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Document Options to Transfer IRAs to Charities or to CRTs

With the probable return to growth of IRAs during the next decade, there will be a dramatic increase in the number of individuals who choose to bequeath IRAs to charity or to testamentary unitrusts. Some of these persons will transfer an IRA to a unitrust for the life of a spouse. Others will transfer an IRA to a unitrust for a term of years or for the lives of children.

What form is required in the actual documents? In order to create a legal transfer of an IRA, profit sharing or 401(k) account to a charity or charitable trust, certain legal procedures must be followed.

IRA Beneficiary Designation

IRAs and pension plans are transferred through a beneficiary designation. With the fairly rare exception of an IRA transferred to an estate, the IRA is not governed by the will of the IRA owner. Thus, it is very important that the IRA beneficiary designation be accomplished correctly.

Quite often, the IRA owner makes a significant planning decision with little thought given to the consequences of the decision. He or she fills out the standard form of an IRA custodian when rolling over an IRA or rolling a defined contribution plan over into an IRA. The IRA owner enters his or her name, address and Social Security number and then turns the form over and completes the beneficiary designation form. Typically, the beneficiary is first a surviving spouse and if the spouse does not survive, a child or children.

The beneficiary designation forms all allow selection of a designated beneficiary. In addition, there is frequently space for a contingent beneficiary. In most cases, the IRA owner should enter the selected person as designated beneficiary on the form and should also enter the name of a contingent beneficiary. For many persons with charitable inclinations, it could be desirable to select a charity as the contingent beneficiary. For example, an IRA owner could select a spouse or child as designated beneficiary and a favorite charity as contingent beneficiary. Depending upon the income and estate tax rules in effect at the time the person passes away, the designated beneficiary may determine that there would be substantial tax savings by "disclaiming" and allowing the distribution to be made to the contingent charitable recipient.

If an IRA owner decides to benefit a spouse, children or other persons through a testamentary unitrust, he or she must decide how to achieve the desired results. It is not acceptable to merely write a request on the beneficiary form, asking your executor to create a unitrust. The Internal Revenue Service has disallowed charitable estate deductions for such requests, since the unitrust must exist as of the date of death of the decedent. Therefore, it is necessary to create an actual trust document and then to designate the trustee of the trust as the beneficiary of the IRA. For example, a person could create a trust for himself and his spouse and then place on the beneficiary designation section the following sentence, "To ABC Bank as trustee of the charitable remainder trust dated July 4, 2012, for the initial benefit of Mr. and Mrs. IRA owner."

There are three principal ways to draft the unitrust document. The options include a funded charitable remainder unitrust with an addition at the death of the IRA owner, an unfunded unitrust and a revocable trust or will with the required language.

Funded Unitrust

One of the favorable benefits of charitable remainder unitrusts is that an addition can be made at death. In order to do so, there must be a provision in the trust instrument that allows contributions from an estate and requires the contribution to be effective as of the date of death, even though payments may not be made until after full trust funding.

A husband and wife could create and fund a two life unitrust during life. If the husband were to pass away first, his IRA could be added to the unitrust for the benefit of his wife. The IRA beneficiary form would merely designate the trustee as recipient under provisions of the charitable remainder unitrust.

A parent or couple with children could create a trust for one life plus a term of years or two lives plus a term of years. A one or two-life plus term trust is permissible if all recipients are named and living when the trust is created and there is a termination provision that requires the trust to terminate if all named beneficiaries pass away prior to the expiration of the term of years. For example, a unitrust for husband, wife and three children for two lives plus 20 years is in effect a trust for the lesser of the five lives or the period of two lives plus 20 years. Note that if children are named as beneficiaries, the Sec. 2056(b)(8) marital deduction will not apply. With community property or joint tenancy assets, one-half of the remaining income interest is included in each taxable estate. However, if one spouse contributes separate property to the trust, under the consideration-furnished rules the income interest will be included in his or her estate.

With a one or two life plus term of years trust, the parent or couple may receive unitrust income distributions during life. For a married couple, the survivor will be the IRA beneficiary and will receive normal IRA distributions for his or her lifetime, plus the income payouts from the unitrust. After both parents pass away, the IRA designated beneficiary is once again the trustee of the trust. This trustee will then receive the IRA distribution, add the IRA proceeds to the unitrust and make payments to children for the term of years.

When the IRA is transferred to the trust, the IRA is terminated and the trust receives the distribution from the IRA. In nearly all cases, an IRA represents 100% untaxed ordinary income and the entire IRA distribution will be allocated to the tier-one ordinary income layer. Thus, distributions to children will be ordinary income. However, since the unitrust is tax-exempt, the full value of the IRA will be available to earn the new income for children.

With a funded unitrust, an addition may also be made from a profit sharing or 401(k) account. However, in this case a spouse must sign a consent form for the beneficiary designation. As a practical matter, since spouses may either live in or move to a community property state, it is good practice for both spouses to sign consents to the plan to create a charitable trust that will later receive IRA or other deferred compensation distributions.

Creating a funded unitrust will require normal trust administration and accounting services. The trustee must invest and manage the trust corpus, do the four-tier trust accounting, make the correct payments to the income recipients and file the annual IRS Form 5227.

Unfunded Unitrust

Some individuals desire to create a plan for transfer of an IRA to a charitable remainder trust, but do not want to fund and administer the trust during life. In the prior example, the person or IRA owner typically has an appreciated asset and would like to create and operate the trust during life. However, for the person who does not wish to operate the trust during life, but would prefer that the unitrust is available to receive the distribution from an IRA, an unfunded unitrust may be created.

Under the laws of some states, it is permissible to create a trust with no or nominal funding. For example, in California, an unfunded trust is valid under state law. The IRA owner may easily sign an unfunded trust and select the trustee as the IRA beneficiary. In other states, the applicable trust law may require funding of $10 or $20. In those states, the typical practice is to create and sign a trust and staple a $10 or $20 bill to the trust instrument.

This unfunded trust has the advantage of validity under state law, but does not require administration under federal statutes until it is funded at the death of the IRA owner. Since no investment or activity is required, Treasury has not objected to this practice. In order to achieve this objective, it is quite important that the trust be structured as a net income trust, net income plus makeup trust or FLIP unitrust. Most counsel also would require capital gain to be allocated to income. Although the income paid to children will be ordinary income under the Sec. 664 four-tier structure, the allocation of capital gain to distributable amounts gives the trustee flexibility in selecting trust investments.

An unfunded unitrust may be a two life unitrust, or could be a one or two life plus term of years trust. The trust should be created prior to signing the beneficiary designation form and filing it with the IRA custodian.

Example A – Unfunded Testamentary Unitrust

UT Beneficiary Designation By IRA Owner
UT, Balance to Spouse or Charitable Bequest

Name: IRA Owner
Address
City, State, Zip

Account Designated Beneficiary For IRA #12345 With Custodian ______________________, City, State Zip Code.

The Designated Beneficiaries of the above IRA shall be as follows:

1. A fractional interest in the above IRA with the Numerator of $500,000 and the Denominator the account balance on the date of my death shall be distributed to IRA Unitrust #1 dated Nov. 2, 2011, with Mrs. IRA Owner as Trustee and Beneficiary and IRA Child as Successor Trustee and unitrust beneficiary.

2. If my spouse Mrs. IRA Owner shall survive me, then the designated beneficiary of any remaining balance of the IRA after the distributions to IRA Unitrust #1 shall be Mrs. IRA Owner.

3. If my spouse Mrs. IRA Owner shall not survive me, then any remaining balance of the IRA after the distributions to IRA Unitrust #1 shall be distributed to Qualified Exempt Charity of City and State.

I hereby acknowledge this to be my Statement of Designated Beneficiaries for IRA #12345, and understand that this designation requires consent of my spouse Mrs. IRA Owner.

_______________________________________________Date_______________
          Name, IRA Owner

Consent of IRA Owner Spouse, Mrs. IRA Owner

I hereby voluntarily and irrevocably Consent to this Statement of Designated Beneficiaries for IRA #12345, understand that beneficiaries other than myself may receive benefits from this IRA and waive any community property or marital interests in this IRA.

_______________________________________________ Date_______________
          Mrs. IRA Owner, Spouse of IRA Owner

(Editor's Note: Bypass IRA Unitrust #1 is a two or more lives unfunded unitrust created during life by IRA Owner. After IRA Owner passes away, Unitrust #1 is funded. Because Unitrust #1 is tax exempt and there is no unrelated business taxable income from the IRA payout, the potential income tax on the $500,000 is avoided and the full value is available to earn income for the lives of Mrs. IRA and IRA Child or Children. The Unitrust distribution uses part of the applicable exclusion amount, and part of the value qualifies for a charitable estate deduction. The balance of the IRA qualifies either for a marital deduction if spouse survives, or a charitable deduction if spouse does not survive. Because the unitrust will benefit charities and other persons than the spouse, Mrs. IRA owner must consent to the beneficiary designation.)

Example B – Unfunded Unitrust For Children

Beneficiary Designation By IRA Owner
Balance to Spouse or Unitrust

Name: IRA Owner
Address
City, State, Zip

Account Designated Beneficiary For IRA #12345 With Custodian ______________________, City, State Zip Code.

The Designated Beneficiaries of the above IRA shall be as follows:

1. If my spouse Mrs. IRA Owner shall survive me, then the designated beneficiary of this IRA shall be Mrs. IRA Owner.

2. If my spouse Mrs. IRA Owner shall not survive me, then a fractional interest in the above IRA with the Numerator of $500,000 and Denominator of the account balance on the date of my death shall be distributed to IRA Unitrust #2 dated Nov. 2, 2011, with IRA Child1 as Successor Trustee and unitrust beneficiary.

3. If my spouse Mrs. IRA Owner shall not survive me, then the balance of the IRA in excess of the distribution to IRA Unitrust #2 shall be distributed to IRA Unitrust #3 dated Nov. 2, 2007, with IRA Child2 as Successor Trustee and unitrust beneficiary.

I hereby acknowledge this to be my Statement of Designated Beneficiaries for IRA #12345.

_______________________________________________ Date_______________
Name, IRA Owner

Revocable Trust or Will

The final option for documentation is to include a trust document in a revocable trust or a will. The trust will generally be a one life trust for a spouse, a term of years trust for children or a one life trust for a child. It should be clearly identified within the revocable trust or will as a separate charitable remainder unitrust effective only at the death of the testator or trust grantor. It should have a specific number or Article designation.

After the living trust or will document has been signed by the trust grantor or the testator, it is then possible to designate that testamentary trust as the beneficiary of the IRA. The beneficiary designation could be similar to the following: "To ABC Bank as trustee of the charitable remainder unitrust for child A, identified as 'Article H' in the Mary Jones living trust dated July 4, 2012." The designation for a will could use comparable language.

IRA beneficiary designations could potentially affect the transfer of several trillion dollars worth of assets in pension plans. Given the magnitude of the sums involved, it is very important for attorneys, CPAs and gift planners discussing these options with clients to make certain that the beneficiary designation is done correctly. With the significant numbers of dollars involved, if the designation is not done correctly, the probability is high that a distant relative will petition the probate court and have the designation declared void. This adverse result could cause unnecessary payment of substantial income and estate taxes, as well as disruption of the IRA owner's distribution plan.

On the other hand, if the beneficiary designation and trust drafting is done correctly, there can be excellent benefits for both family and charity. With over $10 trillion in IRAs, 401Ks, retirement plans and other income in respect of a decedent, all tax advisors will benefit from understanding the substantial savings of a correct beneficiary designation to spouse, charity or a charitable remainder unitrust.