulation trust. • Held: Each share can use that the life expectancy of its initial beneficiary to measure the MRD for that share.

22. IRAs Payable to Trusts Separate Shares – PLR 200537044 • Ruling 3: Payment of Expenses from IRA not considered an accumulation. • The trust provided that “Trust expenses may be deducted prior to any such payment to or for the benefit of the beneficiary of the trust share if the deduction does not disqualify the status of the trust as a conduit trust. This paragraph may be rendered void, ab initio, by the Trust Protector. . .” • Held: Each share can use that the life expectancy of its initial beneficiary to measure the MRD for that share. Why? Even with the deduction for payment of trust expenses, no amounts distributed to the trust during the beneficiary’s lifetime would be accumulated in the trust, and thus would not be kept in the trust for the benefit of any future beneficiaries. Treas. Reg. § 1.401(a)(9)-5 Q&A 7(c)(3), Example 2.

23. IRAs Payable to Trusts Separate Shares – PLR 200537044 • Ruling 4: The trust assets will not be included in the estate of the primary beneficiary of a share upon that beneficiary’s death. • Each trust share would accumulate the net income of the trust, and distributions of income and principal could distribute accumulated income and principal to the primary beneficiary for his or her health, education, maintenance and support only. • The document did not grant any beneficiary a general power of appointment over his or her share. • Held: The provisions of the trust could not result in estate inclusion for the estate of a primary beneficiary upon his death.

24. IRAs Payable to Trusts Naming a Revocable Trust as Beneficiary • Proper apportionment language regarding payment of debts, expenses and taxes of estate (See PLR 9820021) • Recognition of income in respect of a decedent (IRD) if pecuniary funding clause is utilized • Unanticipated loss of designated beneficiary due to the inclusion of power of appointment (general or limited) • Solution – stand-alone IRA trust such as “IRA Legacy Trust”

25. IRAs Payable to Trusts Naming a Revocable Trust as Beneficiary • Fractional v. Pecuniary clauses • Recognition of income • Entire trust irrevocable at death of IRA owner • No separate share treatment • Payment of debts, taxes, and expenses • Apportionment language • Firewall provision • Powers of appointment • Stand alone trust – highly recommended • Adoption of older individuals

26. IRAs Payable to Trusts Naming a Revocable Trust as Beneficiary • Revocable trust should use a fractional funding clause to determine the marital and bypass shares • PLRs in which pecuniary funding clause utilized and no IRD acceleration issue (PLRs 199912040, 9808043, 9744024)

27. IRAs Payable to Trusts Naming a Revocable Trust as Beneficiary Pecuniary Clause - Sample The Marital Share shall consist of assets in a pecuniary amount which, after taking into account all other property included in the Settlor’s gross estate for federal estate tax purposes which qualified for the federal estate tax marital deduction and which passes or has passed to the Settlor’s wife under this instrument or in any other manner, is equal to the smallest amount which will eliminate all federal estate tax payable by the Settlor’s estate, or if that is not possible, the amount which will result in the least federal estate tax payable by the Settlor’s estate. In determining “federal estate tax payable”, all credits and deductions against that tax shall be taken into account, provided that the federal credit for state death taxes shall only be considered for the extent it does not create or increase a state death tax which is based on the federal credit for state death taxes.

28. IRAs Payable to Trusts Naming a Revocable Trust as Beneficiary Fractional Clause - Sample The Marital Share shall consist of that fractional share of the trust estate which shall be determined as follows: (a) The numeration of the fraction shall be the smallest amount which, after taking into account all other property included in the Settlor’s gross estate for federal estate tax purposes which qualifies for the federal estate tax marital deduction and which passes or has passed to the Settlor’s wife under this instrument or in any other manner, will eliminate all federal estate tax payable by the Settlor’s estate, or if that is not possible, the amount which will result in the least federal estate tax payable by the Settlor’s estate. In determining “federal estate tax payable”, all credits and deductions against that tax shall be taken into account, provided that the federal credit for state death taxes shall only be considered to the extent it does not create or increase a state death tax which is based on the federal credit for state taxes. (b) The denominator of the fraction shall be the value of the trust estate

29. Disclaimers

30. Disclaimers Disclaimer must be “qualified.” • In writing • Within 9 months • No acceptance of the interest or any of its benefits, • Interest passes without any direction on the part of the person making the disclaimer

31. Disclaimers Example Alex dies at age 70. Alex’s wife disclaims amount of Alex’s unified credit to bypass trust for benefit of herself and their children Disclaimer must occur within nine months from date of death Disclaimer must be served to the IRA custodian Disclaimer must be fractional to avoid immediate income taxation

32. Disclaimers Revenue Ruling 2005-36 A beneficiary's disclaimer of a beneficial interest in a decedent's IRA is a qualified disclaimer even though, prior to making the disclaimer, the beneficiary receives the required minimum distribution for the year of the decedent's death from the IRA.

33. Disclaimers Revenue Ruling 2005-36 Result: Spouse’s pecuniary disclaimer, after taking RMD, still results in a “qualified disclaimer” IRA Required Minimum Distribution ($100,000) Pecuniary disclaimer of IRA balance ($600,000) plus income earned since date of death ($12,000) SCENARIO 1 – Pecuniary Disclaimer by Spouse Spouse Primary Beneficiary Child A First Contingent Beneficiary – If spouse disclaimed IRA as Primary Beneficiary Key assumptions: IRA Balance (date of death) - $2,000,000 IRA Balance (date of disclaimer) - $2,040,000 Required Minimum Distribution - $100,000

34. Disclaimers Revenue Ruling 2005-36 Result: Spouse’s fractional disclaimer, after taking RMD (plus attributable income), still results in a “qualified disclaimer” Required Minimum Distribution ($100,000) plus income earned since date of death ($2,000) IRA Fractional disclaimer (30%) of net remaining IRA balance after RMD (including income attributable to RMD) plus income earned since date of death SCENARIO 2 – Fractional Disclaimer by Spouse Spouse Primary Beneficiary Child A First Contingent Beneficiary – If spouse disclaimed IRA as Primary Beneficiary Key assumptions: IRA Balance (date of death) - $2,000,000 IRA Balance (date of disclaimer) - $2,040,000 Required Minimum Distribution - $100,000

35. Disclaimers Revenue Ruling 2005-36 Result: Child A’s full disclaimer, after taking RMD (plus attributable income), still results in a “qualified disclaimer “ Required Minimum Distribution ($100,000) plus income earned since date of death ($2,000) IRA Full disclaimer of net remaining IRA balance after RMD (including income attributable to RMD) plus income earned since date of death SCENARIO 3 – Full Disclaimer by Child A Spouse Primary Beneficiary Child A First Contingent Beneficiary – If Child A disclaimed IRA as Primary Beneficiary Key assumptions: IRA Balance (date of death) - $2,000,000 IRA Balance (date of disclaimer) - $2,040,000 Required Minimum Distribution - $100,000

36. QTIP-IRA

37. QTIP-IRA • Qualifying for the marital deduction • Definition of “income” • Qualifying as a “designated beneficiary” trust

38. Qualifying for the Marital Deduction QTIP-IRA In general, in order for a QTIP trust to qualify for the marital deduction under IRC §2056(b)(7), it must meet all of the following requirements: • All the property in the trust was received from the deceased spouse and was included in that spouse’s taxable estate. • The trust provides that during the lifetime of the surviving spouse, all income is paid to that spouse at least annually. • No other person has any right or can receive any benefit from the trust while the during the surviving spouse’s lifetime. • A valid election must be made on the deceased spouse’s estate tax return.

39. QTIP-IRA Fiduciary vs. Tax Accounting Income • Fiduciary accounting income is governed by state law and the trust instrument • Tax accounting income is governed by the federal income tax law

40. QTIP-IRA Traditional Types of “Income” • Interest • Taxable • Tax-exempt • Dividends • Rents (net of expenses) • Royalties

41. Traditional Types of “Principal” QTIP-IRA • IRA value as of date of death • Increases in asset value (i.e. growth) • Realized long-term capital gain • Realized short-term capital gain • Proceeds from covered call writing

42. QTIP-IRA Revenue Ruling 2006-26 • Traditional fiduciary accounting income • Equitable adjustments under UPIA §104(a) • Unitrust payments • “10% rule” under UPIA §409(c) • “Savings clause” under UPIA §409(d)

43. QTIP-IRA Revenue Ruling 2006-26 Equitable Adjustment • UPIA §104(a) provides trustees the power to adjust between income and principal if a trust cannot be administered fairly between the income and remainder beneficiaries NOTE: Revenue Ruling 2006-26 holds that, notwithstanding a trustee’s application of UPIA §104(a), a trust will qualify the marital deduction

44. QTIP-IRA Revenue Ruling 2006-26 Unitrust Payment • Revenue Ruling 2006-26 approves unitrust trust payments paid pursuant to UPIA §409(c) under applicable state law Example: IRA is valued at $1,000,000. Pursuant to state law, the trust is makes a unitrust distribution of 4% ($40,000). In this case, the $40,000 is a qualified “income” interest.

45. QTIP-IRA Revenue Ruling 2006-26 UPIA “10% Rule” • UPIA §409(c) provides that 10% of IRA (and other qualified plan) distributions are considered to be “income” Example: RMD from IRA is $40,000. Pursuant to UPIA §409(c), $4,000 ($40,000 x 10%) is considered to be “income”. WARNING: This type of clause may not qualify as “income” under Rev. Rul. 2006-26.

46. QTIP-IRA Distributable QTIP-IRA “Income” IRA has a current value of $1,000,000 and interest and dividend income of $60,000. RMD is $50,000. $50,000 RMD x 10%

47. QTIP-IRA Savings Clause • UPIA §409(d) provides trustees the discretion to make additional payments in order to qualify the payments as “income” for purposes of the marital deduction. WARNING: This type of clause may not save the QTIP election under Rev. Rul. 2006-26.

48. Other IRA Planning Issues

49. Other IRA Planning Issues Income in Respect to a Decedent (IRD) Income in respect of a decedent (IRD) – is all items of gross income in respect of a decedent which were not properly included as taxable income in a tax period falling on or before a taxpayer’s death and are payable to his/her estate and/or another beneficiary

50. Other IRA Planning Issues Income in Respect to a Decedent (IRD) Specific Items of IRD • IRAs and other qualified retirement plans • Unpaid salaries/wages at the time of death • Dividends and interest earned, but not taxed, prior to death • Unrecognized capital gain on an installment note at the time of the seller’s death • Net Unrealized Appreciation (NUA) on employer securities (see later discussion)