Ruling to Remember: What NOT To Do When a Trust is the IRA Beneficiary

By Beverly DeVeny, IRA Technical Expert

Follow Me on Twitter: @BevIRAEdSlott

In Private Letter Ruling (PLR) 201425023, released by IRS on June 20, 2014, the IRS ruled that a surviving spouse who received IRA proceeds through a trust, which was the beneficiary of her deceased husband’s IRA, could not roll over the IRA funds she received because more than 60 days had passed since she received the funds. The IRS denied her request for more time to do the rollover because she didn’t provide sufficient proof of financial institution error. More importantly, the PLR is a good example of what not to do when a trust is the beneficiary of an IRA.

Facts of the PLR
“Ben” had an IRA and named a trust as the beneficiary of his IRA. The trustees of the trust were his two children. Ben’s wife “Ann” was the beneficiary of 25% of the assets of the trust. After Ben died, the entire proceeds of the IRA were paid to the trust as IRA beneficiary. The funds were deposited into the trust’s checking account. The PLR didn’t say who authorized the IRA distribution, but most likely Ben’s children as trustees ok’d the distribution.

Apparently, Ann had a problem with how the trust was interpreted and administered and started legal action against Ben’s children as co-trustees of the trust. Eventually, they worked out their differences. Ann and the trustees entered into a settlement agreement which said that the trust would attempt to establish a rollover IRA in Ann’s name for her 25% portion of the IRA funds that were distributed from the trust.

As a result of the settlement agreement, Ann opened an IRA in her name assuming that she would be allowed to roll over the amount she received from the trust. Shortly after the settlement agreement in October 2009, her 25% share of the IRA proceeds were paid from the trust and deposited directly (rolled over) into the IRA in Ann’s name. This distribution occurred after 60-days from when the entire IRA was distributed to the trust. Ann received a K-1 from the trust for 2009 showing a taxable distribution.

Ann must have realized that more than 60-days had lapsed since the IRA distribution was made from the trust, so she applied to the IRS for a waiver of the 60-day rollover period for financial institution error. While in the PLR request she referred to “financial institution error,” she really was blaming the trustees and their attorney for the delay, not the financial institution. Specifically, she claimed that the trustees and their lawyer had duties under state law to her as a beneficiary of the trust and that they failed to fulfill those duties.

She alleged that the trustees and their lawyer failed to fulfill their duties under state law when they allowed the entire IRA distribution to the trust. She also alleged that after the distribution, the trustees’ lawyer failed to timely inform the trustees and the IRA custodian of Ann’s rollover options as Ben’s spouse.

IRS Denies Waiver of 60-day Rollover Period
The IRS denied her request for a waiver of the 60-day rollover period. While not giving much detail, the IRS simply stated that the information and documentation that Ann submitted were insufficient evidence of financial institution error. So, the money she received from the trust and then rolled over to her own IRA was not eligible for rollover. As a result, the IRA distribution could not be treated as a tax-free rollover. It also likely created an excess IRA contribution.

Invalid Rollover Creates Excess IRA Contribution
In this case, Ann did the rollover before she requested the PLR. Either she assumed the funds were rollover eligible or she thought the IRS would give her a waiver of the 60-day rule due to the trustees and their lawyer’s alleged mistakes. She was wrong.

Without a 60-day waiver from IRS, the funds were not eligible to be rolled over to her IRA. The fact that she did roll over the money over means that the deposit is treated as a regular tax-year contribution for 2009. Assuming the deposit was more than $6,000 (the IRA contribution limit for 2009 for someone age 50+), then any amount above that is automatically treated as an excess IRA contribution. If an excess contribution is not timely removed by October 15 of the year after, it is subject to a 6% penalty each year until it’s corrected.

The 6% excess contribution penalty is reported on IRS Form 5329. If Form 5329 is not filed, the statute of limitations (normally 3 years) never begins to run adding more penalties and interest to an already costly situation.

Common Mistakes When a Trust is the IRA Beneficiary
While there are many good reasons to name a trust as the beneficiary of an IRA, the main reason is for control. If the IRA owner wants to control how the funds are paid out after he dies, a trust can do that.

Trusts are also often named as the IRA beneficiary for creditor protection purposes. In light of the June 2014 Supreme Court’s ruling in the Clark case where the court ruled that inherited IRAs are not protected in bankruptcy under federal law, more IRA owners may consider naming a trust as the beneficiary of their IRA to protect the money from the beneficiaries creditors.

Trusts by themselves are complicated. The IRA required minimum distributions rules are complicated too. When you mix the two by naming a trust as the IRA beneficiary, problems often occur. Below are some common mistakes that are made after an IRA owner dies with a trust as the beneficiary.

Paying Out Entire IRA to Trust
After the IRA owner dies, paying out the entire IRA to the trust should NOT be done, unless the trust says so. Only the required minimum distribution (RMD) needs to be paid to the trust, not the entire balance. If the entire IRA balance is paid to the trust (a nonsposue beneficiary), the trust cannot roll over the funds back into an IRA. The entire IRA distribution will be taxable.

After the IRA owners dies, the IRA should simply be retitled (transferred) into an inherited IRA for the trust, the same that would be done for any nonspouse IRA beneficiary. For example, the IRA could be retitled: “Jane Doe Family Trust as beneficiary of Jane Doe IRA” or something similar that identifies the deceased IRA owner and the trust as beneficiary.

Naming Family Members as Trustee of a Trust
Naming family members as trustee of trust has potential benefits and pitfalls. Family members will usually know the family dynamics and needs of the trusts’ beneficiaries and may be in better position to know when to make distributions than a third party trustee such as a bank that doesn’t know the family history. This is especially true in an accumulation (discretionary) trust where the trustees have to decide when to pay the IRA funds to the trust beneficiaries or retain them inside the trust.

One of the primary potential pitfalls is that the family members probably don’t have expertise in acting as a trustee and ideally should seek advice from professionals. If a disgruntled trust beneficiary questions whether the trustees are doing their job correctly, it certainly could cause friction in the family to say the least.

In PLR 201425023, it’s wasn’t clear whether the decedent’s children as co-trustees made a mistake, but the fact that the entire IRA balance was paid to the trust is suspect. One of the trust’s beneficiaries, the decedent’s wife, initiated legal action against the trustees which resulted in a settlement agreement. The odds that the settlement agreement caused problems in their family are pretty high.

Advisor Action Plan

• Encourage trustees of a trust to not distribute any IRA funds without first getting professional advice.
• Do not make a total distribution from the IRA to the trust after the IRA owner dies. Only the RMD needs to be paid out.
• After the IRA owner dies, make sure the IRA is set up as an inherited IRA with the trust as beneficiary of the decedent.
• Tell surviving spouse beneficiaries that whenever applying for a 60-day rollover waiver, doing a spousal rollover before the PLR request is received is risky. If the IRS denies the waiver, then an excess contribution will likely happen in the surviving spouse’s IRA.