Advising trustees: Lessons from the revised Uniform Principal and Income Act.

Changes to the rules relating to the determination of income in trusts and estates have given CPAs the opportunity to provide broad financial planning services to trustees.

Trustees are well advised to have an investment statement for all significant assets. These plans should reflect a thought-out approach to investment objects and cash-flow planning given the trust's objectives.

As with business entities, the complexities of advising will depend on the assets held and the trust's objectives. A trust with a modest portfolio intended to fund education could have a relatively simple plan, while one planning for extensive real estate holdings that are intended to provide multiple generations of beneficiaries with income may have a much more complicated plan.

Two Years Later

The accounting rules for trusts and estates were substantially changed as of Jan. 1, 2000. A practitioner working with California trusts and estates should have a copy of the California law and the California Law Revision Commission's report on this subject. The report may be downloaded at http://161.58.165.226/pub/Printed_Reports!; select sPRT-UPAIA-2000.pdf. While the new rules apply to estates and trusts, this article focuses on trusts.

Under the rules, a trustee may create reserves for future expenses for any business the trustee conducts. A definition of business for this purpose is very broad.

While a business does not include the income from a portfolio's management, it may include the following at the election of the trustee: income from real estate, mining, timber or investing in derivatives or options as well as other business operations.

Thus the trustee is charged with the responsibility of accounting for the business--not according to accounting rules--but based on the financial realities, taking into account the trust's purpose. Adjusting Income

Adjusting Income

In addition, the trustee has the power to adjust "income" if three conditions are met:

1) The trust must be investing under the Prudent Investor rules. Virtually all California trusts are covered by these rules unless the document specifically exempts the trust from the rules.

2) The trust has a provision that provides that distribution shall or may be made based on income.

3) The trustees determine that they cannot be impartial between the beneficiaries by applying the mechanical rules.

Since dividends are income and growth in asset value is not income, a trust holding all equities may understate the income that should be distributed to an income beneficiary.

Previously, the trustee was forced to change the investment approach based on the accounting rules. Under the new rules, the trustee may increase the income that is required to be distributed or may be distributed to reflect a fair allocation between the income beneficiary and the remaindermen of the trust.

Under the mechanical rules, income from copyrights, patents or mineral royalty is 10-percent income and 90-percent principal since such income is from liquidating assets. In many cases, it is necessary to make an overall adjustment, as such an allocation would not carry out the intention of the trust's creator.

Adjustments Barred

The adjustment power is prohibited in some circumstances. Previously, some of the limitations depended on the tax result of making such an adjustment. On Feb. 15, 2001, the IRS issued proposed regulations applicable to determining income for trust taxation. These proposed regulations, which can be downloaded at www.irs.gov/pub/irs-regs/1065l300.pdf, have helped to resolve many tax problems related to adjustments.

The key remaining prohibitions are that income cannot be decreased in a trust qualifying for the marital deduction or a charitable deduction, or where the trustees are all beneficiaries of the trust.

Note that if one trustee is not a beneficiary he or she may exercise the adjustment power alone. The only restriction seems to be that the IRS will not accept an unreasonable allocation.

It remains to be seen if this is an opening the IRS wishes to uses in eliminating what they perceive to be unreasonable tax results. Given the IRS' long history of inattention to trust matters, it is unlikely that this will be a major stumbling block to applying the rules as intended.

Capital Gains

The IRS also attempted to deal with the question of when capital gains are included in distributable income. The result seems to give the trustee an election since capital gains can be included in distributable net income if they are allocated to corpus but treated on the trust books as distributed or were utilized in determining the amount of the distribution.

Note that if neither the trust nor the beneficiary has a capital loss carryover, the lowest tax will normally be paid by having the trust pay the tax because of utilizing the lower brackets. The tax savings will not be significant.

Given all of these options and the diversity of purpose for trusts, a trustee is apt to need assistance in determining income under the act as well as the business and investment strategies that are most appropriate for the trust.

Ronald J. Linder, CPA, is a partner with San Francisco-based Delagnes Mitchell & Linder, and a member of CalCPA's state Personal Financial Planning Committee.