Whatever the historical reason for drafting income-only trusts, these types of trusts have several drawbacks. First, they do not properly consider the "total return" approach contemplated by modern portfolio theory. By granting the current beneficiary the right to income, the trustee may be tempted to invest trust property primarily with an eye to increasing the amount of trust accounting income generated. This emphasis on income-producing assets may result in a below-average total investment performance, particularly during a time when investments in stocks perform well. Second, as a "one size fits all" style, it does not consider the needs of a given beneficiary. For example, an income only beneficiary may require more money from the trust than simply its net income.
Drawbacks of Principal and Income Trusts cont.
In California the rights of the beneficiaries in income-only trusts are determined by the definition of "income," which is defined either in the trust itself, or absent a definition in the trust, can be found in California's principal and income law. In California income includes interest, dividends, rents and royalties, but not capital gains, which are a return of principal. This division of returns leads to a conflict between beneficiaries: the income beneficiary would prefer that the trustee invest in income-producing assets (such as bonds), which generally yield little if any growth, while the remainder beneficiary would prefer investment in high-growth, low-yield assets (like equities).
Balancing of Beneficiaries Competing Interests
In an attempt to alleviate the tension between income and remainder beneficiaries over how the trustee should invest trust assets, the National Conference of Commissioners on Uniform State Laws drafted the Revised Uniform Principal and Income Act ("UPAIA"). A major thrust of the UPAIA was to give trustees of income-only trusts the ability to invest for total return instead of having to adopt sub-optimal investment strategies to provide the current income beneficiary with a targeted level of income.
California's Adoption of the UPAIA
In 2000, California adopted a version of the UPAIA which allows trustees to create a diversified portfolio and to consider the appropriateness of each investment asset, not as an isolated asset, but in relationship to the entire portfolio.
Trustee's Power to Make Adjustments
In addition to allowing the trustee to invest trust assets with an eye towards the total return of the trust's investments, California's UPAIA also gives the trustee the "power to adjust," which permits trustees to make allocations between income and principal as necessary to provide the income beneficiary with an appropriate level of income. This would be important, for example, if traditional trust income-producing assets (such as bonds and high-dividend yielding stocks) move out of favor with the market. If the trustee, in response to such market movements, shifted trust assets to more growth oriented assets such as low dividend yielding small cap stocks (as opposed to traditional income producing assets) in order to improve the total investment return of the trust, the income beneficiary would suffer.
Purpose of the Power to Adjust
The purpose of the power to adjust under the UPIA, therefore, is to allow the trustee to provide for the needs of both the income beneficiary and the remainder beneficiaries, as well to encourage an overall return for the trust. With the power to adjust, trustees are able to exercise discretion to establish an overall target level investment return for the trust. Thereafter, to the extent the income of the trust is inadequate to meet the needs of the income beneficiary, the trustee may exercise his or her power to adjust and augment the trust's income by allocating to the income (at least on paper) a certain amount of the trust's principal. In other words, the trustee can allocate principal to income for purposes of increasing the payout to the income beneficiary and vice versa. This gives the trustee greater flexibility to meet the divergent needs of the trust's beneficiaries without sacrificing the total investment return of the trust.
Settlor's Power to Limit Trustee's Power to Make Adjustments
Despite the foregoing, the settlor may limit the trustee's power to adjust between income and principal by including language in the trust that clearly limits the specific power of adjustment provided by California's UPAIA. For example, the trust instrument may indicate how the trustee is to allocate receipts and disbursements between principal and income. The instrument may define what constitutes trust income and principal, how each is to be allocated to the different classes of beneficiaries, and what costs are allocable to either or both. The trustee must follow such directions even if they contradict the UPAIA. That being said, trust instruments often contain clauses giving trustees discretion to determine the allocation of an item as income or principal or as an expense against either of them. Moreover, if the trust is silent about allocation of principal and income and does not give the trustee discretion, the the allocation should be made in accordance with the UPAIA.
Conversion to Unitrust
California also grants to the trustee under its version of the UPAIA the power to release his or her adjustment power and instead convert the trust to a unitrust. In general, a unitrust is a type of trust in which a fixed percentage of the trust property is paid annually to the trust's income beneficiary.
If a trustee elects to convert the trust to a unitrust, then following such a conversion, all provisions relating to distribution of income to the income-beneficiary are instead construed to refer to an annual unitrust distribution of the fair market value of trust assets. California's law allows a range of percentages for the annual unitrust distribution to the income beneficiary. This range must be between 3% and 5% of the net fair market values of the trust assets determined at least annually.
Advantage of a Unitrust
One real advantage with the conversion to a unitrust is that it brings with it a sense of stability and understandability greater than the power to adjust. The unitrust distribution will likely be used so that at the beginning of a year, the beneficiary will know her trust "salary" for the entire year. It can easily be made payable quarterly or even monthly, and this may be of significant benefit to a trust beneficiary in his or her financial planning. It also removes from the trustee the burden of balancing the competing interests of the trust's income and remainder beneficiaries. Instead of exercising an adjustment power to allocate principal to income and vice versa, the trustee can simply make a distribution of a certain percentage of the trust's assets to the income beneficiary annually. A trustee may favor this approach if they are worried about a possible breach of their fiduciary duty by unwittingly favoring one class of beneficiaries over the other.
Management as a Unitrust
Once the trust is converted to a unitrust, the trustee must invest and manage trust assets under California's prudent investor statute. That is, the trustee must invest and manage the funds of the trust as a prudent investor would, in light of the purpose, distribution requirements, and other terms of the trust. California also has separate rules for when and over what period trust assets are valued, and how expenses are to be deducted. For example, California allows the trustee to value the assets for purposes of calculating the unitrust amount at annual or more frequent intervals. California also provides an ordering structure for distributions: absent a trust provision which provides its own order for distributions, distributions are deemed to be made first from net income, as that amount would be determined if the trust were not a unitrust, then from short-term capital gains, then from long-term capital gains, then from tax-exempt and other income and then from principal.
Generation Skipping Transfer Tax Issues
Irrevocable trusts settled before Sept. 25, 1985 are exempt from generation skipping transfer tax. The exemption may be lost by alterations to the trust which increase the amount of trust property passing to the ultimate remainder beneficiaries. Unitrust conversions could increase the amount of trust property available to the remainder beneficiaries because the trust may earn more in income than it pays out as a unitrust percentage -- leaving more trust property for the remainder beneficiaries to inherit. However, Internal Revenue Code regulations make it clear that if a trust is converted to a unitrust for the income beneficiaries, there will not be an impermissible alteration to the terms of the trust if two requirements are met: (1) local law provides for a reasonable apportionment between the income and remainder beneficiaries of the TRUST'S total return; and (2) the trust and local law do not do not fundamentally depart from the traditional notions of income and prinicipal.
Generation Skipping Transfer Tax Issues cont.
The first requirement is met by reason of California's laws on unitrust payouts. For example, as stated previously, California's law provides that the income of a unitrust is an amount of no less than 3% and no more than 5% of the fair market value of the trust assets determined at least annually. This is considered a reasonable appointment of the total return of the trust between the income and remainder beneficiaries under the Internal Revenue Code's regulations. Second, because California law does not significantly depart from the traditional definitions of income and principal the second requirement is also met. Therefore if a trust administered in California meets the foregoing two requirements and converts to a unitrust payout, it will not lose its GST exempt status.
Procedure for Unitrust Conversion
Generally, in order to convert a trust to a unitrust payout to the income beneficiaries, the trustee may give notice to all beneficiaries who are receiving or are entitled to receive income under the trust or who would receive a distribution of principal if the trust were terminated at the time the notice is given. The trustee need not give notice to beneficiaries who consent in writing to the proposed adjustment, or to any beneficiary who is unknown to the trustee or who is known but cannot be located after reasonable diligence.
Procedure for Unitrust Conversion cont.
Any beneficiary may object to the proposed action by mailing a written objection to the trustee within the time specified in the notice, which must be at least 45 days after the notice is mailed. A trustee is not liable to any beneficiary for taking the proposed action if the trustee does not receive a timely written objection. If no beneficiary entitled to notice objects, the trustee is not liable to any current or future beneficiary with respect to the proposed action. If informal communications suggest that there is no opposition to the proposed transaction, the trustee may then seek to take advantage of the protection afforded by the statute-not by sending a 45-day notice but, instead, by asking the beneficiaries to consent in writing.
Procedure for Unitrust Conversion cont.
However, if the trust limits the ability of a trustee to convert to a unitrust, such as if a settlor specifies in the trust instrument how the trustee is to allocate receipts and disbursements between principal and income, a petition seeking court approval to modify the trust may be necessary.
The conversion to a unitrust can bring a sense of stability and understandability to the trust's beneficiaries and can empower trustees to efficiently administer trusts by shifting the fiduciary duty imposed upon a trustee from individual investment decisions to overall investment performance. It should therefore at least be considered as an option for trusts which have lifetime income beneficiaries and remainder beneficiaries as a way balancing their competing interests.
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