by Bradford N. Dewan, J.D., MBA
The importance of the beneficiary designation form for an IRA is often emphasized (and rightly so). An IRA owner typically intends for the distributions from the IRA after death to be “stretched out” to the maximum extent in order to achieve the greatest tax-deferred growth of the assets and investments held in the IRA. By extending the required minimum distributions (“RMDs”) over the longest period, the beneficiaries will likely realize greater financial benefit. Filling out the beneficiary designation form to meet this goal does require a full understanding and knowledge of the rules that apply.
In three related Private Letter Rulings, including PLR 201628004, 1 the IRS denied an attempt to correct an alleged error in the beneficiary designations of the IRA owner, despite such beneficiary designations having been modified retroactively by a court order issued by a state probate court.
The issue with the beneficiary designations occurred either by accident or as a result of bad advice when the IRA owner, after his financial advisors changed firms, rolled his IRA funds into a new IRA with a different custodian and signed a new beneficiary designation form.
In the beneficiary designation forms for the two IRAs with the original custodian, the IRA owner had named “Trust C” as a 50% beneficiary, and “Trust D” and “Trust E” each as 25% beneficiaries of the IRAs, which was consistent with the dispositive provisions of his estate plan. At the time that the IRA owner executed this new beneficiary designation, he had attained the age of 70 ½ and therefore was now required to take required minimum distributions from the IRA during his lifetime.
As noted above, the IRA owner’s financial advisors joined another firm which was affiliated with a different custodian. The IRA owner apparently wanted to continue working with those financial advisors. Accordingly, the IRA owner transferred his IRA assets to the new custodian. One of the financial advisors provided a beneficiary designation form for the IRA owner’s signature which named the IRA owner’s estate as the beneficiary. The IRA owner signed the new beneficiary designation form despite it being very different from the beneficiary designation forms with the prior custodian and materially different from the expressed disposition under his estate plan. It was represented to the IRS in the petitions for the PLRs that, although, the IRA owner signed the new beneficiary designation form, he merely intended to move assets from the prior custodian to the new custodian and that he did not intend to change beneficiaries as part of this rollover.
It was alleged that the IRA owner intended for Trusts C, D, and E to receive the IRA benefits and to comply with the applicable Treasury Regulations that would have allowed for the IRA benefits to be “stretched out” over the life expectancies of the beneficiaries of these three Trusts after his death.2 Under applicable Treasury Regulations, if certain requirements were met, the individuals named as the beneficiaries of the Trusts would be treated as Designated Beneficiaries of the IRA for required minimum distribution purposes. Generally, the life expectancy of the oldest beneficiary of each Trust would control with respect to determining the required minimum distributions for each Trust after the owner’s death.
However, an estate does not qualify as a Designated Beneficiary under the relevant Regulations (only individuals do),3 and the RMD rules provide that if there are no Designated Beneficiaries, then all IRA benefits must be distributed over the deceased IRA owner’s life expectancy as determined in the year of death.4
The Trustees of the three Trusts petitioned the state court for a declaratory judgment that would modify the beneficiary designation based upon the theory that the IRA owner never intended to change the beneficiary designations of his IRA accounts but was simply intending to rollover the IRA funds into an IRA with the new custodian with the beneficiary designations remaining the same.
Based on its finding of the IRA owner’s intent, the state court ordered that the beneficiaries of the new IRA were Trust C as a 50% beneficiary and Trusts D and E as 25% beneficiaries, consistent with the IRA owner’s prior beneficiary designations. The court also ruled that the order was retroactively effective as of the date on which the IRA owner signed the beneficiary designation for the IRA with the new custodian.
Subsequently, the Trustee of each of the three Trusts requested a private letter ruling from the IRS to confirm that the IRA qualified for the RMD stretch out provisions for a “see-through” trust under the Treasury Regulations, and that the life expectancy of the oldest individual beneficiary of each Trust would apply for determining the RMD for each Trust’s share of the IRA account.5
The IRS denied the ruling requests on the grounds that the named beneficiary of the IRA as of the date of the IRA owner’s death controlled for purposes of determining who the beneficiary of that IRA is and whether that beneficiary is a “Designated Beneficiary”. It was clear that the estate was named as the beneficiary and an estate does not qualify as a “Designated Beneficiary” since it is not an individual.6 Thus, the IRS ruled, there was no “Designated Beneficiary” of the IRA, and the RMDs would be based on the life expectancy of the IRA owner.
In its reasoning, the IRS indicated that a court order cannot create a Designated Beneficiary for the purposes of Internal Revenue Code section 401(a)(9) and the Treasury Regulations thereunder. The IRS also stated the following, and cited tax court cases where the courts have disregarded the retroactive effect of state court decrees for federal tax purposes:
“(A)though the Court order changed the beneficiary of IRA X under State law, the order cannot create a ‘designated beneficiary’ for purposes of section 401(a)(9). Courts have held that the retroactive reformation of an instrument is not effective to change the tax consequences of a completed transaction.”
In addition, the IRS provided public policy reasoning for not issuing the requested rulings:
“Were the law otherwise there would exist considerable opportunity for ‘collusive’ state court actions having the sole purpose of reducing federal tax liabilities. Furthermore, federal tax liabilities would remain unsettled for years after their assessment if state courts and private persons were empowered to retroactively affect the tax consequences of completed transactions and completed tax years. 7
The rulings do not necessarily come as a surprise, as it has been fairly well-settled that beneficiaries cannot be added to a beneficiary designation and retirement plan disposition plan following the owner’s death.8 However, in contrast, Treasury Regulations allow a beneficiary to be removed and not considered a beneficiary of the IRA if such removal occurs by September 30th of the year following the calendar year of the owner’s death. Such removal can occur by fully paying the beneficiary its interest in the IRA or the beneficiary can disclaim that interest in the IRA.9
In summary, the rulings emphasize the importance of assuring that an IRA owner’s beneficiary designations are structured appropriately and reflect what is intended as of the time of the IRA owner’s death. Failing to assure that this aspect of an IRA owner’s estate plan is structured correctly can be disastrous. The income tax built up in an IRA or other type of qualified plan could be accelerated and could cause the beneficiaries of the IRA (typically family members of the IRA owner) to recognize substantial income at higher rates than would otherwise be the case if the beneficiary designation was completed in accordance with the IRA owner’s intent.
1. The other two PLRs are 201628005 and 201628006.
2. See Treas. Reg. 1.401(a)(9)-4 Q and A 5 for the requirements of a “see through” trust.
3. Treas. Reg. 1.401(a)(9)-4, Q and A 3.
4. Treas. Reg. 1.401(a)(9)-5, Q and A 5(c)(3). If the IRA owner had not yet attained the age of 70 ½, then all IRA benefits would have been required to have been paid out to the estate within five (5) years following the December 31st of the calendar year in which he died.
5. Treas. Reg. 1.401(a)(9)-4, Q and A 5.
6. Treas. Reg. 1.401(a)(9)-4, Q and A 3.
7. Quote from Van Den Wymelenberg v. U.S., 397 F.2d 443, 445 (7th Cir. 1968).
8. Treas. Reg. 1.401(a)(9)-4, Q and A 4: “In order to be a designated beneficiary, an individual must be a beneficiary as of the date of death.”
9. Treas. Reg. 1.401(a)(9)-4, Q and A 4(a).