The power to adjust and the ability to make a unitrust election are fairly new concepts in trust law, the former created by the Uniform Principal and Income Act (UPAIA) and the latter enacted by various state legislatures. As a result, trustees may not be sure how to properly implement these concepts. A few cases have been decided to provide some guidance to trustees. Undoubtedly, as trustees use these tools more frequently, more decisions will clarify how to correctly use these powers. Here’s a rundown of what we know so far.
The UPAIA provides a mechanism to help a trustee with the asset allocation dilemma created by the prudent investor rules enacted in various jurisdictions throughout the 1990s. These rules require a trustee to invest trust assets for the best total return (that is, income and capital appreciation) possible, taking into account the level of risk appropriate to the portfolio as a whole. The dilemma results because, even though a trustee was required by law to invest for total return, the trustee continued to be saddled with the traditional definitions of “principal” and “income”; therefore, an income beneficiary could be disadvantaged if a trustee invested for growth at the expense of income.
The UPAIA solves this dilemma by providing a trustee with discretion to exercise a “power to adjust” between principal and income. The power is exercisable in a manner that would provide current beneficiaries with an appropriate level of distributions, while preserving and growing the principal for the remainder persons.1 It can be exercised to supplement income from principal or, conversely, to supplement principal with income. A trustee can exercise the power to adjust between principal and income if it meets three conditions:
(1) the trustee is subject to the prudent investor rule; (2) the terms of the trust provide for the distribution of income; and (3) the trustee is otherwise unable to exercise the duty of impartiality between the income beneficiary and remainder persons.2 Forty-seven states and the District of Columbia permit trustees to exercise the power to adjust.3
Some states have enacted a “unitrust” election, either in lieu of or in addition to the power to adjust. A unitrust election allows a trustee to allocate between principal and income, but at a fixed rate, calculated on the fair market value of the trust. Some states provide a range of percentages that the trustee may distribute (generally, 3 percent to 5 percent),4 while others fix the unitrust at a set percentage (generally, 4 percent).5
Recent Court Rulings
Very few cases have interpreted the various principal and income acts across the United States. Below is a discussion of a few rulings that provide some guidance on how to implement the law.
Matter of Burford (Oklahoma).6 This case makes clear that the UPAIA is, fundamentally, an investment statute, not a distribution scheme. If the trust is invested in a manner that favors the income beneficiary, the trustees can’t use the power to adjust to further favor the income beneficiary.
The Burford Trust was created in 1955 and provided income to the settlor’s daughter, Carolyn, for life. Following Carolyn’s death, the trust continued for Carolyn’s daughter, Ann, for life. On Ann’s death, the trust would terminate in favor of Ann’s children and the Oklahoma Annual Conference of the United Methodist Church. During the two income beneficiaries’ lives, no principal invasions were allowed. Both a corporate trustee and an individual trustee were required at all times.
After Carolyn’s death in 1996, Ann became the individual trustee in 1999. Ann began to request an increase in her annual income distributions from $300,000 to $500,000. The corporate trustee sold $2 million of securities to begin to satisfy this request and invested the bulk of the proceeds in a municipal bond fund. Ann’s annual distributions increased to $396,000, or 2.8 percent of the $14 million trust. The corporate trustee suggested further increasing the yield by investing in variable prepaid forward contracts. Additionally, Ann received principal distributions totaling $983,000, which the corporate trustee claimed to have been distributed pursuant to its power to adjust under the Oklahoma UPAIA. The remainder beneficiaries alleged that the corporate trustee committed various breaches of fiduciary duty, including improperly exercising its power to adjust. In an unpublished decision, the court held that the exercise of the power to adjust was a detriment to the remainder beneficiaries. That holding was based on these facts: (1) under Oklahoma law, the trustees weren’t permitted to exercise their discretionary power to adjust because one of the remainder beneficiaries was a charity;7 and (2) the trustees’ investment strategy was already strongly favoring the income beneficiary; therefore, use of the power to adjust was improper.
The court stated:
The purpose of the Act’s power to adjust is to allow a trustee with an otherwise sound investment strategy that violates the duty of impartiality to adjust receipts therefrom to treat different classes of beneficiaries more equally … the Bank’s investment strategy favored the income beneficiary over the remaindermen, but it used its ‘power to adjust’ to transfer even more money from the remaindermen’s principal to the income beneficiary.
Estate of Morse (New York).8 This case provides a good example of the methodology that can be used to consider an appropriate amount for adjustment. A trust was established for the benefit of a widow, and the remainder was to be left to the widow’s stepchildren. The remainder beneficiaries objected to the trustee’s exercise of a power to adjust. They claimed that it favored the income beneficiary.
The court disagreed with the remainder beneficiaries and found the adjustment to be appropriate. To prevail in setting aside a power to adjust, the objectants were required to show abuse of discretion, which they failed to do. Furthermore, the court cited N.Y. Estates Powers & Trusts Law Section 11-2.3A: “A court shall not change a fiduciary’s decision to exercise or not exercise an adjustment power unless it determines that the decision was an abuse of power.”
Matter of Moore (New York).9 The New York Surrogate’s Court found that if a trustee elects unitrust treatment for a trust, that election isn’t binding on any remainder trust that’s created after the termination of the current one. In this case, the income beneficiary brought an action seeking to have the corporate trustee convert the trust into a 4 percent unitrust under New York law. The corporate trustee didn’t object; nor did the income beneficiary’s daughter. However, the daughter’s failure to object was based on her understanding that her remainder trust would also be subject to the 4 percent unitrust conversion.
The court allowed the conversion to a unitrust but, in doing so, acknowledged that the successor income beneficiary was incorrect in her understanding of the law. The court made it clear that on her mother’s death, the daughter’s trust would be a new trust not subject to the current unitrust conversion.
Matter of Orpheus Trust (Nevada).10 The court considered the question of whether a power to adjust could be exercised retroactively. The court held that in Nevada, a 1-year retroactivity would be appropriate:
The determination of whether an adjustment between principal and income distributions is necessary often will require a review of data related to trust investment and returns at the close of the year…[the UPAIA] language clearly indicates that the power to adjust may be exercised correctively, after the trustee has an opportunity to review trust date and trustee investment decisions for the immediately preceding year.
The question of whether retroactivity would have been allowed for prior years wasn’t before the court.
—This article is adapted from Gail E. Cohen’s presentation at the 2014 Heckerling Institute on Estate Planning.
1. The Uniform Principal and Income Act (UPAIA) Section 104 (1997).
2. Ibid., at Section 104(a).
3. Ala. Code Section 19-3A-104, Alaska Stat. Section 13.38.210, Ariz. Rev. Stat. Section 14-7403, Ark. Code Ann. Section 28-70-104, Cal. Prob. Code Section 16336, Colo. Rev. Stat. Section 15-1-404, Conn. Gen. Stat. Section 45a-542c, Del. Code Ann. Tit. 12, Section 61-104, D.C. Code Section 28-4801.04, Fla. Stat. Ann. Section 738.104, Ga. Code Ann. Section 53-12-361, Haw. Rev. Stat. Section 557A-104, Idaho Code Section 68-10-104, Ind. Code Ann. Section 30-2-14-15, Kan. Stat. Ann. Section 58-9-104, Ky. Rev. Stat. Section 386.454, La. Rev. Stat. Section 9:2158, Me. Rev. Stat. Ann. tit. 18-A, Section 7-704, Md. Code Est. & Trusts Section 15-502.2, Mass. Gen. Laws ch. 203D, Section 4, Mich. Comp. Laws Section 555.504, Minn. Stat. Section 501B.705, Miss. Code Ann. SECTION 91-17-104, Mo. Rev. Stat. Section 469.405, Mont. Code. Ann. Section 72-34-424, Neb. Rev. Stat. Ann. Section 30-3119, Nev. Rev. Stat. Ann. Section 164.795, N.H. Rev. Stat. Ann. Section 564C:1-104, N.J. Stat. Ann. Section 3B:19B-4, N.M. Stat. Ann. Section 46-3A-104, N.Y. Est. Powers & Trusts Law Section 11A-2.3(b)(5), N.C. Gen. Stat. Section 37A-1-104, Ohio Rev. Code Ann. Section 5812.03, Okla. Stat. tit. 60, Section 175.104, Or. Rev. Stat. Section 129.215, 20 Pa. Cons. Stat. Ann. Section 8104, R.I. Gen. Laws Section 18-4-28, S.C. Code Ann. Section 62-7-904, S.D. Codified Laws Section 55-13A-104, Tenn. Code Ann. Section 35-6-104, Tex. Prop. Code Ann. Section 116.005, Utah Code Ann. Section 22-3-104, Vt. Stat. Ann. tit. 14, Section 3324, Va. Code Ann. Section 64.2-1002, Wash. Code Rev. Section 11.104A.020, W. Va. Code Section 44B-1-104, Wis. Stat. Section 701.20(4), Wyo. Stat. Ann. Section 2-3-804.
4. Ala. Code Section 19-3A-106(d), Ariz. Rev. Stat. Section 14-11014(E), Del. Code. Ann. Tit 12, Section 61-106, Fla. Stat. Ann. Section 738.1041, Kan. Stat. Ann. Section 58-9-105, Mo. Rev. Stat. Section 469.411, Neb. Rev. Stat. Ann. Section 30-3119.01, Nev. Rev. Stat. Ann. Section 164.797(3), N.H. Rev. Stat. Ann. Section 564-C:1-106, N.C. Gen. Stat. Sections 37A-1-104.21-26, R.I. Gen. Laws Section 18-4-29, S.D. Codified Laws Sections 55-15-1-14, Tenn. Code Ann. Section 35-6-108(f), Tex. Prop. Code Ann. Section 116.007, Va. Code Ann. Section 64.2-1003, Wash. Code Rev. Section 11.104A.040, W. Va. Code Section 44B-104a, Wis. Stat. Section 701.20(4g), Wyo. Stat. Ann. Sections 2-3-901-917. See also Treasury Regulations Section 1.643(b)-1.
5. Alaska Stat. Section 13.38.330, Cal. Prob. Code Section 16336.4, Colo. Rev. Stat. Section 15-1-404.5, Ga. Code Ann. Section 53-12-362, 760 ILL. Comp. Stat. Section 5/5.3, Ind. Code Ann. Section 30-2-15-15, Iowa Code Section 637.608, Me. Rev. Stat. Ann. tit. 18-A, Section 7-705, Md. Code Ann. Est. & Trusts Section 15-502.1, N.M. Stat. Ann. Section 46-3A-106, N.Y. Est. Powers & Trust Law Section 11-2.4, Or. Rev. Stat. Section 129.225, 20 Pa. Cons. Stat. Ann. Section 8105.
6. Matter of Burford, No. PT-2006-013 (Okla. Dist. Ct. Oct. 9, 2012).
7. But see UPAIA Section 104, cmt, ex. 3, which permits a trustee to exercise the power to adjust.
8. Estate of Morse, Index No. 83862 (N.Y. Sur. Ct., Dutchess Cty. 2006).
9. Matter of Moore, 971 N.Y.S.2d 419 (N.Y. Sur. Ct., Nassau Cty. 2013).
10. Matter of Orpheus Trust, 179 P.3d 562 (Nev. 2008).