The power to adjust: expanding the trustee's management tools.
Pursuant to the California Probate Code (CPC) Sec. 16336, which is part of the UPAIA, trustees now can use their discretion in making adjustments between the principal and income of trusts under limited circumstances.
Simply stated, the new power permits trustees to reallocate amounts between principal and income when the income portion of the portfolio's total return is too small or too large due to earlier investment decisions.
Balancing PIA, UPAIA
The new tool tries to balance the tension between the Uniform Prudent Investor Act (PIA) and the UPAIA. The PIA encourages investing for total return, while the UPAIA provides reasoned guidance with respect to the allocation of receipts and disbursements between income and principal.
Many trustees struggle when making investment decisions that produce an optimal total portfolio return without stifling the beneficial interest of the income beneficiary.
Income beneficiaries demand that trustees create investment portfolios biased toward fixed-income assets to produce more income. But remainder beneficiaries want portfolios consisting mostly of equity investments for long-term capital appreciation.
To address this conflict, trustees balance investment decisions from two perspectives--the intrinsic worth of the proposed investment and yields equitable to both sets of beneficiaries.
Eliminating the link between trust income and traditional accounting income rules is one way to avoid this conflict. But this has to be done at the drafting stage.
The possibilities include: a total discretionary trust, such as allowing trustees, within their discretion, to pay the income beneficiary trust income and/or trust principal; an inflation adjusted annuity trust; and a unitrust requiring fixed distribution of the trust corpus paid annually. [See Hoisington, "Modern Trust Distribution Design and Implementing Strategies, Estate Planning," 1998, Chapter 5 (Cal CEB 1998)].
The Power to Adjust
The power to adjust is another solution. Yet, most trustees are not sure when to use it since the statutes' guidelines are inadequate. It is important to note that the power to make adjustment is discretionary--not mandatory.
The UPAIA states that "[n]othing in this section or in this chapter is intended to create or imply a duty to make an adjustment, and a trustee is not liable for not considering whether to make an adjustment or for choosing not to make an adjustment." [CPC Sec. 16336(h)].
Though discretionary, (the trustee is not obligated to consider making adjustments) other fiduciary obligations could be grounds for litigation. For example, trustees owe a duty of impartiality to all beneficiaries. Under CPC Sec. 16003, "If a trust has two or more beneficiaries, the trustee ... shall act impartially in investing and managing the trust property, taking into account any differing interests of the beneficiaries." So, failing to make an adjustment and protect the interests of current income beneficiaries and/or remainder beneficiaries could be grounds for breach of fiduciary obligations.
It's essential that trustees understand the power to adjust. When used appropriately, it can improve the relationship between trustees and trust beneficiaries, as well as reduce trustee liability.
Basics to the Power to Adjust
The power to adjust allows trustees to make adjustments between principal and income when no prohibitions in the trust prevent such discretion. Under CPC Sec. 16336(a), the trustee must adhere to the following prerequisites before making adjustments:
* The trustee must manage the trust assets under the PIA. Under CPC Sec. 16336(a)(1), the power to adjust may not be exercised unless "the trustee manages trust assets under the prudent investor rule." Absent other directions in the document, the trust would be so managed.
* CPC Sec. 16336(a)(2) requires that "the trust describe[s] the amount that shall or may be distributed to a beneficiary by referring to the trust's income," e.g., that the beneficiary is to receive "all of the trust's net income."
The California Law Revision Commission says this requirement is met when the trust's terms allow the trustee to distribute all income at regular intervals; distribute the greater of trust accounting income and a fixed dollar amount (an annuity); and distribute the greater of trust accounting income or a fractional share of the trusts assets (a unitrust amount).
* CPC Sec. 16336(a)(3) requires the trustee to determine, after considering the trust's terms, that the trustee is unable to fulfill its duties to treat all beneficiaries impartially, absent the power to adjust.
Under CPC Sec. 16336(g), the trustee may consider, but is not limited to, any of the following, in deciding whether or not to exercise the power--and to what extent:
* The nature, purpose and expected duration of the trust;
* The intent of the settlor;
* The identity and circumstances of the beneficiaries;
* The need for liquidity, regularity of income, and preservation and appreciation of capital;
* 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;
* The net amount allocated to income under other statutes and the increase or decrease in the value of the principal asset;
* Whether or not, and to what extent, the trust gives the trustee the power to invade principal or accumulate income, or prohibits 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;
* The actual and anticipated effect of economic conditions on principal and income, and effects of inflation and deflation; and
* The anticipated tax consequences of an adjustment.
A trustee can execute the power to adjust by setting a target-level payment for the income beneficiary. Trustees can use various models, such as a Fixed Percentage or Modeled Income Approach.
Fixed Percentage Approach
Assume a trustee decides to use a 4 percent fixed payout based on the nine factors and the generally accepted notion that 4 percent is the highest payout that can be maintained without eroding the principal.
Under this scenario, the trustee would ascertain the portfolio value on a specific date and establish the resulting target payment amount. If the income earned on this portfolio falls below the established amount, the trustee would use the power to adjust and invade the principal for the shortfall.
For example, assume a trust account has a 55-year-old income beneficiary and the distributive income provision calls for the trust income to be paid to his beneficiary quarterly or in more frequent installments with no discretionary power to distribute trust principal. Assume further that the fair market value of the trust portfolio is $1 million.
If the trustee establishes a 4 percent payout rate--and based on the set investment objective, the income earned for the quarter is only $8,000 net of administrative expenses--the trustee would sell securities in the portfolio to generate the $2,000 needed to pay the income beneficiary $10,000 or 1 percent of principal for the quarter (with a cumulative target of 4 percent for four quarters).
And if the $2,000 securities sales result in a capital gains tax, the tax would be paid at the trust level rather than the beneficiary level.
Modeled Income Approach
A trustee also can make payments based on the Modeled Income Approach, which tries to create a "shadow portfolio" that represents how a portfolio would have been invested based on certain principles.
These principles generally include the grantor's intent and the expectation of market returns when the trust was established; the reasonable expectation of the income beneficiaries; and the industry's estimated return based on balanced portfolio available prior to UPAIA enactment.
After evaluating these factors, suppose that the shadow portfolio consists of 60 percent equity securities and 40 percent fixed-income securities. The model income rate would be the sum total percentage rate generated by the above portfolio. Or, the rate represents the income generated by 60 percent equity and 40 percent fixed income portfolios.
Establishing Model Income Rate
Assume: S&P 500 average annual dividend rate equals 3.5 percent and average annual corporate bond yield equals 6.5 percent, then:
* Model Income Rate (60 percent x 3.5 percent + 40 percent x 6.5 percent) = 4.70 percent.
With the same $1 million portfolio, the trustee would expect to pay out $11,750 in income net of administrative expenses for a quarter. If the return is below this amount, the trustee would sell securities in the portfolio to generate the additional funds to pay the income beneficiary $11,750.
Restrictions on Power to Adjust
There are circumstances where a trustee may not make adjustments. According to CPC Sec. 16336(b), a trustee may not make an adjustment between principal and income in any circumstances where:
* It would diminish the income interest in a trust: (A) that requires all of the income to be paid at least annually to a spouse; and (B) for which, if the trustee did not have the power to make the adjustment, an estate tax or gift tax marital deduction would be allowed in whole or in part;
* It would reduce 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:
* It would change the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets;
* It would change the amount set aside for charity;
* Possessing or exercising the power to make an adjustment would cause 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;
* Possessing or exercising the power to make an adjustment would cause 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 adjust; and
* The trustee is a beneficiary of the trust.
Notice of Proposed Action
Under CPC Sec. 16337, the trustee has the option to notify interested parties with respect to a specific adjustment or decision not to make an adjustment. The notice, which must be in writing, enables the trustee to provide advance notice to beneficiaries of the trustee's use of the power to adjust and to give them an opportunity to react to the trustee's proposed exercise of the power. Beneficiaries have 30 days to object in writing. If they fail to do so, the trustee is protected from future claims with respect to the proposed adjustment.
Being an effective trustee is challenging. Aside from making suitable investment decisions in an uncertain economic climate, trustees must balance responsibilities to beneficiaries with opposing interests. To assist them, trustees should consider whether the power to adjust could help.
By Richard E. Gilbert, Esq., and David Jaffer
Richard Gilbert, Esq. is a partner with Los Angeles-based Freeman, Freeman & Smiley LLP, and can be reached at firstname.lastname@example.org. David Jaffer is a CalCPA member and can be reached at (760) 845-8507. For more information on the Estate Planning Committee, visit www.calcpaweb.org/estate.
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|Title Annotation:||estate planning|
|Date:||Nov 1, 2004|
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