Robert A. Mason, CELA
Originally published in The Will and the Way, NC Bar Ass’n (3/2003)Ch-ch-ch-ch-changes Turn and face the strange ch-ch-changes Don’t want to be a richer man Ch-ch-ch-ch-changes Turn and face the strange ch-ch-changes Just gonna have to be a different man Time may change me, but I can’t trace time
David Bowie, Hunky-Dory, 1972
This Spring or Summer should be an interesting time to be an estates and trusts lawyer or, for that matter, a trust officer in North Carolina. Change, radical change, is in the air. As is the case with most change, however, this will be a good news-bad news story. The bad news is that there will be much to learn, and for those used to the comfortable old way of doing things this will be a decidedly uncomfortable time. The good news is that the opportunities for designing trusts that comport with modern portfolio or “total return” theories of investment and for redesigning stodgy old income rule trusts just waiting for litigation are about to open. Regardless of how you may feel, change is coming and is inevitable unless North Carolina wishes to remain one of the fewer than ten states that have not responded to the unitrust/equitable adjustment riptide that has swept the national beach over the past two years.
The modern concepts involved in the changes coming are a response to the age-old trustee’s dilemma: How to invest for income and asset appreciation, how to keep the income beneficiaries happy and the remainder beneficiaries happy . . . and not get sued in the process. The old ways of doing things are imbedded in the prudent man rule of Harvard College v. Armory, 26 Mass. (9 Pick) 446 (1830), and in the categorizations of principal and income that have been fixtures of older versions of the Principal and Income Act and the Internal Revenue Code for decades. The old strategies worked reasonably well in markets accustomed to somewhat elevated but stable interest rates, moderate but steady appreciation of equities and significant distributions of dividends by issuers. Those days are history. The new way of doing things will be based on increased trustee flexibility to invest for total return (income plus appreciation) under a scheme that will allow trustees to reclassify capital gain as income (and vice versa) or to elect to pay a unitrust amount and call it ‘income’ regardless of actual trust income. With the age-old dilemma off her back, the trustee can invest for total return and everyone will be happy (theoretically).
Well over forty states (the numbers will increase as the legislative season heats up) have either adopted or are considering total return legislation, and the Internal Revenue Service is moving full bore with a complete rewrite of its income-versus-principal regulatory scheme that should be in place by late Spring. On Jan. 29, 2003, the Bar’s Executive Committee considered and approved the North Carolina Principal and Income Act of 2003 put before it by our section’s legislative committee. It is now part of the Bar Association’s 2003 legislative agenda. The Proposed Legislation includes both an equitable power of adjustment and the ability to convert an income rule trust to a unitrust. Further references in this article to “Proposed Legislation” or “Prop. N. C. G. S.” are to the Bar’s legislative proposal.
This article discusses the trustee’s dilemma, outlines the modern response to that dilemma, and gives a reading tour of the key points of the Proposed Legislation and the proposed Treasury regulations.
The Current Situation
Since the 1930s, most, if not all, states have provided statutory default definitions of income and principal for purposes of receipts and disbursements from a trust or estate. The default settings take the form of some variation of one of the versions of the Uniform Principal and Income Act, notably the Uniform Principal and Income Act of 1931, the Revised Uniform Principal and Income Act of 1962 and the Revised Uniform Principal and Income Act of 1997 (which act is a subject of this article and, I predict, will be enacted in all but fewer than five or six U.S. jurisdictions by the end of 2003). North Carolina’s current version, enacted in 1973, is a version of the Revised Uniform Principal and Income Act of 1962 and is codified at N.C.G.S. Chapter 37.
The reason one may view the applicable Principal and Income Act as a set of “default provisions” is because the specific provisions of a trust document or will may override the provisions of the act; in the absence of any (or clear) directions under the document, however, the provisions of the act will control. The provisions of the Principal and Income Act are also extremely important because document drafters will invariably fail to address every exigency, the provisions of a Principal and Income Act will provide evidentiary standards of “reasonableness” in the event of inevitable trusts and estates litigation, and numerous provisions of the Internal Revenue Code and the Treasury Regulations work with reference to state law (“if local law so provides . . .”).
The Uniform Principal and Income Act of 1931 (UPIA 1931) and the Revised Uniform Principal and Income Act of 1962 (RUPIA 1962) have governed the classification of trust receipts from various sources for purposes of determining whether those receipts will benefit the income beneficiaries or the remainder beneficiaries, using traditional notions of what is “income” and what is “principal”. Pursuant to those acts, trustees labeled dividends, interest, royalties, lease payments and the like as “income,” and they labeled capital gains and other appreciation of assets as “principal.”
While some version of the Principal and Income Act assisted with trust asset classification issues, the prudent man rule, first enunciated in Massachusetts in 1830, governed trustees’ management of trust assets. The prudent man rule requires trustees to “observe how men of prudence, discretion and intelligence manage 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 the capital to be invested.” Harvard College v. Armory, 26 Mass. (9 Pick) at 461. The prudent man standard later appeared as the Model Prudent Man Rule Statute (1942) and in Section 7-302 of the Uniform Probate Code (1969). In fact, the Prudent Man Rule governs ERISA trustees under Section 404(a)(1)(B) of ERISA.
The Prudent Man Rule works if the primary concern is the preservation and growth of capital (principal), as is the case under most employee retirement plans subject to ERISA or many other trusts that are designed to conserve or grow capital for a single beneficiary (or class of beneficiaries). Even in the case of an “income rule” trust in which all income (as defined under the instrument or the local version of the Principal and Income Act) is to be paid to an income beneficiary for life, remainder to certain other beneficiaries, the Prudent Man Rule may continue to suffice if the trust investments (and for that matter the broader financial markets) are generating reasonable and stable levels of income.
However, the markets and the economy of the last twenty years or so have given everyone a wild ride. Just ten years ago a trustee could hold a portfolio of 60 percent equities and 40 percent bonds and expect an income return of over 5.5 percent. Today that same portfolio might return less than 3 percent income yet produce dramatic capital appreciation. See Lyman W. Welch, “Policy Differences in Total Return Laws,” at www.leimberg.com/tapes/policy_differences.html (adapted from an earlier article in Trusts & Estates (June 2002). Also, new investment vehicles such as derivatives, options and asset-based securities, once novel, now common, generate receipts allocable to principal under current rules. Kimberly Stogner, “A Look at the Uniform Principal and Income Act of 1997,” The Will and the Way 18 (Nov. 1998). In this environment, the investment community began to develop models based on “total return” – a view that the prudence of trust investments should not be determined with respect to an examination of individual investments, but rather an examination of overall investment mix, and whether through wise diversification a trust is generating adequate levels of total return (income plus principal growth). As concepts of modern portfolio theory and total return investing have gained favor, there has been a growing disconnect between the newer theories of investing under the traditional Prudent Man Rule and classifying investment returns as either income or principal under the older notions of UPIA 1931 or RUPIA 1962.
Prudent Investor Act
As a result of increased acceptance of total return investment and modern portfolio theory, the need for statutory guidance other than the Prudent Man Rule became readily apparent. In 1994 the National Conference of Commissioners of Uniform State Laws (the Commissioners) adopted the Uniform Prudent Investor Act (to avoid confusion with UPIA this article refers to the Uniform Prudent Investor Act as the “Investor Act”). The Investor Act, while continuing to balance the income beneficiary’s right to a reasonable distribution of income against the remainder beneficiary’s continuing interest in preserving and growing principal, focuses more on total return performance and the need to balance overall risk versus trust performance. The Investor Act imposes several duties on a trustee: (i) loyalty, (ii) impartiality, (iii) pursuit of an investment strategy that considers both reasonable production of income and safety of capital, and (iv) diversification of trust investments. North Carolina adopted the Investment Act in 1999 as Article 15 of Chapter 36A of the General Statutes, effective January 1, 2000 (the general rule is codified at N.C.G.S. § 36A-162). According to N.C.G.S. section 36A-162(c)(5), one of the elements that a trustee must consider as part of the overall trust investment strategy is “[t]he expected total return from income and the appreciation of capital . . . .”
Promulgation of the Investor Act for consideration by the states was a good start, but it also created problems. Trustees found themselves in a squeeze between the Investor Act mandate to generate total return on an overall investment strategy and the need to generate reasonable income to pay to an income beneficiary. Often, a trustee cannot have it both ways. In fact, as noted above, in the market of the late ‘90s it may have been the case that a prudent total return strategy would not generate reasonable income. The Commissioners reacted swiftly, and by 1997 they issued the Revised Uniform Principal and Income Act of 1997 (“RUPIA”).
Uniform Principal and Income Act of 1997 and the Power to Adjust
RUPIA provides the second leg for a trustee to stand on when implementing a trust investment policy comporting with modern portfolio theory by granting trustees powers to make adjustments between income and principal. Many states have augmented the power to adjust with a mechanism to convert an income rule trust to a unitrust, discussed below. The Proposed Legislation takes this tack. Either approach enables a trustee to, in effect, reclassify as principal what might otherwise have been income and vice versa. Under powers of equitable adjustment, a trustee may reclassify a certain amount of principal or capital gain as income in order to assist the trustee in realizing a reasonable “income” stream to the income beneficiary. On the other hand, a unitrust payout is a payout equal to a fixed percentage of a trust’s assets for a given period.
Part 1 of Article 1 of Proposed N.C.G.S. Chapter 37A tracks RUPIA nearly verbatim. Accordingly, further references to RUPIA sections in this article also may be taken as references to sections of the Proposed Legislation (e.g., RUPIA § 103 is almost identical to Prop. N.C.G.S. § 37A-1-103). RUPIA is available for download or browsing at National Conference of Commissioners on Uniform State Laws website, www.nccusl.org/nccusl/ (select the “Principal and Income Act” from the drop down menu entitled SELECT AN ACT).
RUPIA section 104 (a) provides:
A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee determines, after applying rules in Section 103(a), that the trustee is unable to comply with Section 103(b).
Obviously, three conditions must apply for a trustee to make an equitable adjustment. First, the trustee must be acting as a prudent investor, which the Commissioners’ comments make clear could be satisfied under a common law standard as well as taken in a jurisdiction in which the Uniform Prudent Investor Act applies. Second, the trust must define distributions to at least one beneficiary with respect to the trust’s income. Third, the trustee must determine that she is unable to allocate income in a fair and impartial manner (as required under Section 103 (b)). This would be the case under an income rule trust if, for example, the trust realized significant asset appreciation or capital gain as a result of the trustee’s pursuit of a total return investment policy under the Investment Act that nevertheless generated little or no income in the form of dividends or interest.
RUPIA section 104(b) provides a non-exclusive laundry list of items a trustee should consider when electing to make an equitable adjustment, and Section 104(c) provides a number in situations in which a trustee may not make an adjustment (including a situation in which the trustee is a beneficiary of the trust).
RUPIA provides two very strong protections for a trustee making an election to adjust, no doubt in response to concerns that the breadth of trustee discretion would simply invite litigation. First, RUPIA section 103(b) provides that “[a] determination in accordance with this Chapter is presumed to be fair and reasonable to all the beneficiaries.” RUPIA section 105(a) provides that a “court may not order a fiduciary to change a decision to exercise or not to exercise a discretionary power conferred by this Act unless it determines that the decision was an abuse of the fiduciary’s discretion.” Strong medicine. Potential plaintiffs must rebut a presumption of “fair and reasonable” conduct, and then prove an abuse of discretion.
The equitable power to adjust is not without its critics. Some criticize the powers as difficult to administer due to little guidance. See Mark T. Edwards, “Trusts for the New century – The Third Paradigm,” The Will and the Way, Nov. 1998 at 5, updated and reprinted at www.leimberg.com/tapes/edwards.html (hereinafter “Edwards”). Further, once an adjustment is made, the trustee is in the position of having to continuously monitor her actions with the full knowledge that her decisions will be subject to 20/20 hindsight.
Nevertheless, the overwhelming majority of states that have adopted RUPIA have included the Section 104 equitable powers of adjustment. Perhaps most states recognize that the criticism is unduly harsh in view of the statutory protections (discussed above) offered the trustee; many states may also recognize that adopting the unitrust option can provide the second alternative of conversion to a unitrust, which may provide an even safer alternative for the trustee.
About half of the states adopting or considering RUPIA have added a unitrust feature. The virtues of the power to adjust as opposed to the unitrust conversion feature have been subject to lively debate in the Will and the Way. See Edwards (virtues of unitrusts) and Graham D. Holding, Jr. and Christy Eve Reid, “A Different Viewpoint,” The Will and the Way, Feb. 1999, 1 (virtues of discretionary powers). The Proposed Legislation, following a number of states and perhaps influenced by our own either-or debates, includes both the power to adjust and the unitrust feature. A trustee generally may choose either approach under the Proposed Legislation.
Unitrusts have been used since 1966 in the planned giving context. Perhaps lingering concerns with powers of equitable adjustment, combined with over 30 years of happy experiences managing charitable remainder unitrusts, led many states to explore adding unitrust conversion features to their statutes. For a number of years, some brave and adventuresome practitioners have been drafting private unitrusts and expounding upon their virtues. In certain contexts, however, for every issue a unitrust resolved it raised significant tax issues. While many of the tax issues could be addressed through skillful drafting and planning, not all practitioners have the requisite level of sophistication to plan and draft around those issues. The Internal Revenue Service has recognized the validity of unitrusts by proposing “soon-to-be-final” regulations that encourage the use of unitrusts if “the terms of the governing instrument and applicable law” so allow. The regulations and tax implications will be discussed further below.
With a green light from the Internal Revenue Service, Delaware first enacted a unitrust statute in 2001 with a thinly veiled invitation to trustees to “move on up to Dover” (the legislative notes say that the provisions are available to current domestic trusts and trusts that move to Delaware). Del. Code Ann. § 12-35-3527 (available online at www.delcode.state.de.us). About half of the states that have adopted equitable powers to adjust in the adopted versions of RUPIA have added unitrust provisions. As discussed (as well as in other issues of The Will and The Way) a unitrust permits a trustee to focus on total return, which is simply investing for maximum return (regardless of whether the return is in the form of traditional income or appreciation of principal) within an acceptable level of risk. With an investment philosophy that emphasizes maximum after-tax returns and long term capital growth everyone wins: the “income” beneficiaries receive a larger unitrust payout and the remainder beneficiaries will eventually realize a larger possessory interest. Under the unitrust approach, the greater the total return the trustee is able to realize, the greater the dollar value of the unitrust payout and the greater the remaining trust corpus will be for the remainder beneficiaries.
Those states that have adopted (or are considering) unitrust legislation have generally considered either a “Delaware model” statute (a 3% to 5% unitrust rate with greater trustee flexibility) or a “New York model” statute (a 4% payout rate with less trustee flexibility). The Proposed Legislation (in Part 2 of Article 1) follows the Delaware model nearly verbatim.
Numerous studies have been conducted with respect to setting an optimum unitrust payout percentage. See, e.g., U.S. Trust Co., “The Well-Adjusted Trust: Revisiting the Principal and Income Act (1997)”, Practical Drafting 6918 at 6948-49 (July 2002) (hereinafter “U.S. Trust, Practical Drafting); Robert B. Wolfe, “Estate Planning With Total Return Trusts: Meeting Human Needs and Investment Goals Through Modern Trust Design”, 36 Real Prop. Prob. & Trust J. 169, 208-13 (2001). Computer modeling seems to suggest payout rates of between 3 percent and 5 percent work well for trusts invested primarily in equities, especially if combined with a “three year smoothing rule” (discussed below). Robert B. Wolf and Stephen R. Leimberg, “Total Return Unitrusts: The (TRU) Shape of Things to Come”, www.leimberg.com; see, also, U.S. Trust, Practical Drafting at 6948-50. A thoughtful selection of a unitrust payout rate should depend upon whether distributed capital gains will be treated as part of distributable net income (DNI) and taxed to the income beneficiary (justifying a higher rate) or will remain as non-DNI capital gains and be taxed in the trust (justifying a lower payout rate). Of course, higher payout rates, especially if coupled with a longer anticipated payout term, will favor the income beneficiary, and lower payout rates, especially coupled with a shorter anticipated term, will tend to favor the remainder beneficiaries. In the proposed regulations, the IRS has placed its imprimatur on the 3 percent to 5 percent range. The decision to include capital gains in DNI, and the impact of that decision on payout rates and trustee impartiality, is discussed further below.
Selecting the appropriate unitrust percentage has not been the only concern with respect to creating a sustainable trust. Most unitrust statutes contain a “smoothing rule” that averages the value of the trust assets over a three-year period. The purpose of this rule is to protect current beneficiaries from a sudden loss of income and to spare the trust from the potential ravages of an extended bear market. A smoothing rule is mandatory in most (if not all) New York model/4 percent statutes. The three year smoothing rule is available, in the trustee’s discretion, under the Delaware model. See Prop. N.C.G.S. § 37A-1-104.4(a).
Mechanics of Conversion
Prop. N.C.G.S. section 37A-1-104.2 provides that a trustee (other than an Interested Trustee) may elect to convert an income rule trust to a unitrust (or vice versa) or change the unitrust percentage if (1) the trustee adopts a written policy involving the proposed action, (2) the trustee sends written notice of her intentions, together with the written policy, to the grantor (if living), all current beneficiaries and all beneficiaries “who would receive principal of the trust if the trust were to terminate at the time of the giving of such notice” and any trust advisors. If none of the foregoing beneficiaries object within 60 days of the receipt of notice, the trustee is free to take the proposed action without any court intervention. If there is no trustee other than an Interested Trustee, the trustee (or a majority of the trustees if there are multiple trustees) may without court approval propose to convert to a unitrust (or vice versa) by taking the same actions discussed above with the addition of appointing a Disinterested Person who, acting in a fiduciary capacity, determines the unitrust percentage. An “Interested Trustee” is a trustee to whom income or principal could currently be distributed, or who could be replaced by a beneficiary who has a current income or principal distribution right, or a trustee with a support obligation to a beneficiary if distributions could be used to satisfy those legal obligations. An interesting query: Could the provisions of N.C.G.S. section 32-34 (prohibiting a fiduciary from exercising on her own behalf what would otherwise be a general power of appointment), in some situations, convert what would otherwise be an Interested Trustee into a Disinterested Trustee?
Prop. N.C.G.S. section 37A-1-104.3(a) provides a safe shelter for the timid trustee. Rather than exercising discretion to make a unitrust conversion, a trustee may petition Superior Court for an order “the Trustee deems appropriate.” Under subsection (b), a beneficiary may request a trustee to either convert to a unitrust (or vice versa) or change the unitrust percentage. If the trustee fails to take the action, the beneficiary may petition the Superior Court to order the trustee to take the action. Subsection (c) says that “[a]ll proceedings under this Section shall be conducted as provided in G.S. 37A-1-105.”
Under Prop. N.C.G.S. section 37A-1-105(a), as discussed above, a court will not interfere with the trustee’s decision absent an abuse of discretion. Further, under subsection (d) a trustee may petition the court to determine whether her proposed action will result in an abuse of discretion. If the trustee’s petition adequately describes the proposed action, explains the underlying rationale for the action and explains how the various beneficiaries will be affected by the proposed action, a challenging beneficiary must meet the burden of establishing that the proposed action will be an abuse of discretion.
Under the foregoing procedures of the Proposed Legislation, apparently if a trustee would rather not exercise the discretion to convert to a unitrust (perhaps she believes it will be inviting litigation, not withstanding the very high burdens that a challenging beneficiary must meet), or if the beneficiaries object, the court will proceed under Prop. N.C.G.S. section 37A-1-105. On the other hand, if a current beneficiary wishes to force a conversion to a unitrust because the trust has not generated a 3 percent income return, either because the trustee refuses to exercise her power of equitable adjustment or because of other breaches of the Prudent Investor Act (perhaps lack of diversification or demonstrated partiality towards remainder beneficiaries), the current beneficiary should not have a difficult time proving up an abuse of discretion under Prop. N.C.G.S. section 37A-1-105. Presumably remedies would remain available under general fiduciary standards and under the Prudent Investor Act.
As discussed above, both the equitable powers of adjustment and the use of unitrusts present significant tax issues, many of which either could be avoided through careful drafting or would lurk as silent traps for the blissfully unwary.
For once, however, the Internal Revenue Service may be coming to the rescue. Aware of modern portfolio theory, the Restatement (Third) of Trusts, the Uniform Prudent Investor Act reliance on total return investing, the growing interest in unitrusts and the popularity of the Uniform Principal and Income Act of 1997 with its equitable power of adjustment, the Service issued proposed regulations on Feb. 15, 2001, blessing what it perhaps viewed as the inevitable. The regulations, when final, will certainly facilitate the exercise of powers of adjustment, the design of unitrusts and the conversion of existing trusts to unitrusts. In fact, the proposed regulations were issued over five months before Delaware enacted the first unitrust statute on June 21, 2001. Although the regulations remain “proposed” and were to have been finalized by the end of 2002, Bradford Poston, a key developer of the proposed regulations, has given emphatic assurances that the regulations are moving quickly through multiple divisions of the Service and will be finalized no later than June 30, 2003. Telephone Interview with Bradford Poston, Attorney Advisor, Office of Chief Counsel, Internal Revenue Service (Dec. 17, 2002).
Perhaps the most important provision of the proposed regulations is a re-definition of income under Code section 643(b). The new definition of income states:
For purposes of subparts A through D, part I, Subchapter J, Chapter 1 of the Internal Revenue Code, income, when not proceeded by the words “taxable”, “distributable net”, “undistributed net”, or “gross”, means the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Trust provisions that depart fundamentally from traditional principles of income and principal, that is, allocating ordinary income to income and capital gains to principal, will generally not be recognized. However, amounts allocated between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains, and appreciation. For example, a state law that provides for the income beneficiary to receive each year a unitrust amount of between three percent and five percent of the annual fair market value of the trust assets is a reasonable apportionment of the total return of the trust. Similarly, a state law that permits the trustee to make equitable adjustments between income and principal to fulfill the trustee’s duty of impartiality between the income and remainder beneficiaries is generally a reasonable apportionment of the total return of the trust. These adjustments are permitted when the trustee invests and manages the trust assets under the state’s prudent investor standard, the trust describes the amount that shall or must be distributed to a beneficiary by referring to the trust’s income, and the trustee after applying the state’s statutory rules regarding allocation of income and principal is unable to administer the trust impartially. In addition, an allocation of capital gains to income will be respected if the allocation is made either pursuant to the terms of the governing instrument and local law or pursuant to a reasonable and consistent exercise of a discretionary power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law.
Prop. Reg. § 1.643(b)-1. Obviously, the new definition is significant because it sanctions both the power to adjust and unitrust payouts if “applicable local law” provides for apportionment between principal and income through a power to adjust or unitrust provisions. Note that the conditions for exercising the power to adjust track RUPIA section 104 and Prop. N.C.G.S. section 37A-1-104(a). The regulations then apply the new definition in the context of marital deductions, GST grandfathering and definitions of distributable net income.
Marital deduction Issues. In the marital deduction context, both the power of appointment trust under Code section 2056(b)(5) and the QTIP provisions under Code section 2056(b)(7) require the annual distribution of all income to the surviving spouse to qualify for the estate tax marital deduction; similarly an inter vivos power of appointment trust requires distribution of income to the spouse to qualify for the gift tax deduction under Code section 2523(e). Without regulatory reform of the definition of “income”, exercise of a power to adjust or conversion to a unitrust could result in withholding income from the surviving spouse or be viewed as a prohibited power of appointment under the QTIP rules. Of course, the careful and knowledgeable planner could draft a marital trust containing a power of adjustment or a unitrust payout as long as language providing that the greater of trust income (under traditional definitions of income) or, as the case may be, the adjusted or unitrust amount was distributed. The proposed regulations redefine income, for these purposes, by reference to proposed Treasury Regulations section 1.643(b)-1. Prop. Reg. §§ 20.2056(b)-5(f)(1), -7(d)(1), 20.2523(e)-1(f)(1).
GST Grandfathering Issues. Irrevocable trusts settled before Sept. 25, 1985, and testamentary trusts under instruments executed before Oct. 22, 1986, with respect to decedents dying before Jan. 1, 1987, are exempt from generation skipping transfer taxation. Treas. Reg. § 26.2601-1(b). The exemption may easily be lost by alterations to the terms of the trust or additions of additional property to the trust. However, the power of a GST grandfathered trust to accumulate income is not a constructive addition unless the power to accumulate income is enhanced (or a new power is added). Treas. Reg. § 26.2601-1(b)(1)(vi), (b)(4)(i)(D). Obviously, powers of adjustment or conversions to unitrusts pose issues of possible accumulations of income or constructive additions. The proposed regulations specify that if pursuant to state law a trustee elects to exercise a power of adjustment or the trust is converted to a unitrust payout there will not be an impermissible enhancement of an existing power to accumulate or the addition of a power to accumulate income for the benefit of skip beneficiaries. Prop. Reg. § 26.2601-1(b)(4)(i)(D)(2), (E).
DNI Issues. The most profound change advanced by the proposed regulations involves the potential inclusion of capital gains in distributable net income under Code section 643(a). The interplay between the proposed regulations, the terms of governing instruments and state law is at best tricky and merit careful practitioner attention. Unfortunately, the proposed regulations, carefully read in conjunction with the preambles, are not a model of clarity. It is important to bear in mind that Code section 643 is a definitional section. As discussed above, Code section 643(b) provides the definition of “income” when not preceded by various adjectives (including “distributable net”). As discussed, the proposed regulations under Code section 643(b) are significant because proposed regulations applicable to the marital deduction rules and rules applicable to GST exempt trusts reference the proposed rules under Code section 643(b) and allow total return concepts to be applied to marital trusts and GST exempt trusts.
What is “respected” for Code section 643(b) purposes (complying with martial deductions rules, for example) does not necessarily mean that an item of 643(b) income will be included in distributable net income under Code section 643(a), however. Although the last sentence of proposed Treasury Regulation section 1.643(b)-1 and proposed Treasury Regulation section 1.643(a)-3(b) (which provides new rules for determining when capital gains will be includable in distributable net income) provide that allocations of capital gains to income will be respected if the allocations are “pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and consistent exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by local law or by the governing instrument, if not inconsistent with local law) . . . ” the similarity stops there. To fully move capital gains into DNI, the fiduciary must make the allocation pursuant to the foregoing standards and (1) allocate the capital gains to income, (2) allocate the capital gain to corpus but treat it on the books, records and tax returns as part of a distribution, or (3) allocate the gain to corpus but utilize it in determining the amount which will be distributed to a beneficiary. Prop. Reg. § 1-643(a)-3(b).
To make the allocation of capital gains to DNI, the fiduciary must derive her authority from either “the terms of the governing instrument and applicable law” (query whether that means applicable law must affirmatively grant the authority or whether the authority is merely allowable under local law), or by the exercise of “reasonable and consistent” discretion granted by “local law or by the governing instrument.” Pursuant to the foregoing, a provision in the governing instrument or applicable statute can direct distributions to be treated as coming from realized gains to the extent those gains exceed ordinary income. Absent specific provisions in the instrument and state law, the trustee is put to an irrevocable election (the regulation requires her to be “consistent”). Once she has elected to treat capital gains as either distributions of principal or distributions of gains includable in DNI, she will be locked into that election for (presumably) the remainder of the trust term (a “consistent” exercise of discretion).
A critical consideration for the trustee working with the Proposed Legislation (or similar legislation in another state) and the proposed Treasury regulations is, notwithstanding a unitrust distribution (or for that matter a distribution subsequent to a power to adjust) that includes capital gains, whether the gains will be taxed at the trust level under traditional taxation approaches, or included in DNI and taxed to the beneficiary. Proposed Treasury regulations make the inclusion of capital gains in DNI much easier than under current Treasury Regulation section 1.643(a)-3(a) (where it is possible, but difficult). Prop. N.C.G.S. section 37A-1-104.4(d)(2) gives the trustee the discretion to allocate net short term, and then net long term, capital gains to income. In view of the proposed Treasury regulations and the idea that capital gains need no longer be “trapped” at the trust level, it may be tempting to assume that inclusion of gains in DNI is an always to-be-desired result. U.S. Trust Company recently published a thoughtful discussion of the topic and cautioned against a rush to inclusion of capital gains in DNI. U.S. Trust, Practical Drafting at 6918-25. The article makes sound arguments, backed with data, that tax neutrality between the income beneficiaries and the remainder beneficiaries is enhanced (and a lower payout justified) by continuing to tax gains at the trust level. Id. Both U.S. Trust, Practical Drafting and Wolf’s Real property & Trust Law Journal article are excellent resources and recommended reading for an in depth treatment of this subject.
A massive nationwide shift in trust law is underway. In response to market shifts towards capital appreciation and away from traditional notions of income, modern portfolio theories are mandating new ways of thinking with regard to a trustee’s duties of impartiality as between different classes of beneficiaries while investing for total return. The legislative shift began with the Prudent Investor Act, and North Carolina joined that movement. The shift continues in legislatures across the nation with adoption of the Uniform Principal and Income Act of 1997 and other forms of total return legislation, joined by the Internal Revenue Service with regulations designed to work with those new laws. The General Assembly has an opportunity to assure that North Carolina remains with the modern trend . . . or is left behind as one of the very few states to have not responded to that trend.
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