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For those estate planners who represent married clients, the unlimited marital deduction is of paramount importance. In this age of uncertainty as to the size of the unified credit for estate taxes, or even as to whether the estate tax will continue past 2009 in its present form, the marital deduction, allowable under Sec. 2056 of the Internal Revenue Code ("Code"), is perhaps one of the most important and certainly most "client pleasing" tools in our planner's toolbox.

Recently issued, Revenue Ruling 2006-26 is of critical importance in obtaining a marital deduction for amounts held in an IRA or other defined contribution plan when the beneficiary of the IRA (or other plan, trust or account) is the Trustee of the QTIP trust rather than the surviving spouse. While Revenue Ruling 2006-26 is focused upon the client designating the Trustee of a QTIP trust as the beneficiary of an IRA, it is worth noting from the beginning that in almost every situation, designating the surviving spouse as the outright beneficiary of the IRA will have a better income tax result. For example, assume that the surviving spouse is the outright beneficiary and the surviving spouse rolls the proceeds from that IRA (or other defined contribution plan) into his or her own IRA. In that instance, the survivor can have Required Minimum Distributions determined using the "recalculated life expectancy tables" thereby minimizing the Required Minimum Distributions. Nevertheless, there are many situations in which the client decides that he or she must make the IRA payable to the Trustee of a QTIP trust, and that situation is the focus of this article.

Within Wealth Transfer Planning's SmartContent^SM in the Will, Revocable Trust and Joint Revocable Trust, the authors have modified the language to specifically comply both with the direct holdings of Rev. Rul. 2006-26 and with the assumptions that the Service makes to reach those holdings.

Overview

Four factors come together to make Revenue Rule 2006-26 important to every estate planner.

First, the unlimited marital deduction, enacted in 1982, allows virtually every estate to defer tax until the death of the survivor of Husband and Wife.

Second, the "QTIP" exception to the terminable interest rule, through Code sec. 2056(b) (7), allows what would otherwise be a non-deductible terminable interest to nevertheless qualify for the marital deduction. Many initially thought of a QTIP trust as a strategy for second and later marriages, where the grantor needed assurance that the marital deduction property would pass at the surviving spouse's death to the grantor's intended beneficiaries—rather than pursuant to the exercise of a previously required general power of appointment in the surviving spouse. However, the QTIP trust has become the standard planning tool even for first marriages anticipating and addressing the possibility of a later marriage following the grantor's death. A QTIP trust for the surviving spouse may provide significant asset protection from creditors claims for the surviving spouse.

Third, more and more couples have substantial wealth tied up in various tax exempt qualified plans, such as IRAs, 401ks, and various other defined contribution plans.

Fourth, the Uniform Principal and Income Act (the "UPIA") rules relating to the determination of income versus principal, both for assets within a trust and for assets received from another trust, have reached widespread adoption, introducing a new variable to the mix. This determination in turn affects what will be distributed (as income versus principal) and the characterization of what is distributed—that is, whether the beneficiary received income or principal.

Herein we focus upon the drafting provisions needed to obtain a marital deduction when an IRA (or other qualified retirement plan that is described in 4974(c) of the Code that is a defined contribution plan) is payable to the Trustee of a QTIP trust for the benefit of the surviving spouse. The previous pronouncement on this subject, Rev. Rul. 2000-2, is superseded by Rev. Rul. 2006-26, but in a manner which affirms and expands the core holding of Rev. Rul. 2000-2.

Our conclusion, as reflected herein and as automatically produced in the provisions of the Will, Revocable Trust and Joint Revocable Trust for those estate planning lawyers who use the Wealth Transfer Planning SmartContent^SM drafting system, is that you cannot rely exclusively upon the provisions of the UPIA and an otherwise qualifying QTIP trust to obtain a marital deduction for the assets held in the decedent's IRA which is payable to the Trustee of the QTIP trust. Instead, specific and detailed provisions conforming to the requirements of Code sec. 2056, as detailed in Rev. Rul. 2006-26, must be included. While Rev. Rul. 2006-26 focuses upon an IRA, and we shall so focus herein, the requirements are equally applicable to every qualified retirement plan described in section 4974(c) that is a defined contribution plan. For the purpose of this Article, we shall refer to all such plans simply as an IRA.

State Laws Considered

Rev. Rul. 2006-26 considered the laws of three hypothetical states, dividing those state laws into three independently described fact situations. As discussed below, without specific non-UPIA language included in the Will, Revocable Trust or Joint Revocable Trust (collectively "the governing instrument") no marital deduction would be available with respect to the IRA at issue for any one of the three hypothetical state law situations.

The governing instrument contained several important provisions, which collectively were critical to the allowance of the marital deduction. These were:

The QTIP trust under the governing instrument and the IRA which was payable to the Trustee of that QTIP trust were to be considered as separate marital deduction trusts for purposes of allocating income and principal and determining whether each qualified for the estate tax marital deduction;
The surviving spouse (herein "SS") had the right to require that the assets of both the QTIP trust and the IRA would be made reasonably productive of income;
It was clear, either under the governing instrument or state law, that the determination of income and principal for the QTIP trust and for the IRA are made completely independently of each other; and
The SS had the absolute right annually to require (a) that the Trustee of the QTIP trust withdraw all of the income from the IRA and (b) that all of that withdrawn income immediately be distributed to the SS.

Situation 1

Under situation 1, the law of state X contained provisions similar to §§104(a), 409(c) and 409(d) of UPIA. By way of background, §104(a) of UPIA provides that under certain circumstances the Trustee is authorized to make adjustments between income and principal to fulfill the Trustee's duty of impartiality between the income and remainder beneficiaries. This is known as a "power to adjust." The revenue ruling makes clear that this determination, made separately as to the IRA and as to the QTIP trust itself, constitutes a reasonable apportionment of the income and principal under both Reg. § 20.2056(b)-(5)(f)(1) and Reg. §1-643(b)-1. This means that a sufficient level of income is generated to allow the IRA and the QTIP trust to qualify for the marital deduction.

However, state X's enactment of UPIA §§409(c) and (d) does not fare so well in the Service's view. §409(c) provides that if no part of the payment from a "retirement" plan is characterized as interest, dividend, or an equivalent payment, and all or any part of the payment is required to be distributed currently, then the receiving trustee must allocate 10% of the payment to income and 90% to principal. If no part of the payment is required to be paid currently, then all of the payment must be allocated to principal. Of course, these required classifications bear no relationship to the actual income of the IRA for that year, and the ruling was clear that this provision satisfies neither Reg. §20.2056(b)-(5)(f)(1) nor Reg. §1-643(b)-1 and as a result the IRA, payable to the Trustee of the QTIP trust, will not qualify for the marital deduction.

Recognizing the potential problem, UPIA §409(d) (and the corresponding law of state X) requires an additional allocation to income if necessary to qualify for the marital deduction. Here, the Service was somewhat ambiguous, stating that this may not qualify the arrangement for the marital deduction, citing authority both for the proposition that savings clauses may be used to determine intent, and for the proposition that a savings clause is ineffective to reform an instrument for Federal estate tax purposes.

In considering the effect of UPIA §409(d) (which the Service did not have to determine, as noted below), it seems important to remember that even if UPIA §409(d) is effective to require that the entire distribution be allocated to income, that is still not enough to assure that the SS will in fact annually receive, or be entitled to demand, all of the income from the IRA. The required minimum distribution ("RMD") for any particular year of the IRA may or may not be equal to the income of the IRA for that year. Simply put, the determination of the RMD from an IRA for a particular year is unrelated to the amount of income produced by that IRA for that year. Thus, the annual income requirement under Code sec. 2056 is simply not met under the combination of §409(c) and §409(d).

Of course, Rev. Rul. 2006-26 did not have to directly address and make a definitive determination of these issues, since as noted above, the governing instrument itself gave the SS the independent right to demand annually that the Trustee of the QTIP trust withdraw all of the income of the IRA and distribute it directly to the SS. As noted below, and as incorporated into the current Wealth Transfer Planning SmartContent^SM for the Will, Revocable Trust and Joint Revocable Trust, this right of withdrawal is critical to the success of the marital deduction in these matters.

Situation 2

Situation 2 considers the laws of hypothetical state Y, pursuant to which all beneficiaries had agreed that the Trustee could determine the income of the QTIP trust and the income of the IRA (separately) to be 4% of the current fair market value of the QTIP trust and the IRA, respectively. Thus, the Trustee of the QTIP distributed a 4% unitrust percentage from the QTIP trust to the SS each year.

Although the manner of the determination of the income of the IRA was determined to be reasonable, it was the right of the SS to demand that the Trustee withdraw the income of the IRA and distribute it to the SS that provided the key to the allowance of the marital deduction. For without that power, even though the income of the IRA was reasonably determined under the unitrust conversion effected under state law, the SS still would not have had the right to all of the income from the IRA on an annual or more frequent basis.

Situation 3

Situation 3 considers the laws of hypothetical state Z, which had not enacted the UPIA. Thus, state X required determination of income and principal under traditional state law rules, without power (as described in §104(a) of UPIA) to reallocate between income and principal based upon issues of impartiality. The ruling again stressed that the income of the IRA and the income of the QTIP would be determined separately.

As in situations 1 and 2 above, the power of the SS to demand annually that the Trustee withdraw and distribute all of the income of the IRA saved the marital deduction with respect to the IRA. Without that right, although income and principal might be correctly determined for both the QTIP trust and the IRA, there would be no way for the SS to be assured of the right to at least annually receive all of the income of the IRA.

Ruling Summary

The focus of this revenue ruling is the circumstances under which a marital deduction will be allowed for an IRA, the beneficiary of which is the Trustee of a QTIP trust. To understand the ruling, it is helpful to divide the relevant questions concerning allowance of the marital deduction into two separate questions. First, there is the question of determination of a reasonable level of income. Under state law, the income of the IRA and the QTIP trust must be separately determined in a reasonable manner. On this issue, the ruling acknowledges that each of the three methods, (a) adjustment under UPIA §104(c), (b) determination on a unitrust basis, and (c) determination using traditional state law, could produce a sufficient amount of income to support the marital deduction.

However, the question of whether state law appropriately determines the amount of income inside the IRA is only the first question. The second question is whether, under the governing instrument, the SS has the unqualified right, at least annually, to demand that the Trustee of the QTIP trust (the beneficiary of the IRA) withdraw all of the income of the IRA and distribute that income to the SS.

Drafting Considerations

Ultimately, the allowance of the marital deduction comes down to adequate drafting. To accomplish this we suggest the following actions—all of which are implemented in the appropriate Wealth Transfer Planning's SmartContent^SM documents.

Include language clearly giving the SS the requisite power to demand the income. The language might read something like the following:

My spouse shall have the power, exercisable annually, to compel the Trustee to withdraw from the plan, trust or account an amount equal to all the income of that plan, trust or account for the year and to distribute that income to my spouse.

In addition, the prudent drafting lawyer may wish to include specific language concerning the obligation of the Trustee of the QTIP trust to withdraw (a) the greater of the income of the IRA and the RMD if the SS exercises the right to demand the income of the IRA for that year, and (b) the RMD only in those years in which that right to demand the income is not exercised. Further, for years in which the right to demand the income of the IRA is not exercised by the SS, the estate planner should consider a specific override of UPIA §409(c), so that the Trustee of the QTIP trust allocates to income that portion of the RMD (up to all) which is equal to the previously undistributed income of the IRA, with any excess RMD allocated to principal.

Include language to be clear that income, as defined in §643(b) of the Code, is to be determined separately as to the IRA and as to the QTIP trust.
Include language clarifying that the right of the SS to require that the Trustee make property productive is applicable both to the QTIP trust and to the IRA.

Additional Consideration Concerning SS's Right to Withdraw

Rev. Rul. 2006-26 contemplates that the SS will have the "right" to demand that the Trustee of the QTIP trust withdraw and distribute all of the income of the IRA each year. Rev. Rul. 2006-26 also expressly approves the alternative structure in which, as described in Rev. Rul. 89-89, all income of the IRA must be distributed to the SS on an annual basis. However, annual distribution of income, even if not required under the RMD rules, is usually not directed by estate planning lawyers. The preference instead is to merely give the SS the right to demand the income, because a typical planning goal is to leave all assets in the IRA as long as possible so they can grow tax deferred. Of course, the rules are different with respect to a Roth IRA because distributions from a Roth IRA are income tax free.

The strategy of not withdrawing all of the income unless mandated by the RMD rules may create complications where the QTIP trust is a "Reverse QTIP" (one in which the first decedent remains the grantor for generation skipping tax purposes, "GST"). Leaving income in the IRA, where it may be eventually distributed to the QTIP trust for the benefit of a successor beneficiary, may mean that the SS would become a grantor for GST purposes as to a portion of the Reverse QTIP. Whether or not to mandate the distribution of the income is probably a balancing decision, taking into account the income tax consequences of an unnecessary early distribution and the potential problems of not distributing all of the IRA property to which the SS is entitled.

Conclusion

Revenue Ruling 2006-26 clarifies the application of §§104(c), §409(c) and 409(d) of the UPIA, giving comfort as to the issues of determination of income and principal. It reaffirms and extends the requirements of Rev. Rul. 2000-2, providing that the UPIA provisions will not take the place of proper drafting Will or Trust Agreement creating the QTIP trust. Prudent estate planners are well advised to study the ruling and carefully apply it to their drafting.

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