Fall 2001: DB&M Reports to Clients

Estate and Tax Planning Fall 2001

NEW YORK LEGISLATION WILL ENHANCE TOTAL RETURN TRUSTS

In This Issue: New York Legislation Will Enhance Total Return Trusts

New York's Prudent Investor Act, which became effective in 1995, encouraged Trustees to invest for "total return" as part of an overall strategy implementing those risk and return objectives suitable to the particular trust, and without regard to whether that return is in the form of ordinary income or capital appreciation. See our Fall, 1999 Report to Clients, "The Total Return Trust," at www.dunnington.com.

To complement the Prudent Investor Act, Governor Pataki signed legislation in September, 2001, which is designed to add flexibility to the administration of eligible New York trusts. In addition to modifying the rules for allocating receipts and disbursements between Income and Principal, the new statute offers two very significant options to Trustees:

Under certain conditions, Trustees will be authorized to exercise a "Power to Adjust" whereby Principal can be allocated to Income (and distributed to the income beneficiary) or Income can be allocated to Principal in an appropriate situation, in order to balance the interests of the income beneficiary and the remaindermen of the trust.
Trustees may elect to administer a trust as a statutory unitrust (the "Unitrust Option"), meaning that for electing trusts in 2002, an amount equal to 4% of the fair market value of the trust would be distributable to the income beneficiary, regardless of whether the sum is paid from Income or Principal of the trust, and without regard to the actual amount of net income collected.

The rules are generally effective with respect to existing New York trusts being administered after December 31, 2001, and to new trusts created after that date.

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Power to Adjust. In determining whether to exercise the Power to Adjust, a Trustee is directed to take into account a number of factors set forth in the Prudent Investor Act, including the size of the particular trust and its anticipated duration, the liquidity and distribution requirements, the general economic conditions, expected tax consequences and the projected return on the trust portfolio. In addition, a Trustee must consider the intent of the creator of the trust, the nature of the trust assets, any powers or prohibitions in the governing instrument, and the anticipated net income and appreciation in the trust Principal. After weighing these factors, the Trustee may exercise the Power to Adjust if the Trustee determines an adjustment will be "fair and reasonable" for all of the beneficiaries.

There are several statutory restrictions on the use of this power. For example, the Power to Adjust may not be utilized:

When it would reduce the income interest in a trust which qualifies for the estate tax Marital Deduction.
When the Trustee is a current beneficiary or a presumptive remainderman.
When possessing or exercising the Power would cause the trust or any portion thereof to be included in the gross estate of someone who has the authority to remove or appoint a Trustee.
When the adjustment would directly or indirectly benefit the Trustee.

A Trustee may seek the protection of a judicial authorization for a proposed exercise of a Power to Adjust. Likewise, a beneficiary who disagrees with an exercise of the Power may ask the court to restore the trust to its pre-exercise position.

Unitrust Option. Alternatively, a Trustee can consider electing the Unitrust Option, in which case an amount equal to a fixed percentage of the fair market value of the trust on the first day of the year will be distributable to the beneficiary. For the year 2002, the New York statute provides that the Unitrust amount shall be 4% of the value of the trust. If the Unitrust Option is elected, beginning with the fourth year after the election, the value of the trust will be based on the average value of the trust over the preceding three-year period. All expenses are to be paid from trust Principal, so the 4% payout will not be reduced by Trustee commissions, investment fees, or any other expenses otherwise chargeable to Income.

To elect this Option, a Trustee will be required to (a) exercise discretion, (b) obtain the consents of all present and future beneficiaries who are the "interested parties" or (c) obtain court approval. In addition, notice of the election must be given to the court and the interested parties. Once elected, the Unitrust Option will continue from year to year. The statute provides that a court proceeding is required in order to opt-out.

Use of the Unitrust Option will provide an element of uniformity for both the beneficiary and the Trustee, since payment of equal installments of the annual amount may be arranged on a periodic basis. At the same time, beneficiaries should recognize that the Unitrust amount payable from year to year will be affected by volatility in the marketplace.

While existing trusts can elect the Unitrust Option any time up until December 31, 2005, new trusts (created after 12/31/01) will have just two years after funding within which to opt-in.

Tax Considerations. Earlier in 2001, the IRS issued Proposed Regulations that will impact the income taxation of trusts being administered as "total return trusts" and the beneficiaries who receive distributions from such trusts. When trust principal is distributed to the beneficiary in satisfaction of the Unitrust amount or in connection with the exercise of a Power to Adjust, the Regulations state that the Service will respect the Trustee's allocation of capital gains to the beneficiary or to the trust as long as such allocation is made on a reasonable and consistent basis.

To qualify for the QTIP estate tax Marital Deduction, the surviving spouse must be entitled to all income for life. Accordingly, Reg. §20.2056(b)-7 would be amended to provide that a Trustee's exercise of the Power to Adjust in order to fulfill the Trustee's duty of impartiality will not cause the spouse's income interest to fail as a qualifying interest for QTIP purposes.

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Observations. The rigid distinction between Principal and Income need not drive the Trustee's investment strategy in trusts to which the new law applies. For example, assume a trust instrument requires that all net income be distributed to the income beneficiary and does not authorize the Trustees to distribute Principal, i.e. a traditional income-only trust. Starting in 2002, the Trustees of such a trust may be entitled to utilize the Power to Adjust or the Unitrust Option and coordinate their investment decisions to take maximum advantage of the financial marketplace, regardless of the amount of net income earned by the trust. The Trustees are not required to implement either of these statutory options, and could continue to distribute the net income as in the past.

The investment flexibility allowed by the new rules comes with a few strings attached. A Trustee's decision-making process must take into account the tax rules embodied in the Proposed Regulations, some of which will likely be refined when Final Regulations are published. The various criteria peculiar to each trust as set forth in the Prudent Investor Act must be weighed on a regular basis. To avoid future problems, the prudent Trustee may be obliged to communicate to all interested parties any decision to exercise the Power to Adjust or the Unitrust Option and be prepared to explain those decisions, including presumably any decision not to exercise either of such options. Thus, more work will be required of the Trustee under New York law, but the interests of all trust beneficiaries should be enhanced.

This report is distributed as general information only. No action should be taken solely on the basis of its contents. We welcome requests for more detailed information on any topic discussed in this report.