THE UNIFORM PRINCIPAL AND INCOME ACT OF TEXAS

Transcription

1 THE UNIFORM PRINCIPAL AND INCOME ACT OF TEXAS As Enacted by the 78 th Texas Legislature (2003) Effective January 1, 2004 With the Official Comments of The National Conference of Commissioners on Uniform State Laws and The Real Estate, Probate and Trust Law Section of the State Bar of Texas The comments and prefatory note to the Uniform Prudent Investor Act are copyrighted 1997 by the National Conference of Commissioners on Uniform State Laws. Used with permission. And With the Comments, Observations and Suggestions of Glenn M. Karisch Barnes & Karisch, P. C D Bee Caves Road Austin, Texas (512) FAX (512) by Glenn M. Karisch Chapter 3 The Uniform Principal and Income Act with Comments Page 1

2 Chapter 3 The Uniform Principal and Income Act with Comments Page 2

3 Table of Contents INTRODUCTION UNIFORM ACT PREFATORY NOTE TEXAS TRUST CODE CHAPTER 116. UNIFORM PRINCIPAL AND INCOME ACT SUBCHAPTER A. DEFINITIONS, FIDUCIARY DUTIES, AND OTHER MISCELLANEOUS PROVISIONS Sec SHORT TITLE Sec DEFINITIONS Sec UNIFORMITY OF APPLICATION AND CONSTRUCTION Sec FIDUCIARY DUTIES; GENERAL PRINCIPLES Sec TRUSTEE'S POWER TO ADJUST Sec JUDICIAL CONTROL OF DISCRETIONARY POWER Sec PROVISIONS REGARDING NONCHARITABLE UNITRUSTS SUBCHAPTER B. DECEDENT'S ESTATE OR TERMINATING INCOME INTEREST Sec DETERMINATION AND DISTRIBUTION OF NET INCOME Sec DISTRIBUTION TO RESIDUARY AND REMAINDER BENEFICIARIES SUBCHAPTER C. APPORTIONMENT AT BEGINNING AND END OF INCOME INTEREST Sec WHEN RIGHT TO INCOME BEGINS AND ENDS Sec APPORTIONMENT OF RECEIPTS AND DISBURSEMENTS WHEN DECEDENT DIES OR INCOME INTEREST BEGINS Sec APPORTIONMENT WHEN INCOME INTEREST ENDS SUBCHAPTER D. ALLOCATION OF RECEIPTS DURING ADMINISTRATION OF TRUST PART 1. RECEIPTS FROM ENTITIES Sec CHARACTER OF RECEIPTS Sec DISTRIBUTION FROM TRUST OR ESTATE Sec BUSINESS AND OTHER ACTIVITIES CONDUCTED BY TRUSTEE PART 2. RECEIPTS NOT NORMALLY APPORTIONED Sec PRINCIPAL RECEIPTS Chapter 3 The Uniform Principal and Income Act with Comments Page 3

4 Sec RENTAL PROPERTY Sec OBLIGATION TO PAY MONEY Sec INSURANCE POLICIES AND SIMILAR CONTRACTS PART 3. RECEIPTS NORMALLY APPORTIONED Sec INSUBSTANTIAL ALLOCATIONS NOT REQUIRED Sec DEFERRED COMPENSATION, ANNUITIES, AND SIMILAR PAYMENTS Sec LIQUIDATING ASSET Sec MINERALS, WATER, AND OTHER NATURAL RESOURCES Sec TIMBER Sec PROPERTY NOT PRODUCTIVE OF INCOME Sec DERIVATIVES AND OPTIONS Sec ASSET-BACKED SECURITIES SUBCHAPTER E. ALLOCATION OF DISBURSEMENTS DURING ADMINISTRATION OF TRUST Sec DISBURSEMENTS FROM INCOME Sec DISBURSEMENTS FROM PRINCIPAL Sec TRANSFERS FROM INCOME TO PRINCIPAL FOR DEPRECIATION Sec TRANSFERS FROM INCOME TO REIMBURSE PRINCIPAL Sec INCOME TAXES Sec ADJUSTMENTS BETWEEN PRINCIPAL AND INCOME BECAUSE OF TAXES EFFECTIVE DATE PROVISION Chapter 3 The Uniform Principal and Income Act with Comments Page 4

5 INTRODUCTION The 78 th Texas Legislature enacted a Texas version of the Uniform Principal and Income Act of HB 2241 becomes effective January 1, This legislation was part of the 2003 legislative package of the Real Estate, Probate and Trust Law Section of the State Bar of Texas. The Section studied three uniform acts promulgated by the National Conference of Commissioners on Uniform State Laws (NCCUSL) the Uniform Prudent Investor Act of 1994, the Uniform Principal and Income Act of 1997 and the Uniform Trust Code of 2000 for more than two years. The Section urged the adoption of Texas versions of two of those acts Prudent Investor and Principal and Income in 2003, and both were enacted into law. Following are the provisions of the Uniform Principal and Income Act of 1997 (the Act ) as enacted in Texas, the official NCCUSL notes and comments to the Act and each section of the Act (identified as Uniform Act Notes or Uniform Act Comments ) and the official comments of the Real Estate, Probate and Trust Law Section of the State Bar of Texas (the Section ) on the Texas variations of the Act (identified as Texas Bar Comments ). Also included are the section-by-section comments, observations and suggestions of Glenn M. Karisch. Glenn was the chair of the Trust Code Committee in , while the Uniform Principal and Income Act was being studied by the Section. Glenn s comments are contained in boxes and italicized. Chapter 3 The Uniform Principal and Income Act with Comments Page 5

6 UNIFORM ACT PREFATORY NOTE This revision of the 1931 Uniform Principal and Income Act and the 1962 Revised Uniform Principal and Income Act has two purposes. One purpose is to revise the 1931 and the 1962 Acts. Revision is needed to support the now widespread use of the revocable living trust as a will substitute, to change the rules in those Acts that experience has shown need to be changed, and to establish new rules to cover situations not provided for in the old Acts, including rules that apply to financial instruments invented since The other purpose is to provide a means for implementing the transition to an investment regime based on principles embodied in the Uniform Prudent Investor Act, especially the principle of investing for total return rather than a certain level of income as traditionally perceived in terms of interest, dividends, and rents. Revision of the 1931 and 1962 Acts The prior Acts and this revision of those Acts deal with four questions affecting the rights of beneficiaries: (1) How is income earned during the probate of an estate to be distributed to trusts and to persons who receive outright bequests of specific property, pecuniary gifts, and the residue? (2) When an income interest in a trust begins (i.e., when a person who creates the trust dies or when she transfers property to a trust during life), what property is principal that will eventually go to the remainder beneficiaries and what is income? (3) When an income interest ends, who gets the income that has been received but not distributed, or that is due but not yet collected, or that has accrued but is not yet due? (4) After an income interest begins and before it ends, how should its receipts and disbursements be allocated to or between principal and income? Changes in the traditional sections are of three types: new rules that deal with situations not covered by the prior Acts, clarification of provisions in the 1962 Act, and changes to rules in the prior Acts. New rules. Issues addressed by some of the more significant new rules include: (1) The application of the probate administration rules to revocable living trusts after the settlor s death and to other terminating trusts. Articles 2 and 3 [Subchapters B and C, Chapter 116, Texas Trust Code]. (2) The payment of interest or some other amount on the delayed payment of an outright pecuniary gift that is made pursuant to a trust agreement instead of a will when the agreement or state law does not provide for such a payment. Section 201(3) [Texas Trust Code (3)]. (3) The allocation of net income from partnership interests acquired by the trustee other than Chapter 3 The Uniform Principal and Income Act with Comments Page 6

7 from a decedent (the old Acts deal only with partnership interests acquired from a decedent). Section 401 [Texas Trust Code ]. (4) An unincorporated entity concept has been introduced to deal with businesses operated by a trustee, including farming and livestock operations, and investment activities in rental real estate, natural resources, timber, and derivatives. Section 403 [Texas Trust Code ]. (5) The allocation of receipts from discount obligations such as zero-coupon bonds. Section 406(b) [Texas Trust Code (b)]. (6) The allocation of net income from harvesting and selling timber between principal and income. Section 412 [Texas Trust Code ]. (7) The allocation between principal and income of receipts from derivatives, options, and assetbacked securities. Sections 414 and 415 [Texas Trust Code and ]. (8) Disbursements made because of environmental laws. Section 502(a)(7) [Texas Trust Code (a)(7)]. (9) Income tax obligations resulting from the ownership of S corporation stock and interests in partnerships. Section 505 [Texas Trust Code ]. (10) The power to make adjustments between principal and income to correct inequities caused by tax elections or peculiarities in the way the fiduciary income tax rules apply. Section 506 [Texas Trust Code ]. Clarifications and changes in existing rules. A number of matters provided for in the prior Acts have been changed or clarified in this revision, including the following: (1) An income beneficiary s estate will be entitled to receive only net income actually received by a trust before the beneficiary s death and not items of accrued income. Section 303 [Texas Trust Code ]. (2) Income from a partnership is based on actual distributions from the partnership, in the same manner as corporate distributions. Section 401 [Texas Trust Code ]. (3) Distributions from corporations and partnerships that exceed 20% of the entity s gross assets will be principal whether or not intended by the entity to be a partial liquidation. Section 401(d)(2) [Texas Trust Code (d)(2)]. (4) Deferred compensation is dealt with in greater detail in a separate section. Section 409 [Texas Trust Code ]. (5) The 1962 Act rule for property subject to depletion, (patents, copyrights, royalties, and the like), which provides that a trustee may allocate up to 5% of the asset s inventory value to income and the balance to principal, has been replaced by a rule that allocates 90% of the amounts received to principal and the balance to income. Section 410 [Texas Trust Code ]. Chapter 3 The Uniform Principal and Income Act with Comments Page 7

8 (6) The percentage used to allocate amounts received from oil and gas has been changed 90% of those receipts are allocated to principal and the balance to income. Section 411 [Texas Trust Code but see this section and the Texas Bar Comment for changes from uniform act]. (7) The unproductive property rule has been eliminated for trusts other than marital deduction trusts. Section 413 [Texas Trust Code ]. (8) Charging depreciation against income is no longer mandatory, and is left to the discretion of the trustee. Section 503 [Texas Trust Code ]. Coordination with the Uniform Prudent Investor Act The law of trust investment has been modernized. See Uniform Prudent Investor Act (1994); Restatement (Third) of Trusts: Prudent Investor Rule (1992) (hereinafter Restatement of Trusts 3d: Prudent Investor Rule). Now it is time to update the principal and income allocation rules so the two bodies of doctrine can work well together. This revision deals conservatively with the tension between modern investment theory and traditional income allocation. The starting point is to use the traditional system. If prudent investing of all the assets in a trust viewed as a portfolio and traditional allocation effectuate the intent of the settlor, then nothing need be done. The Act, however, helps the trustee who has made a prudent, modern portfolio-based investment decision that has the initial effect of skewing return from all the assets under management, viewed as a portfolio, as between income and principal beneficiaries. The Act gives that trustee a power to reallocate the portfolio return suitably. To leave a trustee constrained by the traditional system would inhibit the trustee s ability to fully implement modern portfolio theory. As to modern investing see, e.g., the Preface to, terms of, and Comments to the Uniform Prudent Investor Act (1994); the discussion and reporter s note by Edward C. Halbach, Jr. in Restatement of Trusts 3d: Prudent Investor Rule; John H. Langbein, The Uniform Prudent Investor Act and the Future of Trust Investing, 81 Iowa L. Rev. 641 (1996); Bevis Longstreth, Modern Investment Management and the Prudent Man Rule (1986); John H. Langbein & Richard A. Posner, The Revolution in Trust Investment Law, 62 A.B.A.J. 887 (1976); and Jeffrey N. Gordon, The Puzzling Persistence of the Constrained Prudent Man Rule, 62 N.Y.U. L. Rev. 52 (1987). See also R.A. Brearly, An Introduction to Risk and Return from Common Stocks (2d ed. 1983); Jonathan R. Macey, An Introduction to Modern Financial Theory (2d ed. 1998). As to the need for principal and income reform see, e.g., Joel C. Dobris, Real Return, Modern Portfolio Theory and College, University and Foundation Decisions on Annual Spending From Endowments: A Visit to the World of Spending Rules, 28 Real Prop., Prob., & Tr. J. 49 (1993); Joel C. Dobris, The Probate World at the End of the Century: Is a New Principal and Income Act in Your Future?, 28 Real Prop., Prob., & Tr. J. 393 (1993); and Kenneth L. Hirsch, Inflation and the Law of Trusts, 18 Real Prop., Prob., & Tr. J. 601 (1983). See also, Jerold I. Horn, The Prudent Investor Rule Impact on Drafting and Administration of Trusts, 20 ACTEC Notes 26 (Summer 1994). Chapter 3 The Uniform Principal and Income Act with Comments Page 8

9 TEXAS TRUST CODE CHAPTER 116. UNIFORM PRINCIPAL AND INCOME ACT SUBCHAPTER A. DEFINITIONS, FIDUCIARY DUTIES, AND OTHER MISCELLANEOUS PROVISIONS Sec SHORT TITLE. This chapter may be cited as the Uniform Principal and Income Act. Sec DEFINITIONS. In this chapter: Former Subchapter D of Chapter 113 of the Trust Code, which contained the principal and income allocation rules prior to January 1, 2004, did not contain a separate definitions section. Note that Section of the Trust Code contains definitions applicable to the entire Trust Code, including Chapter 116, and some of the same terms are defined. (1) "Accounting period" means a calendar year unless another 12-month period is selected by a fiduciary. The term includes a portion of a calendar year or other 12-month period that begins when an income interest begins or ends when an income interest ends. This useful definition accounting period was not included in the prior statute. (2) "Beneficiary" includes, in the case of a decedent's estate, an heir, legatee, and devisee and, in the case of a trust, an income beneficiary and a remainder beneficiary. Beneficiary also is defined in Texas Trust Code (2) as follows: Beneficiary means a person for whose benefit property is held in trust, regardless of the nature of the interest. While this definition and the one in Section (2) are not the same, they are not inconsistent. Note that, in the universe of the Uniform Principal and Income Act, the only beneficiaries are income beneficiaries and remainder beneficiaries, both of which terms are defined below in ways one may not expect. (3) "Fiduciary" means a personal representative or a trustee. The term includes an executor, administrator, successor personal representative, special administrator, and a person performing substantially the same function. It is useful to have a definition of fiduciary because much of the Uniform Principal and Income Act applies to estates as well as trusts. Note that the definition does not expressly include guardians of the Chapter 3 The Uniform Principal and Income Act with Comments Page 9

10 estate or agents under a power of attorney. Perhaps this is because NCCUSL did not consider principal and income allocations to be relevant to these types of fiduciaries. Note, however, that a guardian s commission is based in part on the gross income of the ward s estate [see Texas Probate Code 665(a). There is no clear tie between these income and principal allocation rules and the guardianship part of the Probate Code, however, so it is not clear if courts supervising guardianships will import these concepts for purposes of determining guardianship compensation. The compensation of the trustees of guardianship management trusts (so-called 867 Trusts ) is tied to the Section 665 standard, so it will be interesting to see if courts apply Uniform Principal and Income Act standards to determining 867 Trust trustee compensation. (4) "Income" means money or property that a fiduciary receives as current return from a principal asset. The term includes a portion of receipts from a sale, exchange, or liquidation of a principal asset, to the extent provided in Subchapter D. The definition of income in Section (5) refers to this definition, so this definition of income applies throughout the Trust Code. Note that the definition ties into the sections of Subchapter D (Texas Trust Code ) that provide that certain receipts on sale or liquidation of a principal asset are income such as the income portion of receipts from oil and gas properties (Texas Trust Code ). (5) "Income beneficiary" means a person to whom net income of a trust is or may be payable. This is a key definition which is not entirely intuitive. If, under the terms of the trust, net income may be payable to a person, they are an income beneficiary. Thus, the current beneficiary of a trust which may receive discretionary income distributions (or income distributions based upon an ascertainable standard, such as health, education, maintenance and support ) is an income beneficiary, even though they may not have a right to receive income distributions. (6) "Income interest" means the right of an income beneficiary to receive all or part of net income, whether the terms of the trust require it to be distributed or authorize it to be distributed in the trustee's discretion. This definition is consistent with the definition of income beneficiary an interest is an income interest if the beneficiary may receive income, regardless of whether or not the trustee is required to distribute income to the beneficiary. This definition is useful in specifying what happens when there are transitions due to persons dying or aging out of trusts in other words, when income interests begin and end. See Texas Trust Code (7) "Mandatory income interest" means the right of an income beneficiary to receive net income that the terms of the trust require the fiduciary to distribute. Chapter 3 The Uniform Principal and Income Act with Comments Page 10

11 (8) "Net income" means the total receipts allocated to income during an accounting period minus the disbursements made from income during the period, plus or minus transfers under this chapter to or from income during the period. The interesting part of this definition is that it includes not only receipts allocated to income minus disbursements charged to income, but also transfers to or from income. The official NCCUSL comment (see below) says that the transfers to which this definition refer mean transfers made under Section (a) [the power to adjust although this section refers to these as adjustments and not transfers ), Section [allocations of receipts for renewable water], Section (b) [transfers related to encumbered assets], Section (b) [transfers for depreciation probably the most common type of transfer as used in this context], Section (a) [certain transfers to reimburse principal] and Section [adjustments between principal and income because of taxes]. (9) "Person" means an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government; governmental subdivision, agency, or instrumentality; public corporation, or any other legal or commercial entity. Person also is defined in Section (10). The two definitions are slightly inconsistent. The defintion in Section (9) appears to be slightly broader, since it includes certain modern business organizations which are left out of the definition in Section (10). (10) "Principal" means property held in trust for distribution to a remainder beneficiary when the trust terminates. The definition of principal in Section (11) refers to this definition, so this definition of principal applies throughout the Trust Code. (11) "Remainder beneficiary" means a person entitled to receive principal when an income interest ends. A person who is entitled to become an income beneficiary when the current income interest ends is not a remainder beneficiary. A person can be a remainder beneficiary even if he or she must wait for successive income interests to end not just the current income interest. For example, if the terms of the trust provide Income to A for life, then income to B for life, then remainder to C, A and B are income beneficiaries (even though B has no current right to receive income distributions while A is alive) and C is the remainder beneficiary. (12) "Terms of a trust" means the manifestation of the intent of a settlor or decedent with respect to the trust, expressed in a manner that admits of its proof in a Chapter 3 The Uniform Principal and Income Act with Comments Page 11

12 judicial proceeding, whether by written or spoken words or by conduct. See the official NCCUSL comment below for an explanation of why terms of a trust was used with this definition, rather than terms of the trust instrument. In addition to addressing oral trusts, this definition and the comment appear to open the door to extraneous testimony in construction cases. While one can argue that, under this definition, oral statements are only relevant if they are expressed in a manner that admits of its proof in a judicial proceeding, and, therefore, the statute makes no change to existing law regarding admissibility of extraneous statements in trust construction cases, one may also argue that Texas law now specifically anticipates that extraneous evidence will be admitted, at least in construction cases where principal and income allocations are relevant. (13) "Trustee" includes an original, additional, or successor trustee, whether or not appointed or confirmed by a court. Trustee also is defined in Section (18). The definitions are not inconsistent. The definition in Section (13) may help a successor trustee in cases where the trust does not specifically say that the powers given to the trustee in the instrument also are given to the successor trustee, but Trust Code seems to give successor trustees all the powers of the original trustee in most cases. Uniform Act Comment Income beneficiary. The definitions of income beneficiary (Section 102(5) [Texas Trust Code (5)]) and income interest (Section 102(6) [Texas Trust Code (6)]) cover both mandatory and discretionary beneficiaries and interests. There are no definitions for discretionary income beneficiary or discretionary income interest because those terms are not used in the Act. Inventory value. There is no definition for inventory value in this Act because the provisions in which that term was used in the 1962 Act have either been eliminated (in the case of the underproductive property provision) or changed in a way that eliminates the need for the term (in the case of bonds and other money obligations, property subject to depletion, and the method for determining entitlement to income distributed from a probate estate). Net income. The reference to transfers under this Act to or from income means transfers made under Sections 104(a) [Texas Trust Code (a)], 412(b) [Texas Trust Code (b)], 502(b) [Texas Trust Code (b)], 503(b) [Texas Trust Code (b)], 504(a) [Texas Trust Code ], and 506 [Texas Trust Code ]. Terms of a trust. This term was chosen in preference to terms of the trust instrument (the phrase used in the 1962 Act) to make it clear that the Act applies to oral trusts as well as those whose terms are expressed in written documents. The definition is based on the Restatement (Second) of Trusts 4 (1959) and the Restatement (Third) of Trusts 4 (Tent. Draft No. 1, 1996). Constructional preferences or rules would also apply, if necessary, to determine the terms of the trust. Sec UNIFORMITY OF APPLICATION AND CONSTRUCTION. In applying and construing this Uniform Act, consideration must be given to the need to Chapter 3 The Uniform Principal and Income Act with Comments Page 12

13 promote uniformity of the law with respect to its subject matter among states that enact it. This provision, similar to provisions included in all uniform acts promulgated by NCCUSL, makes the court decisions in other cases relevant in construing Texas s version of the uniform act (assuming Texas s version does not differ in a material respect). Sec FIDUCIARY DUTIES; GENERAL PRINCIPLES. (a) In allocating receipts and disbursements to or between principal and income, and with respect to any matter within the scope of Subchapters B and C, a fiduciary: (1) shall administer a trust or estate in accordance with the terms of the trust or the will, even if there is a different provision in this chapter; Section (a)(1) makes it clear that the Uniform Principal and Income Act imposes default rules. If the trust instrument (oops, I mean the terms of the trust see Section (12)) or the will override the default rules, the trustee must follow the terms of the trust or will. (2) may administer a trust or estate by the exercise of a discretionary power of administration given to the fiduciary by the terms of the trust or the will, even if the exercise of the power produces a result different from a result required or permitted by this chapter; Many trust instruments permit the trustee to exercise discretion in allocating principal and income. Section (a)(2) makes it clear that the Uniform Principal and Income Act does not take away that discretion. Under prior law (old Section (b), no inference arose from the fact that a trustee made an allocation other than according to the statute, if the trust instrument gave the trustee discretion to make the allocation. Under the old standard, an appellate court held that it was not an abuse of discretion for a trustee to exercise its discretion to allocate a capital gain to income, but it was an abuse of discretion for the trustee to call a trust asset income and distribute it to the income beneficiary. Thorman v. Carr, 408 S. W. 2d 259 (Tex. Civ. App. San Antonio 1966), aff d per curiam, 412 S. W. 2d 45 (Tex. 1967). Of course, in many cases where allocation is left to the trustee s discretion, the trustee chooses to follow the statutory allocation rules as an informal safe harbor, operating on the theory that if the trustee follows the statute in exercising its discretion, it is unlikely to be deemed to have abused its discretion. (3) shall administer a trust or estate in accordance with this chapter if the terms of the trust or the will do not contain a different provision or do not give the fiduciary a discretionary power of administration; and This may seem obvious that the trustee must follow the statutory rules if the terms of the trust do not provide otherwise and do not give the trustee discretion. On the other hand, this is an affirmative Chapter 3 The Uniform Principal and Income Act with Comments Page 13

14 statement that these allocation rules must be followed, which could be helpful. (4) shall add a receipt or charge a disbursement to principal to the extent that the terms of the trust and this chapter do not provide a rule for allocating the receipt or disbursement to or between principal and income. Section (a)(4) is an important provision: NCCUSL unabashedly states the uniform act s proprincipal bias. If neither the terms of the trust nor the statute says that a receipt or charge is principal or income, then it is principal. Understanding this bias makes it easier to understand the uniform act. There were places where the Section believed that this bias got out of hand such as in the case of oil, gas and mineral allocations and deferred compensation plan allocations and the Texas version does not follow the uniform act. Prior Texas law did not have this bias. Under old Section (a)(3), if neither the trust instrument nor the code provided an answer to an allocation issue, the allocation was to be made in accordance with what is reasonable and equitable in view of the interests of those entitled to income and to principal. It will be interesting to see how courts will this pro-principal bias. (b) In exercising the power to adjust under Section (a) or a discretionary power of administration regarding a matter within the scope of this chapter, whether granted by the terms of a trust, a will, or this chapter, a fiduciary shall administer a trust or estate impartially, based on what is 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 fiduciary shall or may favor one or more of the beneficiaries. A determination in accordance with this chapter is presumed to be fair and reasonable to all of the beneficiaries. Section (b) both giveth to, and taketh away from, trustees: Discretionary determinations are presumed to be fair and reasonable to all beneficiaries, so the trustee starts from a good point in any challenge to its actions under the Act. Under prior law, no such presumption arose. On the other hand, the trustee must act impartially based on what is fair and reasonable to all beneficiaries unless a different intention is clearly manifested in the trust. This duty of impartiality has long been a part of Texas trust law, but until January 1, 2004, it was a common law doctrine. Now it is statutory law. Section of the new Uniform Prudent Investor Act contains a more general statement of the statutory duty of impartiality. In some ways it is difficult to understand how the impartiality of Section (b) can be applied in light of the pro-principal bias stated in Section (a)(4). However, they aren t directly contradictory, since Section (a)(4) applies in cases where allocations must be made when both the statute and the trust instrument is silent, while Section (b) applies to discretionary decisions. Chapter 3 The Uniform Principal and Income Act with Comments Page 14

15 Uniform Act Comment Prior Act. The rule in Section 2(a) of the 1962 Act is restated in Section 103(a) [Texas Trust Code (a)], without changing its substance, to emphasize that the Act contains only default rules and that provisions in the terms of the trust are paramount. However, Section 2(a) of the 1962 Act applies only to the allocation of receipts and disbursements to or between principal and income. In this Act, the first sentence of Section 103(a) [Texas Trust Code (a)] states that it also applies to matters within the scope of Articles 2 and 3 [Subchapters B and C of Texas Trust Code Chapter 116]. Section 103(a)(2) [Texas Trust Code (b)(2)] incorporates the rule in Section 2(b) of the 1962 Act that a discretionary allocation made by the trustee that is contrary to a rule in the Act should not give rise to an inference of imprudence or partiality by the trustee. The Act deletes the language that appears at the end of 1962 Act Section 2(a)(3) and in view of the manner in which men of ordinary prudence, discretion and judgment would act in the management of their affairs because persons of ordinary prudence, discretion and judgment, acting in the management of their own affairs do not normally think in terms of the interests of successive beneficiaries. If there is an analogy to an individual s decision-making process, it is probably the individual s decision to spend or to save, but this is not a useful guideline for trust administration. No case has been found in which a court has relied on the prudent man rule of the 1962 Act. Fiduciary discretion. The general rule is that if a discretionary power is conferred upon a trustee, the exercise of that power is not subject to control by a court except to prevent an abuse of discretion. Restatement (Second) of Trusts 187. The situations in which a court will control the exercise of a trustee s discretion are discussed in the comments to 187. See also id. 233 Comment p. Questions for which there is no provision. Section 103(a)(4) [Texas Trust Code (a)(4)] allocates receipts and disbursements to principal when there is no provision for a different allocation in the terms of the trust, the will, or the Act. This may occur because money is received from a financial instrument not available at the present time (inflation-indexed bonds might have fallen into this category had they been announced after this Act was approved by the Commissioners on Uniform State Laws) or because a transaction is of a type or occurs in a manner not anticipated by the Drafting Committee for this Act or the drafter of the trust instrument. Allocating to principal a disbursement for which there is no provision in the Act or the terms of the trust preserves the income beneficiary s level of income in the year it is allocated to principal, but thereafter will reduce the amount of income produced by the principal. Allocating to principal a receipt for which there is no provision will increase the income received by the income beneficiary in subsequent years, and will eventually, upon termination of the trust, also favor the remainder beneficiary. Allocating these items to principal implements the rule that requires a trustee to administer the trust impartially, based on what is fair and reasonable to both income and remainder beneficiaries. However, if the trustee decides that an adjustment between principal and income is needed to enable the trustee to comply with Section 103(b) [Texas Trust Code (b)], after considering the return from the portfolio as a whole, the trustee may make an appropriate adjustment under Section 104(a) [Texas Trust Code (a)]. Duty of impartiality. Whenever there are two or more beneficiaries, a trustee is under a duty to deal impartially with them. Restatement of Trusts 3d: Prudent Investor Rule 183 (1992). This rule applies whether the beneficiaries interests in the trust are concurrent or successive. If the terms of the Chapter 3 The Uniform Principal and Income Act with Comments Page 15

16 trust give the trustee discretion to favor one beneficiary over another, a court will not control the exercise of such discretion except to prevent the trustee from abusing it. Id. 183, Comment a. The precise meaning of the trustee s duty of impartiality and the balancing of competing interests and objectives inevitably are matters of judgment and interpretation. Thus, the duty and balancing are affected by the purposes, terms, distribution requirements, and other circumstances of the trust, not only at the outset but as they may change from time to time. Id. 232, Comment c. The terms of a trust may provide that the trustee, or an accountant engaged by the trustee, or a committee of persons who may be family members or business associates, shall have the power to determine what is income and what is principal. If the terms of a trust provide that this Act specifically or principal and income legislation in general does not apply to the trust but fail to provide a rule to deal with a matter provided for in this Act, the trustee has an implied grant of discretion to decide the question. Section 103(b) [Texas Trust Code (b)] provides that the rule of impartiality applies in the exercise of such a discretionary power to the extent that the terms of the trust do not provide that one or more of the beneficiaries are to be favored. The fact that a person is named an income beneficiary or a remainder beneficiary is not by itself an indication of partiality for that beneficiary. Texas Bar Comment Texas Trust Code (a)(4) provides that a receipt or disbursement shall be allocated to principal if neither the terms of the trust nor the Act addresses how such receipt or disbursement is to be allocated. In contrast, former Section of the Texas Trust Code provided that the trustee must allocate such receipts and disbursements in accordance with what is reasonable and equitable. While this appears to be a significant change, its effect is mitigated by Texas Trust Code , which gives the fiduciary the power to make adjustments between income and principal and such adjustments must be based on what is fair and reasonable to all of the beneficiaries. Texas Trust Code (b) provides greater protection for fiduciaries by providing that an allocation in accordance with the Uniform Act will be presumed to be fair and reasonable to all beneficiaries. The Section believes that this is a positive adjustment to former Section (b) of the Texas Trust Code, which provided that no inference arises from the fact that the fiduciary makes an allocation contrary to the Texas Trust Code. Sec TRUSTEE'S POWER TO ADJUST. (a) A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust's income, and the trustee determines, after applying the rules in Section (a), that the trustee is unable to comply with Section (b). The power to adjust conferred by this subsection includes the power to allocate all or part of a capital gain to trust income. The power to adjust is the heart of the Uniform Principal and Income Act. Note that the power to adjust is available only if all of the following conditions are met: 1. The trustee must be investing and managing the trust assets as a prudent investor -- in other words, Chapter 3 The Uniform Principal and Income Act with Comments Page 16

17 following the prudent investor rule stated in the Uniform Prudent Investor Act. If the terms of the trust provide a different investment standard and override the Act, the power to adjust is not available. What if the terms of the trust only partially override the Act? For example, what if the terms of the trust permit the trustee to retain certain assets without diversification but do not override the Act completely? In that case, is the trustee investing as a prudent investor, making the power to adjust available, or is the trustee precluded from using the power to adjust? I think the likely answer is, with respect to the asset(s) being held based on the override of the diversification rule, the trustee is not investing as a prudent investor and cannot use the power to adjust. However, if there are sufficient other assets in the trust which are being managed as a prudent investor, then the trustee may be able to take the position that this portion of the trust is being so managed and the power to adjust is available with respect to this portion. If this is the case, then the trustee would not be able to balance out inequities caused by the concentration of assets (in other words, cure the problem of the concentrated assets producing too much or too little income) by using other trust assets as a source of adjustments between principal and income. 2. The terms of the trust must describe the amount that may or must be distributed to a beneficiary by referring to the trust s income. My interpretation of this is that if the trustee has discretion to make principal and income distributions to a beneficiary, or if the trustee may make principal and income distributions to a beneficiary based upon an ascertainable standard such as health, education, maintenance and support (HEMS), then the trustee may not use the power to adjust. If one reads it any differently (for example, to permit adjustments when the distribution standard is all income to spouse plus HEMS principal distributions to spouse), then the second requirement makes very little sense, since of course virtually all trusts will speak in terms of income and/or principal distributions. As a practical matter, if the trustee has authority to make principal distributions to the income beneficiary (whether on a totally discretionary basis or limited to an ascertainable standard such as HEMS), it will almost always be preferable to make the principal distribution using that power even if the Section power to adjust is available. It almost always will be easier to justify the principal distribution than the adjustment. 3. The trustee must determine that, after applying the general allocation rules of Section (a), the trustee cannot comply with duty of impartiality stated in Section (b) without making the adjustment. 4. None of the prohibitions stated in Section (c) apply (discussed below). The Texas version of Section (a) includes an express statement that the power to adjust gives the trustee the power to allocate all or part of a capital gain to trust income. This was added to allow the newly allocated income to be treated as distributable net income, in light of proposed treasury regulations under Section 643 of the Internal Revenue Code. The statute and the examples in the official NCCUSL comments, below, speak in terms of adjustments between principal and income, rather than between principal receipts and income receipts. Thus, it appears that an adjustment from principal to income can be made from unrealized capital appreciation and not just from realized capital gains. Of course, there probably needs to be sufficient cash to distribute, but the adjustment need not be tied to the amount of realized capital gains. The statute does not say whether or not a trustee can make a prospective adjustment for future years Chapter 3 The Uniform Principal and Income Act with Comments Page 17

18 (for example, saying that in future years the trustee will treat the trust as a 5% unitrust). I think it is likely that the adjustment power must be exercised periodically and not once for all time. See, however, my comment to Section (d), below, where I suggest the possibility of a judicial advisory opinion proceeding for prospective adjustments (aka a unitrust). Doing a prospective adjustment without a judicial proceeding could be risky. (b) In deciding whether and to what extent to exercise the power conferred by Subsection (a), a trustee shall consider all factors relevant to the trust and its beneficiaries, including the following factors to the extent they are relevant: The factors to be considered in determining whether or not to make an adjustment are broad and to a large extent are tied to the Uniform Prudent Investor Act. Section (c) lists a number of factors that a trustee applying the prudent investor rule must consider, including: Other resources of the beneficiaries( (c)(6)), which is related to the identity and circumstances of the beneficiaries (Section (b)(3)); Needs for liquidity, regularity of income, and preservation or appreciation of capital (Section (c)(4)), which is virtually identical to Section (b)(4); The role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property (Section (c)(4)), which is closely related to Section (b)(5); the possible effect of inflation or deflation (Section (c)(2), which is closely related to Section (b)(8); the expected tax consequences of investment decisions or strategies (Section (c)(3), which is related to Section (b)(9). (1) the nature, purpose, and expected duration of the trust; (2) the intent of the settlor; If the settlor intended the income beneficiary to receive a reasonable amount of income distributions, but the trustee invests for total return under the prudent investor rule and produces nothing but capital gains, the trustee can take into consideration the settlor s intent in making an adjustment of capital gains to income. (3) the identity and circumstances of the beneficiaries; Chapter 3 The Uniform Principal and Income Act with Comments Page 18

19 Since the Uniform Prudent Investor Act permits the trustee to consider the other resources of the beneficiaries( (c)(6)), and since Section (b)(3) permits the trustee to consider the circumstances of the beneficiaries in deciding whether or not to make an adjustment, this may give the trustee a basis for not adjusting capital gains receipts to income in cases where the income beneficiary has other resources and does not need the income distribution. Of course, the income beneficiary may not see things the same way. See also Example #3 in the official NCCUSL comments, below, which indicates that an adjustment to increase income may be necessary even in cases where the income beneficiary does not need the extra income. (4) the needs for liquidity, regularity of income, and preservation and appreciation of capital; (5) 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; (6) the net amount allocated to income under the other sections of this chapter and the increase or decrease in the value of the principal assets, which the trustee may estimate as to assets for which market values are not readily available; This seems obvious that the trustee may consider whether the allocation rules of the Uniform Principal and Income Act otherwise would require too much income or too much principal. (7) 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; (8) the actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation; and (9) the anticipated tax consequences of an adjustment. (c) A trustee may not make an adjustment: Even if the trustee otherwise could make an adjustment, Section (c) lists several cases in which the trustee is prohibited from making an adjustment. (1) that diminishes the income interest in a trust that requires all of the Chapter 3 The Uniform Principal and Income Act with Comments Page 19

20 income to be paid at least annually to a spouse and for which an estate tax or gift tax marital deduction would be allowed, in whole or in part, if the trustee did not have the power to make the adjustment; Marital deduction (QTIP) trusts require all of the income to be distributed to the spouse. The power to adjust cannot be used to diminish the spouse s income interest in a QTIP trust, but it can be used to increase the spouse s income interest. (2) that reduces the actuarial value of the income interest in a trust to which a person transfers property with the intent to qualify for a gift tax exclusion; (3) that changes the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets; (4) from any amount that is permanently set aside for charitable purposes under a will or the terms of a trust unless both income and principal are so set aside; No amount that is set aside for charitable purposes may be adjusted away from those purposes. Presumably this keeps the power to adjust from being used in a net income charitable remainder unitrust, where an adjustment from principal to income could increase the distribution to a noncharitable beneficiary. (The power to adjust would not be needed in a unitrust without a net income provision.) If the entire trust (principal and income) is charitable, then the power to adjust can be used. (5) if possessing or exercising the power to make an adjustment causes an individual to be treated as the owner of all or part of the trust for income tax purposes, and the individual would not be treated as the owner if the trustee did not possess the power to make an adjustment; (6) if possessing or exercising the power to make an adjustment causes all or part of the trust assets to be included for estate tax purposes in the estate of an individual who has the power to remove a trustee or appoint a trustee, or both, and the assets would not be included in the estate of the individual if the trustee did not possess the power to make an adjustment; (7) if the trustee is a beneficiary of the trust; or (8) if the trustee is not a beneficiary, but the adjustment would benefit the trustee directly or indirectly. Chapter 3 The Uniform Principal and Income Act with Comments Page 20