[IMGCAP(1)]Naming a trust as an IRA beneficiary may offer many benefits. If drafted properly, a trust can protect the account from creditors and reduce the risk that money will be mishandled.
On the other hand, naming a trust as IRA beneficiary makes it more challenging to stretch out the required minimum distributions. Maximum tax deferral is possible, but only if the trust is crafted carefully and if the trustee follows proper procedures.
In reality, many IRA trusts are flawed, for purposes of extended tax deferral, and trustees often fail to meet a crucial deadline. Advisors may face difficult after-the-fact decisions with noncompliant IRA trusts, and failure to take appropriate action could have unfortunate consequences.
Imagine Jim, an advisor focused on retirement planning, suggests to one of his clients that she name a trust as her IRA beneficiary. Jim even recommends an attorney who could draft this trust. As Jim explained the process, the client’s children could be the trust beneficiaries. After the client’s death, the IRA would pass to the trust and the required minimum distributions would be stretched out over the oldest child’s life expectancy.
Fast forward some years. Jim’s client has died, the trust establishes an inherited IRA, and the children are receiving RMDs. Then Jim learns of a flaw that should have accelerated taxable distributions from the IRA.
What should Jim do? If he tells his new clients, or the attorney who drafted the trust or the trustee, that might trigger extensive finger-pointing and unhappy reactions that could cost Jim business.
However, if Jim keeps silent and the distribution shortfall eventually is revealed, Jim could wind up facing a lawsuit.
What could derail an IRA trust? Perhaps the most common error is failing to meet an October 31 deadline. If a trust is named as the beneficiary of an IRA, the IRS requires the trustee to submit certain paperwork to the IRA custodian by October 31 of the year following the IRA owner’s death. There are two options for satisfying this requirement.
One option is to provide a list of all the beneficiaries of the trust (including contingent and “remainderman” beneficiaries), meet several other conditions, and agree to provide a copy of the trust instrument to the IRA custodian upon demand. Option two is to simply send a copy of the actual trust document to the IRA custodian. Generally, the latter method will be easier for the trustee.
Either way, the trustee should send a letter to the IRA institution by certified mail, return receipt requested, to prove that this deadline has been met. The entire process sounds straightforward, but many advisors, including attorneys and accountants, are not aware of this requirement.
When a trustee fails to meet this October 31 deadline, RMDs from the IRA to the trust will be accelerated. If the IRA owner had begun RMDs, post-death RMDs will be based on the decedent’s remaining life expectancy, by IRS tables. If the owner had not begun RMDs, the IRA must be emptied within five years.
Problems for Trusts with Charitable Beneficiaries
When the October 31st deadline has been met, distributions from the IRA to the trust may be stretched out over the life expectancy of the trust beneficiary. If there are multiple beneficiaries, the shortest life expectancy will be used. However, such an RMD stretch is not automatic. To qualify, an IRA trust must meet several conditions. It must be a valid trust under state law, for instance. The trust beneficiaries must be identifiable and it must be irrevocable at the IRA owner’s death. Other technical issues may arise.
In particular, some clients include charitable bequests as part of their estate plan. From a tax-planning viewpoint, making such bequests from an IRA can be appealing. However, charitable bequests and IRA trusts may not mix well. Improper drafting of the trust might result in the charity being the beneficiary that the IRS looks at to calculate RMDs. A charity has no life expectancy, so distributions from the IRA will be accelerated.
In one possible scenario, Kate has a $500,000 IRA. She leaves her IRA to a trust, providing that her son Mike will receive trust income until he reaches age 35, when he will be entitled to the trust principal.
The trust terms state that if Mike dies before age 35, the remaining trust assets will pass to a certain charity. Unfortunately, such trust language will not permit Mike to be considered a designated beneficiary for the purpose of stretching RMDs from the IRA. Under state trust law, an income beneficiary is not the same as the beneficiary for RMDs. Instead, the charity, which has no life expectancy, will be used to calculate RMDs.
Lawyers’ Responsibilities for Faulty Trusts
In sum, there are many traps that can prevent a full stretchout of RMDs from an IRA trust. If an advisor learns that a client is taking insufficient RMDs from a faulty IRA trust, for any reason, what is the proper course of action? That depends on the type of advisor they are.
Let’s start with “Lynn,” an attorney who discovers that an IRA trust is noncompliant. Under the American Bar Association’s Model Rules of Professional Conduct, Lynn is obligated to tell her client that the IRA trust is faulty. The greater Lynn’s involvement with the trust, the greater her obligations can be. Lynn might have played a role in drafting the trust, and she might have prepared the fiduciary income tax returns and estate tax returns. In such circumstances, Lynn may be required to inform her malpractice insurance company, and she might have to end her professional relationship with this client.
As recent court cases, such as Fabian v. Lindsay (Supreme Court of South Carolina, 10/29/14), illustrate, many jurisdictions are willing to allow third-party beneficiaries (individuals other than a lawyer’s client) to bring malpractice actions against estate planning attorneys. That could affect an attorney who drafted a noncompliant IRA trust or one who was hired to administer the trust but missed the October 31 filing deadline.
CPA Responsibilities for Faulty Trusts
In another situation, “Mark,” a CPA, learns that his client has been receiving RMDs from an IRA trust that has been taking insufficient distributions. Here, Treasury Department Circular No. 230 would apply. Circular 230 states that practitioners must notify clients about omissions or errors relating to tax issues. Practitioners “must exercise due diligence,” as Circular 230 puts it.
In this situation, Mark should advise his client about the IRA trust’s shortcomings and the resulting RMD shortfall and recommend the steps necessary to remedy the situation. Again, the extent of Mark’s involvement with the IRA trust may determine the actions he should take.
Circular 230 was amended on June 12, 2014, adding a provision that practitioners must possess the necessary competence regarding IRS matters: “Competent practice requires the appropriate level of knowledge, skill, thoroughness and preparation necessary for the matter for which the practitioner is engaged. A practitioner may become competent for the matter for which the practitioner has been engaged through various methods, such as consulting with experts in the relevant area or studying the relevant law.” If a practitioner has been shown to lack those attributes, the chance of losing a lawsuit increases.
Financial Advisors' Responsibilities for Faulty Trusts
If advisors hold a Certified Financial Planner designation, they are guided by the CFP Board’s Code of Ethics. The first principle in that code, integrity, “demands honesty and candor which must not be subordinated to personal gain and advantage.”
Moreover, one of the CFP Rules of Conduct states, “A CFP Board designee shall offer advice only in those areas in which the CFP Board designee has competence. In areas where the CFP Board designee is not professionally competent, the CFP Board designee shall seek the counsel of qualified individuals and/or refer clients to such parties.” That would indicate that CFPs shouldn’t position themselves as experts in IRA trusts, unless they truly have the requisite background.
Non-CFP advisors, of course, may be held to similar standards by any number of parties. Exposure may be especially severe for advisors who present themselves to clients as being knowledgeable about retirement planning, yet lack an understanding of IRA trusts. Therefore, financial advisors should be very cautious about claiming expertise in IRA trusts. It may be best to avoid recommending an attorney to draft the trust without absolute certainty that the lawyer is up to the task.
Seymour Goldberg, CPA, MBA, JD, is a senior partner in the law firm of Goldberg & Goldberg, P.C., in Woodbury, N.Y. He is professor emeritus of law and taxation at Long Island University. Sy is the recipient of the American Jurisprudence Award in Federal Estate and Gift Taxation from St. John’s University School of Law. He has written two manuals on IRA rules for the American Bar Association, “The IRA Guide To IRS Compliance Issues” and “Inherited IRAs: What Every Practitioner Must Know,” both of which are available at americanbar.org. Mr. Goldberg is also the author of a newly published book,"Can You Trust Your Trust? What You Need to Know about the Advantages and Disadvantages of Trusts and Trust Compliance Issues." He can be reached at 516-222-0422 or firstname.lastname@example.org.
This article was reprinted with permission from the December 2014 issue of Ed Slott's IRA Advisor.
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