By Stephen C. F. Diamond
In Brief
Legislative Initiatives Facilitate Trust Planning
In recognition of the enormous run-up in the value of investment securities during the 1990s, New York State amended the estates, powers, and trusts law to allow trustees to elect new allocations between income and principal interests under certain circumstances. The legislation provides a means for income beneficiaries to benefit from gains in their trust’s investment portfolios that would have been allocable only to principal under prior law. The author briefly explains the public policy issues that led to the law’s revision and details the major provisions that affect the new elections.
New York has just enacted two significant changes in its law concerning income and principal of trusts and estates. These changes do not abolish traditional concepts of principal and income. They do, however, authorize executors and trustees to redefine or adjust income, and trustees can now convert an “all income to beneficiary” trust into a unitrust. The changes offer exciting new opportunities for changing beneficial interests in existing trusts (with or without court proceedings). They are all the more attractive because the changeover can be made retroactively, giving the fiduciary the benefit of hindsight in making the decision.
The new legislation, coupled with federal income tax regulations proposed earlier this year by the Treasury Department that affect the definition of trust income under IRC section 643 and corresponding sections, enhances the power to adjust or create a unitrust payout. This will enable many trusts (especially income-only trusts) to implement total return investing for trust beneficiaries. The legislation’s new planning alternatives may create a duty to analyze various investing options and their potential returns for trust beneficiaries. Knowledge of their purpose, the policy that led to their creation, and their operations is necessary for an informed analysis.
Background
For almost two centuries traditional legal concepts had strictly divided principal and income interests. The division was so strict that, for purposes of virtual representation (where the representor and the represented must have the “same interest”) in judicial accounting proceedings, the rule was that “principal cannot represent income, and income cannot represent principal.”
A relatively recent breach of the rule separating principal and income interests came in a judicial ruling on the issue of virtual representation on an accounting proceeding. Matter of Putignano [82 Misc.2d 389 (Surr. Ct. Kings Co. 1975)] redefined “same interest” as an “identity of economic interests in a particular proceeding.”
The breach was significantly widened by the 1995 enactment of the Prudent Investor Act (EPTL 11-2.3, effective January 1, 1995).This law’s investment philosophy focused a fiduciary to invest for “expected total return of the portfolio (including both income and appreciation of capital) ... for present and future distributions.”
This total return investment philosophy mirrored the then current investment philosophy, but created an unbearable tension in many trusts that were prepared and administered under the old principal, and income dichotomy. Income-only trusts, with an income for life to one individual, the remainder to another, and no power to invade principal, were affected most adversely by the new law. Trustees were now told by law to invest one way, but told by the trust instrument to administer another way. Because of the run-up in the stock market, a demand arose for income beneficiaries to enjoy a fair share of the increases in the principal value of trusts invested for their benefit.
Accounting Income Distributable to Beneficiaries
Under the new law, two options are available to redefine trust income:
Fiduciary’s power to adjust between principal and income. New York’s new Prudent Investor Act (EPTL 11-2.3) contains a subsection captioned “trustee’s power to adjust” [EPTL 11-2.3(b)(5)]. The effective date of this power is January 1, 2002. The statute uses the terms trustee and trust, but it also applies to estates and fiduciaries that administer estates, such as executors.
The new statute is permissive and not mandatory, meaning that trustees can decide whether to adopt it. Wherever a trust describes “the amount that may or must be distributed to a beneficiary by referring to the trust’s income,” the amended prudent investor standard “authorizes a trustee to adjust between principal and income to the extent the trustee considers advisable ... so that current beneficiaries may be given such use of the trust property as is consistent with preservation of its value.”
In addition to other standards in the prudent investor statute, the trustee may consider the following factors, to the extent relevant:
(i) the intent of the settlor, as expressed in the governing instrument; the assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor;
(ii) the net amount allocated to income under article 11-A [the new principal and income act] and the increase or decrease in the value of the principal assets ...; and
(iii) whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income or prohibit the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income.
The trustee may not make an adjustment if doing so would adversely affect certain enumerated favorable tax treatments of a trust (such as a marital or charitable deduction), or if it would cause the trust to be considered an available asset for a public benefit program. In some instances, a co-trustee could make the adjustment. The trustee may release the power, in whole or in part, if it is uncertain whether exercising the power could cause an adverse result. The trust instrument may also expressly override the adjustment power.
The new provisions of EPTL 11-2.3-A give a trustee great latitude to allocate between principal and income. A court may not change a fiduciary’s decision to adjust unless it determines the decision was an abuse of discretion. The court may only surcharge the trustee if adjustments cannot be made out of the principal and income of the trust and if the trustee’s determination was “dishonest or arbitrary and capricious.” The fiduciary may petition the court for an advance ruling on allocation changes.
Optional unitrust provision. The new EPTL 11-2.4 adds an optional unitrust provision for certain trusts (described below) that are required to pay income to a beneficiary or class of beneficiaries. Basically, a trustee can elect to convert an old-law trust required to pay income to a beneficiary into a unitrust required to pay a defined percentage of the trust’s principal, as valued each year.
For the first three years of the trust, the unitrust amount equals 4% of the net fair market value of the assets held in the trust on the first business day of the current valuation year. Beginning with the fourth year, the unitrust amount equals 4% of the blended average value of the value on the first day of the current year and the first day of the preceding two years. “The term ‘prior valuation year’ shall mean each of the two years of the trust immediately preceding the current valuation year.” [EPTL 11-2.4(c)(3)]
There are provisions for adjustments in the case of incorrect values, underpayments, and overpayments, and there is proration for short years, similar to those for charitable remainder trusts under IRC section 664. There are additional adjustments for trust ownership of residential or tangible personal property used by a beneficiary.
Application and Effective Date
The new law applies to the following trusts:
Effective date of election. An important provision of the new statute is the effective date of the election. The election is effective as of the first year in which assets become subject to the trust, unless it is expressly made effective as of the first day of the year of the trust beginning after the election is made.
Advantages of the New Options
The new elections provide significant new opportunities for income only, no principal invasion trusts. These trusts will be beyond the reach of the new statute only if the creator of the trust has specifically negated application.
A special opportunity exists for trusts that have enjoyed significant appreciation during the recent decade of growth in the securities market. A trustee could retroactively elect to adjust between principal and income under the new EPTL 11-2.3(b)(5) in order to provide income beneficiaries with a portion of the benefit from the run-up of stock prices.
Nonetheless, the circumstances of certain trusts are such that an election to implement the new statutes would not be advantageous, such as credit shelter trusts that will pass estate tax–free upon the death of the beneficiary (assuming, of course the beneficiary has sufficient other assets), because they could cause unintended estate taxes on the death of the beneficiary. Such assets in the hands of the beneficiary could also be subject to claims of creditors and divorcing spouses, and could cause the beneficiary to become ineligible for government medical benefits.
There may be another good, though not strictly economic, reason not to elect the principal-income adjustment statute. The present statute (which continues to govern unless the fiduciary opts out of it), with its time-honored classifications and principles, is much simpler to administer. The new adjustment statute is highly subjective, and some trustees may not want to go through the bother of making an individualized determination (Although the trustee should be able to show, if questioned, that it considered the adjustment option). Others may not want to deal with argumentative beneficiaries who would seek to have more trust assets allocated to them.
In addition, a trustee is ineligible to elect the new adjustment statute if the trustee is a current beneficiary or presumptive remainderman, or if the trustee would benefit directly or indirectly (although not a current beneficiary or a presumptive remainderman). Under these circumstances, however, a co-trustee who would not be benefitted could make the election, unless prohibited by the trust instrument.
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