IRS Issues Two Seemingly Contradictory Rulings on Effects of Transfer of IRA to Special Needs ''Grantor'' Trust

By Deborah M. Beers, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

PLR 201116005 

In PLR 201116005, the IRS ruled that a proposed transfer of inherited IRAs to a special needs trust will not cause recognition of income in respect of a decedent (IRD) by the beneficiary, reasoning that, because the special needs trust was a grantor trust for income tax purposes, its assets are deemed to be owned by the beneficiary. Within a short period of time, perhaps a week (based on the IRS's PLR numbering system) of releasing that ruling, however, the IRS, in PLR 201117042 (see below), appeared to agree with the premise that the transfer of a Taxpayer's own (not inherited) IRA to a similar trust was taxable.

Generally, under §691, certain items of income that would have been taxable to a decedent had he or she received them while alive are treated as IRD and included in income when received post-death by the decedent's estate, legatee or beneficiary. Amounts held in an IRA account (less any previously nondeductible contributions) are items of income that would have been taxable to the decedent, and, thus, are IRD assets. However, the transmission at death of an IRD asset to a person "pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent" does not trigger the acceleration of income or gain inherent in the IRD asset.

However, if the right to receive an IRD amount is transferred (by sale, exchange or other disposition) by a person who received such right upon the death of the decedent or by bequest, devise, or inheritance from the decedent, that transferor must include in income at the time of the transfer the fair market value of such right, plus the amount by which any consideration for the transfer exceeds such fair market value.

PLR 201116005 applies the foregoing rules to a situation in which the designated beneficiary ("Beneficiary") of inherited IRA accounts transfers the IRAs to a newly established IRA for the benefit of a "special needs trust."

The facts state that Beneficiary is disabled and eligible to receive public benefits. Beneficiary's father ("Account Owner") died owning two individual retirement accounts (IRAs) of which Beneficiary and Beneficiary's siblings are the designated beneficiaries. Beneficiary proposes to transfer his share of the IRAs to a newly established IRA benefitting "Trust" - which is intended to be a special needs trust - and the beneficiaries thereof.

The terms of Trust provide that Beneficiary is the sole beneficiary of Trust during Beneficiary's lifetime. Distributions of income and principal for the benefit of Taxpayer are totally within the discretion of the trustee during Beneficiary's lifetime. These and other provisions, in effect, established a "special needs trust," a type of trust that may not be used to reduce Beneficiary's entitlement to government benefits during his lifetime.

Applying the principles set forth above, the IRS explained that, generally under §691(a)(2), the transfer of an IRD item by a beneficiary would cause the inclusion of the fair market value of such right in the income of the beneficiary for the taxable period in which the transfer occurred - in this case accelerating the income from the IRA. However, the IRS ruled that Beneficiary would not recognize income on the transfer of the inherited IRAs to Trust because Trust was a grantor trust with respect to Beneficiary under §677(a) (regarding income distributable for the benefit of the grantor). Because Trust was a grantor trust with respect to Beneficiary, his proposed transfer of the inherited IRAs to Trust - essentially a (disregarded) transfer to himself1 - will not be a transfer that triggers the acceleration of income for purposes of §691(a)(2).

The ruling is premised on an assumption that Beneficiary's transfer to Trust "is not a gift by [Beneficiary]." This statement seemingly implies that a gift to a third party would take the transfer out of the ambit of the grantor trust rules for IRD purposes. We note, however, that the existence of a gift to a grantor trust would, in most cases, have no impact on the income tax status of the trust, so that this statement is puzzling to say the least.

PLR 201117042 

Perhaps more puzzling than the "gift" reference, however, is that fact that, the IRS - one week later - in PLR 201117042 - appeared to accept a financial institution's characterization of the transfer of a taxpayer's own (not inherited) IRA to a special needs grantor trust established for his benefit as a taxable distribution.2 

In that ruling, "Taxpayer" was diagnosed as having muscular dystrophy, and had been determined to be disabled by the Social Security Administration and thus eligible to receive Medicaid and other public benefits. Taxpayer was the owner of "IRA X," which had been established by him for his own benefit prior to his illness.

A State court authorized the creation of a trust for the Taxpayer's benefit, which was intended to qualify as a "special needs trust" under state and federal law. This trust would have had terms very similar to the trust in PLR 201116005 and would similarly have been categorized as a grantor trust. The court ordered that an amount equal to the balance of IRA X should be placed in the trust for Taxpayer's benefit. Taxpayer's mother was the trustee of the special needs trust.

Taxpayer and his mother, as trustee, upon the advice of their financial advisor, signed the paperwork to transfer the amounts held in IRA X to the trust. The IRA custodian, however, denied Taxpayer's request to set up an IRA in the name of the trust and instead deposited the IRA proceeds in a non-IRA trust account.  The custodian treated that transfer, on a Form 1099 issued to Taxpayer, as a taxable distribution from the IRA "because an IRA cannot be set up and maintained in the name of a trust."

Taxpayer eventually was required to rollover the funds held in the non-IRA trust to an IRA in his own name in order to maintain the funds as an IRA. At issue in the ruling was a waiver of the 60-day period that normally applies to the rollover of a distribution from an IRA.

While the IRS waived the 60-day rollover requirement (because Taxpayer was acting on erroneous advice from a financial advisor), it accepted the underlying premise of the necessity for the ruling, i.e., that an IRA cannot be maintained in the name of a trust - even a grantor trust. The ruling thus states:"Company N, the financial institution which accomplished the transfer, correctly noted that an individual retirement account cannot be set up and maintained in the name of a trust, and appropriately issued a federal Form 1099 treating the … transfer as a taxable distribution."3 

The difference in the outcome of the two rulings is difficult to explain. It is possible that the IRS regards the transfer of an inherited IRA to a grantor trust as being essentially different from the transfer of a taxpayer's own IRA to a grantor trust.  Or, it is possible that the IRS, in the second ruling, did not even consider whether the trust in question was a grantor trust - certainly neither the taxpayer, his advisors, nor his financial institution appears to have brought it up. Finally, the difference may be accounted for simply by the fact that PLR 201116005 was issued by the "Passthroughs and Special Industries" Branch, which may be expected to have more familiarity with trusts, while PLR 201117042 was issued by the Employee Plans Branch.

For more information, in the Tax Management Portfolios, see Acker, 862 T.M., Income in Respect of a Decedent,  and in Tax Practice Series, see ¶6150, Income in Respect of a Decedent. 

1 See Rev. Rul. 85-13, 1985-1 C.B. 184.

2 Note that the IRS has issued at least two other private letter rulings according nontaxable treatment to the transfer of an inherited IRA to a grantor trust. See PLR 200620025 and PLR 200826008.

3 Emphasis supplied.