IRC Section 678 Powers Can Cut Trust Tax on IRA Funds
Estate-planning attorneys may wish to use Internal Revenue Section 678 withdrawal powers over trust income in their drafting to counteract Congress’s various attacks on the payment of individual retirement account and IRC Section 401k proceeds to trusts, including the high federal income tax rates on trusts and the SECURE Act requirements, which generally limit post-death required minimum distribution payments to 10 years. Below is a sample annotated trust form with five subsections that incorporate IRC Section 678 withdrawal powers, along with explanations of why each subsection is included. The subsections should come under this heading: “Section 1. Distribution of Income and Principal During Lifetime of Beneficiary,”
Subsection 1.1
Sample language. Subject to the remaining provisions of this subsection 1.1, during the beneficiary’s lifetime the beneficiary (including any legal representative acting on behalf of the beneficiary if the beneficiary is under a legal incapacity) shall have the annual noncumulative power to withdraw all or any portion of the trust accounting income on or before December 31 of the calendar year; PROVIDED, HOWEVER, that (i) the foregoing power of withdrawal shall not extend to the portion of the trust accounting income which, for the calendar year, would be exempt from federal income tax, and (ii) if Section 2041(b)(2) and/or 2514(e) of the Internal Revenue Code, or any successor section the thereto, is/are in effect during the calendar year, the beneficiary’s power of withdrawal under this subsection 1.1 shall lapse at the end of the calendar year (or on the date of the beneficiary’s death, if earlier), but only to the extent the same shall not constitute a release of a general power of appointment by the beneficiary pursuant to the provisions of either or both Section 2041(b)(2) and/or 2514(e) of the Internal Revenue Code, or any successor sections thereto in effect at the time of the lapse, assuming the beneficiary possessed no other similar power of withdrawal which lapses on the same date. The portion of the trust accounting income for the calendar year subject to the beneficiary’s foregoing power of withdrawal which is not withdrawn by the beneficiary (including by any legal representative acting on behalf of the beneficiary if the beneficiary is under a legal incapacity) during the calendar year and in which the beneficiary’s withdrawal power has not lapsed pursuant to the foregoing provisions of this subsection 1.1 shall accumulate and continue to be subject to a power of withdrawal in the beneficiary (including any legal representative acting on behalf of the beneficiary if the beneficiary is under a legal incapacity) pursuant to the provisions of subsection 1.2, below. Any such withdrawable trust accounting income which is not withdrawn by the beneficiary (or by a legal representative acting on behalf of the beneficiary if the beneficiary is under a legal disability) by the end of any calendar year (or by the time of the beneficiary’s death, if earlier) shall be added to the principal of the trust estate.
Why include. Subsection 1.1 is the starting point for creating a trust that will cause the beneficiary to be taxed on the trust’s income, including, potentially, capital gains, but without requiring the trustee to actually distribute the trust income to the beneficiary, which would have the effect of exposing the trust income to lawsuits and estate taxes, including state estate taxes. The subsection is based on IRC Section 678(a)(1).
Note that the beneficiary’s withdrawal power in this subsection excludes federally tax-exempt income, because the high federal trust income tax rates won’t apply to this type of trust income.
The beneficiary’s withdrawal power also lapses at the end of each calendar year, but only to the extent the lapse wouldn’t be treated as a taxable gift under IRC Section 2514(e). Most state laws don’t treat the portion of a power of withdrawal that’s lapsed pursuant to Section 2514(e) as being subject to creditors of the beneficiary.
Contrary to the common belief that the beneficiary will continue to be taxed on trust income attributable to the lapsed portion of the withdrawal power, Section 678(a)(2) clearly provides that this rule only applies in the event the beneficiary has “previously partially released or otherwise modified” their power of withdrawal. A lapse of the power of withdrawal doesn’t rise to the level of a release or modification of the power, which implies some affirmative step on the part of the withdrawal power holder. More importantly, regardless of the position one takes on the “(a)(2) question,” it’s actually good if the beneficiary remains taxed on this portion of the trust’s income, as this is the entire goal of Section 678 planning.
Subsection 1.1 is typically accompanied by trust administration clauses that grant the trustee the power to allocate capital gains and distributions from retirement assets to income for trust accounting purposes and define the term “retirement assets.” Here are two such sample formulations:
Determine Principal and Income. All capital gains and losses and all receipts from retirement assets (as defined below) shall be allocated between trust accounting income and principal by the trustee in a reasonable and impartial manner, in the trustee’s sole discretion, giving due regard to the respective interests of all current and remainder beneficiaries of the trust, including permissible appointees and takers in default under a testamentary power of appointment, and factoring in as one goal the after-tax maximization of wealth to the trust and its beneficiaries.
Retirement Assets. The term “retirement assets” shall mean any asset classified as part of a qualified plan pursuant to Section 401 of the Internal Revenue Code, or any successor section thereto, as part of a nonqualified annuity, as part of an annuity payable under Section 403(a) or 403(b) of the Internal Revenue Code, or any successor sections thereto, as part of an individual retirement account (including a simplified employee pension) pursuant to Section 408 of the Internal Revenue Code, or any successor section thereto, as part of a ROTH IRA pursuant to Section 408A of the Internal Revenue Code, or any successor section thereto, as part of an inherited IRA established by the trustee pursuant to Section 402(c)(11) of the Internal Revenue Code, or any successor section thereto, as part of a retirement plan pursuant to Section 457 of the Internal Revenue Code, or any successor section thereto, or as part of any similar qualified retirement arrangement under the Internal Revenue Code.
Subsection 1.2
Sample language. Subject to the remaining provisions of this subsection 1.2, during the beneficiary’s lifetime the beneficiary (including any legal representative acting on behalf of the beneficiary if the beneficiary is under a legal incapacity) shall have the annual power to withdraw from the principal of the trust an amount equal to all or any portion of the trust accounting income for all previous years of the trust which was has not previously been withdrawn by the beneficiary (either pursuant to the provisions of subsection 1.1, above, or this subsection 1.2) and over which the beneficiary’s withdrawal power has not previously lapsed either pursuant to the provisions of subsection 1.1, above, or this subsection 1.2. The beneficiary’s power of withdrawal under this subsection 1.2 shall lapse at the end of the calendar year (or on the date of the beneficiary’s death, if earlier), but only to the extent the lapse shall not constitute a release of a general power of appointment in the beneficiary pursuant to the provisions of either or both Section 2041(b)(2) and/or 2514(e) of the Internal Revenue Code, or any successor sections thereto in effect during the calendar year, assuming the beneficiary possessed no other similar power of withdrawal which lapses on the same date other than pursuant to the provisions of subsection 1.1, above. The portion of the beneficiary’s withdrawal power under this subsection 1.2, which is not exercised by the beneficiary during the calendar year and which has not lapsed pursuant to the foregoing provisions of this subsection 1.2, shall accumulate and continue to be applicable to the principal of the trust withdrawable by the beneficiary pursuant to the provisions of this subsection 1.2.
Why include. Subsection 1.2 is the so-called “hanging power.” It applies to the portion of the beneficiary’s income withdrawal rights under subsection 1.1 that hasn’t lapsed under that subsection, that is, to avoid annual taxable gifts under the first sentence of IRC Section 2414(e).
Subsection 1.3
Sample language. Satisfactions of any right of withdrawal of the beneficiary pursuant to the provisions of subsections 1.1 and 1.2, above, must be made in cash, although the trustee may liquidate any asset of the trust (including but not limited to by withdrawing retirement assets (as defined above) and other assets which are payable to the trust over time and not yet paid to the trust) in order to generate said cash; PROVIDED, HOWEVER, that the trustee may not utilize current trust accounting income to satisfy the beneficiary’s right of withdrawal under subsection 1.2, above.
Why include. Subsection 1.3 makes clear that the trustee may use any asset of the trust, including the trust’s right to receive IRA and/or Section 401k proceeds, to satisfy the beneficiary’s withdrawal rights under subsections 1.1 and 1.2. This clause is important because it has the effect of minimizing the amount of the beneficiary’s withdrawal power that must “hang” under subsection 1.2. It accomplishes this by maximizing the IRC Section 2514(e)(2) “aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied.”
Subsection 1.4
Sample language. The trustee other than a trustee having any beneficial interest in the trust (other than solely as a contingent taker under ARTICLE __, below) may, in the sole and absolute discretion of said trustee, suspend the beneficiary’s withdrawal power under subsection 1.1 and/or 1.2, above, in whole or in part, by instrument in writing executed by said trustee before January 1 of the calendar year in which such withdrawal power would otherwise exist. Reasons for such suspension may include, but shall not be limited to, overall tax savings for the trust and its beneficiaries (including remainder beneficiaries), creditor protection for the beneficiary, and unwise or immature use of withdrawn funds by the beneficiary. In the event the beneficiary shall have the beneficiary’s aforesaid power of withdrawal suspended, in whole or in part, the trustee other than a trustee having any beneficial interest in the trust (other than solely as a contingent taker, as defined below) may also, in the sole and absolute discretion of said trustee, restore the beneficiary’s withdrawal power under subsection 1.1 and/or 1.2, above, in whole or in part, at any time, by instrument in writing executed by said trustee. The trustee shall be exonerated from any liability for any decision or non-decision under this subsection.
Why include. Subsection 1.4 authorizes an independent trustee to suspend the beneficiary’s withdrawal powers under subsections 1.1 and/or 1.2 if such suspension is in the best interest of the beneficiary. Examples include the immature or unwise use of trust income, creditor attacks and state and local estate tax issues. Any such suspension won’t be effective until the next tax year to avoid potentially running afoul of the Section 678(a)(1) requirement that the beneficiary’s power be “exercisable solely by himself.” If the trust document doesn’t already designate an independent trustee or co-trustee, it should be revised to authorize the appointment of one by the existing trustee or co-trustees.
Section 1.5
Sample language. For tax or other reasons the trustee other than a trustee having any beneficial interest in the trust (other than solely as a contingent taker, as defined below) may, in the sole and absolute discretion of said trustee, assign up to one-half (1/2) of the beneficiary’s future withdrawal powers under subsection 1.1 and/or 1.2, above, to the beneficiary’s spouse who was married to the beneficiary at the time of the surviving grantor’s death and who is still married to the beneficiary, effective January 1 of the following calendar year. For tax or other reasons said trustee may also, in the sole and absolute discretion of said trustee, revoke the subsection 1.1 portion of said assignment by instrument in writing executed by said trustee, effective January 1 of the following calendar year, at which time the beneficiary’s withdrawal powers under subsections 1.1 and 1.2, above, shall be fully restored, the beneficiary’s spouse’s previously-accumulated subsection 1.2 withdrawal power being retained by the beneficiary’s spouse, subject to the terms of said subsection 1.2. In the event of the filing of a petition for divorce or legal separation of the beneficiary and the beneficiary’s spouse, or in the event of the death of the beneficiary’s spouse, the beneficiary’s spouse’s withdrawal power under subsection 1.1 shall terminate on January 1 of the following calendar year (or on the date of the beneficiary’s death, if earlier), at which time the beneficiary’s withdrawal powers under subsection 1.1 and 1.2, above, shall be fully restored, the beneficiary’s spouse’s previously-accumulated subsection 1.2 withdrawal power being retained by the beneficiary’s spouse (or by the beneficiary’s spouse’s personal representative), subject to the terms of said subsection 1.2. In the event of an assignment pursuant to this subsection 1.5, the previous subsections of this Section 1 shall apply to the beneficiary’s spouse as though the beneficiary’s spouse is the “beneficiary” referred to in each of said subsections.
Why include. The problem the SECURE Act has presented is that, in general, trusts must withdraw all the plan participant’s Section 401k or IRA proceeds within 10 years of the participant’s death. This creates a drafting problem when so-called “hanging powers” are included in the trust. See subsection 1.2, above.
Assume, for example, that the decedent’s taxable Section 401k or IRA proceeds are paid out to the trust equally over a 10-year period commencing with the participant’s death, or 10% per year. Because generally only an amount equal to 5% of the trust principal (including, if a provision such as subsection 1.3, above is included, the undistributed portion of the Section 401k or IRA proceeds made payable to the trust) may lapse each year without potential estate and gift tax consequences, the SECURE Act will likely trigger a significant “hanging amount” accumulation over a 10-year period, which would then be subject to potential estate taxes and lawsuits against the withdrawal power holder.
Subsection 5.1 addresses this dilemma by adding a provision to the trust instrument that allows a disinterested trustee to add the trust beneficiary’s spouse as a permissible Section 678 withdrawal power holder of the trust’s income, in appropriate circumstances. By invoking this clause, the maximum annual lapse can double, to 10% per year.