News on Total Return UniTrusts: Too Hot to Wait!

Robert Wolf, Esq.
Tener, Van Kirk, Wolf & Moore,P.C.
Pittsburgh, Pa.

Article Courtesy of Leimberg Information Services, Inc. (http://www.leimbergservices.com) All Rights Reserved

DELAWARE ENACTS FIRST TRU STATUTE:                                                                  

June 21^st, 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?

Wrong!

THE DELAWARE DIFFERENCE: (Can Alaska be far behind?)

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 conditions,

(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 JERSEY STATUTES:

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:  (The new UPAIA with the unitrust option was signed in Missouri on Friday, July 6th, 2001. New York and New Jersey await their Governor's signature.)

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 to adjust.

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:

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 into law.

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.

PENNSYLVANIA: 

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:

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 Bread!, Estate Planning Magazine (May 2001). Also, don't miss Estate Planning Magazine (July 2001, Vol. 28, No. 7, Pg. 308) where you'll find 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 13^th entitled, "The TRU Takes Off".