In even the closest of families, there's always a tension between a trust's current income beneficiary and the remainder beneficiaries over the investment strategy. In general, the income beneficiary wants the assets in the trust invested heavily in high-yield assets, such as bonds, while the remainder beneficiary wants the assets to grow, which typically means investing in stocks. The bull markets of the 1980s and 1990s provided returns that generally satisfied both camps. But of late, the combination of declining interest rates and the stock market's poor performance has restarted the tug-of-war.

Given this situation, many states have recently enacted trust legislation allowing trustees to convert to total return trusts (TRTs), often referred to as unitrusts. Most estate planning professionals are familiar with the concept of the total return trust: It pays the current beneficiary a percentage of the value of the trust, determined annually, in lieu of paying out the trust accounting income.

As of February 2004, 17 states had enacted legislation permitting conversion to TRTs,1 which is impressive considering that the first such law was only enacted in June of 2001.2 Most of these states allow the trustee to select the rates of payment to the current beneficiary, ranging from 3 percent to 5 percent of the value of the trust. For example, New York mandates a 4 percent rate.3 Illinois permits the trustee to choose a rate from 3 percent to 5 percent, if all of the beneficiaries agree, or else a default rate of 4 percent applies.4 Florida uses a floating rate equal to 50 percent of the Internal Revenue Code Section 7520 rate, with a minimum of 3 percent and a maximum of 5 percent.5

Thirty-five states and the District of Columbia had adopted “equitable adjustment” provisions as of February 2004. Of these states, 12 also had TRT statutes and 10 had adopted neither statute. These provisions permit the trustee to make impartial equitable adjustments between income and principal to be fair and reasonable to all beneficiaries. In a low-yield portfolio, the trustee in such a state could allocate trust principal to income and pay it out to the income beneficiary. In a high-yield portfolio, the trustee could allocate the extra income to principal, thus building up the trust for the future benefit of the income beneficiary and for the remainder beneficiaries.

The enactment in January 2004 of the final regulations for IRC Section 643 came nearly three years after the proposed regulations were first published on Feb. 15, 2001. The final regulations answered many questions for estate planners concerning the use of, and the conversion to, total return trusts. As more states adopt statutes authorizing the use of TRTs and provide the trustee with new powers of equitable adjustment, trustees are empowered to make distributions to the current income beneficiary in a manner not necessarily related to traditional concepts of income. These techniques now should be considered in all trust administrations.

DEFINITION OF INCOME

Trust income continues to be defined in IRC Section 643(b) and the final regulations as the amount of income of the trust “determined under the terms of the governing instrument and applicable local law.”6 The regulations used to say that “[t]rust provisions which depart fundamentally from concepts of local law in the determination of what constitutes income are not recognized for this purpose.” The new final regulations say, “Trust provisions that depart fundamentally from ‘traditional principles of income and principal’ will generally not be recognized.”7

The final regulations do provide a safe harbor for TRTs, in stating that, “A state statute providing that income is a unitrust amount of no less than 3% or more than 5% of the fair market value of the trust assets, is a reasonable apportionment of the total return of the trust.”8

The final regulations also permit fair market value to be determined either annually or over multiple years, if allowed by state law.9 Furthermore, these new rules apply both to trusts that require payment of the income to the beneficiary and trusts where the income payment is discretionary,10 and can be applied to sprinkle and spray trusts in the same manner as a single beneficiary trust.11

The IRS makes it clear that allocations of income to principal, and vice versa, will only be respected if authorized by state statute.12 Treas. Reg. Section 1.634(b) also provides that “a switch between methods of determining trust income authorized by state statute will not constitute a recognition event for purposes of [S]ection 1001 and will not result in a taxable gift from the trust's grantor or any of the trust's beneficiaries.”

Given the explicit safe harbor provisions applicable to total return trusts, their increasing popularity and the competition for trust business, we expect a significant increase in the number of states that adopt a statute authorizing conversion to this type of trust.

ALLOCATION OF CAPITAL GAIN

The final regulations under Section 643 include specific rules governing the allocation of gains from the sale or exchange of capital assets. The general rule is that capital gains are not allocated to distributable net income (DNI). However, under the final regs, three exceptions are permitted, but only if capital gains are allocated to trust income either: (1) by the terms of the governing instrument and applicable state law; or (2) pursuant to a reasonable and impartial exercise of discretion by the trustee in accordance with a power granted to the fiduciary (a) under applicable state law, or (b) by the governing instrument alone so long as state law does not prohibit the allocation.13 The first test requires that both the governing instrument and local law mandate the allocation. We believe this test was intended to be, and should be, disjunctive rather than conjunctive.14

The three exceptions are: (1) when, in fact, the capital gains are allocated by the trustee to trust income; (2) when the capital gains are allocated to principal, but are treated consistently by the trustee on the trust's books, records and tax returns as part of a distribution to a beneficiary; and (3) when the capital gains are allocated to principal, but are actually distributed out to a beneficiary or utilized by the trustee in determining the amount that is distributed or required to be distributed to a beneficiary.

NEW RULES APPLY

Among the different types of trusts that can be drafted as TRTs under the new regulations, a significant type is the marital deduction trust. The final regulations provide that, as long as local law permits it, a marital deduction trust can be converted to or drafted as a TRT as long as the annual payout is between 3 percent and 5 percent, inclusive, without loss of either an estate tax or gift tax marital deduction.15 Similar exceptions are made for a marital deduction trust operating under an equitable adjustment statute and for qualified domestic trusts.

While an equitable adjustment creates no present right in a remainder beneficiary, it might be wrongly construed that a power to allocate income to principal is a power to distribute to someone other than the spouse, in violation of the rules applicable to qualified terminable interest marital deduction trusts. The final regulations make it clear that this is not a problem.16

The final regulations also specify that the administration of a grandfathered exempt generation skipping trust in conformance with either a statute permitting TRTs or an equitable adjustment statute will not cause the loss of the GST exemption.17

WHY CONVERT?

Coversion to a TRT greatly relieves the tension between income and remainder beneficiaries. After conversion, the income beneficiary wants the trust to grow so the amount received each year also will increase. The remainder beneficiaries want the trust to grow because they will ultimately receive a larger amount of money. The trustee also wants growth, to carry out the trustee's duty to the beneficiaries, reduce complaints about investment strategy and performance, and increase fees based on the size of the trust. (See, “All Income Trusts vs. TRT,” p. 32).

Another factor to consider in converting to a TRT is that yields from common stocks, whether they be from appreciation or dividends, are currently more favorably taxed than yields from bonds. Appreciation is taxed at low capital gains rates, then they're taxed only as gains are realized and to the extent not offset by losses. Qualified dividends are also subject to lower rates, at least through 2008.

There are numerous examples in which the income beneficiary has persuaded the trustee to invest for substantial current income, only to find that years later, even if yields have stayed the same, the portfolio no longer generates nearly the same level of inflation-adjusted dollars, thus gradually impoverishing the beneficiary. TRTs can greatly alleviate this situation by encouraging an investment strategy that strives for the best overall return and — assuming that return is better than the payout rate- provides an ever-increasing stream of payments to the income beneficiary from an ever-expanding trust fund.

TALKING TO CLIENTS

The TRT finds ready acceptance among clients in a broad spectrum of economic circumstances. Any situation that would have previously called for a long-term income-only trust, or in which the client wants a fixed or inflation-adjusted payout made periodically, is a candidate for a TRT.

It is also an excellent technique when the income beneficiary and the remainder beneficiaries are not part of a loving, unselfish relationship.

An added bonus is that a TRT is not difficult to administer. It typically only requires a valuation of the trust's portfolio at the end of each year (which is either already a requirement or a good practice for all trusts). That value is then multiplied (or perhaps the average value for the last two to three years) with the percentage factor established by the instrument, in order to determine the next year's payout.

One key decision that has to be made is whether to add a discretionary right in the trustee to make payments above the unitrust payout amount. It may not work well in a second-marriage, kids-by-the-first-marriage situation, or with the high-spending beneficiary who can never get enough and will not save for a rainy day.

TRUSTEE LIABILITY

While the ability to create TRTs may work well for the client, it could create new concerns for the trustee. Now, a trustee has an increased liability, falling into two categories: failure to convert and failure to notify. But in a few states, many of the statutes that authorize the use of total return statutes protect the trustee against liability for either of these two areas.

The Illinois statute, for example, not only provides that the trustee has no duty to inform beneficiaries of the right to convert, but also that the trustee does not even have a duty to conduct a review to determine whether conversion is appropriate.18 But a prudent trustee should inform beneficiaries of the conversion right and should conduct such a review.

Another issue in states that allow the trustee to choose a unitrust percentage is what that percentage should be. While the courts generally respect the trustee's discretion in this matter, the prudent trustee will make a careful analysis of the needs of the current beneficiary in light of the beneficiary's other resources, age, health and lifestyle, in setting the percentage rate. Liability on conversion will often be only for actions taken unreasonably or in bad faith.19

Reliance on sophisticated investment advisors also will be a prudent approach for trustees. Such advisors can quantify the probabilities of the trust underperforming, especially the risk of exhausting the trust during the current beneficiary's lifetime. Such analysis can be very useful in picking both the percentage payout and the allocation between equities and fixed income investments.

TECHNIQUES THAT WORK

There are a few tried-and-tested techniques that produce maximum results with minimum risks. One such technique that can be drafted into a TRT is a floor on the amount distributable to the beneficiary. TRTs work wonderfully when they increase appreciably in the early years, providing a cushion against future market downturns. But it can be disastrous when that downturn occurs early in the life of the trust. Setting a floor guards against such a disaster, although it may cause the trust to be used up at a quicker rate.

It is also possible to set a ceiling on the distribution, so that funds not really needed for the beneficiary's current needs can be kept within the trust. This can: (1) protect the current beneficiary in future years and/or (2) provide these excess funds to the remainder beneficiaries instead of the current beneficiary's family, thus causing the excess funds to avoid taxation in the current beneficiary's estate.20

If it is true that equities outperform fixed income securities, there will be a temptation for the trustee to skew the trust investment allocation dramatically toward equities. The statutes dealing with TRTs do not give trustees carte blanche to do this, as they have to adhere to the governing prudent investor statute in determining the trust investment allocation.

NEW COMFORT

The final regulations under IRC Section 643 give estate planners new comfort with the TRT and equitable adjustment statutes that are appearing all over the country. Although the use of the tools authorized by these statutes should be carefully considered, these tools may not be beneficial in all situations.

Endnotes

  1. Ashlea Ebeling,“Opening the Income Tap,” p. 124, Forbes, Feb. 16 2004.
  2. The State of Delaware enacted the first total return statute followed by Missouri, New York and New Jersey.
  3. McKinney's EPTL Section 11-2.4(b)(1).
  4. 760 ILCS 5/5.3(b) and 760 ILCS 5/5.3(d)(3).
  5. West's F.S.A. Section 738.1041-(2)(b)2.a.
  6. In this article, when the term “trust income” is used it means trust accounting income, as opposed to a trust's income for tax purposes.
  7. Treas. Reg. Section 1.643(b)-1
  8. Ibid.
  9. Ibid.
  10. Ibid.
  11. Ibid.
  12. Ibid. The preamble also states that if a state's highest court announces a general principle or rule of law that would be applicable to all trusts administered in that state, it would be treated the same as a statutory provision. But nowhere in the text or examples of the final regs is this statement repeated.
  13. Treas. Reg. Section 1.643((a)-3(b).
  14. Treas. Reg. Section 1.643((a)-3(e), Example 4, provides a fact situation on which the state law is silent, and the governing instrument mandates the allocation of capital gains to income. The example opines that the capital gain should be included in DNI. It also makes no sense that a discretionary allocation can be made if authorized under either state law or the governing instrument, but a mandatory allocation requires both. We believe this is a misprint or was overlooked by the drafters of the final regs.
  15. The regulations applicable to QDOTs have been amended to provide that a unitrust payout or a payout due to an equitable adjustment shall be deemed income for purposes of this provision.
  16. Treas. Reg. Section 20.2056(b)-7(d)(1).
  17. Treas. Reg. Section 26.2601-1 (b)(4)(i)-(D)(2). While this does not specifically cover the conversion of a trust, one of the examples in the generation skipping regulations promulgated in 2000 permits the conversion of a trust that pays all its income to a trust paying the greater of its income or a unitrust percentage, without loss of GST exemption.
  18. 760 ILCS 5/5.3(c)(6).
  19. 760 ILCS 5/5.3(k).
  20. Floors and ceilings that do not fall within the 3 percent to 5 percent unitrust payout range may be problematic for certain kinds of trusts, such as a marital trust that needs to comply with the provisions of the final regulations.

ALL INCOME TRUSTS VS. TRTS

Consider the case of a surviving spouse with a 20-year life expectancy. Here is a comparison of payouts from an income-only, qualified terminable interest property (QTIP) marital trust and a total return trust (TRT), based on the assumptions below.

Assume a surviving spouse has a 20-year life expectancy and inherits a $3 million traditional QTIP marital trust, from which the spouse is to receive all of the income. Assume also that the trustee agrees to invest 50 percent in bonds and 50 percent in stocks, and keeps it so invested over the life of the trust by periodically selling stocks and buying bonds. The investment return on the bond portion of the portfolio averages 5 percent over the life of the trust, all of which is income, and the investment return on the stock portion averages 10 percent, of which 2 percent is income and 8 percent is growth. (All returns are after taxes.)

Alternatively, assume that the QTIP trust is a TRT, paying out each year based on 4 percent of the value of the trust as of the end of the preceding year. Instead of 50-50, the trustee invests 80 percent in stocks and 20 percent in bonds, and keeps it that way over the life of the trust.

The All-Income Trust The Total Return Trust
Year Income Payment Value of Trust Unitrust Payment Value of Trust
1 $105,000 $3,120,000 $120,000 $3,150,000
2 109,200 3,244,800 126,000 3,307,500
3 113,568 3,374,592 132,300 3,472,875
4 118,111 3,509,576 138,915 3,646,519
5 122,836 3,649,959 145,861 3,828,845
6 127,749 3,795,957 153,154 4,020,287
7 132,858 3,947,795 160,811 4,221,301
8 138,173 4,105,707 168,852 4,432,366
9 143,700 4,269,935 177,295 4,653,985
10 149,448 4,440,733 186,159 4,886,684
11 155,426 4,618,362 195,467 5,131,018
12 161,643 4,803,097 205,241 5,387,569
13 168,108 4,995,221 215,503 5,656,947
14 174,833 5,195,029 226,278 5,939,795
15 181,826 5,402,831 237,592 6,236,785
16 189,099 5,618,944 249,471 6,548,624
17 196,663 5,843,701 261,945 6,876,055
18 204,530 6,077,450 275,042 7,193,663
19 212,711 6,320,548 287,747 7,553,346
20 221,219 6,573,369 302,134 7,931,014
— Laurence J. Kline and Karl R. Anderson

TRT PROVISIONS

A sample of the language that shows how a TRT might be implemented for a QTIP marital trust

Unitrust Payment:

“Commencing at my death and during the life of my spouse, the trustee shall pay the greater of (1) the net income,1 or (2) the amount, first from income, then from principal, necessary to provide my spouse with aggregate distributions under this subparagraph in each taxable year of the fund an amount equal to four percent of the net fair market value of the fund assets, excluding residential real estate,2 valued initially as of the day of funding the trust fund and thereafter as of the close of business on the last business day of the prior taxable year (provided that, if any additional property is added to the fund after the first day of a taxable year, the amount for such year shall be increased by four percent of the net fair market value of the additional property as of the date of addition multiplied by a fraction, the numerator of which is the number of days, including the date of the transfer) remaining in the taxable year of the fund and the denominator of which is three hundred sixty-five. For a taxable year that is for a period of less than twelve months, the total amount distributable in such year pursuant to this subparagraph shall be a fraction of the amount otherwise so distributable, the numerator of which is the number of days in such taxable year of the fund and the denominator of which is three hundred sixty-five.”

  1. Requiring that at least all of the net income be paid to the spouse will be necessary if the state governing law does not permit a unitrust payout in lieu of income of between 3-5 percent, inclusive.
  2. The exclusion of residential real estate from the value of the trust, for purposes of computing the annual payout, should not cause the loss of the marital deduction, assuming the wife is given the rent-free use of the property. But there is no guidance in the final regulations on this issue. Presumably, state law will govern. The Illinois total return trust law provides that “if…real property is…occupied by a beneficiary, the trustee shall not limit or restrict any right of the beneficiary to use the property in accordance with the governing instrument, whether or not the trustee treats the property as an excluded asset.” The laws of other states should be reviewed to see if they offer similar comfort.
    Laurence J. Kline and Karl R. Anderson