Life and Death Planning for Retirement Benefits

Chapter 6: Leaving Retirement Benefits in Trust

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Scenario 2: Alternatively, if Jody’s trust requires that each beneficiary receive an equal share of each asset; or if the trust is silent on that topic but applicable state law requires such pro rata funding of the beneficiaries’ shares; the separate share rule will require that the DNI resulting from the retirement plan distribution be allocated equally to Brad’s and Angelina’s shares. Thus, under Scenario 2, even though the trust distributed $1 million to Angelina, the trust’s income tax deduction is only $500,000, and Angelina includes only that much in her gross income for Year 1. The trust will have taxable income of $500,000 for Year 1. This is the fair result the separate share rule was designed to bring about: Under a trust where the beneficiaries “own” fractional shares, no one beneficiary bears a disproportionate share of income tax just because he Allocation Respected Despite No Economic Effect Under the regulation, a trust instrument’s allocation of an IRD-corpus item to a particular beneficiary’s share is given effect for income tax purposes even if such allocation has no independent economic effect ( i.e., it does not change the amount each beneficiary receives, it affects only the taxability of what each beneficiary receives). In other contexts, the regulations give effect to the allocation of a particular class of income to one beneficiary or another “only to the extent that it has an economic effect independent of the income tax consequences of the allocation.” See Reg. § 1.652(b)-2(b) and Prop. Reg. § 1.643(a)-5(b) , discussed at ¶ 7.4.03 (E). Scenario 3: Continuing the Jody Example from ¶ 6.5.05 , suppose Jody’s trust provides that “The Trustee shall not be obligated to allocate each asset equally to the two shares, but rather may allocate different assets to each child’s share, provided that the total amount allocated to each child’s share is equal.” The trust thus authorizes discretionary pick-and-choose (non-pro rata) funding. The trustee has exercised its authority to choose which assets to use to fund each beneficiary’s share: The trustee, in proper exercise of its discretion, allocated the entire $1 million 401(k) plan distribution to Angelina’s share. Does this enable the trustee to deduct the entire distribution as DNI? Probably not. Though other interpretations are possible, the usual interpretation of the regulation is that, since the trustee could have elected to fund either beneficiary’s share of the trust with the IRD, the trustee must (in computing its taxable income and DNI) allocate the IRD equally to the two shares. Under this interpretation, discretionary pick-and-choose funding generally produces the same result as mandatory pro rata funding (see exceptions below). If the trustee of a trust that (1) is subject to the separate share rule and (2) permits discretionary pick-and-choose funding wants the gross income arising from a retirement plan to be allocated disproportionately, there are two ways to avoid the separate share rule and its apparently-mandatory pro rata allocation of IRD-corpus, assuming these techniques can be used consistent with the fiduciary’s obligations to all trust beneficiaries: happened to receive more distributions in a particular year. 6.5.06 IRD, separate shares, and discretionary funding