UTC Notes UTC STATE OUTLOOK 2004 UNIFORM TRUST CODE INSIDE... 4th Quarterly Issue Winter Why Banks Should Support The Uniform Trust Code...

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1 UNIFORM TRUST CODE UTC Notes 4th Quarterly Issue Winter 2003 INSIDE... Why Banks Should Support The Uniform Trust Code...3 Current and Upcoming Projects at NCCUSL...4 Effect of Uniform Laws on Trustee Investment...5 UTC STATE OUTLOOK 2004 (This report is derived from a longer article titled "Enacting the Uniform Trust Code" by Michelle Clayton published this month in E-State (2003.3), the new electronic newsletter produced by the American Bar Association Real Property Probate and Trust Law Section.) At least a dozen state legislatures are likely to introduce the Uniform Trust Code (UTC) in 2004 with many having groups finishing studies of the UTC that lasted at least one year. The UTC will also be reintroduced in several of the states in 2004, after earlier introductions resulted in a determination that further study was needed. Other UTC bills will be introduced with the intention of either creating a legislative study committee or having the bill "carry over." Carrying over a bill provides additional opportunity for comment and final adjustments. Introduction of the UTC is expected in the following states next year: UTC NOTES UTC Notes is a is quarterly a newsletter quarterly published newsletter by the National published Conference by the of National Commissioners Conference on of Uniform Commissioners State Laws on under Uniform the State direction Laws of David under English, the direction Chair, of UTC David Advisory English, Committee. Chair, Michelle UTC Advisory Clayton, Committee. Editor. Michelle Clayton, Editor. Alabama has thoroughly studied the UTC through the Alabama Law Institute and the Alabama Bar Association. The bill will likely contain some minor changes, some to reflect current and long-standing Alabama law. The Colorado Bar completed its study in July 2001 and, like Nebraska, published an excellent report that recommended little change to the UTC. An attempt to introduce the bill in 2002 was unsuccessful, and a bill that was introduced in 2003 was withdrawn because of a negative fiscal report issued by the State Judicial Department. The Colorado Bar Association UTC Committee is working with the Judicial Department to remove the fiscal note. No other state UTC bills have had fiscal notes attached indicating added cost to the state. In fact, many surmise that the UTC will lower court costs. See, Maurice Hartnett, "A Judge's View of the Uniform Trust Code", UTC Notes, Fall The UTC has strong support from the Connecticut Bar Association which has done a tremendous job of promoting the UTC through seminars and articles. However, some opposition from the banking community has delayed the bill for two years in a row, despite a number of requested banking changes being incorporated into the bill. The Connecticut Bar plans to re-introduce the bill in Maine is an example of a state that had a bill introduction turn into a legislative study in It has a substantial committee from its Bar actively engaged in a study of the UTC and, to the extent necessary, working on amendments to Maine's Uniform Probate Code. The committee is working feverishly to meet certain end of the year deadlines for possible introduction.

2 The Missouri UTC committee studied the UTC for several years. It is opting to include some unique provisions from Missouri's current trust law, but generally have a UTC without major changes. It has full support from the Missouri Bar and is likely to pass in New Hampshire's UTC committee includes members of the bar, the banking community, the judiciary and the legislator who is expected to introduce the bill in early The committee hopes to make New Hampshire the first state to enact the UTC on the East Coast. A study group in New Jersey is preparing to have the UTC introduced in New Jersey's Legislature meets all year; thus, the study group is under less pressure than those states whose legislatures are in session for only two to three months. A joint committee of bankers, lawyers and judges studying the UTC in Ohio are now carefully reviewing a UTC draft. It will be widely available for comments through the winter. A bill will may be introduced and possibly passed in 2004, but is more likely to pass sometime in A bill re-introduction in Oklahoma with support from the Oklahoma Bar and Bankers is likely. Additional review of the UTC was required after an earlier introduction of the bill failed in The UTC committee in Utah is in the process of completing its second review of the UTC with the intention of resubmitting it in the 2004 legislative session starting in January. Certain provisions in last year's bill had to be modified due to the adoption last year of a bill allowing self-settled spendthrift trusts in Utah. The Tennessee Bar conducted a study of the past couple of years and will support adoption of the Uniform Trust Code this year. Virginia's UTC committee expects to see an introduction of a bill in 2004 with the intention to carry the bill over for passage in This approach will permit additional review by the Virginia Bar and allow for comments and issues from other interested parties to be addressed throughout the year. West Virginia may see another introduction of the UTC in An introduction in 2002 resulted in a determination by the Bankers and Bar that further study was needed. Getting Closer Numerous groups in the states are in the midst of a study, but are not yet ready for a bill introduction in Some states do not have legislative sessions until The states with study groups aiming for introductions at some point after 2004 include: Florida is a state with a comprehensive trust statute already in place. The Florida Bar Real Property Probate and Trust Law Section has an ongoing study of the UTC and recently appointed an ad hoc trust code revision committee to begin drafting legislation. Like some state committees, they hired a reporter to assist in the drafting. They hope to have a bill prepared for introduction in The Idaho UTC study committee continues monthly meetings and is almost through with its first run through the UTC. The committee anticipates introduction will not be earlier than 2005, partly because the bill must be completely prepared to pass within the limited 60 days that the Legislature meets. Montana, which passed both the Uniform Prudent Investor and Uniform Principal and Income Acts last year, is laying the groundwork for introduction of a UTC bill. It has no legislative session in The North Carolina Bar is working steadily to get a draft bill prepared for further review by the various committees that must review it before it can be a part of the Bar's legislative package in Oregon began its study in The subcommittees submitted their written reports to the Study Committee in September During the coming months, various Oregon State Bar Sections will be asked for input regarding UTC provisions affecting their areas of interest. The Study Committee's goal is to prepare a final legislative proposal by May 2004, for consideration by the 2005 legislature. Texas has an ongoing UTC study and may opt to "cherry-pick" UTC provisions to add to its already comprehensive statutory trust law. It is not a state quick to adopt uniform trust and estate acts. Texas just last year enacted the Uniform Prudent Investor and Uniform Principal and Income Acts, which have each been adopted in approximately 40 other states. Other states that have ongoing study groups include: Maryland, Michigan, New York, Vermont and Washington State. Just Getting Started Several states have just begun review of the Uniform Trust Code. The beginning of a study involves numerous Page 2

3 considerations. It is hoped that the groups will start out with the presumption of enacting the UTC rather than "cherry-picking" it for attractive provisions. The benefits of uniformity are lost when the format is not adopted and unintended consequences result when portions of the Code are cut and pasted into an existing statute. States starting out must also consider the repeal of existing statutes including those uniform acts that would be superseded. Each must decide how it will handle the Uniform Prudent Investor Act which is intended to be The Uniform Trust Code ("UTC") is primarily default law, but it is important because it consolidates the law on trusts and puts it in a clear, accessible format. As enactment of the UTC occurs throughout the country, financial institutions dealing with many jurisdictions across state lines will benefit. Without codification, banks must rely on case law (which may not address an issue at hand) and the Restatements. Codification will provide the chance of wider authority on the points of law covered by the UTC. The UTC will also provide an educational resource for lawyers and bank personnel learning the law on trusts. Wide adoption of the UTC will result in greater efficiency and cost-savings for banks as trust administration procedures are standardized. Financial institutions will want to carefully review all UTC provisions and be actively involved in enactment in the states in which they do business. Following are some more specific examples of how the UTC benefits financial institutions: Article 1 - General Provisions Provides for nonjudicial settlement agreements to help keep trust administration outside of the courts. 111 Allows some actions such as combining/dividing trusts solely on notice to the beneficiaries. 111 Permits beneficiary consent for other actions such as selecting a successor trustee and releasing a trustee from potential liability. 111 Details specific rules for determining when an organization "knows" something. 104(b) Article 3 - Representation Provides detailed rules for beneficiary representation, both by fiduciaries and what is known as virtual representation. Page 3 placed into Article 9, but has already been adopted in approximately 40 states. Other considerations include optional bracketed provisions in the UTC, key local law issues, accommodation of variations in local court systems, what to do about "fiduciary statutes" and identifying other policy and political issues. States just starting up late this year include: Arkansas, Mississippi, Georgia and South Carolina. They will be considering legislative activity beginning no earlier than WHY BANKS SHOULD SUPPORT THE UNIFORM TRUST CODE by Scot Boulton* Allows binding consent by another person having a substantially identical interest with respect to a particular issue either - in court or nonjudicially - through virtual representation broadening the ability to obtain finality without the necessity of court action. 304 Offers protections for those inadequately represented, and provides assurance to fiduciaries with respect to information and notice requirements. 305 Article 4 - Modification and Termination Continues the overarching principle that the settlor's intent is paramount while providing some needed flexibility due to dynasty trusts and lengthened rules against perpetuities. Recognizes the validity of animal trusts, an increasingly popular trust provision. 408 Permits creation of non-charitable trusts without a beneficiary presently named. 409 Allows termination without having to go to court when a trust's value dips below $50, Allows reformation for mistake to conform to the settlor's intention. 415 Allows courts to modify the terms of a trust to achieve a settlor's tax objectives as long as the settlor's probable intention is not violated. 416 Article 6 - Revocable Trusts Provides that capacity requirements for these popular will substitutes be the same as that required to make a will. 601 Makes trusts revocable by default. 602(a)

4 Benefits trustees dealing with revocable trusts because of a mechanism within the UTC for establishing the validity of that trust and eliminating contests. 604 Establishes final validity after 3 years or in 120 days after giving notice. 604 Protects trust distributions made earlier without knowledge of contests. 604(b) Article 7 - Office of Trustee Clarifies trustee acceptance and rejection rules and steps that can be taken without being deemed to accept Provides actions that can be taken by a co-trustee when the ability of other trustee to act is in question. 703(b). Allows trustees to seek a change in compensation if unreasonably high or low. 708 Article 8 - Duties and Powers of Trustee Clearly states the fundamental duties of a trustee and lists trustees powers. Protects trustee action on the direction of a settlor of a revocable trust even if contrary to the term of the trust Provides well-drafted and comprehensive tax savings provision. 814 Protects a trustee for making distributions pursuant to a pre-announced distribution schedule. 817 Article 10 - Liability of Trustees and Rights of Persons Dealing with Trustees Provides a one year statute of limitations for breach actions against trustees from the date that the trustee sent the beneficiary or their representative a report adequately disclosing the existence of a potential claim of breach and stating the time allowed for commencing a proceeding Protects trustees taking reasonable care to ascertain the happening of event that might affect distribution, such as marriage or death, and allows trustees to rely on the trust instrument. 1006,1007 Offers protection for trustees against personal liability for contract or tort liability Provides that parties may rely on the certification of trust, thereby reducing the need for a third party to request a copy of the trust instrument Provides that knowledge of trust terms are not presumed from possession of trust document. 1013(f) Conclusion The Uniform Trust Code will be a significant improvement over present trust law and will make great strides in the cost efficiency and standardization of providing trust services, particularly with financial institutions operating in more than one state. Fair and balanced provisions in the UTC protect the settlor, beneficiary and trustee and will further increase the desire of settlors to create trusts to carry out estate planning goals. The UTC affords trustees significantly more protection and certainty than under current law. Banks and other financial institutions should be involved in and support the enactment of the Uniform Trust Code in every state. * Scot Boulton is Vice President and Senior Trust Officer of U.S. Bank Private Client Group in St. Louis, Missouri and recently chaired the Missouri Bar UTC Study Committee. He authored "How Uniform Will the Uniform Trust Code Be: Vagaries of Missouri Trust Law Versus Desires for Conformity"(MO L. Rev Vo. 67 Spring 2002) and has lectured on the UTC for ALI-ABA and the University of Miami Hecklering Institute. Current and Upcoming Projects at NCCUSL The National Conference of Commissioners on Uniform State Laws (NCCUSL) continues to advance our other important uniform trust and estate acts which include: Uniform Custodial Trust Act, Uniform Disclaimer of Property Interests Act, Uniform Principal and Income Act, Uniform Probate Code, and Uniform Prudent Investor Act. The latest uniform act in the area of trust and estates is the revision to the Uniform Estate Tax Apportionment Act and UPC The final version with comments is available on the NCCUSL website at A drafting committee was appointed earlier this year to draft amendments to the Uniform Durable Power of Attorney Act. The committee is chaired by Jack Burton of New Mexico and the Reporter is Professor Linda Whitton from Valparaiso University School of Law. A study committee on amendments of the jurisdictional provisions to the Uniform Guardianship and Protective Proceedings Act has been appointed and is currently seeking comments from interested parties before a drafting committee is appointed. Final uniform acts and drafts of current projects can be found on the NCCUSL website. For additional information on these or other uniform acts, please contact Michelle Clayton at mclayton@nccusl.org. Page 4

5 EFFECT OF UNIFORM LAWS ON TRUSTEE INVESTMENT by David M. English (The following article is the first of two excerpts from "The Effect of Uniform Laws on Trustee Investment" by David M. English, first published in the Journal of Investment Consulting (Vol. 6, No. 1, Summer 2003), a publication of the Investment Management Consultants Association (IMCA). This first excerpt focuses on the Uniform Prudent Investor Act and the Uniform Principal and Income Act. The second excerpt concentrates on the Uniform Trust Code and will be included in the Spring 2004 UTC Notes. Together, these three Uniform Acts represent a complete codification of the law of trusts for those states enacting them. To order reprints of the full article, see Within the last decade, the standards for trustee investment in the United States have been dramatically impacted by uniform laws. Most significant is the Uniform Prudent Investor Act (UPIA), which was completed in 1994 and which has since been enacted in 40 states. Also significant is the latest revision of the Uniform Principal and Income Act (UPAIA), which recasts the rules on accountings by trustees. This latest revision, which was completed in 1997, has since been enacted in 36 states. The most recent uniform law, the Uniform Trust Code (UTC), was completed in 2000 and has been enacted in 5 states. The impact of this last Act on trustee investment decisions is less direct, but because it codifies most of trust law, its effect, when enacted, will be significant. The UTC is currently under study for enactment in over 30 other states. Copies of uniform laws and lists of enacting jurisdictions can be obtained at Trusts Largely Controlled by State Not Federal Law Laws in the United States are created at different levels of government. Laws created by the United States government take precedence over those created by the fifty states. Federal law applies to all citizens, regardless of their state of residence. Laws created by particular states normally apply only to persons located in that state. With a few notable exceptions such as the law relating to pension trusts, the law of trusts in the United States is the subject of state, not federal law. Consequently, in the United States there are currently fifty different laws of trusts, one for each state, sharing many similarities but also many differences. Uniform Laws in the United States Uniform laws in the United States are drafted by an organization known as the National Conference of Commissioners of Uniform State Laws. The Conference is a national body consisting of representatives appointed by the governments of the individual states. The function of the Commissioners is to draft model laws called uniform acts. The function of the Reporter is to act as the scrivener. In performing these tasks, the Commissioners and Reporter are assisted by an array of advisors and observers representing interested organizations. The result, when it works well, is the production of a consensus document. Upon completion, uniform acts are recommended for enactment by the fifty states. As their name suggests, uniform laws are designed to reduce the conflicts and inconsistencies inevitable in a system of laws controlled by the legislatures of fifty separate jurisdictions. Hopefully, uniform laws also serve as models that improve existing law, reflecting the latest and best thinking on the subject addressed. Uniform Prudent Investor Act The UPIA prescribes a series of duties relevant to the investment and management of trust property. Although the UPIA can stand apart from the Uniform Trust Code, states enacting the UTC are encouraged to codify the UPIA as Article 9 of the larger Act. Legislative drafting instructions are provided in the UTC comments to avoid duplicative provisions. The UPIA makes five fundamental alterations in the former criteria for prudent investing: (1) The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. (2) The tradeoff in all investing between risk and return is identified as the fiduciary's central consideration. (3) All categoric restrictions on types of investments are eliminated; the trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of Page 5

6 the trust and that meets the other requirements of prudent investing. (4) The long familiar requirement that fiduciaries diversify their investments has been integrated into the definition of prudent investing. (5) The much criticized former rule of trust law forbidding the trustee to delegate investment and management functions has been reversed. Delegation is now permitted, subject to safeguards. Prudent Investor Rule UPIA 1 imposes the obligation of prudence in the conduct of investment functions and identifies other sections of the Act that specify aspects of prudent conduct. A trustee who invests and manages trust assets owes a duty to the trust beneficiaries to comply with the prudent investor rule set forth in the Act. Like most other provisions of the Code, UPIA 1(b) clarifies that the prudent investor rule is a default rule that may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust. To the extent the trustee acted in reasonable reliance on these provisions, the trustee is not liable to the beneficiaries. Standard of Care; Portfolio Strategy; Risk and Return Objectives. UPIA 2 is the heart of the Act. A trustee must invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee must exercise reasonable care, skill, and caution. Investment decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust. An investment that might be imprudent standing alone can become prudent if undertaken in sensible relation to other trust assets, or to other nontrust assets. In the trust setting the term "portfolio" embraces the entire trust estate. Section 2 also lists factors that commonly bear on risk/return preferences in fiduciary investing. This listing is nonexclusive. The factors are: (1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; (8) an asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries. The Act impliedly rejects the emphasis in older law on avoiding "speculative" or "risky" investments. Low levels of risk may be appropriate in some trust settings but inappropriate in others. It is the trustee's task to invest at a risk level that is suitable to the purposes of the trust. Diversification UPIA 3 requires that a trustee diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying. Circumstances can, however, overcome the duty to diversify. For example, if a tax-sensitive trust owns an underdiversified block of low-basis securities, the tax costs of recognizing the gain may outweigh the advantages of diversifying the holding. The wish to retain a family business is another situation in which the purposes of the trust sometimes override the conventional duty to diversify. Also, it can be difficult for a small trust fund to diversify thoroughly by constructing its own portfolio of individually selected investments. Transaction costs such as the round-lot (100 share) trading economies make it relatively expensive for a small investor to assemble a broad enough portfolio to minimize uncompensated risk. For this reason, pooled investment vehicles have become the main mechanism for facilitating diversification for the investment needs of smaller trusts. Duties at Inception of Trusteeship UPIA 4, requiring the trustee to dispose of unsuitable assets within a reasonable time, is old law. The duty extends as well to investments that were proper when purchased but subsequently become improper. The same standards apply to successor trustees. Within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee must review the trust assets and make and implement decisions concerning the retention and disposition of assets, in order to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust, and with the requirements of the Act. The question of what period of time is Page 6

7 reasonable turns on the totality of factors affecting the asset and the trust. Language Invoking Standard of Act UPIA 10 facilitates implementing of the Act by providing rules of interpretation for construing formulaic language commonly used in trust instruments. All such phraseology, unless otherwise limited or modified is assumed to have authorized any investment or strategy permitted under the Act even though the trust instrument predates the Act's enactment. The following phrases are enumerated: "investments permissible by law for investment of trust funds," "legal investments," "authorized investments," "using the judgment and care under the circumstances then prevailing that persons of prudence, discretion, and intelligence exercise in the management of 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 their capital," "prudent man rule," "prudent trustee rule," "prudent person rule," and "prudent investor rule." Effect of Enactment John Langbein, the Reporter for the Uniform Prudent Investor Act, anticipates that enactment of UPIA will have the following impact on trustee investment: (1) Greater Use of equities; (2) More pooling, less individual security selection; (3) Greater international investing; (4) Increased use of derivatives; (5) Less reliance on trustee's internal procedures in assessing trustee performance; (6) Increased scrutiny of uneconomic settlor instructions; (7) Fractionation of trusteeship responsibilities relating to investment, management, and distribution; (8) Increased attention to how trustees allocate receipts and disbursements between the income and principal accounts. See John H. Langbein, The Uniform Prudent Investor Act and the Future of Trustee Investing, 81 Iowa L. Rev. 641, (1996). Uniform Principal and Income Act (UPAIA) The current and prior versions of the Uniform Principal and Income Act (UPAIA) provide rules for determining how receipts and disbursements are to be credited or Page 7 charged to the principal and income accounts of an estate or trust. More specifically, principal and income acts determine: (1) How income earned during administration of a decedent's estate is to be distributed to trusts and to persons entitled to outright devises of specific property, cash gifts, and the residue; (2) When an income interest in a trust begins and how receipts received after that date are to be allocated; (3) Upon termination of an income interest, who is entitled to the income that has been collected but not yet distributed, or that is due but not yet collected, or that has accrued but is not yet due; and (4) After an income interest begins and before it ends, how receipts and disbursements are to be allocated between principal and income. See UPAIA (1997) Prefatory Note. The UPAIA, like the UPIA, works well with the UTC, with the three acts together codifying most of the law of trusts. The UPAIA, however, is not meant to be included within the text of the UTC. The UPAIA is not limited to trustees but also provides accounting rules for personal representatives of estates. For this reason, the UPAIA is best enacted separately from the UTC. The 1997 Uniform Act: Significant Changes The most significant new provision in the 1997 Uniform Act is the grant to the trustee of a power to transfer funds from principal to income, or vice versa. This power to adjust complements the prudent investor rule by allowing a trustee to invest for total return rather than selecting investments primarily with an eye toward achieving a desired level of income. The trustee may instead achieve the desired level of income by utilizing the Section 104 power to adjust. The 1997 revision of the Uniform Principal and Income Act also makes numerous and mostly desirable changes in the technical rules governing allocation of particular categories of receipts and disbursements. The Act not only updates provisions of the former Uniform Acts but also provides rules for the first time for numerous types of receipts and disbursements. New Rules Topics addressed for the first time in the 1997 Act include: (1) The allocation of receipts and disbursements upon the death of the settlor of a revocable trust. UPAIA (1997)

8 ; (2) The treatment of distributions from partnerships, limited liability companies, regulated investment companies, real estate investment trusts, and common trust funds. UPAIA (1997) 401; (3) The grant to a trustee of authority to account for a business operated by the trustee as if it were a separate legal entity. UPAIA (1997) 403; (4) The allocation of receipts from discount obligations, including zero coupon bonds. UPAIA (1997) 406(b); (5) The allocation of receipts from the harvesting and sale of timber. UPAIA (1997) 412; (6) The allocation of receipts from newer types of investments such as derivatives, options, and asset-backed securities. UPAIA (1997) ; (7) The charging of disbursements made because of environmental laws. UPAIA (1997) 502(a)(7); and (8) The addition of a power to make compensating adjustments to offset the shifting of economic interests or tax benefits caused by tax elections or the effect of the fiduciary income tax. UPAIA (1997) 506. Changes in Existing Rules. Topics addressed in the prior versions of UPAIA but substantially updated and revised in the 1997 revision include: (1) Revision of the method for computing net income to be paid to an income beneficiary's estate at the beneficiary's death. UPAIA (1997) 303; (2) Revision of the provisions on the treatment of deferred compensation, including payments from qualified plans and IRAs. UPAIA (1997) 409; (3) A change in the allocation rules for receipts on property subject to depletion (patents, copyrights, royalties, and the like). UPAIA (1997) 410; (4) A change in the allocation percentages for receipts on oil and gas interests. UPAIA (1997) 411; (5) Elimination of the unproductive property rule for trusts other than marital deduction trusts. UPAIA (1997) 413; and (6) Making optional instead of mandatory the decision to create a reserve for depreciation. UPAIA (1997) 503. General Principles (UPAIA (1997) 103) Section 103 collects in one place three general principles that set the tone for the entire Act. First, it clarifies that the Act is a default statute--provisions of the trust or will control over those of the Act. Second, where the Act fails to provide a specific rule, receipts or disbursements must be credited or charged to principal. Finally, the more specific rules later in the Act are subject to the trustee's duty to administer a trust impartially. The duty to act impartially is a basic principle of the common law of trusts but including it in the Act makes it relevance to principal and income accounting more apparent. The Power to Adjust (UPAIA (1997) 104) This section grants a trustee a power to make adjustments in the principal and income accounts. The power to adjust is available to trusts where the interests of the beneficiaries are described by referring to the trust's income. UPAIA (1997) 104(a). This includes trusts which require the distribution of the trust's income to specified beneficiaries, and trusts which require the distribution of the income but grant the trustee discretion as to the shares to be distributed to particular beneficiaries. The power to adjust does not apply to and would be meaningless for trusts in which the trustee has discretion to distribute both income and principal to the same beneficiary or group of beneficiaries. See UPAIA (1997) 104 Comment. Before exercising the power to adjust, the trustee must invest and manage the trust assets as would a prudent investor, and must determine that exercise of the adjustment power is necessary in order to comply with the duty to act impartially. UPAIA (1997) 104(a). A trustee is prohibited from making an adjustment in a variety of circumstances, most designed to avoid loss of a tax benefit. See UPAIA (1997) 104(c). These include the estate or gift tax marital deduction, the gift tax annual exclusion, and the charitable income tax deduction. The power to adjust is also denied if the power would result in inclusion of the trust in the gross estate of a person holding a power to remove or replace the trustee, or cause the trustee to be treated as the grantor of the trust for income tax purposes. Finally, a trustee who is also a beneficiary may not exercise the power. This final restriction, in addition to avoiding possible adverse tax consequences to the trustee-beneficiary, also avoids an obvious conflict of interest. While the reasons for an adjustment power have been widely discussed, practical rules of thumb for determining when and how much of an adjustment to make are still in their infancy. But the Act, by including a detailed list of factors, provides a good start in formulating such parameters. In deciding whether and to what extent to exercise the adjustment power, the trustee must consider: (1) the Page 8

9 nature, purpose, and expected duration of the trust; (2) the settlor's intent; (3) the identity and circumstances of the beneficiaries; (4) the needs for liquidity, regularity of income, and preservation and appreciation of capital; (5) the nature of the trust assets, 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 increase or decrease in the value of the principal assets; (7) the extent to which the trust gives the trustee the power to invade principal or accumulate income; (8) the effects of economic conditions, including inflation and deflation, on the income and principal; and (9) the anticipated tax effects of an adjustment. UPAIA (1997) 104(c). Reception in Other States The 1997 revision of UPAIA has been enacted to date in 36 states. Twenty-nine enactments over five years is a significant success by uniform law standards. The enactments have not occurred without controversy, however. The technical provisions of the Uniform Act have been enacted with little or no change. The controversy has instead centered around whether the enactment of a power to adjust is the appropriate method for responding to the dilemma caused by the prudent investor rule, with its emphasis on total return, and the often low levels of income which that approach produces. During the drafting of the Uniform Act, numerous solutions were devised to achieve a better match between investments made and income produced. These included various forms of unitrust under which an income beneficiary would receive a set percentage of the value of the trust each year regardless of the amount of income earned under more traditional accounting methods. The power to adjust, while receiving the most votes in the end, was hardly the unanimous choice. This lack of consensus has spilled over into the states. Iowa, Maryland, and North Dakota avoided the controversy altogether by dropping the power to adjust from their versions of the Act. Numerous jurisdictions (e.g., Alabama, Arizona, Arkansas, Connecticut, District of Columbia, Kansas, New Mexico, Oklahoma, and Virginia) have enacted the adjustment power without change, and others (e.g., California, Colorado, Hawaii, Idaho, Nebraska, Tennessee, West Virginia, and Wyoming) rely heavily on a so-called notice of proposed action procedure. Prior to making the adjustment, the trustee sends notice to the beneficiaries. If no objection is made following a specified period, the trustee may proceed without concern. If objection is made, a trustee concerned about liability must take the issue to court. But several states (Delaware, Florida, Missouri, New York, Pennsylvania, Washington) take a radically different approach. In addition to granting a trustee an adjustment power, each state allows a trustee instead to convert a beneficiary's income interest into a unitrust amount. This will result in a distribution each year to the former income beneficiary of an amount equal to a specified percentage of the value of the trust assets. Missouri's statute is among the more conservative. The conversion power is available only for trusts created prior to the Act's 2001 effective date. Once made, the election is irrevocable. Other states, including Delaware and New York, allow a trustee to convert a trust created following the date of the Act's enactment. Florida allows a trustee to convert a unitrust back to an income interest. Each of the state statutes provide a "smoothing" rule, allowing for the average value of the trust over the prior three years to be taken into account in determining the unitrust amount for the current year. But the enactments differ in other details. For example, in Missouri the unitrust percentage is 3% or such higher rate as the trustee specified in a notice to the beneficiaries; in New York, Pennsylvania, and Washington the rate is 4%; in Delaware and Florida, the trustee must select a rate between 3% and 5% as appropriate to the particular trust. The debate over the adjustment power must be placed in perspective. Most trusts today grant trustees discretion over both income and principal payments, making the power to adjust irrelevant. Also, an increasing number of estate planners are drafting trusts requiring payment of a unitrust amount instead of traditional income. For these trusts, the adjustment power is also irrelevant. Finally, the use of the adjustment power will be rare in situations where the trustee is given liberal invasion powers. The trustee often will be able to remedy for shortfalls in income by making discretionary distributions of principal. A Final Note on UPAIA The 1997 Uniform Principal and Income Act has two main purposes. The first is to update the technical rules to account for changes in estates and trusts practice which had occurred in the 35 years since the last revision of the Act. While one might quibble with some of the specific provisions, the Act in this respect does its job well, bringing the rules into the modern age and addressing many issues of importance on which the prior Acts were silent. The second purpose is to conform principal and income allocation to the requirements of the prudent investor rule, with its emphasis on total return. Only time will tell whether the unitrust alternative is a better solution to this dilemma than is the purer adjustment power found in the unmodified Uniform Act. on to this dilemma than is the purer adjustment power found in the unmodified Uniform Act. Page 9