Robert Wolf, Esq.
Tener, Van Kirk, Wolf & Moore,P.C.
Courtesy of Leimberg Information Services, Inc. (http://www.leimbergservices.com)
All Rights Reserved
DELAWARE ENACTS FIRST TRU STATUTE:
June 21st, 2001, Delaware became the
first state in the country to enact a statute expressly allowing
trustees of income trusts to convert their regime to one employing
the Total Return Unitrust concept. While both New York, which
passed its statute the day before, and Missouri, which passed
its statute at the end of May were ready to put their laws into
effect, Delaware's Governor had the quickest pen. But as Judy
Mccue said at the Miami Institute in January, this is one trend
that will be "coming soon to a legislature near you."
What Judy didn't know in January that would guarantee
her prescience was that Treasury would come out with Proposed
Regulations on February 15th approving both the Power to Adjust
contained in the Uniform Principal and Income Act, and the Total
Return Unitrust approach, under consideration in a number of states.
These regulations impact positively on planning for purposes
of the marital deduction, for purposes of conversion of a GST
grandfathered trust, for purposes of qualifying for QDOT's, and
incidental to the unitrust approach, approved the use of an ordering
rule in which short and long term capital gains would be a part
of Distributable Net Income for Income Tax Purposes.
But those good things would only come to trustees
and estate planners in states that have adopted these new concepts
in connection with their principal and income rules.
And so we have the unusual role of Treasury acting so promptly
to state law changes that their guidance itself becomes an initiating
and facilitating factor.
CHANGE OR DIE!
Those states that do not initiate change will
not have the benefit of that
change even for trusts drafted in the future.
Why? Well because the concept of income to be
considered such for federal tax purposes must not be a fundamental
departure from existing state law. Hence an attempt to draft a
power to adjust without the statutory power will fail for marital
deduction purposes. So also will a Total Return Unitrust, unless
the trust is drafted on the basis of distributing the unitrust
amount or income, whichever is the greater.
So the Proposed Regulations have kick-started
statutory reform across the country because no forward thinking
state wants their trust businesses to be at a competitive disadvantage.
DO THEY ALL LOOK ALIKE?
But all such unitrust statutes would be pretty
much alike, right?
THE DELAWARE DIFFERENCE: (Can Alaska be
Actually, the statute in Delaware is quite different
from the Bills passed in New York and Missouri.
Delaware's Unitrust Statute Delaware's statute
allows a trustee to convert an income trust to a unitrust or a
unitrust to an income trust, by giving proper notice to the current
and remainder beneficiaries. If no one objects within a 60 day
period after the notice, the change can be made with no court
involvement. Even if there are no disinterested trustees, the
statute provides a mechanism to appoint a disinterested person
to make the decision about the conversion, so that court involvement
should only rarely be necessary (famous last words perhaps).
The unique feature of the Delaware statute is
that the trustee has a choice to set the rate between 3 and 5%
(the range for which was probably taken from the range noted as
acceptable in the Proposed Regulations).
In making its decision as to the rate, the trustee
is directed to take into account:
(1) the intentions of
the trustor, as reflected in the governing instrument,
(2) general economic
(3) projected current
earnings and appreciation for the trust, and
(4) projected inflation
and its impact on the trust.
The trustee has discretion to determine the effective
date of the conversion, the timing of distributions, and the valuation
dates or the averages of valuations
dates as are deemed appropriate.
The Delaware law specifically grants the trustee
the power to allocate short and long term capital gains to income
for purposes of determining DNI. This is important because it
may both lower the total tax burden and makes a higher payout
rate prudent. All pretty good powers, as long as your trustees
don't mind making choices.
Note: Delaware's statute with its discretion
to choose a unitrust rate between 3 and 5% gives the trustee some
significant flexibility. Delaware does not include in its principal
and income law the power to adjust. By making the unitrust provisions
available to virtually all trusts, the legislative summary notes
that it should be available to Delaware trusts and those trusts
which are moved to Delaware (hint!)
NEW YORK, MISSOURI, PENNSYLVANIA, AND NEW
Now let's take a brief look at the statutes passed
and awaiting signature in New
York as well as Bills in Pennsylvania and New Jersey:
UPAIA with the unitrust option was signed in Missouri on Friday,
July 6th, 2001. New York and New Jersey await their Governor's
Unlike Delaware, the New York, Missouri and the
Pennsylvania Proposals all have both the power to adjust and a
separate unitrust section. The idea in having both is that no
one of the two solutions is optimal for all trusts. There are
trusts and families for which the greater flexibility of the power
to adjust is superior, and there are trusts and families for which
the unitrust is superior.
New York's law will allow the trustee to choose
between one and the other regime. The unitrust will have to be
elected by 12/31/05 for trusts in existence before 1/1/02, and
for those in existence after that, on or before the end of the
second full year of the trust, with the consent of all persons
interested in the trust. The trustee or the beneficiary can raise
the issue, and if there is disagreement, the court will decide
which regime is to be followed.
New York adopted a 4% rate, and applies a three
year "smoothing rule" after the first three years of the trust.
The New York statute does not contain anything expressly dealing
with the ordering rule, or granting express discretion to the
trustee, as does Delaware. This is likely because the Bill was
presented earlier and was largely complete by the time the Proposed
Regulations came on the scene. There is no express reference to
the possibility of adopting a different percentage, though this
could be accomplished in effect by using the alternative power
WHY AN "ORDERING RULE" IS SO IMPORTANT:
Note again that the reason for the importance
of the "ordering rule" is that it affects the prudence of a particular
payout rate. If the taxes on short and long term capital gains
are paid in the trust, the rate that can be paid out is lower--likely
30-40 basis points lower in the long term, than if the gains are
pushed out to the beneficiary. For a low basis trust, the difference
could be as much as twice that much. It is likely that even without
the enabling legislation, the selection of a consistent practice
by a trustee of paying out the short and long term capital gain
as part of the unitrust payout would be honored by the IRS, though
some state law support for this would be helpful.
Missouri's Statute Shows TRU Grit. Missouri, like New York, has both the unitrust and the power to
adjust. The power to adjust and the unitrust sections are protected
by short statutes of limitations, so that after a two year period
from the action of an adjustment or a unitrust conversion, the
action becomes incontestable. Missouri's statute has been signed
THE NEED FOR LIMITS AND RULES:
Probably the most interesting (and perhaps problematic)
portion of the Missouri statute is that the unitrust percentage
must be at least 3%, but it has no upper limit. Nor is there any
ordering provision or express power in the trustee to allocate
short and long term capital gain to the unitrust amount.
This may well encourage some pretty unreasonable
demands of Missouri's trustees, since in the eyes of your average
beneficiary, 5% or even 10% may not sound like an unreasonable
request for the unitrust rate. Perhaps it is no coincidence that
under the Missouri statute, only the trustee is empowered to make
the conversion, and choose the rate. It will be interesting to
observe the experience of trustees who have been given such discretion
to see what pressures will be brought to bear on them to exercise
that discretion. Of course that difficulty can be even greater
with the power to adjust, which does not have any explicit limit
either on the up or down side.
On the same day that Delaware's statute became
law, Pennsylvania's proposal became Senate Bill 1014 (perhaps
numbered wistfully to help take our minds off of the scheduled
loss of our beloved step-up some years down the road). Pennsylvania's
Bill, like New York, adopts a default rate of 4%, but references
specifically the right to adopt a different rate by Court action.
(Although most of the actions and decisions contemplated under
the PA Bill would not require Court Action.)
Pennsylvania's bill has an express ordering rule,
eschewing a grant of discretion in light of the fact that it is
quite unlikely that the trustee would rationally choose to pay
the tax in the trust, where the tax will be at least as large
or larger, and where it is likely to impair the ability of the
trustee to keep the value of the trust up with inflation.
The PA Bill gives the trustee the power to release
the power to adjust and stay with the present regime, utilize
the power to adjust, or opt for the unitrust, in which case the
power to adjust is expressly waived. The power to adjust and the
unitrust statute are intended to be very broadly available in
the Pennsylvania proposal, as the requirement of the trustee acting
as a prudent investor, contained in the uniform act was omitted
as being unduly restrictive.
Most of the smaller administrative decisions
are left to the trustee, similar to the Delaware approach, while
New York adopted a more detailed statutory framework. Pennsylvania's
approach was designed to make the trustee's choice a simple one-using
a 4% rate and an ordering rule and a three year smoothing rule.
Other rules and rates could be used, but these are new decisions
for our trustees. It is well to make the decisions easy to implement.
New Jersey is taking a different hybrid approach
by adding a TRU safe harbor to its power to adjust. The safe harbor
allows the trustee to increase the payout rate to no more than
4%, or to reduce the payout rate to no less than 6% by its power
to adjust. The Bill has been passed and awaits only the Governor's
signature to become law.
Whether this approach will attract the same imprimatur
from the Proposed and Final Regulations as the separate statutory
regimes is unclear. Clearly it should work within its borders,
using the power to adjust, though 6% is above the range mentioned
in the Proposed Regulations. But what will the New Jersey statute
do for trusts which are drafted as unitrusts to begin with? Will
a 5% unitrust in a marital trust qualify for the marital deduction,
without paying out the income if greater than the 5%? That is
not so clear. And what about a conversion from an income rule
trust to a unitrust--is that O.K. for GST purposes? These questions
do not have as clear answers as they do in states that have used
the dual approach, making the power to adjust and the unitrust
both expressly available.
A further argument against this safe harbor approach
is that a safe harbor, or range of safe harbors, will tend to
dictate the way in which the power to adjust is used. If the safe
harbor legislation approves an increase in payout up to 4%, who
will feel good about the more conservative and growth oriented
3% rate? Not your average current beneficiary! Mind you on the
old income basis, a 3% rate would require at least 50% of the
portfolio in bonds. My thought is the 3-5% makes the most sense
if a range is to be specified. Reducing a payout to no less than
6% in a higher interest rate environment and with perhaps an all
bond portfolio is better than nothing, but not nearly enough to
protect the value of the trust. And investment mix is critical
to all of this. If the trust is invested in 60% equities and 40%
fixed income, my software shows that a 6% payout rate will preserve
the real value in the trust in only 13% of all of the rolling
periods in history, and the average result would be a decrease
of 28% in real terms! (Sorry, sometimes I get carried away.) Of
course in the current investment climate, a reduction of the income
payout to 6% is clearly academic.
WHAT'S THE BEST WAY TO DO THIS?
What's the best approach? Well, time will tell.
Are other states considering such statutes? You
bet! It is likely that TRU statutes will be considered in one
variety or another in many other states very soon. Interest has
been shown in Maryland, Colorado, Texas, Iowa, Alaska, Ohio, California,
Florida, Illinois and others.
WHERE CAN I LEARN MORE?
For articles and outlines on TRUs by David Diamond,
Michel Nelson, Mark Edwards, Bob Wolf, Patti Spencer, Jim Dam,
and from Forbes, go to http://www.leimberg.com and look on the
far right hand side under TRUs. And be sure to search Leimberg
Information Services archives
for more). Multi disciplinary
practitioners will find "Proposed Regs. On the Definition of
Trust Income: The Best Thing for Life Insurance Since Sliced
Estate Planning Magazine (May 2001). Also, don't miss Estate
Planning Magazine (July 2001, Vol. 28, No. 7, Pg. 308) where
Laura Howell-Smith's comprehensive and well presented analysis,
"How Prop. Regs. On the Definition of Income Affect Total Return
Trusts" which analyzes tax consequences of TRUs.
The most recent article published in the popular press
can be found in Bloomberg News, Friday, July 13th entitled,
"The TRU Takes Off".