Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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income tax deduction is limited to the amount of the trust’s distributable net income or DNI, so this is usually called the “DNI deduction.” § 651 , § 661 . If the trust’s income resulting from retirement plan distributions can be passed out to the individual beneficiaries of the trust as part of DNI, the income tax burden is shifted to the individual beneficiaries, and overall income taxes will be lowered if those beneficiaries are in a lower tax bracket than the trust. Unfortunately, the DNI deduction is not as simple as some practitioners might wish. First the good news: Retirement plan distributions received by a trust, like other items of IRD, become part of the trust’s DNI. See definition of DNI at § 643(a) ; Reg. § 1.663(c)-5 , Examples 6 and 9; and CCA 2006-44016. Accordingly, distributions of such IRD are eligible for the DNI deduction when passed out to the trust beneficiary, and are includible in the beneficiary’s income. § 661(a) ; § 662(a)(2) ; Reg. § 1.662(a)-3 . Even though IRD, like capital gain, is a form of gross income that is usually allocated to “principal” for trust accounting purposes ( ¶ 6.1.02 ), IRD is not subject to the special rules that limit a trustee’s ability to pass out capital gain as part of DNI. IRD goes straight into DNI just as interest and other “ordinary income” items do. CCA 2006-44016. In contrast, capital gains are not included in DNI (and accordingly cannot be passed through to the trust beneficiary) unless various tests are met. Reg. § 1.643(a)-3(a) , (b) . Now the bad news: The mere fact that a trustee receives a retirement plan distribution and later makes a distribution to a trust beneficiary does not automatically mean that the distribution to the beneficiary carries with it the gross income arising from the retirement plan distribution. The trust might still be liable for the income tax on the retirement plan distribution it received. The question is (in trust administration lingo) whether such distribution “carries out DNI.” Here are the six hurdles the trustee must clear in order for the trust’s distribution of IRD to carry out the income tax burden to the trust beneficiary as part of DNI: A. Trust must authorize the distribution. The DNI deduction will not be available unless the beneficiary is entitled to receive the money; thus, obtaining this deduction requires attention at the trust drafting stage. See ¶ 6.5.03 . B. Income must be required to be, or must actually be, distributed, in year received. The DNI deduction is available only for gross income that either is required to be distributed, or is actually distributed, to the individual beneficiary in the same taxable year it is received by the trust (or within 65 days after the end of such taxable year, if the trustee elects under § 663(b) to have such distribution treated as made during such taxable year). § 651(a) , § 661(a) . Thus, in the case of discretionary distributions, the trustee must take action prior to the deadline; if no one considers the problem until it is time to prepare the trust’s tax return, it will be too late. C. Allocation of DNI when separate share rule applies. If there are two or more beneficiaries, and they have “substantially separate and independent shares,” a distribution to one beneficiary will not carry out DNI that is allocated under the “separate share” rule to a different beneficiary. See ¶ 6.5.05 – ¶ 6.5.06 for how this rule applies to retirement benefits. D. Transfer of the plan does not carry out DNI. Though a distribution from a retirement plan to a trust is IRD, and becomes part of DNI, the retirement plan itself, which is a “right