What Is "Trust Income" in 2001?

omething very significant just hit the world of estate planning and it wasn't a repeal of the estate tax.¹ The arrival of proposed regulations to redefine trust income has had an immediate impact on investment strategies and financial planning. Trusts qualifying for marital and charitable deductions will need to be drafted with the new rules in mind.

Yet the current concern over the tax accounting rules that apply to the distribution of income between a lifetime beneficiary and a remainderman is but one small facet of a timeworn debate of great lineage. This is a debate that has confronted courts and legislatures for centuries. Draftsmen, aware of the morass of conflicting rules, have routinely included customized provisions in wills and trusts to establish their own parameters. And as society has grown to accept the "total return" approach of investing, the standards to which we hold trustees have been changing. Let's review how we arrived at this juncture, and what the new rules will mean for popular trusts.

When Men Were Prudent

Once upon a time, in 1830, there was a trust filled with securities that fell in value from $50,000 to $30,000. A Massachusetts court found that the investment in bank stocks was proper and the trustee was not held liable to the remainderman. More significant than the decision was dicta from which the prudent-man standard emerged. Trustees were "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested."²

Just at face value, this venerable 1830 standard wouldn't appear to preclude the modern trustee from adopting a total return investment approach for a trust since the same approach might well be used "in regard to the permanent disposition of their funds."³ Yet, freighted with the cumulative definitions of 170 years of case law and statutes, the prudent-man standard would compel an imprudent investment program.⁴

By comparison, the prudent investor rule that has emerged looks beyond individual assets, seeks the overall value of the portfolio, and recognizes the need for diversification. Instead of categorically forbidding an investment, its risk must be managed in the context of the overall portfolio. Given the specialized advice and services that professionals rely upon, the delegation of certain investment duties is permitted.⁵

Modern Day Trader Mentality

Times have changed. When the prudent-man standard was included in the Restatement 2nd of the Trusts in 1959, there were about 155 mutual funds. By 1998, the number was in excess of 8,000 and growing. At one time, financial assets were a minor part of most estates. Today, investors study the holdings of their self-directed IRAs or their employer's 401(k) plan with real-time quotes over the Internet and can make nearly instantaneous trades at minimal cost. Between 1989 and 1998, financial assets grew from 30.4% to 40.6% of total household assets while the value of a primary residence slipped from 32% to 28% of total household assets.⁶

In this environment, grantors and beneficiaries grow impatient with overly conservative portfolios-obviously more so during a period of bullish market runs. They are more concerned with total growth and not whether a dividend is issued. Perhaps as a result, income returns from equities have fallen to 1.2% in recent years, placing more pressure on the conflict between income beneficiaries and remaindermen. The compression of the income tax rate schedule, which hits the top rate of 39.6% for trust income in excess of $8,650 for the 2000 tax year, has also shifted investment emphasis away from income and toward equity growth.⁷

A Vast Body of Law

How many centuries does it take to determine what items are income and what are principal? How many have you got? It all comes down to the issue of money. Who will get it? How much? Every penny is in contention. Every nuance of every transfer is scrutinized, adjudicated, legislated, litigated, annotated, restated, retried, and refried.⁸

Attempts to unify the various rules were made in good faith. The Uniform Principal and Income Act of 1931 was adjusted by the Revised Uniform Principal and Income Act of 1962, which in turn has been updated by the new Uniform Principal and Income Act of 1997. Apparently, there are always more issues.⁹

Codifying Discretion: Is there a way to bypass the bureaucratic tedium, the conflicting jurisdictional approaches, and the regulatory restrictions? What about just giving the trustee discretion? Yes, that approach has been pursued and it can work. But as soon as the power of "discretion" is given to a trustee, that power becomes a fresh battleground. How much discretion is given concerning investments and the distribution of income? Should the trustee be required by trust language to consider the needs of other beneficiaries, the needs of those dependent on a beneficiary, or the other sources of income that a beneficiary has?¹⁰

And once these guidelines are imposed, they engender another round of judicial interpretation and statutory limitation. For example, the Revised Uniform Principal and Income Act provides (at �2(b)) that if the trustee has discretion on principal and income matters, no inference of imprudence or partiality arises from the fact that the trustee has made an allocation contrary to a provision of the Act. Discretion may be given to liquidate unproductive assets and allocate portions of the proceeds to income. Discretion may be given to allocate charges and expenses to income or principal. Discretion may be given to disregard the duty of impartiality.

Redefining income

The traditional approach to trust income has been to classify everything in one of two categories, income or principal. Interest and dividends are generally income and capital gains are generally part of principal. Though logical and clear in theory, this concept provided little consensus in practice. For example, the treatment of corporate dividends resulted in three approaches.¹¹

Over time, the real world has further blurred the lines of income and principal. The modern "total return" approach to investing gives more priority to long-term returns, so to provide a beneficiary with support, trust distributions to a lifetime beneficiary can take a unitrust approach and be defined as percentages of the total corpus of a trust. A growing number of states are enacting or considering legislation that permits a trustee to exercise discretion in making equitable adjustments between income and principal, if necessary, to ensure that the income and remainder beneficiaries are being treated fairly.¹²

The revised definition of trust income will continue to disregard disbursements that fundamentally depart from the traditional concepts of income and principal, but state law will be respected if it provides for a reasonable apportionment between income and remainder beneficiaries of the total return of the trust for the year. The revision to Reg. �1.643(b)-1 specifically provides: "For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between 3% and 5% of the annual fair market value of the trust assets is a reasonable apportionment of the total return of the trust."

Impact on Popular Trusts

Although the entire system of transfer taxation may soon be drastically altered, current laws involve several deductions that are dependent on the respective amounts of income and principal of a given trust. Because proposed state laws affect how income and principal amounts are determined, the IRS has proposed amending regulations affecting trusts that qualify for the gift and estate tax marital deduction, qualified domestic trusts, and trusts that are exempt from generation-skipping transfer taxes.

To qualify for the marital deduction for property that is transferred to a trust, a basic premise is that all trust income must be paid to the spouse for life. This is true of a life estate with a general power of appointment pursuant to �2056(b)(5) as well as qualified terminal interest property (QTIP) pursuant to �2056(b)(7). Under the proposed amendments to Reg. ��20.2056(b)-5(f) and 25.2523(e)-1(f), this standard would be met even though the income interest is determined, based on state law, to be based on a reasonable apportionment of the trust's total return between income and remainder beneficiaries. Such "reasonable apportionment" can be accomplished by defining income in terms of a unitrust or by empowering the trustee to make equitable adjustments between income and principal.

Note that the marital deduction can only be based on a unitrust payout or the power to adjust income and principal in those states that adopt the Uniform Principal and Income Act with the Power to Adjust Between Principal and Income or some comparable law. In the absence of such a law, an income interest would have to be drafted as "the greater of income or a unitrust."

GST Tax: In the context of the generation-skipping transfer (GST) tax, the major concern is whether the recharacterization of trust corpus as income would cause a trust established prior to September 25, 1985, to lose its grandfathered status and expose the assets to GST tax liability. The proposed regulations provide that equitable adjustments between income and principal to ensure impartiality and that meet the requirements of Reg. �1.643(b)-1(a) would not be treated as a modification that shifts a beneficial interest to a lower generation or triggers the GST tax.

Ordering Rules: The inclusion of capital gains within distributable net income (DNI) is also clarified by the proposed regulation. At the present time, �643(a)(3) excludes capital gains from DNI to the extent they are not paid, credited, distributed, or set aside for a charitable purpose. The proposed regulations would amend Reg. �1.643(a)-3(a) to clarify that capital gains would be included in DNI if, under local or the governing instrument, they are allocated to income, or allocated to corpus but treated by the fiduciary on the trusts books, records, and tax returns as a distribution to a beneficiary.¹³

The proposed regulations also address the order in which ordinary income, short-term gains, and long-term capital gains are allocated when there is state law on point (Example 9) or when there is neither state law nor an ordering rule in the governing instrument of the trust (Example 10). It is not perfectly clear whether an ordering rule in the governing instrument could be relied upon in the absence of state law.

Charitable Deductions: The shifting of principal to income also has important ramifications where a charitable deduction is based on the amount of principal, i.e., the remainder interest. In this context, the proposed regulations do not embrace the modern approach to trust income.

Where the "income" of a noncharitable beneficiary is to be defined as a unitrust (under proposed State statutes), portions of the principal could be treated as income, reducing the share belonging to charitable beneficiaries. Thus, the proposed regulations would amend Reg. �1.642(c)-2(c) to prevent the long-term capital gain of a pooled-income fund from qualifying for the charitable deduction if income may be a unitrust amount or include an equitable adjustment that encompasses the unrealized appreciation of the principal.

Similarly, proposed state statutes would allow trust income from a charitable remainder unitrust (CRUT) to be a fixed percentage that is less than 5% of the annual fair market value of the trust (in violation of �664(d)(2) which requires amounts distributed to noncharitable beneficiaries to be a fixed percentage not less than 5% nor more than 50%). To address this, the IRS has proposed regulations that amend Reg. �1.664-3(a)(1)(i)(b) to provide that CRUT income may not be determined by reference to a fixed percentage of the annual fair market value of the trust. And if applicable state law defined income as a unitrust amount, the governing instrument of the CRUT must provide its own definition of trust income.

Looking Ahead

The proposed amendments to the regulations will be effective for tax years of trusts and estates beginning on or after the date the regulations are finalized. A public hearing is scheduled for June 8, 2001. In addition to adjustments to the final regulations, this area has unresolved issues and will remain quite dynamic.¹⁴

Technical References

¹ Notice of proposed rulemaking, REG-106513-00.

² Harvard College v. Amory, 26 Mass. (9 Pick.) 446 (1830).

³ Ironically, the prudent-man rule is seen as rigid as compared to the modern prudent investor standard, but the original standard was quite flexible. However, the standard may not have spread beyond the borders of Massachusetts until the 1940s. Rather, there was a general tendency to classify investments as permissible or not, leaving no grey areas. See, Cheris, Making responsible investment decisions in light of the evolving prudent person rule, 14 EP 6, at p. 338 (1987).

⁴ The prudent-man standard applies to each separate investment. As a result, legal actions could challenge a single underperforming asset in a portfolio that was, on the whole, outperforming the market. This was an unforgiving approach that discouraged sound investments since even a carefully diversified plan can contain a single bad investment. Certain categories of investments were simply considered unacceptable by definition, while others, such as bank certificates of deposit and other safe investments, were automatically assumed to preserve capital. Also, under the prudent-man standard, a trustee may not delegate investment responsibilities.

⁵ The Prudent Investor Rule was adopted in 1990 in Restatement of Trust 3d by the American Law Institute. It had been adopted by 29 states as of 1999.

⁶ The 1998 Survey of Consumer Finances was released by the Federal Reserve in February, 2000.

⁷ The income tax rates on nongrantor trusts were compressed to remove the incentive for multiple trusts, supposedly closing an exploited loophole. Yet the net result was to penalize the majority of personal trusts that provide living expenses. Prior to the Revenue Reconciliation Act of 1993, a 36% rate applied to income in excess of $115,000 and the top rate of 39.6% applied to income in excess of $250,000.

⁸ The National Conference of Commissioners on Uniform State Laws has repeatedly provided model legislation addressing trusts and trust income. These include: The Uniform Fiduciaries Act, the Uniform Principal and Income Act (with versions in 1931, 1962, and 1997), the Uniform Trusts Act, the Uniform Trustees' Accounting Act, the Uniform Common Trust Fund Act, the Uniform Testamentary Additions to Trusts Act, the Model Prudent Man Investment Act, the Uniform Trustees' Powers Act, the Uniform Act of Simplification of Fiduciary Transfer of Securities, the Uniform Probate Code, and the Uniform Commercial Code. Various states have their own trust legislation, most notably New York's Estate's Powers and Trusts Law (1966), but also California, Georgia, Indiana, Illinois, Louisiana, Maryland, Michigan, Minnesota, Missouri, Montana, North Dakota, Oklahoma, Pennsylvania, South Dakota, Texas, and Wisconsin. England has its own set of trust laws: The Judicial Trustee Act (1896), the Public Trustee Act (1906), the Trustee Act (1925), the Charitable Trusts Act (1925), the Variation of Trusts Act (1954), the Validation of Charitable Trusts Act (1958), the Charities Act (1960), and the Perpetuities and Accumulations Act of 1964. Bogert, Trusts ��6 and 7 (West, 1987).

⁹ A Restatement of the American Law of Trusts was completed by the American Law Institute in 1935 and then revised and repromulgated as the Restatement of Trusts, Second in 1957. The Restatement Third of the Laws of Trust, a 307-page volume which included the new prudent investor rule, was adopted in 1992. The Uniform Prudent Investor Act arrived in 1992. The prudent investor rule and other modifications were then included in the new Uniform Principal and Income Act that was approved in 1997.

¹⁰ For example, a discretionary clause might provide: "I authorize my Trustee, in its discretion, to make any one or more of the elections allowed by the Internal Revenue Code or tax law of any state. The Trustee need not, but may, make offsetting adjustments to the interest of income or principal beneficiaries to recognize what the Trustee in its discretion deems substantial benefits or detriments arising from any such election." Variations of this clause would require the trustee to make adjustments to compensate for any reduction in income tax or any increase in estate tax. Another variation would dictate the allocation and prohibit such adjustment. Nossaman, Trust Administration and Taxation (1956; revised, 1982).

¹¹ The original Kentucky rule (now replaced by statute) had treated all cash dividends as income. The Pennsylvania rule, now abandoned, had required trustees to determine which dividends were derived from corporate earnings. The Massachusetts rule treated cash dividends as income and stock dividends as principal.

¹² The Uniform Principal and Income Act with the Power to Adjust Between Principal and Income has recently been adopted by 13 states. Four additional states, Delaware, Missouri, New York, and Pennsylvania, are considering legislation to allow unitrust definitions of income to be utilized in addition to a trustee's power to adjust income and principal.

¹³ Several examples are provided by the revised Reg. �1.643(a)3. In Example 1, a Trustee allocates $10,000 of capital gain to principal and distributes $12,000 to the lifetime beneficiary pursuant to the discretionary power to distribute principal. Capital gains realized during the year were not included in distributable net income (DNI). However, in Example 2, under similar facts, the Trustee is following a regular practice of treating discretionary distributions as being paid first from any net capital gains realized by the trust during the year. In this example, the Trustee includes the $10,000 of capital gains for the year in DNI. This is a reasonable discharge of the Trustee's discretion. In future years, the Trustee must continue to treat all discretionary distributions the same way.

¹⁴ Future regulations may be needed to address modern techniques for trust income distributions such as adjusting the payout of income based on an average value for trust assets over three years so as to reduce the volatility of income payments. Other trusts adjust payments for inflation but impose a ceiling amount in the form of a unitrust. It is possible to have unitrusts of different amounts that phase in as a beneficiary reaches certain ages.

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The Estate Analyst is written by Robert L. Moshman, JD. (c) 4/2001

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