The CPA Journal

Proposed TRUST LAW WILL ENABLE Investment for Total Return

By David Schaengold

Proposed TRUST LAW WILL ENABLE Investment for Total Return By David Schaengold The EPTL-SCPA (Estates, Powers, and Trusts Law–Surrogate’s Court Procedure Act) Legislative Advisory Committee has proposed legislation that would make changes in the definition of trust accounting income “designed to facilitate trust investing for total return” [Fifth Report issued May 11, 1999, amended May 26, 2000]. The committee recommended changes to the prudent investor rule [EPTL 11-2.3] and the principal and income act [EPTL 11-2.1] that would unify both toward the goal of providing “appropriate distributions” to current and future beneficiaries.

According to the committee, providing appropriate distribution to beneficiaries can most effectively be achieved by investing for total return, as required by the 1995 prudent investor rule. However, unless changes are made to the principal and income act, the effectiveness of total return investing is considerably diminished.

Prior to 1995, the prudent investor rule guided fiduciaries in their investment decisions. The rule was understood to mean that the criteria for selecting an investment would be those of a “prudent” investor of “discretion and intelligence.” In practice it boiled down to the preservation of capital with consideration to providing a certain level of income to an income beneficiary. The rule did not look at whether the portfolio was appreciating at the same rate as inflation.

The enactment of the prudent investor rule in 1995 changed the focus of fiduciaries. In keeping with the tenets of total return investing and other contemporary techniques, the act requires a fiduciary to develop an overall investment strategy which will enable appropriate present and future distributions to beneficiaries in accordance with risk and return objectives suitable for a portfolio in its entirety.

However, the problem that typically arises in applying the prudent investor rule lies in balancing the goal of providing “accounting income” to income beneficiaries against investing for total return. The rigidity of the traditional rules for determining accounting income constrains the fiduciary to select from only those investments which yield a particular kind of income return—dividends and interest—actually preventing the fiduciary from making investment decisions based purely on total return.

The committee argued that the current definition of trust accounting income (i.e., dividends and interest) “has become increasingly unsatisfactory in recent years … and operates as an inappropriate investment restriction on New York trusts to the detriment of income beneficiaries and remaindermen alike.” The specific problem is that the definition of accounting income does not include capital appreciation, “and yet over extended periods of time equity securities have produced the greatest overall return for investors. Moreover, if the trend of recent years continues the return on equity securities will be more and more from capital appreciation and less and less from dividends.”

The committee’s proposed legislation remedies this situation in two ways. First, it amends the prudent investor rule to give a trustee an adjustment power between principal and income so as to make appropriate distributions not otherwise permitted. Second, it provides the principal and income act with an elective alternative definition of trust accounting income by defining it as a unitrust amount set at 4 % of the total value of trust assets determined annually.

This “trustee’s power to adjust” will permit the modification of principal and income in situations where investing for total return does not produce sufficient accounting income to provide current beneficiaries with what otherwise would be a fair and reasonable use of the trust property consistent with preservation of value. This will allow the trustee to invest for total return without concern over whether the chosen investments will impartially allocate investment return between principal and income. The power to adjust spares the fiduciary from having to rely on asset allocation as the primary means for achieving impartiality. For example, it frees the fiduciary from having to sell appreciated securities (at a tax cost) in order to buy bonds to raise the level of income being distributed to an income beneficiary. The power to adjust enables a fiduciary to raise the level of distributable income without altering the portfolio.

The “optional unitrust provision” has been proposed as an alternative remedial solution. It allows the trustee to make investment decisions based purely on total return criteria by defining accounting income as “the unitrust amount.” The unitrust amount is set at 4% of the net fair market values of the assets held in trust (averaged over three years). This elective provision changes the trust to a unitrust for all future periods.

The committee developed the proposed legislation after five years of study, then amended it after receiving and reviewing suggestions and commentary from bankers, accountants, and lawyers. The New York Bankers Association and the New York State Bar Association Trusts & Estates Law Section have endorsed it. The proposed legislation will be brought up in the January 2001 legislative session and is expected to be enacted later in the year.

David Schaengold, CPA, practices in New York City and specializes in estate and trust matters. He served as the AICPA observer to the drafting committee to revise the Uniform Principal and Income Act and is a member of the NYSSCPA Income of Estates and Trusts Committee.

Editors:
Lawrence M. Lipoff, CPA
Deloitte & Touche LLP

Susan R. Schoenfeld, JD, LLM, CPA
Bessemer Trust Company N.A.

Contributing Editors:
Jerome Landau, CPA

Debra M. Simon, CPA
Merdinger Sruchter Rosen & Corso P.C.

Richard H. Sonet, JD, CPA
Marks Paneth & Shron LLP

Peter Brizard, CPA

Ellen G. Gordon, CPA
Margolin Winer & Evens LLP

Jeffrey S. Gold, CPA
Joseph R. Beyda & Company P.C.

Harriet B. Salupsky, CPA
Weinick Sanders Leventhal & Company LLP

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