Determining whether IRA distributions to a trust are income or principal.

• Author: Moore, Philip E.

Trusts have become standard entities used in estate planning. IRAs are often a major asset in taxpayers' estates. The combination of these two facts makes it inevitable that taxpayers will increasingly name trusts as their IRA beneficiaries.

Once a trust is the beneficiary of an IRA and distributions begin, it is necessary to determine, for fiduciary accounting purposes, how much of the distribution is income and how much is principal. The IRA's value as of the date of the IRA owner's death, when the trust becomes the beneficiary, is principal for this purpose. This allocation of the IRA distribution proceeds between income and principal is important in determining how much an income beneficiary receives versus how much a remainderman receives, and also in determining who is responsible for paying the income tax on the distribution.

In the context of a trust, there is a distinction between "accounting income" and "taxable income." Accounting income is determined by the trust instrument or by state law, and quantifies the amount a trustee is required (or allowed) to distribute to income beneficiaries. Taxable income of a trust includes trust receipts subject to income tax. A distribution from an IRA receives different treatment, depending on whether it is accounting income or taxable income. Because the entire distribution is treated as income in respect of a decedent for income tax purposes (in a traditional deductible IRA), the entire distribution will be treated as taxable income. On the other hand, the distribution is likely to consist of both income and principal for trust accounting purposes.

Generally, accounting income is important for ensuring that a trust qualifies for the purposes for which it was established. For instance, in a qualified terminable interest property trust, all income requires distribution, at least annually. Or, in the case of a credit shelter trust, the income often is to be distributed to the spouse. In both these cases, the income referred to is accounting income. It is unlikely that an entire IRA distribution will have to be distributed to the income beneficiaries to meet the terms of these trusts.

How does a trustee determine income and principal? The primary source of guidance is the trust document. Properly drafted, the document can be relied on to allocate receipts between income and principal. Therefore, if a practitioner is involved in the estate planning process and knows that a trust will be named as...