What NOT To Transfer into a Trust
If you have a revocable living trust prepared by estate planning attorney Vince Taormina of The Taormina Firm, you should know which of your assets should NOT be transferred into the trust.
Many of my estate planning clients ask me which of their assets should be transferred into their newly created Revocable Living Trust. While I provide them with plenty of resources to help transfer those assets, the reason behind transferring certain assets into trust, and leaving some out of the trust, are never really explored. So, in this blog post, I want to highlight a few different assets that should absolutely not be transferred to a revocable living trust.
- IRAs (traditional or Roth)
To receive the benefit of an inherited Individual Retirement Account ("IRA"), one must be a "designated beneficiary." The Internal Revenue Code ("IRC") defines a "designated beneficiary" as any individual designated to receive a distribution from the IRA after the death of the IRA owner. In other words, an entity, such as a revocable living trust, cannot be considered a "designated beneficiary" for IRA purposes.
However, there is an exception to this rule. A trust may be treated as a "designated beneficiary" for IRA purposes if certain conditions are met. This type of trust is called a "see through" trust. To qualify as a "see through" trust for Required Minimum Distribution ("RMD") rules, the following requirements must be satisfied: (1) the trust must be valid; (2) the trust must be irrevocable at death; and (3) the trust beneficiaries must be identifiable.
The problem with "see through" trusts is the third requirement above. In many circumstances, it may be difficult to determine who the trust's beneficiaries are. While the recently passed SECURE Act eliminates stretch-out distributions and imposes a strict 10-year rule for RMDs, thus negating the old rule that stretch-IRAs be determined by the life expectancy of the oldest "designated beneficiary," it is still difficult to qualify as a "see through" trust because successor and contingent beneficiaries are difficult to identify.
For example, A names his trust as the beneficiary of his IRA in hopes that it qualifies as a "see through" trust. A has one child: B. B has two children: C and D. The trust document specifically identifies B as the successor beneficiary of A's trust. However, B's children, C and D, are not specifically identified by A in his trust document. If B dies before A, and A fails to amend the trust to specifically identify C and D as beneficiaries of the trust, then the trust might not qualify as a "see through" trust, and the RMDs will be subject to a penalty by the IRS.
Moreover, there are other complicating factors associated with naming a revocable living trust as a beneficiary, particularly in light of sparse guidance from the IRS. Therefore, from an estate planner's perspective, you should not transfer an IRA (be it traditional or Roth) into your revocable living trust.
- Annuities (of all kinds)
An annuity is a financial product that pays out a fixed stream of payments to an individual, usually for the purpose of income during retirement. Annuities are contracts issued and distributed by financial institutions, and they help individuals address the risk of outliving their savings. When an individual receives a disbursement from their annuity, that disbursement is subject to income tax.
Some annuities offer income tax deferral benefits so long as the annuity contract is between the company offering the annuity and an individual. Under Internal Revenue Code § 72(u), however, an annuity contract held by a non-natural person (i.e. a trust) generally cannot defer income taxation on the annuity.
With that said, IRC § 72(u)(1) may allow a revocable living trust to be the owner of an annuity contract, but, when that revocable living trust becomes irrevocable upon the death of the Settlor, the IRS has not made it clear whether the tax deferral benefits still apply. With such little guidance from the IRS, and with potentially troublesome tax consequences for clients, it is not a good idea to change ownership of the annuity contract or even designate the trust as a beneficiary under the contract.
- Closely Held Stock
If you are a small business owner, you may wish to transfer the stock in your small business (i.e. closely held stock) into your revocable living trust. That is not a particularly good idea, as your business's bylaws and Articles of Organization may require approval for, or otherwise restrict, such transfers. Moreover, if you own shares in an S Corporation, you cannot hold these shares in trust unless the trust is considered a "qualified trust" under the IRS guidelines. Therefore, closely held stock in a small business should not be transferred into a trust.
- Restricted Stock and Qualified Stock Options
If you provide services for someone and are paid in property (i.e. stock), instead of cash, the Internal Revenue Code allows for you to defer payment of income taxes on that property payment until (1) the property is not subject to a substantial risk of forfeiture, or (2) the property is freely transferable. This often arises in situations where you are an executive at a company receiving stock options.
For example, Executive provides services to Company. Company gives Executive stock worth $2,000 in the Year 1, but that stock is not freely transferable until Year 3 by Executive since Executive has a contract which states that she must continue to work for Company in order to retain the stock. When the stock vests in Executive in Year 3, it is now worth $5,000. Executive will now be taxed on the $5,000 of ordinary income, instead of being required to pay the income tax on the stock over the previous 2-year period.
Transferring this type of asset into a trust would forfeit your tax deferral benefits because it shows that the property is "freely transferable" since it was transferred freely into a trust. Thus, income taxes would be immediately owed on the property instead of deferred. Therefore, if any of my clients have restricted stock or stock options, I advise that those assets not be transferred into their revocable living trust.
There may be other assets out there that should not be transferred into a revocable living trust for various reasons. Otherwise, it is important to note that freely transferable property (i.e. mutual funds, stocks, bonds, savings bonds, certain life insurance policies) may be transferred into the trust with few if any adverse consequences for you. It is also important to note that even though you have a living trust document, your revocable living trust does not exist until that trust is funded with appropriate assets.
If you have any questions about this, or need clarification, please do not hesitate to contact The Taormina Firm.