Private Letter Ruling 201021038 (May 28, 2010) shows the importance of careful drafting for a trust designated as the beneficiary of a retirement plan. This ruling involved an individual retirement account owned by a surviving spouse. The surviving spouse named a bypass trust created under his wife's revocable trust as the IRA's beneficiary. The bypass trust provided that upon the husband's death, certain specific bequests would be made from the property held in the bypass trust, and the remaining property would be divided between two protective trusts for the benefit of each of the surviving spouse's daughters. The terms of the protective trusts authorized the trustees to distribute income and principal for the daughters' (and their descendants') health, maintenance, support and education. Each daughter had a lifetime and testamentary power of appointment over her trust, both of which included charities as permissible appointees.

The trust agreement included a general savings provision that provided that the settlor intended the trustees to make appropriate elections to defer the payments from retirement plans payable to the trusts and use the minimum distribution rules to structure payments according to the “stretch IRA” rules.

Under Internal Revenue Code Section 401(a)(9)(B), when the owner of an IRA dies after reaching his required beginning date, the payments are calculated using the life expectancy of the deceased IRA owner (the surviving spouse in this case). However, if the IRA has a designated beneficiary, payments from the IRA may be made over the life expectancy of the beneficiary. Therefore, if a designated beneficiary is younger than the IRA owner, the payments will be made over a longer period of time.

However, Treasury Regulations Section 1.401(a)(9)-4 provides that only individuals who are beneficiaries as of the date of death may be designated beneficiaries. In addition, designated beneficiaries must be individuals, which means that trusts aren't designated beneficiaries. However, one can “look through” a trust and consider its beneficiaries as designated beneficiaries if the trust is valid and irrevocable, the beneficiaries are identifiable and the proper documentation has been provided to the plan administrator.

To stretch out the IRA distributions, all of the beneficiaries (including contingent beneficiaries and remaindermen) must be individuals, and the oldest beneficiary's life expectancy is used for the payment schedule. However, if the trust requires that all IRA distributions be currently paid out to the beneficiaries (a conduit trust), then only those beneficiaries are considered for this purpose; remaindermen and objects of powers of appointment aren't considered beneficiaries. In this case, the trust wasn't a conduit trust because it allowed the trustee to receive distributions from the IRA and accumulate them in the trust. Any accumulated distributions would be subject to the daughters' powers of appointment, which were exercisable in favor of charities. Therefore, since IRA distributions to the trust could ultimately be appointed to non-individuals, the IRA didn't have designated beneficiaries.

Because of this problem, after the surviving spouse died, the two daughters obtained a local court order to amend the trust. The amendment was clearly intended to provide the IRA with a designated beneficiary: It required the trustees to pay out all amounts received from the IRA to the beneficiaries and removed charities as potential appointees.

The IRS, however, ruled that it wouldn't respect the post-death court-ordered amendment for tax purposes. Citing a recent Tax Court case, the IRS explained that while it will look to local law to determine the nature of interests in a trust, it will not give effect to a local court order that modifies the dispositive provisions of a trust agreement after the IRS has the right to tax revenues from the trust property.

Because the amendment was ineffective for tax purposes, charities, as non-individuals, were considered beneficiaries of the IRA due to the potential for accumulation of plan distributions and the powers of appointment. Accordingly, the IRS ruled that the plan didn't have a designated beneficiary. Without a designated beneficiary, the distributions from the plan would be calculated using the surviving spouse's life expectancy based on his age at death.