Mary E. Vandenack: Reconsidering the Design of Trusts Used As IRA and Qualified Account Beneficiaries Post-Clark
As published in Steve Leimberg's Asset Protection Planning Newsletter on 7/7/14.
Reproduced Courtesy of Leimberg Information Services, Inc. (LISI) at http://www.leimbergservices.com.
"The Supreme Court recently ruled in Clark v. Rameker that inherited IRAs are not retirement funds for purposes of the federal bankruptcy statute. The effect of the ruling is to allow bankruptcy creditors to attach inherited IRAs. While some states have opted out of the federal bankruptcy statutes and adopted their own exemptions for inherited IRAs, a practitioner should avoid relying on those exemptions in doing asset protection planning. Beneficiaries may move from state to state or the exemptions offered in a particular state may change. To the extent that asset protection is desired by an account owner on behalf of his or her beneficiaries, a trust should be part of the plan."
In her commentary, Mary Vandenack suggests that in a post-Clark world when asset protection is desired by an account owner on behalf of his or her beneficiaries, advisors should reconsider the important distinctions between conduit and accumulation trusts when used as IRA and qualified account beneficiaries.
Mary E. Vandenack is founding and managing partner of Vandenack Weaver LLC in Omaha, Nebraska. Mary practices in the areas of tax, high net worth estate planning, asset protection planning, business succession planning, and tax-exempt entities. Mary's practice serves business owners, executives, real estate investors, health care providers and tax exempt organizations. Mary is a member of the American Bar Association Real Property Trust and Estate Section, Taxation Section, and Business Section and serves on several committees in those sections. Mary regularly writes and speaks on tax, asset protection planning, and estate planning topics. Mary is also a member of the American Bar Association Law Practice Division and is a regular contributor to the Law Practice Magazine, of which she currently serves as Features Editor. As a school shooting survivor, Mary is a member of the American Bar Association Youth at Risk Commission and has developed a passion for advocating for mental health legislation and designing trusts that facilitate recovery for youth at risk as well as gun trusts.
Here is her commentary:
The Supreme Court recently ruled that inherited IRAs are not retirement funds for purposes of the federal bankruptcy statute. The effect of the ruling is to allow bankruptcy creditors to attach inherited IRAs. While some states have opted out of the federal bankruptcy statutes and adopted their own exemptions for inherited IRAs, a practitioner should avoid relying on those exemptions in doing asset protection planning. Beneficiaries may move from state to state or the exemptions offered in a particular state may change. To the extent that asset protection is desired by an account owner on behalf of his or her beneficiaries, a trust should be part of the plan.
Supreme Court Case
On June 14, 2014, the United States Supreme Court ruled in Clark v. Rameker that inherited IRAs are not "retirement funds" within the meaning of the exemption for such funds provided in the federal bankruptcy statute, 11 U.S.C. §522(b)(3)(C).[i] In making its decision, the court distinguished between inherited IRAs and IRAs established and held by the owner who originally deposited the funds. In the hands of the original owner, the funds are retirement funds. In the hands of a beneficiary, the funds are not. The impact of this ruling on spousal rollover IRAs is not clear.[ii]
Heidi Heffron-Clark became the holder of an inherited IRA in 2001 when her mother passed away leaving Heidi as sole beneficiary of an IRA account. Heffron-Clark and her husband filed bankruptcy in 2010 claiming the inherited IRA as an exempt asset under 11 U.S.C. §522(b)(3)(C). The Bankruptcy Court disallowed the exemption. The District Court reversed. The Seventh Circuit reversed the District Court. The Supreme Court granted certiorari to resolve a conflict between the Seventh and Fifth Circuits.
The Court based its conclusion on three legal characteristics of inherited IRAs:
- The holder of an inherited IRA cannot invest additional funds into an inherited IRA.
- Holders of inherited IRAs are required to withdraw money from the accounts regardless of their age when they inherit the IRA.
- The holder of an inherited IRA can withdraw the entire IRA, without penalty, at any time whereas original IRA owners are subject to penalties on withdrawals before the age of 59 1/2.
The petitioners argued that funds in an inherited IRA are retirement funds because the initial owner set aside the funds at some point in time for retirement by placing the funds in an IRA. The Court rejected the argument noting that such a definition would have the result of treating funds that had been set aside for retirement at some point in time as being treated forever as retirement funds regardless of their later withdrawal and location. By way of example, the Court suggested that such definition would mean that an original IRA owner could withdraw funds, give the funds to a friend who would put the funds in a checking account and then later claim exemption based on the concept that the funds had once been deposited in a qualified retirement account for the purpose of saving for retirement.
The Clark case was decided based on the federal bankruptcy exemption for retirement funds. Many states opt out of the federal exemptions and adopt their own. Five states currently have exemptions for inherited IRAs.[iii] While it is possible that a beneficiary may reside in a state with protection for an inherited IRA, practitioners assisting account owners with planning should keep in mind the possibility that beneficiaries may move to a different state and lose that protection.
The Challenges of Transitioning IRAs or Qualified Retirement Plan Accounts to Beneficiaries: Income Taxes, Estate Taxes and Asset Protection
For those who have significant qualified accounts (IRAs or qualified plan accounts for purposes of this commentary) as part of their estates, the planning challenges are how to achieve the goals of the owner while dealing with the interplay of estate taxes, income taxes, and asset protection issues.
Income Tax Challenges in Planning with IRAs and Qualified Plan Accounts
From an income tax perspective, the estate planner must deal with the complex web of minimum required distribution (MRD) rules and qualified beneficiary (QB) rules. If MRD rules are satisfied, to the extent that funds in a qualified account (QA) remain within the QA, the funds (and income earned thereon) are not subject to income taxes. When funds are distributed from a QA, such funds are subject to income taxation. [iv]
During the account owner's life, the owner will be required to take MRDs based on his or her life expectancy. After the account owner's death, MRDs must continue under the post-death rules. The period over which MRDs can be stretched following the account owner's death depends on whether there is a qualified beneficiary and a determination as to the life expectancy that applies.[v]
Income tax cost can be reduced and deferred by "stretching" distributions over the longest possible period. The stretch is achieved by choosing an individual beneficiary (or trust qualifying as a designated beneficiary) who can choose to take MRDs over the beneficiary's life expectancy. In most cases, the greatest stretch results by naming the youngest possible beneficiary.
It is not untypical for account owners to expend significant energy planning for the stretch on behalf of beneficiaries only to have one or more beneficiary cash out the QA quickly after the account owner's death. The account owner who wants to be certain that QA distributions will be stretched over the beneficiary's life should consider naming a qualifying trust as beneficiary and limiting distributions to the beneficiary to the MRDs.
If the account owner dies leaving a surviving spouse named as beneficiary of a QA, the surviving spouse has the option to roll over the QA to an IRA and make it his or her own IRA or to establish the IRA as an inherited IRA. If the spouse rolls the account over and makes it the spouse's own IRA, MRDs can be deferred until the spouse turns age 70 ½.
If a non-spouse is the beneficiary of a QA, then the post-death distribution rules depend on the age of the account owner at the date of death and whether or not there is a designated beneficiary of the QA. "Designated beneficiary" in this context has a specific tax meaning. An individual and certain trusts will qualify as a designated beneficiary. An estate, a charity, a business entity, and most trusts will not qualify as a designated beneficiary. [vi]
The post-death MRD rules generally work as follows:
- If the account owner dies before his or her Required Beginning Date (RBD) for MRDs (April 1 of the year following the year in which the account owner turns 70 1/2) and there is a designated beneficiary, then MRDs are based on the life expectancy of the beneficiary.
- If the account owner dies after the RBD and there is a designated beneficiary, future MRDs are based on the longer of the beneficiary's life expectancy or that of the deceased account owner's.
- If the account owner dies before his or her RBD and there is no designated beneficiary, then the entire balance of the QA must be distributed no later than the end of the year five years after the date of the account owner's death.
- If there is no designated beneficiary and the account owner dies after the RBD, the MRDs are based on the deceased account owner's life expectancy.[vii]
If there are multiple beneficiaries of a QA, the MRD is based on the life expectancy of the oldest beneficiary.[viii] Separate accounts can be established at the QA level for each beneficiary so that the MRD for each account will be based on the life expectancy of the beneficiary of the separate account. [ix] The separate account rules are not available to trust beneficiaries.[x]
Estate Tax Challenges in Planning with QAs
The fair market value of a QA is included in the account owner's estate. Because the QA is also subject to income taxes as funds are distributed, the combined income and estate taxes can have a substantial effect on a QA in those estates subject to estate taxes.
If there is a surviving spouse, the best strategy for the QA may be to name the spouse as beneficiary. Naming the spouse as beneficiary will qualify for the estate tax marital deduction. If doing so results in an under-utilized credit of the deceased account owner, portability can result in the un-utilized exemption being available to the surviving spouse. The surviving spouse can choose to roll over the QA to an IRA for the surviving spouse and spread distributions over his or her lifetime. If an account owner does not want a QA to go outright to his or her spouse, the account owner may establish a trust that qualifies as a designated beneficiary for the QA rules as a QTIP under the estate tax rules and achieve similar results.
When there is no surviving spouse, the account owner can name his or her children, nieces, nephews or other individuals as beneficiaries. Doing so would use the applicable credit exemption for estate tax purposes and could allow the beneficiaries to stretch distributions over a period of time for income tax purposes. After the Clark decision, this approach provides very little creditor protection for beneficiaries. Even in those states providing protection to the inherited IRA, the distributions will likely be subject to attachment.
A credit shelter trust can be named beneficiary of a QA; however, to the extent that a credit shelter trust is used, careful consideration should be given to the design to avoid unfavorable results. If the trust design results in distributions under the five year rule, the impact is to substantially diminish the asset (the QA) funding the credit shelter. To reduce income taxes at the trust level, substantial distributions can be made to beneficiaries; however doing so diminishes the assets held in trust and defeats one of the usual goals of naming a trust beneficiary. When there is no surviving spouse and when the account owner doesn't want to name beneficiaries directly, for smaller QAs or where there are numerous beneficiaries, using a credit shelter trust will make sense.
Asset Protection Challenges in Planning with QAs
While QA principal typically cannot be attached, distributions from QAs to the owner of a beneficiary can be attached. The same rules typically apply to trust distributions. In those states that have adopted the Uniform Trust Code, the principal of a spendthrift trust generally cannot be attached by creditors; however, once a distribution is made to a beneficiary, the distribution can be attached. A recent Illinois case allowed a creditor to have an ongoing lien in favor of the creditor against any proceeds or distributions to be paid.[xi]
If an individual is named beneficiary of an IRA, MRDs can be attached as they are made. If a trust is named as beneficiary of an IRA, to the extent that distributions from the trust must be made, a creditor can attach the distributions. If other jurisdictions follow the recent Illinois case, then creditors will be able to have continuing liens against trust distributions.
The QA owner who wants to achieve asset protection for the account owner's beneficiary along with favorable estate and income tax results will want to consider using a trust as the beneficiary of the QA. While a conduit trust may be useful to protect the principal of a QA, given the requirement to distribute MRDs to the beneficiary, a "conduit trust" is not the best tool for asset protection as distributions are subject to attachment. An accumulation trust will likely achieve better results for asset protection purposes. Because the requirements to draft an accumulation trust may pose a challenge, in some cases, the QA owner may consider foregoing some of the income tax advantages of using stretch provisions. While I am rejecting the conduit trust as an asset protection vehicle, I will briefly revisit the conduit trust structure before evolving the accumulation trust.
The Conduit Trust
A conduit trust is a type of trust that qualifies as a designated beneficiary for purposes of the MRD rules. If a trust satisfies the applicable rules, the trust can be "looked through" to the individual beneficiaries to determine the life expectancy that will apply for MRDs.
The Internal Revenue Service regulations specify a set of rules that create a safe harbor for a trust to be treated as a conduit trust:
- The trust must be valid under state law.
- The trust must be irrevocable upon the death of the account owner.
- The beneficiaries of the trust must be identifiable from the trust instrument.
- Certain documentation must be provided to the plan administrator.[xii]
A conduit trust requires the trustee to take MRDs and to distribute all distributions from the QA to the trust to the beneficiary. The trustee has no power to accumulate or hold the distributions even to the extent of distribution in excess of the MRD.[xiii]
The conduit trust may be used in a variety of ways.
- The account owner might want to name a spouse as beneficiary for the spouse's life but control the disposition of the remainder upon the spouse's death. In such a case, the account owner can establish a conduit trust and direct the trustee to take MRDs from the IRA and distribute the MRDs to the spouse. The trustee can be authorized to take additional withdrawals from the QA for the spouse in certain circumstances. Such additional withdrawals may be subject to a maximum annual withdrawal limit. The trust can qualify as a QTIP if desirable and provide for distribution upon the death of the surviving spouse to children or other beneficiaries of the deceased account owner. The Internal Revenue Service, in a private letter ruling, has ruled that a trust naming the spouse as beneficiary for her life and then dividing into subtrusts for the account owner's children qualifies as a look through trust; however, because the separate account rules are not available to trust beneficiaries at the trust level, upon the spouse's death, the life expectancy of the oldest living beneficiary of any of the subtrusts applied to all of the subtrusts for MRD purposes.[xiv]
- The account owner might have adult children who have struggled financially or are in unstable relationships and desire to ensure that such children have something to fall back on for life. A conduit trust could be established whereby the trustee is directed to withdraw the MRDs and distribute the MRDs, and nothing more, to the conduit trust beneficiary. While this approach achieves a stretch over the beneficiary's lifetime for income tax purposes, distributions may be subject to creditor claims, and in such a case, the trust will fail to achieve the goal of providing the beneficiary a lifetime stream of income.
Because distributions cannot be accumulated in a conduit trust, the approach fails to achieve asset protection. An accumulation trust, designed with asset protection features, offers a better solution. If a conduit trust is used, consider providing a trust protector the power to convert the trust from a conduit trust to an accumulation trust.
The Accumulation Trust
An accumulation trust is one that allows the trustee to accumulate withdrawals from a QA. An accumulation trust can qualify as a designated beneficiary if the trust is designed so that only individuals are beneficiaries. The life expectancy that will be used for MRD purposes for an accumulation trust is that of the oldest living beneficiary. Certain contingent beneficiaries are considered for that purpose. A successor beneficiary who merely takes as the successor of a prior beneficiary is not a contingent beneficiary for this purpose.[xv]
The advantage of the accumulation trust over the conduit trust is that the trustee is not required to distribute QA withdrawals to the beneficiary but may retain the funds in the trust. The ability to do so, assuming the trust is a spendthrift trust, provides asset protection. To the extent that QA withdrawals are not distributed annually, they are subject to income tax at trust tax rates, which reach the maximum tax bracket at only $12,150.00 of income. If an accumulation trust is designated as an IRA beneficiary, consideration should be given to obtaining a private letter ruling from the IRS.
Drafting the Accumulation Trust for Asset Protection, Income Tax Deferral and Estate Tax Effectiveness
Income Tax Structure
A trust that allows accumulations of retirement plan withdrawals can qualify as a designated beneficiary for income tax purposes. To achieve this goal, the following should be incorporated into trust drafting:
(1) Establish a trust or trust share for each beneficiary and designate such separate shares as the beneficiary of the QA. For example, if there are three primary beneficiaries, create Trust Share A, Trust Share B, and Trust Share C. The beneficiary designation of the IRA can then be 1/3 to Trust Share A, 1/3 to Trust Share B, and 1/3 to Trust Share C. When a separate account for each individual beneficiary is established, each individual will be able to use his or her own life expectancy.[xvi] Of course, in the case of the accumulation trust, it is important that such beneficiary be the oldest living beneficiary of the trust designated as beneficiary.
(2) Only individuals should be beneficiaries of each trust share. For example, avoid any provision that could result in the estate of the account owner being a beneficiary of the trust. Specify that any debts, taxes, or expenses of the estate payable from the trust must be paid no later than September 30 following the year of the death of the account owner. Note that payment of ongoing administration expenses of the trust, including trustee and attorney fees does not result in the estate being considered a beneficiary.
(3) The life expectancy that will be used for MRD purposes will be that of the oldest living beneficiary including contingent beneficiaries except for those contingent beneficiaries who are a mere successor in interest. In determining the primary beneficiary, the IRS will go through the sequence of beneficiaries to the first person who will receive the trust assets immediately or outright upon the death of the prior beneficiary.
(4) Prohibit trust distributions to anyone who is older than the trust beneficiary whose life expectancy is to be used for calculating MRDs.
(5) Avoid using a typical "heirs-at-law" contingent beneficiary clause.
(6) The beneficiaries of the trust must be identifiable. If a beneficiary class is named, the beneficiaries will be considered identifiable if it is possible to identify the class member with the shortest life expectancy.
(7) A testamentary power of appointment can be provided to a beneficiary if the power can be exercised only in favor of an individual who is younger than the beneficiary.
(8) It is possible to name a charity as an ultimate contingent beneficiary. Doing so requires that the charity be a "mere successor beneficiary."[xvii]
(9) Provide a trust protector with the power to limit the permissible beneficiaries to individuals who are not older than the beneficiary. Do not provide the trust protector any power that could result in the trust protector adding an older beneficiary or a beneficiary other than an individual.
(10) Provide a trust protector with the power to limit any power of appointment.
Asset Protection Structure
To enhance the asset protection features of the trust, consider the following:
(1) The trust, and any trust share, should be a spendthrift trust.
(2) Direct the Trustee to take MRDs annually from the QA; however the Trustee should have sole discretion as to amounts distributed to the beneficiary and the amounts accumulated. Any required distributions will be subject to attachment so do not provide for any required distributions.
(3) Do not give the Trustee unlimited ability to withdraw and distribute all of the QA.
(4) Permit or direct the Trustee to pay expenses directly on behalf of the beneficiary. Evaluate the state law that will be applied to the trust to determine whether a creditor is likely to be able to prevent such payments.
(5) Establish the trust situs in a state that provides favorable asset protection to debtors who are trust beneficiaries. While many states provide reasonable protection to third party spendthrift trusts, those states that have adopted statutes providing protection for self-settled trusts (domestic asset protection trusts) often have laws applying to trusts that are generally more favorable towards debtors and more progressive in the arena of trusts.[xviii] A detailed analysis of establishing trust situs for third party trusts in an asset protection state will be the subject of another newsletter; however, for purposes of an accumulation trust for a settlor with asset protection goals, I am suggesting that the trust drafter consider the state laws of the settlor and any beneficiaries and consider the possibility of whether the laws of an asset protection state might provide the most protective trust structure.
(6) In choosing the situs, also consider the possibility of choosing a state with no state income tax. In most instances, doing so will avoid state income tax on the amounts that are accumulated in the trust.xix]
(7) Do not name the beneficiary as the Trustee. Use a professional trustee qualified in the state of trust situs.
(8) Name a Trust Protector with the ability to veto distributions and to make such modifications to the trust as may be necessary to protect the trust. Do not give the Trust Protector any power to add or change beneficiaries that could result in the Trust Protector adding a beneficiary who is older than the beneficiary upon whose life expectancy the MRDs are being calculated or any beneficiary that would not qualify as an individual.
Estate Tax Structure
If there is a spouse beneficiary, the trust can be structured to qualify for the estate tax marital deduction, if desirable. Such share can be a QTIP so that ultimate disposition can be controlled.
The trust shares can qualify as a credit shelter trusts and utilize some portion of the applicable credit. If there is no spouse, and the overall estate is subject to estate tax, the QA balance will be subject to estate tax. If there are any charitable inclinations, consider those in the structure.
The trust shares can qualify for the generation skipping tax exemption. In an estate with estate tax exposure, allocation of GSTT may be an excellent strategy.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
TECHNICAL EDITOR: DUNCAN OSBORNE
LISI Asset Protection Planning Newsletter #252 (July 7, 2014) at http://www.LeimbergServices.com ©Mary E. Vandenack 2014. Reproduction in ANY Form or Forwarding to ANY Person - Without Express Permission - Prohibited.
[i] Clark v. Rameker, 573 U.S. ___ (2014).
[ii] Asset Protection Planning Newsletter #248 (June 16, 2014).
[iii] See Fla. Stat. § 222.21; Ohio Rev. Code § 2329.66(A)(10); Mo. Rev. Stat. § 513.430; Alaska Stat § 09.38.017; Tex. Prop. Code § 42.0021.
[iv] See generally Internal Revenue Code §408.
[v] Internal Revenue Code §401(a)(9) and Internal Revenue Code 408.
[vi] See Treas. Reg. §1.401(a)(9)-4.
[vii] Treas. Reg. §1.401(a)(9)-5, A-A-5(c)(3).
[viii] Treas. Reg. 1.401(a)(9)-5, A-7.
[ix] See Treas. Reg §1.401(a)(9)-8.
[x] Treas. Reg. §1.401(a)(9)-4, Q & A 5(c) (However, separate account like treatment may be available with proper drafting. See PLR 200537044).
[xi] Treas. Reg. §1.401(a)(9)-5 Q&A 7; Community Bank of Elmhurst v. Klein, 2014 IL App(2d) 121074.
[xii] Treas. Reg §1.401(a)(9)-4, A-5(b).
[xiii] See Treas. Reg. § 1.401(a)(9)-5, A-7(c)(3).
[xiv] PLR 201202042.
[xv] Treas. Reg. §1.401(a)(9)-5, Q&A 7(b).
[xvi] See PLR 200537044; PLR 201210045.
[xvii] See PLR 201203033.
[xviii] The following states have enacted asset protection trust statutes: Alaska, Delaware, Nevada, Ohio, South Dakota, Wyoming, Tennessee, Missouri, Mississippi, New Hampshire, Hawaii, Rhode Island, Utah, Virginia, Mississippi, Oklahoma.
[xix] The following states have no state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming.
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