Unitrust provisions: trustees, advisers: be aware of changes to California Probate Code.

The California Uniform Principal and Income Act (California Probate Code (CPC) secs. 16320 et seq.) gives trustees the power to "adjust" the allocation of total return on trust assets between income and principal (CPC Sec. 16336).

Gov. Schwarzenegger recently signed SB 754, which adds "unitrust" conversion provisions to the act. Beginning next year, trustees may treat an annual percentage (at least 3 percent, but not more than 5 percent) of a trust's asset value as trust income (CPC secs. 16328, 16336.4).

The adjustment and unitrust provisions, which must comply with detailed notice and beneficiary consent requirements, will prove important to trustees and their advisers.

Principal Income Rules

The act makes an important distinction between trust principal and income, and almost every document creating a trust also makes this distinction.

For example, marital deduction trusts must normally distribute all income to the surviving spouse [IRC Sec. 2056(b)(7)]. Credit shelter trusts normally subject principal distributions to some need-based standard, such as "health, education, support or maintenance" [IRC Sec. 2041(b)(1)(A)].

These and many other trusts often have non-tax objectives of providing for a lifetime beneficiary's support and also preserving assets for the remainder beneficiaries.

Trust accounting income rules are based on state law and do not necessarily track income tax rules (e.g., capital gains are taxable income generally allocated to trust accounting principal rather than income). The act allocates trust receipts and disbursements between principal and income (CPC secs. 16370, 16371).

The trustee makes the allocation, nets receipts and disbursements in a trust accounting, and then distributes or withholds principal and income as permitted or directed in the governing document.

The act's principal and income allocation provisions constitute default rules a trust settler may override through specific instructions or trustee discretionary powers (CPC Sec. 16335). Overrides can be useful, especially in connection with seemingly arbitrary rules in the act, like those allocating 90 percent of certain "wasting asset" receipts to trust principal (CPC Sec. 16363).

Examples

The traditional rules, the adjustment power, and the unitrust operate in different ways.

For example, if a trust sells real estate for a $1,025,000 gain before $50,000 of sales costs and commissions--and the trust also has $75,000 of rental income with $50,000 of related expenses--the $1 million net economic benefit normally would be allocated $975,000 to principal and $25,000 to income.

With the adjustment power, the trustee could allocate some of the capital gain to an income beneficiary, even though that gain is principal.

If the trust were a unitrust with a $1 million value and a 5 percent payout rate, the trustee would distribute $50,000 to the beneficiary as trust income, even if it required asset sales, thus allocating some of the capital gain as income.

Although the unitrust would reclassify some principal as income, the trustee would track trust principal for other purposes, such as making distributions under an ascertainable standard [CPC Sec. 16336.4(g)].

Adjustment and Unitrust Background

The background of these rules is important. The act superseded outdated 1962 legislation and allows trustees to effectively balance their duties to treat all trust beneficiaries impartially [CPC Sec. 16335(b)] and invest trust assets under the Uniform Prudent Investor Act [CPC Sec. 16045 et seq.], passed in California in 1995.

The Prudent Investor Act and its Prudent Investor Rule (CPC Sec. 16046) articulate new standards for trustee investment performance, measuring a trustee's performance in terms of the total investment return (i.e., accounting income plus principal appreciation) [CPC Sec. 16047].

In the current financial environment of low dividend and interest rates, a trustee who favors income beneficiaries under the traditional allocation approach will hold fixed income securities and thus sacrifice asset appreciation potential. The adjustment power and unitrust conversion provisions allow the trustee to both invest for total return and treat all beneficiaries fairly.

Tax Regulations

Treasury Regulation Sec. 1.643(b)-1, as recently amended, provides updated tax guidance regarding when the IRS will respect principal and income allocations for tax purposes.

Those regulations provide, in part, that "a state statute providing that income is a unitrust amount of no less than 3 percent and no more than 5 percent of the fair market value of the trust assets" generally will be respected.

The unitrust drafters focused on these regulations.

Prerequisites to Adjustment or Unitrust Conversion

The prerequisites to, and limitations on, adjustment and conversion are largely the same. Absent a clear trust document prohibition, a trustee may make the adjustment or unitrust conversion after proper notice and beneficiary consent if:

1. The Prudent Investor Rule applies to the trust (it almost always will due to CPC Sec. 16046);

2. The trust document describes distributions by reference to trust income; and

3. The trustee determines that under the circumstances it cannot treat trust beneficiaries impartially as required by the act [CPC Sec. 16336(a), 16336.4(b)(1)].

In deciding whether and how to adjust or convert, the trustee may consider a non-exclusive list of factors provided in CPC Sec. 16336(g). These factors include, for example, the trust's purposes and expected duration, the settlor's intent, the beneficiaries' circumstances, the expected impact on trust assets and the expected tax consequences of the action.

Prohibitions on Adjustment or Unitrust Conversion

A trustee generally may not make the adjustment or conversion if that action:

* Jeopardizes the federal gift or estate tax marital deduction;

* Alters a fixed annuity or fractional trust share payment;

* Impacts funds set aside for charitable purposes (except in limited cases);

* Causes an individual to be treated as the trust's owner for income tax purposes; or

* Alters estate tax inclusion results [CPC secs. 16336(b), 16336.4(h)].

Additionally, the adjustment power generally is not available (1) where it would reduce a transfer tax deduction based on income interest actuarial value; (2) if the trust is operated as a unitrust; or (3) if the trustee is also a beneficiary of the trust [CPC Sec. 16336(b)].

This final limitation is important. For example, a surviving spouse who is also an income beneficiary and the sole trustee of a trust cannot adjust between principal and income, but may make the unitrust conversion.

The surviving spouse could find the conversion a vitally important way to avoid conflict of interest claims by remainder beneficiaries--an event that will likely become more common in second marriage situations.

Unitrust Default Rules

The trustee must determine some unitrust matters in the trustee's discretion [CPC Sec. 16336.4(f)].

Under CPC Sec. 16336.4(e), certain default rules apply unless under CPC Sec. 16336.5 the trustee properly overrides them. This includes a default 4 percent payout rate the trustee may want to override to another rate not less than 3 percent or more than 5 percent.

Conclusion

Trustees and their advisers should always keep potential adjustments and unitrust conversions in mind as ways to treat all trust beneficiaries fairly and avoid litigation.

By Sil Reggiardo, CPA 

Sil Reggiardo, JD, CPA is a partner with Sacramento-based law firm Downey Brand LLP. He is also legislation chair of the State Bar Trusts and Estates Section Executive Committee. You can reach him at [e-mail].