Total Return Trusts. New Power To Adjust Between Income and Principal

Total Return Trusts New Power To Adjust Between Income and Principal

BY BROOKS J. HOLCOMB AND CHARLES F. MYERS Arizona has adopted the 1997 version of the Uniform Principal and Income Act (UPAIA), which became effective January 1, 2002. 1 The UPAIA enables a trustee to invest in assets that produce a greater total return without regard to the amount of income generated allows the trustee to adjust the amount of distributions to be equitable to both income and remainder beneficiaries Attorneys advising trustees or beneficiaries must reexamine trust provisions to consider the impact of the UPAIA on their respective interests. Trustees now have greater flexibility with the types of investments and asset allocations. But they also have increased responsibilities to evaluate what is fair and reasonable to all beneficiaries and to maintain the related detailed records. MODERN PORTFOLIO THEORY The UPAIA is in the third version 2 promulgated by the National Conference of Commissioners on Uniform State Laws and was drafted to enable states to modify their probate and trust statutes, most of which were modeled after the 1962 version of the Unform Principal and Income Act, 3 to be more consistent with modern portfolio theory. 4 This theory has fundamentally transformed fiduciary investments in the last decade. 5 It is a variation of the tenet that the whole is greater than the sum of the parts an efficient combination of equities can create a portfolio that will have a lower risk than the average risk of the same equities held individually. The most significant aspect of modern portfolio theory is diversification, in which investors lower their risk by holding several investments rather than ensuring that each specific investment is safe. As equities are now no longer generally perceived as risky investments for fiduciaries, 6 even highly speculative investments may be acceptable if acquired as part of a diversified portfolio. As modern portfolio theory has gained widespread acceptance, trust investment managers began challenging the application of the prudent person rule, which provided that a fiduciary s investment performance should be evaluated on an asset-by-asset basis rather than on the portfolio as a whole. 7 This could result in liability being imposed on the trustee for a poor performing asset, even though the balance of the portfolio performed well. And there was concern that inflation was eroding the economic value of trust assets. It became clear that trust investment policies needed to be reformed. This resulted in the Prudent Investor Rule 8 of 1992, which became the foundation for the Uniform Prudent Investor Act promulgated in 1994. REVISED ARIZONA PRUDENT INVESTOR ACT Arizona s adoption of the UPAIA was the logical offspring of the Revised Arizona Prudent Investor Act (the Act), which became effective July 20, 1996. The Act allows fiduciaries to invest in a wider variety of assets such as annuities, IRAs and mutual funds that have challenged the traditional distinction between principal and income. 9 The Act acknowledges the growing trend in asset allocations toward a larger percentage of investments in equities. Computer modeling has demonstrated this allocation to be more favorable to current and remainder beneficiaries, 10 as compared to a trust portfolio substantially invested in bonds, which often results in no real economic appreciation in trust assets for the remainder beneficiaries and perhaps a claim against the trustee for failing to satisfy its duty of impartiality. 11 Reflecting this trend, the Act applies prudent investor standards to the entire trust portfolio rather than to each individual investment and directs the fiduciary to develop an investment strategy to maximize the total return and to minimize risk based on the terms of the trust. 12 INCOME RULE TRUSTS This total return approach created a problem for the income rule trusts, whose distributions are measured by reference to the amount of income generated by the trust assets. The typical income rule trust provides for mandatory or discretionary payments of net income to current beneficiaries and, as a result, the trustee would have to follow the traditional accounting definitions of income and principal in allocating income to income beneficiaries and principal to remainder beneficiaries. Under these traditional definitions, income includes bond interest and ordinary dividends on stocks; principal includes capital gains recognized from the sale of assets and stock dividends on stocks. 13 It became clear that the principal and income rules needed to be updated. This was accomplished with the promulgation in 1997 of the third revision of the UPAIA. TRUSTEE S POWER TO ADJUST Section 14-7303 of the UPAIA modifies the traditional trust accounting approach to allocations of trust receipts and disbursements between income and principal and the related distributions to the beneficiaries by granting the trustee the power to adjust between principal and income if three conditions are satisfied: 1. The trustee must be subject to the prudent investor standard. 2. The determination of trust income must affect distributions to the beneficiaries. 3. The trustee must determine that the administration of the trust would not be fair and reasonable without an adjustment between principal and income. The trustee s exercise of this power allows it to allocate between income and principal to balance the interests of the income and remainder beneficiaries, without regard to the investment strategy. However, this power does not entitle the trustee to recharacterize WWW.AZBAR.ORG MAY 2002 ARIZONA ATTORNEY 25

principal as income for either tax or trust accounting purposes. It simply allows the trustee to allocate principal or income (as defined under other provisions of the UPAIA) to a different class of beneficiaries than would otherwise receive it. This adjustment power is a default rule; it does not apply if the governing instrument expressly negates the power. 14 TRUSTEE S DUE DILIGENCE In determining what is fair and reasonable to all beneficiaries, nine factors are required to be considered by the trustee: (1) the nature, purpose and expected duration of the trust, (2) the intent of the settlor, (3) the identity and circumstances of the beneficiaries, (4) the need for liquidity, regularity of income and preservation and appreciation of capital, (5) the type of assets held in the trust, 15 (6) the net amount allocated to income under the UPAIA and the increase or decrease in the value of trust assets, 16 (7) the nature and extent of the trustee s power to invade principal or accumulate income and the prior exercises of the trustee s power in these areas, (8) the actual and anticipated effect of economic conditions on principal and income and the effects of inflation and deflation, and (9) the anticipated tax consequences of an adjustment. 17 PROHIBITED ADJUSTMENTS A trustee is prohibited from making any adjustment between income and principal (1) if it would jeopardize an estate tax or gift tax marital deduction, (2) if it would reduce the actuarial valuation of an income interest in a trust to which a person transfers property with an intent to qualify for a gift tax exclusion, (3) if it changes the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets, 18 (4) to any amount permanently set aside for charitable purposes unless both income and principal are so set aside, (5) if possessing or exercising such power would cause the trustee to be treated for income tax purposes as an owner of all or any portion of the trust, (6) if possessing or exercising such power would cause all or any portion of the assets of the trust 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, (7) if the trustee is a beneficiary of the trust, or (8) even if the trustee is not a beneficiary, but the adjustment would benefit the trustee directly or indirectly. 19 If any of the prohibitions identified in items (5) through (8) apply to a trustee and there is more than one trustee, the cotrustee to whom the prohibition does not apply may exercise the power to adjust, unless such exercise by the remaining trustee or trustees is not allowed under the terms of the trust. 20 In addition, a trustee may release the power to adjust if the trustee is uncertain as to whether its existence or exercise will constitute a prohibited action under A.R.S. 14-7403(C)(1) through (8), except (7), or if the trustee determines that possessing or Trustees will be forced to communicate more than ever before and must confront the ambiguities and confusion wrought by the related regulations. exercising the power will or may deprive the trust of a tax benefit or impose a tax burden not described in A.R.S. 14-7403(C). 21 Any such release may be permanent or for a specified period of time, including a period measured by the life of an individual. 22 The terms of a trust that otherwise would limit the power of a trustee to make an adjustment between principal and income will not prohibit the trustee s exercise of the power to adjust, unless the trust provisions clearly are intended to deny the trustee such power conferred by A.R.S. 14-7403(A). TRUSTEE LIABILITY A court cannot change a fiduciary s decision to exercise or not to exercise any discretionary power under the UPAIA, unless the court determines that the decision was an abuse of discretion. 23 A judicial review of a fiduciary s decision to exercise or not to exercise a discretionary power conferred by the UPAIA includes (1) a determination of whether and to what extent an amount should be transferred between principal and income and (2) the determination of how to apply the nine factors in assessing what is fair and reasonable to the beneficiaries. 24 ABUSE OF DISCRETION REMEDIES If the court decides that a fiduciary has abused its discretion, the remedy is to restore all beneficiaries to the positions they would have occupied if the fiduciary had not abused its discretion, under three separate circumstances. 25 First, if there were no distribution to a beneficiary or a distribution is too small, the fiduciary would be required to distribute to the beneficiary the amount necessary to restore the beneficiary to an appropriate position. Second, if the distribution to a beneficiary was too large, either the fiduciary could be required to withhold an amount from future distributions or the beneficiary could be required to return some or all of the distribution to the trust. Third, if either or both of the foregoing remedies are inadequate, the court may require the fiduciary to pay an appropriate amount from its own funds either to the beneficiaries or to the trust, or to both. COURT APPROVAL OF FIDUCIARY PROPOSED DECISION The fiduciary may petition the court for a judicial determination of whether its proposed specific exercise or nonexercise of a discre- 26 ARIZONA ATTORNEY MAY 2002 WWW.AZBAR.ORG

tionary power granted under the UPAIA will result in an abuse of the fiduciary s discretion. 26 The petition must contain sufficient information to inform the beneficiaries of the proposal s reasons, the facts relied upon by the fiduciary and an explanation of the effect of the proposal on the beneficiaries. Then, the burden shifts to the beneficiary who challenges the petition to establish that the proposal will result in an abuse of discretion. 27 ALTERNATIVE ADVANCE DETERMINATION As an alternative method for an advanced determination of a trustee s 28 proposed action, which is specifically defined in this section to include a course of action or a decision not to take a course of action, 29 a trustee may, but is not required to, give notice of a proposed action on any matter covered by the UPAIA. 30 If the trustee decides to give notice, it is required to be mailed to all actual or potential income beneficiaries and to all beneficiaries who would receive a distribution of principal if the trust were terminated at the time that notice is given. 31 The contents of such notice are set forth in A.R.S. 14-7431(D), and a beneficiary may object to the proposed action by timely mailing a written objection to the trustee. 32 A trustee is not liable to a beneficiary for a proposed action if no written objection is timely received. 33 If the trustee receives a timely written objection, the trustee or the beneficiary may then petition the court to have the proposed action (1) taken as proposed, (2) taken with modification or (3) not taken at all. 34 An objecting beneficiary must prove that the proposed action should not be taken, and a trustee may respond to a beneficiary s objection by deciding not to take the proposed action. Such a decision and the reasons for the decision must be communicated to the beneficiaries. PROPOSED TREASURY REGULATIONS Although beyond the scope of this article, in response to many states adoption of the 1997 version of the UPAIA, proposed Treasury Regulations were issued on February 15, 2001, which primarily redefine trust income. 35 Generally, capital gains realized by a trust are not part of distributable net income (DNI), which is distributed and taxed to the beneficiary. However, the proposed Regulations address when such capital gains may be included in DNI and thus may be distributed to the beneficiary under the trustee s power to adjust. 36 A number of articles analyze the impact of these proposed regulations and offer guidance to trustees and their professional advisers on the numerous tax implications raised by the 1997 version of the UPAIA. 37 CONCLUSION Arizona s adoption of the UPAIA already has had a significant impact on corporate trustees, who now are in the process of updating their policies and procedures to incorporate the additional due diligence required under the new law, including the immediate need to identify and locate all WWW.AZBAR.ORG MAY 2002 ARIZONA ATTORNEY 27

actual and potential income beneficiaries and principal beneficiaries. Trustees will be forced to communicate with remainder beneficiaries more than ever before and will be required to maintain detailed records on the results of their findings in assessing the nine factors that are crucial in determining whether and how to exercise their power to adjust. Trustees also must confront the ambiguities and confusion wrought by the related federal income, gift, estate and generation-skipping transfer tax considerations raised by the proposed Treasury regulations, 38 which may not become final for several years. Despite these challenges, the prudent trustee should carefully document the discovery mandated by the new law and seek to limit its liability through the procedures set forth in the UPAIA. The added duties and record-keeping will substantially increase the amount of time spent by trustees on trust administration and investment matters and may result in an increase in trustees fees to justify the additional labor and expenses. On the other hand, the increased communications with the beneficiaries should help the trustee develop and maintain a more serviceoriented relationship, a benefit to all interested parties. Brooks J. Holcomb, J.D., LL.M., is an associate at Quarles & Brady Streich Lang LLP in Phoenix practicing with the taxation and trusts and estates groups. Charles F. (Chikk) Myers is with Charles F. Myers, P.A. (chikk@cfmlaw.com) in Phoenix and was the Managing Editor of the 2000 PROBATE CODE PRACTICE MANUAL. The authors acknowledge the assistance of Kjersten Grubka, a second-year law student at the University of Arizona, with this article. endnotes 1. The new law replaces article 4 of chapter 7 of Title 14 of the Arizona Revised Statutes with a new article 4 at 14-7401 through 14-7431. As of Mar. 21, 2002, the 1997 Act has been adopted in the District of Columbia and in 23 states. See www.nccul.org/nccul/uniformact_factsheets/uniformacts-fs-upia.asp. 2. The prior two versions of the UPAIA were promulgated by the National Conference of Commissioners on Uniform State Laws in 1931 and 1962, respectively. See id. 3. Arizona s version of the 1962 UPAIA was effective April 18, 1984. Forty-one states adopted that version. See Spalding, Put Your Trust in Trustees, 186 J. ACCOUNTANCY 69, 71 (November 1998). 4. The 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 principal of investing for total returns rather than a certain level of income as traditionally perceived in terms of interest, dividends, and rents." See www.nccusl.org/nccus1/uniformact_factsheets/uniformacts-fs-upia.asp. 5. Harry Markowitz first proposed the modern portfolio theory in 1952 and, with several other economists, won the Nobel Prize in economics. See www.nobel.se/economics/laureates/1990/index.htm. 6. However, the 2000 and 2001 calendar years have been a rude awakening for investors accustomed to double-digit returns on their equity portfolios, as the S&P 500 produced a negative return of 9.1 percent in 2000 and a negative return of 11.9 percent in 2001. See www.spglobal.com/usbenchmark.pdf (February 23, 2002). 7. A.R.S. 14-7601 through 14-7611. 8. RESTATEMENT (THIRD) OF TRUSTS, Prudent Investor Rule (1992). 9. Id. 227-229. 10. See Robert B. Wolf, Estate Planning With Total Return Trusts: Meeting Human Needs and Investment Goals Through Modern Trust Design, 36 REAL PROP. PROB. & TRUST J. 169, 213-215 (2001). 11. Under its duty of impartiality, a trustee is required to balanc[e] the elements of return between production of current income and the protection of purchasing power. RESTATEMENT (THIRD) OF TRUSTS, Prudent Investor Rule 227. 12. A.R.S. 14-7602(B). 13. Id. 14-7401(1) and (4) (UPAIA 1962). 14. See id. 14-7402(A)(1). 15. The statute expands this inquiry (1) to the extent to which the trust assets consist of financial assets, interests in closely held enterprises, tangible and intangible personal property or real property, and whether any asset is being used by a beneficiary and (2) whether an asset was purchased by the trustee or received from the settlor. Id. 14-7403(B)(5)(a) and (b). 16. The trustee may estimate the fair market value of any asset of which a market value is not readily available. 17. A.R.S. 14-7403(B)(1) through (9). 18. This prohibition would therefore exclude 28 ARIZONA ATTORNEY MAY 2002 WWW.AZBAR.ORG

CRATs, CRUTs, GRATs, GRUTs or a total return trust. 19. A.R.S. 14-7403(C)(1) through (8). 20. Id. 14-7403(D). 21. Id. 14-7403(E). 22. Id. It is not clear under the statute whether such a release is irrevocable. For example, if a trustee who released a power subsequently resigns or is removed, is the successor trustee bound by the prior trustee s release? 23. Id. 14-7404(A). A judicial determination of an abuse of discretion will not be rendered because the court would have exercised the discretion in a different manner or would not have exercised the discretion at all. 24. The latter determination will now require trustees to develop and maintain detailed records of their due diligence in assessing the nine factors described in 14-7403(B). 25. Id. 14-7404(C)(1) through (3). 26. Id. 14-7404(D). 27. Id. 28. This alternative method is available only to a trustee, whereas the UPAIA generally addresses the actions of fiduciaries. A.R.S. 14-7431(A); 14-7401(3). 29. Id. 14-7431(H). 30. Id. 14-7431(A). 31. Id. 14-7431(B). 32. Id. 14-7431(E). 33. Id. 14-7431(F). Unfortunately, this section also states a second condition that the other requirements of this article [UPAIA] are satisfied, so that the beneficiary s failure to timely file a written objection may not be conclusive on the liability issue. 34. Id. 14-7431(G). 35. Prop. Treas. Reg. 106513-00, 66 Fed. Reg. 10396-10402 (Feb. 15, 2001). 36. Gains from the sale or exchange of capital assets are included in distributable net income to the extent that they are, pursuant to the terms of the governing instrument and applicable law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary (in accordance with the power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law). Id. 1.643(a)-3. 37. See, e.g., Stephen R. Leimberg & Albert E. Gibbons, Prop. Regs. on the Definition of Trust Income: The Best Thing for Life Insurance Planning Since Sliced Bread! 28 ESTATE PLANNING 231 (May 2001); Carol Cantrell, Sec. 643 Prop. Regs. Redefine Trust Income, 32 THE TAX ADVISOR 542 (Aug. 2001); Jerry A. Kasner, Capital Gains: A New Definition for Income and Principal? 90 TAX NOTES 1519 (Mar. 12, 2001). 38. Insightful criticism of the proposed Regulations has been offered by several commentators. See, e.g., Conrad Teitell, Income Redefined for CRTs, PIRs, Other Trusts- Proposed Regs., 140 TRUSTS & ESTATES 45 (Aug. 2001); John E. Hembera, Jr., IRS Urged to Keep Trust and Estate Regs. Consistent with State Laws, 91 TAX NOTES 1959 (June 18, 2001). WWW.AZBAR.ORG MAY 2002 ARIZONA ATTORNEY 29