Picture this: On the phone, income beneficiary Spouse #2 is complaining vehemently to the trustee that the trust’s portfolio isn’t producing enough income. Beforehand, remaindermen children from the first marriage also complained bitterly that the portfolio isn’t growing enough. The trustee is caught in the middle trying to please them all and investing in a balanced asset allocation that pleases no one. Sound familiar? Knowing if, how and when to use tools under the Uniform Principal and Income Act (UPAIA), in conjunction with Uniform Prudent Investor Act (UPIA) or similar versions enacted by the states, could be the trustee’s answer.
The UPAIA was enacted in response to the changing economic investment environment, along with evolving prudent investor standards, as a result of the UPIA. The trustee’s mandate is to integrate these two acts and not view each as a separate silo. The trustee also has a duty of impartiality to exercise the powers under the UPAIA for the mutual benefit of current and remainder beneficiaries. The UPAIA can potentially increase a trust’s economic growth and stability, if the trustee effectively knows if, how and when to exercise its powers.
Typically, the trustee may exercise powers under the UPAIA if the trust document provides for distribution of net income but limited or no principal distributions. These distribution provisions can create potential disputes between the trustee and the beneficiaries, as well as among the beneficiaries themselves, as to the trust’s investments. The issue may be exacerbated if the governing instrument doesn’t give the trustee guidance as to preferential treatment among beneficiaries. Under the UPAIA, the trustee can characterize trust income to include accounting principal for distributions to the current beneficiaries. By including accounting principal in income for distribution purposes, the trustee can provide additional income to the current beneficiaries, while investing for total return under the UPIA.
Purpose (the “If”)
Together, the UPAIA and UPIA promote the trustee’s investment strategy of total return to grow trust assets, sustain its purchasing power and reduce the likelihood of depleting trust assets. There may be a misconception among beneficiaries that the UPAIA is primarily intended to address their specific needs or expectations. While it’s important for trustees to attempt to meet the beneficiaries’ specific needs, that’s not the UPAIA’s primary purpose. As in any trust administration, it’s important to manage realistic expectations for beneficiaries. The trustee’s duty of impartiality must be adhered to in exercising the powers under the UPAIA. The trustee must administer the trust impartially, based on what’s fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will clearly manifest an intention that the trustee favor one or more of the beneficiaries. Fiduciaries, grantors, beneficiaries and drafting attorneys should recognize these parameters during the planning process and trust administration.
To effectuate the primary purpose of the UPAIA, the fiduciary and investment advisor must consider the UPIA when investing a trust portfolio. Central to the UPIA is investing for total return, which mandates asset allocation between income-producing assets for current income beneficiaries and growth-oriented assets for remaindermen (and current income beneficiaries). The portfolio is to be considered in its totality, not just its individual holdings. Taxes, fees and inflation are other important factors affecting the portfolio and its purchasing power over the trust term.
The challenge of the trustee’s duty of impartiality is particularly evident in the present economic and investment environment because fixed income investments have low yields to the detriment of current income beneficiaries. The trustee may not be able to overweight the fixed income allocation of the portfolio because of the apparent detriment to the remaindermen and less obvious long-term detriment to the current income beneficiaries. If the portfolio isn’t invested for total return and remains stagnant, increased fees, taxes and inflation will diminish the trust assets’ purchasing power over the trust term. Through the adjustment power or unitrust conversion, the UPAIA addresses this conflict between allocating sufficient assets to the income beneficiaries to increase distributions to address their needs, while not sacrificing the asset growth that investing in equities could potentially provide for remainder beneficiaries.
Approaches (the “How”)
The UPAIA provides the trustee with two primary approaches to addressing these situations by exercising: (1) an adjustment power, or (2) a unitrust conversion payout. The trustee initiates choosing which approach is more suitable for a particular trust or under state law (see “UPAIA Adoption Status,” pp. 43-44). There are currently 48 jurisdictions that have adopted the adjustment power provision from the UPAIA and 33 jurisdictions that have added a unitrust alternative to their statutes. Generally, the adjustment power is more flexible than a unitrust conversion because court action is required under many unitrust statutes. With the exception of Maryland, no jurisdiction has indicated a preference for a trustee to use one method over the other. Maryland requires the trustee to determine that a unitrust conversion is an inappropriate method for complying with the trustees’ fiduciary duties after review of all of the relevant factors before the trustee can use the adjustment power.
The adjustment power under UPAIA Section 104(a) acknowledges the potential inherent conflicts between the current income beneficiaries and the remaindermen, while the trustee exercises its duty of impartiality. The UPAIA provides for the trustee first to look to the governing instrument to determine the allocation between principal and income, and then state law when making distributions. If the trustee still can’t exercise its duty of impartiality with regard to investment asset allocations, then it can adjust between income and principal to make distributions. This ability to adjust between principal and income allows the trustee to invest consistent with prudent investor standards, rather than have an investment strategy that doesn’t provide for total return. For instance, the trustee doesn’t have to hold an asset that primarily focuses on dividends or interest at the expense of growth or sound investing.
The second approach—unitrust conversion—is, generally, used less frequently because, in part, there are greater limitations based on state law. Depending on the jurisdiction, the trustee may be allowed to make unitrust payouts. The trustee can invest for total return to address the realities of the investment environment and mitigate conflict between current and remainder beneficiaries. The varying state laws tend to be more restrictive, both substantively and procedurally, when exercising unitrust conversions than an adjustment power.
Accordingly, the trustee can decide if, how and when to exercise the adjustment power or a unitrust conversion based on a number of factors. The situations when it may be appropriate to implement the powers under UPAIA are if:
• There are no trustee powers of invasion of principal in the document for the current income beneficiary or beneficiaries, so the trustee can exercise either:
(1) the preferred method of an adjustment power; or (2) a unitrust conversion.
• The trustee has a discretionary limited power of invasion for principal distributions, so the trustee will most likely exercise an adjustment power, even if a unitrust conversion is permissible.
• The trust generates insufficient accounting income, but the document provides for principal distributions, so the trustee will most likely exercise an adjustment power, even if a unitrust conversion is permissible.
After the governing instruments, the effective use of the UPAIA integrates three major factors. First, the trustee must determine whether state law provides for an adjustment power, a unitrust conversion or both (see “UPAIA Adoption Status,” pp. 43-44). Based on the governing document and what’s permissible under state law, the trustee determines its powers to distribute principal or income to the beneficiaries.
Second, is the investment strategy and investment policy statement consistent with the governing instrument and the prudent investor standards under state law? Typically, the investment strategy will provide for an asset allocation that addresses current income and future growth. Investment advisors have different asset allocation models or strategies that range from highly favoring or overweighting fixed income investments, to the other end of spectrum of heavily favoring public equities or alternative investments (such as real estate, hedge funds or private equities). Depending on the trust’s objectives, the strategy may favor either growth or income. For example, marital trusts may differ from generation-skipping transfer (GST) tax-exempt trusts.
A trustee also may have the right to exercise powers under the UPAIA, even if the trustee has the power to invade principal under the governing instrument. The power may be limited, or the trust assets may not lend themselves to consistently expect liquidity for income or principal distributions. For example, trusts that are substantially overweight in alternative investments may have superseding liquidity requirements to maintain those investments. However, if a document provides for distribution of income and invasion of principal (even limited), it may be unnecessary for the trustee to exercise rights under UPAIA, even if the income is insufficient. It might be sufficient for the trustee to exercise its power to distribute principal under the document, especially if the distributions are based on beneficiaries’ needs.
The third factor that may create more nuances is the effect income or transfer tax has on the exercise of the powers. For example, inclusion of taxable gains in distributable net income (DNI) (under Internal Revenue Code Section 643 and Treasury Regulations Section 1.643(a)-3(b)), instead of a charge to trust corpus, can have an evident effect on the income beneficiaries or the trust corpus. Under IRC Section 643(b), the allocation of taxable income or realized gains to an income beneficiary for a portion of the distributions being accounting principal can reduce the benefit of the distribution. Treating distributions of realized gains as DNI to the income beneficiary, which typically are charged to trust principal, benefits the trust corpus and remaindermen. On the other hand, if accounting principal is distributed to the income beneficiary but realized capital gains are charged to the trust principal, the income beneficiary benefits. Under those circumstances, a portion of the total distributions is accounting principal, but only the distribution of accounting income is taxable to the income beneficiary. These scenarios illustrate that the trustee must remember its duty of impartiality when exercising its discretion. The trustee may factor in the amount of the principal distributions or unitrust percentage based on whether the trust or beneficiary will bear the tax burden. Also, the trustee’s tax treatment between the trust and its beneficiaries, under Treas. Regs. Section 1.643(a)-3(b), must be consistent during the trust administration. The trustee can’t change the approach from year to year or as between beneficiaries. Therefore, a trustee should consider whether the current beneficiary or trust will be responsible for realized gains when initially exercising the adjustment power or unitrust conversion.
Another factor to consider is the recent imposition of the 3.8 percent Medicare surtax under the Affordable Care Act. The trust corpus or beneficiaries’ after-tax distributions may be affected to the extent the surtax is taxable to the trust principal or the beneficiaries. A non-grantor trust is more likely to have the surtax imposed than certain individual beneficiaries because the surtax is typically triggered at a significantly lower income threshold for the trust. Therefore, the trustee should consider the trust’s and various beneficiaries’ tax situations when determining if, how and when to exercise the powers under the UPAIA.
The trustee also shouldn’t inadvertently disqualify a marital deduction trust or a GST tax-exempt trust. Under a marital trust, the spouse must receive all the net income at least annually (IRC Section 2056). Any principal distributions must be in addition to all net income. Thus, a unitrust conversion must provide that the spouse gets the greater of net income or the unitrust amount to avoid disqualifying the marital deduction treatment. Any adjustment power must not reduce the spouse’s right to all net income. A trustee must pay particular attention to distributions from a qualified domestic property trust (for a non-U.S. citizen spouse (IRC Section 2056A)). First, the spouse must receive the greater of net income or the unitrust amount to satisfy the marital deduction. Also, if principal is distributed to the spouse by either a unitrust distribution or adjustment power, then estate or gift tax will be accelerated, requiring the trustee to set aside the amount of estate or gift tax prior to the distribution. Additionally, a trustee must take care not to disqualify a GST tax-exempt trust by inadvertently paying out greater benefits to succeeding generations if that’s not permissible under the document or state law.
Some corporate trustees have elected to calculate the amount of income to be paid through the adjustment power by providing their officers with a range of allowable percentages. Some use other methods to pay income beneficiaries. One method in which the range might be determined is an analysis of what amount of income a model investment portfolio, based on a balanced asset allocation, should earn (on a percentage basis). This technique could allow for a consistent payout determination even with a wide variation in the types of assets held in various accounts. Some trustees run simulations to estimate the probability of what percentage could be paid out as income without risking the long-term viability of the trust. Some trustees have calculated their percentage payout, not based on the anticipated income, but rather on the anticipated total return of the account. This method would include an assumed income return from the cash and bonds and an assumed growth component for the equities. Trustees that use this approach may determine that the income beneficiaries should also receive a portion of the principal.
Trustees may also add other mechanisms to their processes to allow for additional “smoothing” (that is, reducing distribution volatility). Some techniques provide for a floor below which the distributions may not fall from one year to the next. For example, the floor may be 90 percent or 95 percent of the prior year’s distributions. There also may be a ceiling on how much the distributions can increase from one year to the next. For example, the ceiling might be 110 percent or 115 percent of the prior year’s distributions. In many cases, when trustees use a floor, they’ll also use a ceiling to “pay” for the floor. By providing for both a floor and ceiling, trustees can better manage beneficiaries’ distribution expectations for the succeeding year or years, and the beneficiaries can plan accordingly.
There are various methods to determine the adjustment power payout formula. Certain trustees may average the trust’s account balances over a period of time and exclude certain assets in the valuation, such as a closely held business. Other trustees employ an entirely different approach to arrive at the income to be paid to the beneficiaries. Industry standard benchmarks may be used. A trustee may choose different benchmarks for income returns for cash, bonds and equities. A trustee then may assume a hypothetical balanced asset allocation and calculate what anticipated income the portfolio may earn based on it and the benchmarks.
If the trustee decides to elect the adjustment power, it needs to determine when the power will apply—retroactively or prospectively. One method is to wait until the end of the calendar year and make a determination as to whether the income beneficiary received sufficient income based on all of the facts and circumstances. This mechanism may not adequately address the beneficiaries’ needs if they don’t have sufficient funds during the year. Another method is to prospectively determine prior to the start of the year the amount of income (and possibly principal) the trustee is going to pay the beneficiary. This approach allows the beneficiaries to know in advance how much and when they’ll receive distributions to allow them to plan and budget for their expenses.
Generally, the trustee will want to review and recalculate the adjustment annually. To do so more frequently could become administratively burdensome.
Fewer jurisdictions statutorily provide for a unitrust conversion than an adjustment power. Some jurisdictions provide for both. (For example, Delaware provides for a unitrust conversion payout of between 3 percent to 5 percent and an adjustment power). The trustee may find this unitrust range creates, rather than avoids, conflicts between the competing interests of the current and remainder beneficiaries. For instance, simulations may demonstrate that a 5 percent unitrust payout for a non-grantor, non-charitable trust significantly decreases the trust’s asset base or purchasing power over time due to distributions, fees, taxes and inflation. The likelihood of diminution is greater if fees and taxes are charged to principal.
New York, for instance, has a 4 percent unitrust payout, which many trustees consider unreasonably high based on actual economic circumstances. As such, many New York trustees opt for an adjustment power. They view a lower payout under an adjustment power to be more advantageous to the trust because there’s a significantly less likelihood of substantial diminution of trust assets over the trust term. Also, the 4 percent unitrust payout doesn’t include fees, so the diminution of the trust assets each year may be at least 5.5 percent. In today’s economic environment, a 3 percent payout would facilitate enhancing total return over a typical investment cycle of seven to eight years. To avoid a breach of the trustee’s duty of impartiality, in those scenarios, the trustee should establish a well-reasoned approach to determine the appropriate payout under the adjustment power (instead of unitrust conversion) based on the trust objectives investment horizon, value of the portfolio and anticipated trust term.
Under certain circumstances, a trustee may prefer a set unitrust payout for its presumed consistency and average the trust’s account balances over a certain period of time in meeting a current beneficiary’s needs and expectations. The payout percentage is a constant and may allow the investment advisor to invest accordingly and set aside sufficient liquidity to meet the distribution schedule.
Some of the unitrust statutes have specific requirements regarding the calculation of the unitrust payment, including the valuation period, valuation dates and assets that may or must be excluded. Many statutes require that the assets be valued as of the first day of the current and prior two years. Many statutes exclude hard-to-value assets or those used or occupied by a beneficiary from the calculation. No one formula will apply because of varying state statutes.
A major disadvantage of a unitrust conversion is that under certain state laws, the trustee must petition the court for approval if the trustee decides to opt out of the unitrust conversion or change the unitrust percentage payout. Because of the cost of court proceedings, this potential requirement may be reason enough for certain trustees to exercise an adjustment power instead of a unitrust conversion when available. Also, a unitrust percentage may be suitable for a given year, but depending on the economic circumstances, may not be suitable in another year.
Procedure (the “When”)
The trustee should consider a set policy regarding notice to and consent of beneficiaries. The most common method is for the trustee to notify both the current and remainder beneficiaries when it elects to exercise the adjustment power. In addition, several state statutes require notice of the exercise and, in some cases, provide the beneficiaries with a period of time to object to it. In most jurisdictions, the trustee can choose to notify only the current beneficiaries, but it’s sound practice to notify all of them. Some of the unitrust conversion statutes require not only notification of the decision to convert, but also consent from all of the beneficiaries. The jurisdiction’s law will dictate procedure for unborn beneficiaries or those under a legal disability.
In some cases, court approval to opt in or out may be required or desired when converting to unitrust payouts. None of the adjustment power statutes require court approval to start or stop using the adjustment power, although a few jurisdictions permit a trustee to petition the court for approval to use the adjustment power. The unitrust statutes generally provide a mechanism so that the trustee (or, in some cases, the beneficiary) can petition the court for permission and/or approval of a conversion. This allowance will provide the trustee with additional comfort in knowing that a court has ordered the conversion after consideration of all the relevant facts and circumstances and that all of the beneficiaries were before the court and had the opportunity to object. In addition, some states require court approval to stop using the unitrust approach.
The various jurisdictions’ laws differ widely in what procedural requirements are necessary to compute a unitrust payment. However, there are no specific requirements in the adjustment power statutes to help a trustee with determining how to calculate the payout to the beneficiary.
The trustee should provide written notice to the beneficiaries explaining the adjustment power or unitrust conversion, including a brief explanation of the power, the calculation methodology and the gross and net income amounts of the distributions. It also may be helpful to advise the beneficiaries how often the amount of income will be recalculated.
There are a number of changes in circumstances that may necessitate a trustee to change its approach and stop using the adjustment power. For instance, if a portfolio’s assets are allocated towards growth and don’t provide a reasonable income stream, the trustee can reallocate the portfolio towards income and then may consider no longer exercising the adjustment power. Also, if a beneficiary has a significant change in his distribution needs and there’s a power to invade principal, the trustee may elect to use the distribution power and discontinue using the adjustment power. A beneficiary’s death could be another instance. A trustee should have a process in place to periodically review its decision. The trustee needs to ensure that its choice isn’t motivated by an attempt to favor one class of beneficiaries over the other. If a decision is made to stop, the trustee should provide notice to the beneficiaries, especially in those jurisdictions where notice is required.
Integration of Factors
In the final analysis, the trustee’s approach in deciding if, when and how to exercise its rights under the UPAIA and duty of impartiality will depend on the integration of the governing instrument’s distribution provisions and objectives, state law, investment horizon, beneficiaries’ needs and expectations, trust assets, investment strategy, trust term and taxes. If a grantor or testator is primarily concerned about the needs and desires of a particular beneficiary or class of beneficiaries, he should consider providing explicit direction under the document to address them. Accordingly, it’s preferable for the trustee to invade principal if the trust provides for principal distributions and the accounting income is insufficient, instead of exercising rights under UPAIA. However, absent the trustee’s power to invade principal (or with limited invasion power) under the governing instrument, the adjustment power is preferable to a unitrust conversion, when both are permitted.
The chart mentioned above can be found here.
—The authors thank their colleague, Lori J. Campbell, senior vice president and regional fiduciary officer at U.S. Trust in Fort Worth, Texas, for her assistance and input.
—This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances.
The content represents thoughts of the authors and does not necessarily represent the position of U.S. Trust or Bank of America.
U.S. Trust, Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation, Bank of America, N.A., Member FDIC.