A FRESH IDEA BRINGS DOWN THE WALL BETWEEN INCOME AND PRINCIPAL, TRUSTEE AND BENEFICIARY

As of January 1, 1995, a Trustee of a New York trust must follow the tenets of the Prudent Investor Rule (the "Rule") set forth in § 11-2.3 of the Estates, Powers & Trusts Law (EPTL). The Rule was enacted to conform New York’s laws governing trust administration to modern principles of market theory. The Rule serves as a model standard of fiduciary conduct with respect to the trust portfolio and the soundness of the Trustee’s investment decisions. Unless the governing trust instrument specifically provides otherwise, the Rule applies by default to all investments made by a New York fiduciary (including a trustee of a lifetime or testamentary trust, or an executor or administrator of a decedent’s estate).

The Rule was enacted in response to widespread dissatisfaction with its long-established predecessor, the Prudent Man Rule (the "former Rule"). The former Rule, which governed Trustees for more than 100 years, required the Trustee "to make such investments and only such investments that a man of prudence would make of his own property, having in view the preservation of the estate and the amount and regularity of the income to be derived." In addition, the former Rule imposed upon Trustees a strict duty to act impartially with respect to the income and remainder beneficiaries by prohibiting any investment approach that would unduly favor one over the other. Critics argued that the former Rule was rigid and arbitrary, and that it hindered wise investing because it (a) focused on the propriety of each asset in isolation rather than as an integral part of the trust portfolio; (b) encouraged preservation of the nominal value of principal at the risk of decreased purchasing power over the long-term; (c) proscribed certain investments entirely; (d) provided a "safe harbor" for original investments; and (e) deterred the fiduciary from acquiring new types of investments. Most significantly, in order to balance the current income beneficiary’s goal of maximum income with the remainder beneficiary’s desire for growth, the Trustee was compelled to invest the trust assets as though principal and income were separate funds.

Although the current Rule continues to define prudence as acting with care, skill and caution, it provides greater flexibility and allows the Trustee to pursue an overall investment strategy for "total return," regardless of whether that return is in the form of ordinary income or capital appreciation. Specifically, the Trustee is now authorized to (a) manage the trust as a whole (the "entity theory"); (b) incorporate risk and return objectives reasonably suitable to the purpose of the trust; and (c) delegate investment authority, subject to certain safeguards. Furthermore, while the current Rule does not classify any investments as imprudent per se, the Trustee has an affirmative duty to both limit risk through diversification and justify each asset’s role in the overall plan.

Because many traditional trusts define the current benefit payable to a beneficiary as the amount of interest and dividends (ordinary income) received on principal, they perpetuate the distinction between income and principal and fail to comport with "total return" investing. As a result, many Trustees are not able to take advantage of the greater discretion permitted by the current Rule. For example, assume the governing trust instrument requires that all income is payable to A for life with the principal payable to B upon A’s death. Because A’s interest as the current beneficiary is entirely dependent upon trust accounting income, A will desire high-yield investments and be less concerned with capital appreciation. On the other hand, B, as the eventual beneficiary of principal, will desire high-growth investments and will not be concerned with income distributions except to the extent they directly impact principal. Bearing in mind that the Trustee continues to owe a duty of impartiality to both A and B under the Rule, how should he invest the trust estate? Achieving an appropriate asset allocation for the trust may pose a difficult challenge. For example, a portfolio primarily invested in bonds or other fixed income securities will generate a steady income stream at the risk of the erosion of principal by inflation. On the other hand, a portfolio primarily invested in equities should keep pace with inflation but will render less annual income. This dilemma suggests that in order to draft future trusts that take into account such economic concerns as inflation and the preservation of purchasing power, it may be necessary to define the current beneficiary’s interest in terms other than pure accounting income.

One possible solution is the so-called "unitrust," a type of trust traditionally used for split-interest charitable transfers. A total return unitrust is a private non-charitable trust from which the current beneficiary is entitled to receive an amount equal to a fixed percentage of the fair market value of the total trust estate (the "unitrust amount") determined annually. The unitrust amount may be paid to the current beneficiary from either income or principal or both. Some commentators suggest that a 4% unitrust payout will simultaneously preserve both the purchasing power of the current beneficiary as well as that of the remainder beneficiary, provided the investment portfolio is reasonably balanced. The creator of the unitrust is, of course, free to specify the unitrust payout, to index the unitrust payout, or to provide the Trustee with the discretion to modify the payout in light of changing economic conditions.

In general, the unitrust is an attractive vehicle for a trust creator who wants the required payout to represent an unvarying percentage of a potentially fluctuating asset value while allowing the Trustee to take maximum advantage of the peaks and valleys of the marketplace. The unitrust also provides other benefits: It gives both the income and remainder beneficiaries reasonable expectations for current and future distributions, thereby lessening tension between them; it creates a partnership between the beneficiaries and the Trustee that enables the Trustee to avoid conflict and carry out his duty of impartiality more efficiently; and, if properly drafted, it permits potential income tax savings to the extent capital gains are used to satisfy the required payout and taxed to the current beneficiary at his or her possibly lower tax bracket.

Caveat: The unitrust structure is not suitable for a marital deduction trust under Section 2056(b)(7) of the Internal Revenue Code, otherwise known as a "QTIP Trust," unless the governing instrument defines the required payout as the greater of the unitrust amount or accounting income. The Internal Revenue Code still mandates the distribution of all income from a QTIP Trust to the surviving spouse in order for the trust to qualify as marital deduction property.

For additional flexibility, the unitrust could be structured as a "give me five" unitrust. Rather than requiring the Trustee to distribute a stated unitrust amount, the "give me five" unitrust grants the current beneficiary a lapsing right to withdraw up to 5% of the total trust assets each year. Having the option to forego a current distribution in a given year, the current beneficiary of a "give me five" unitrust may exhaust his or her own resources before consuming the trust assets if he or she so chooses. This is especially attractive, for example, if the current beneficiary does not need distributions and wishes to conserve the trust assets for the remainder beneficiaries, who may be his or her children and grandchildren.

Caveat: Granting the current beneficiary a right to withdraw not more than 5% of the trust assets will avoid adverse gift tax consequences. However, the current beneficiary of a "give me five" unitrust would be subject to income tax on at least a portion of the income attributable to the property subject to the withdrawal right, whether or not the right is exercised.

Another possible option is the use of a fully discretionary or "sprinkle" trust. The discretionary trust provides the Trustee with a direct, dispositive power to distribute some or all of the trust income and/or principal to one or more beneficiaries, as the Trustee deems appropriate. In turn, the Trustee can invest the trust assets for total return and make a fair allocation of the return by distributing a portion to the current beneficiary and reinvesting the undistributed portion. The Trustee, not the governing trust instrument, defines the current beneficiary’s interest within his sole judgment, as exercised from time to time. It is important to remember that the fully discretionary trust is designed to allow the Trustee the total flexibility to control and adjust the timing, manner and amount of trust distributions. Thus, the lack of articulated guidelines in the governing instrument (or in an accompanying letter of intentions) may impose additional pressure on the Trustee. The fully discretionary trust would be emotionally satisfying to the trust creator who has confidence in the Trustee to take advantage of marketplace fluctuations and appropriately allocate the return among the beneficiaries.

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The Prudent Investor Rule has precipitated other changes in New York trust law. Currently, the New York legislature is actively considering changes to the New York Principal and Income Act (the "Act") under EPTL § 11-2.1. The Act is the default statute that directs the allocation of trust receipts and expenses to either trust income or principal. According to legislative reports, the revised Act will dispense with outdated notions of "current benefit" and incorporate modern concepts of investment theory. Once enacted, the revised Act would presumably address the constraints Trustees of traditional "all income" trusts currently face. As of the date of this Report, it is unclear when the proposed legislation would become final and the extent to which existing irrevocable trusts will be affected. In the meantime, creating either a unitrust or fully discretionary trust may be a prudent means of achieving total return in many circumstances.

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CURRENT EVENTS AT THE DUNNINGTON FIRM

• In September 1999, the Firm opened an office for the practice of law in California. Located in Westlake Village near Los Angeles, this presence expands the Firm’s ability to represent West Coast and Pacific Rim clients and will initially focus on corporate/SEC law, mergers and acquisitions, and other practice areas.
• The Firm has welcomed back Frederick W. London as a Partner effective September 1, 1999. Fred originally joined the Firm as an associate following graduation from Georgetown University Law Center in 1976. Fred is operating out of the California office, where he continues to focus on corporate and SEC matters in the Corporate and Business practice group. His e-mail address is flondon@dunnington.com.
• The Firm is proud to announce that Carolyn M. Glynn has become a Partner as of October 1, 1999. After graduating from Brooklyn Law School in 1991, Carolyn practiced Trusts and Estates law with a small Manhattan firm and then worked at United States Trust Company of New York for two years. Carolyn joined the Firm in January 1995 and is a member of the Trusts, Estates and Private Clients practice group. She has written and lectured on various estate planning subjects. Her e-mail address is cmg@dunnington.com.
• In 1952, the Dunnington Firm moved its offices from Wall Street to its present Midtown Manhattan location. The Firm was the first tenant in the then brand-new building known as The Chrysler Building East at 161 East 42^nd Street. Subsequently renamed The Kent Building after it was acquired by Jack Kent Cooke, its mailing address was also changed to 666 Third Avenue in the 1980’s. Following Mr. Cooke’s death in 1997, The Kent Building and The Chrysler Building, with its stylish art deco lobby, were sold to real estate developer Tishman Speyer. The new owner began in early 1999 the process of refurbishing and structurally upgrading the building, now part of The Chrysler Center, including the facade, elevators, lobby, security desk and entryways. If you have visited the Firm this year, you have seen the workmen and the equipment making this project possible. We appreciate any special efforts you have made to find our 27^th Floor elevator bank among the changing lobby features and to navigate around the obstacles. We are, of course, pleased to be a part of the very real upgrading of the Midtown area, including the magnificent restoration of Grand Central Terminal, from the "starry night" ceiling in the Main Concourse to the handsome Vanderbilt Hall expanse. The best news is that there is an end to our construction project in sight just a few months down the road.

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

©1999 Dunnington, Bartholow & Miller LLP. All Rights Reserved.