Reprinted with permission of Lawyers Weekly USA, the national newspaper for small-firm lawyers. All rights reserved. You can get three free issues of Lawyers Weekly USA by calling 800-451-9998 or visiting www.lawyersweekly.com.

Should Estate Planners Be Revising Their Trusts?

By James L. Dam

More and more lawyers are drafting trusts that don't simply pay out their income each year, but instead pay a fixed percentage of the value of the trust's assets.

These "total return unitrusts" allow trustees to invest for both income and appreciation, or "total return," without worrying that there won't be enough income for the current beneficiaries.

Proponents say they're better than traditional trusts, because trustees aren't under pressure to produce income and don't have to skew their investment strategy toward bonds rather than stocks.

This has been a growing problem in recent years, as stocks have had tremendous appreciation but very small dividend yields.

"The way we learned to draft trusts in 1960 doesn't work in today's environment," says attorney Mark Edwards of Charlotte, N.C.

The unitrusts can also prevent feuding between beneficiaries over how funds should be invested, give clients more control over the division of trust assets and reduce income taxes.

In New York, the state legislature is considering a bill that would make the unitrust rule the default rule for all future trusts, and allow existing trusts to elect it.

Critics, however, say that traditional trusts work just fine as long as the trustee is given some discretion to pay additional amounts. Most trusts today provide such discretion, typically allowing the trustee to pay more than the income if it's for the beneficiary's "health, education, support or maintenance."

Such discretion is also provided by the revised "Uniform Principal and Income Act," which allows trustees in certain circumstances to pay more than income if this is necessary to prevent the investments from favoring remainder over income beneficiaries. This uniform law was approved by the ABA in January 1998 and has now been adopted by seven states (Arkansas, California, Connecticut, Iowa, North Dakota, Oklahoma and Virginia).

But unitrust advocates respond that such discretion isn't good enough, because many trustees are reluctant to use it and will pay only the income anyway.

Trustees are often nervous about using their discretion because they may have to justify to the remainder beneficiaries why they did so, says Edwards.

They feel it's safer just to increase the income by investing in more bonds, says San Francisco estate planning attorney William Hoisington.

Even a trustee who is also the income beneficiary may be nervous if, for example, the remainder beneficiaries are his or her stepchildren and are likely to question any excess payments, says attorney David Diamond of Napa, Calif.

Critics also say that unitrusts have a number of disadvantages. For instance, to make the required annual payments, a trustee might be forced to sell assets that can't be easily sold, such as real estate or an interest in a closely held business.

Unitrust advocates acknowledge such drawbacks, and say that because of them, many clients would be better off with a trust that instead gives the trustee complete discretion over payments.

But many clients don't want to give complete discretion to a trustee. And such discretion cannot be given to a trustee who is also a beneficiary, or else the entire trust would be included in his or her estate.

Where full discretion isn't appropriate, the unitrust is almost always better than a traditional trust, advocates contend.

Here is a closer look at what experts tell Lawyers Weekly USA are the key advantages and disadvantages of the unitrusts:

The Advantages

* Better investing.

Most trustees of traditional trusts are under pressure to produce income, experts agree.

One reason is that unless the trust document specifies otherwise, they generally have a duty under state law to be impartial as between the income and remainder beneficiaries in their investment decisions.

If they don't produce enough income and aren't able or willing to pay out principal, they risk being sued by the income beneficiary for not being impartial.

To produce much income, however, at least in today's market, trustees generally must invest heavily in bonds and other fixed-income investments, not in stocks or equity mutual funds.

The yield on a 30-year Treasury note is currently about 6.14%, while the average dividend yield on the 500 stocks in the Standard & Poor's Index is just 1.15%.

Even a trust invested 40% in bonds and 60% in stocks will produce an income payout of only about 2.5% after trustees' fees, according to Pittsburgh attorney Robert Wolf, who is one the leading advocates of the unitrusts and taught a seminar on them at the University of Miami School of Law's prestigious annual estate planning conference last month.

To make the income payout 3%, the trustee must invest almost 50% in bonds. To make it 5%, the investment must be about 80% in bonds, Wolf says.

But if trustees invest heavily in fixed-income investments, the total return in a trust will not be nearly as great as if they invested more in stocks. The inflation-adjusted long-term return from stocks historically has been almost four times the return from bonds, says Wolf.

Trustees might try to focus on stocks with relatively high dividend yields, but this may also reduce total return, because many successful companies today are paying little or no dividends.

In fact, a quarter of the value of the Standard & Poor's Index comes from companies that did not pay any dividends at all last year, including 14 of the index's top 15 performers, according to The New York Times. For example, no dividends were paid by Microsoft, Cisco or America Online.

Of course, trustees face pressure not just from income beneficiaries, but also from remainder beneficiaries, who want the trustee to invest for growth and might sue the trustee for failing to do so.

The basis for such a suit may be especially strong in states that have adopted the new "Uniform Prudent Investor Act," which requires trustees to invest for total return as a default rule. The Act has been adopted in 33 states.

"Trustees are caught between a rock and a hard place," says Alvin Golden of Austin, Texas, a regent of the American College of Trust and Estate Counsel.

Most respond by taking a middle approach, investing 40 to 50% in bonds and 50 to 60% in stocks, says Wolf.

The result is that the total return is less than it should be, and the income and remainder beneficiaries are hurt equally, he says.

"Both parties lose," says attorney Stephan Leimberg of Bryn Mawr, Pa., who is the author of several books on estate planning and co-taught with Wolf the unitrust seminar in Miami last month.

Total return unitrusts and fully discretionary trusts avoid the whole problem by freeing trustees from the obligation to produce income.

Trustees then are free to invest in the mix of stocks and bonds "that makes the most money with an acceptable amount of risk," says Wolf.

They are not forced to make "second-best or third-best investment decisions," says estate planner Noel Ice of Fort Worth, Texas.

* Less feuding.

Since both the current and the remainder beneficiaries benefit from a higher total return, regardless of how much is income and how much is appreciation, the unitrust approach also prevents feuding between the beneficiaries over investment strategy.

"They are in the same investment boat and can get along," says Leimberg.

For instance, Kathleen Bay, an attorney in Austin, Texas, says a unitrust would have prevented a lawsuit by an income beneficiary against a trustee she represents who is also the remainder beneficiary, as well as the income beneficiary's stepson.

The trust assets in the case were invested about 60% in stocks and 40% in bonds and Treasury bills and produced income of about 3.5%, Bay says. The income beneficiary is arguing for more investment in bonds and Treasury bills.

* More control.

The unitrust also gives clients more control over the division of assets between the current and remainder beneficiaries.

With a traditional trust, this division depends on how much income is produced during the payout period, which in turn depends on interest and dividend rates and the investment mix the trustee chooses.

It also depends on how much appreciation there is. And if the trustee has discretion to pay more than income, it depends on how this discretion is exercised.

With a fully discretionary trust, as well, the division depends on how the trustee exercises his or her discretion.

With a unitrust, however, the assets are divided according to the percentage rate the client chooses - a higher rate causing more of the assets to go to the current beneficiary, and a lower rate causing more to go to the remainder beneficiary.

If the unitrust gives the trustee the discretion to pay more than the percentage amount, the trustee might alter the division.

However, unless the percentage the client chooses is very low, it's less likely than with an income trust that the discretion will ever be exercised, say experts.

Thus, the unitrust allows the client "a much greater hand" in the division, says Wolf.

The client doesn't "just punt the problem to the trustee," says New York estate planning attorney Anne Hilker.

It also requires the client to carefully consider how much the beneficiaries are likely to need, and how much the trust is likely to provide, which can result in more realistic planning, says Wolf.

The discovery of how little a trust is likely to provide "blows the minds of a lot of clients who are accustomed to the 11% growth that the S&P 500 has shown in recent years," says Edwards.

The beneficiaries, too, will often get a better idea of what will happen and can plan for it, says Leimberg.

The beneficiaries also may appreciate not having to ask a trustee to exercise discretion, he says. "Even if the trustee is her best friend, a widow doesn't want to be at a trustee's mercy."

Another benefit of the client's greater control is that it can make the client and the beneficiaries more willing to accept a corporate trustee, since the trustee's only job will be to invest for total return, says Edwards.

Corporate trustees "are almost always the better choice," because of their investment expertise, he says.

Knowing there will be a certain payment stream from a unitrust can also make clients more willing to accept a fully discretionary trust, says Wolf.

For example, if there will be a "marital unitrust" that provides a payout to a client's spouse after the client dies, the client may be more willing to accept a fully discretionary "credit shelter trust," he says.

* Lower income taxes.

There is also an income tax advantage to unitrusts, because annual payments won't consist only of interest and dividends, but often will include proceeds from the sale of stocks and other assets. Such proceeds will be taxed as capital gains rather than income, and part will be a recovery of cost basis and not taxed at all, says Wolf.

The Disadvantages

* Only good for stocks and bonds.

Total return unitrusts are generally only good for stocks and bonds, experts agree.

They generally are not good, for example, for a house or other real estate or an interest in a closely-held business.

Such assets may not produce the cash needed for making payments, and it would be a problem to sell them. In addition, it would difficult to value them each year for purposes of determining the amount of the annual payout.

Also, if it's a closely-held business, the family may have control over its distributions, eliminating any pressure on the trustee to produce income by investing in bonds, says Wolf.

In some cases, it may make sense to include such assets in the unitrust but exclude them from the calculation of the annual payment, says Hoisington.

Another approach is to include them but give the trustee flexibility when it comes to valuing them, so as not to force annual appraisals, says Wolf.

You might provide that the trustee can use an old value until requested to revalue the asset, and that if the request comes from the current beneficiary, he or she has to pay for it, suggests George Gregory, an estate planning attorney in Birmingham, Mich.

If a piece of real estate makes up 20% of the trust, there may not be a problem, says Wolf. But the more illiquid or hard-to-value the assets are, the more appropriate it is to just put them in a separate trust, he says.

* Not best for some 'shelter' trusts.

In situations where money left in a trust is sheltered from death tax, but money paid out is not, a unitrust often won't make sense because it would force money to be taken out of the shelter.

These situations would include a "credit shelter trust" where the current beneficiary is a surviving spouse, or a "generation-skipping-transfer tax exempt trust" where the current beneficiary is a child and the remainder beneficiary is a grandchild.

In most such cases, the client would be better off with a discretionary trust that provides for the trustee to make payments only in the case of extraordinary need.

A unitrust may also be inappropriate in other cases where required payments would be a problem, such as a trust meant to hold funds for a child until he or she reaches a certain age and to make payments in the meantime only in an emergency, says Wolf.

In some cases, however, an alternative would be to provide for a very low payout rate, such as 2%, he says.

Also, if a credit shelter trust will continue after the surviving spouse's death, you might provide that it "flip" to a unitrust at that time, says Edwards.

Another alternative would be to provide that the beneficiary not be paid automatically, but that each year the beneficiary can withdraw up to a certain percentage of the trust's value if he or she chooses, says Jerold Horn of Peoria, Ill., a past president of the American College of Trust and Estate Counsel.

To avoid tax problems, the beneficiary should not be allowed to take out more than 5%, Horn says. He calls this the "Give Me Five" unitrust.

* Needs may change.

Another drawback of the unitrust approach is that while the annual percentage rate is fixed, the beneficiary's needs may change.

Clients may have an idea of what those needs will be, but they can't be sure, says Washington estate planning attorney Edward Beckwith.

This problem can be solved to some extent by giving the trustee limited discretion to pay more than the percentage amount, similar to the discretion often given to pay more than income in traditional trusts.

Wolf says he routinely includes such discretion in the unitrusts he drafts.

However, trustees may be no more willing to exercise it in unitrusts than in traditional trusts.

Clients also might try to anticipate how a beneficiary's needs will change and choose a series of percentages rather than a single percentage, suggests Diamond.

For example, he says, a trust might provide that distributions will be completely discretionary until a child turns 30, and that the trust will then become a unitrust with a 3% annual payout while the child is in her 30s, a 4% payout while she is in her 40s, and a 5% payout while she is in her 50s, and then continue at 5% thereafter.

* The payout will fluctuate.

The client also doesn't know how the value of the trust's assets will change, says Beckwith.

The unitrusts "are great when the economic climate is like today's," says Golden. "But if we hit a bear market, distributions will drop even though the beneficiary's standard of living stays the same."

To reduce the impact of such changes, lawyers typically provide in unitrusts that the payout each year will be based on the average value of the assets during the previous three years.

"If the market goes down for just a year or two, the beneficiary still gets a decent payout," says attorney Thomas Begley of Morristown, N.J.

As an additional safety valve in cases where the trustee is independent, Wolf sometime includes a provision allowing the trustee to change the annual percentage, but only if there are changes in the investment marketplace that are "permanent, substantial and fundamental."

* The rate may be too high.

Some critics also say that the percentage rates selected for unitrusts are generally too high to maintain the inflation-adjusted value of payouts and principal for a long period of time.

As a result, they say, many current beneficiaries may receive diminished payments later in life, and the remainder beneficiary, a diminished remainder - contrary to the intent of the grantor.

What Wolf and other unitrust advocates generally recommend is a rate between 3 and 5%.

As a rule of thumb, says Hoisington, "3% should be low enough to build the remainder. 4% should keep things about equal. 5% will likely reduce the remainder in inflation-adjusted terms."

The unitrust default rule proposed for New York has a 4% payout.

However, two unitrust critics, investment manager James Garland of Columbus, Ohio, and economist David Levine of New York, contend that if the inflation-adjusted value of the payout and principal are to be maintained, 4% is too high.

They say the correct rate to be applied to the value of the bonds in a trust is the current interest rate less inflation, and that the rate to be applied to the value of the stocks should be roughly equal to the dividend yield (currently about 1.15%).

"Four percent is egregiously high," says Levine. To avoid the risk of depleting the trust by paying out too much when stock prices are high, the percentage has to be much lower, he contends.

But Garland and Levine are basing their analysis on extremely pessimistic assumptions about the stock market, says Wolf.

Anyway, for most clients, this issue may not be very important, he says, because they are more concerned about giving the current beneficiary enough to live on than with maintaining long-term values.

Most people would want the rate to be 4% or higher "even if it would deplete the trust over time," says Dallas attorney Steve Akers.

"What Garland doesn't really focus on is that if you have a trust that is basically designed to take care of the spouse and then go to the kids, you are not really worrying about what will happen that far out," says Edward Koren of Tampa, Fla., a regent of the American College of Trust and Estate Counsel.

* Special rule for QTIPs.

Lawyers note that the unitrust is especially good for QTIP trusts in a second marriage situation, where the surviving spouse is the remainder beneficiary's stepparent, because of the potential feuding between the parties over investments.

A small problem, however, is that the QTIP unitrust must provide for the payout of the greater of the income or the annual percentage amount, in order to qualify for the marital deduction.

Unless the percentage is set extremely low, this generally shouldn't matter, because the percentage amount will generally be greater than the income. But it's a trap that lawyers need to be aware of.

* 'A lot of work.'

Drafting a total return unitrust for the first time isn't easy, warns Joel Dobris, a law professor at the University of California at Davis and the author of a book on estate planning.

He estimates it will take lawyers about three weekends to learn what they need to know. Then, "not only does the lawyer have to draft a new form and explain it to the client, but there may be income tax headaches."

"While most accountants know how to do a Form 1041 for a traditional trust, they have no idea how to do one for a unitrust," says Dobris.

"People who prepare smaller estates will regard these as a lot of work and change without creating a lot of benefit," says James Gamble of Bloomfield Hills, Mich., who is also a past president of the American College of Trust and Estate Counsel.

"There's a lot of stuff to get into and explain to the client, and I don't know how many lawyers have the background to do that or want to take the time," he says.

However, the concept of a unitrust has been used since the 1960s in "charitable remainder unitrusts," says Harrison Gardner of Madison, N.J. Lawyers who are familiar with those will have a head start, he says.

* Clients may be 'old-fashioned.'

Some lawyers say that another problem is that some clients are just uncomfortable with the idea of spending principal.

"They still believe in and feel comfortable with the old concept of leaving principal intact and living off the income," says Martin Shenkman of Teaneck, N.J., the author of several books on estate planning. "It's ingrained in them, and it's how they built their nest egg."

But others say they have not run into this problem.

"Clients are receptive to this," says Ice.

The most receptive are those in the financial industry, such as financial planners and bankers, says Gregory.

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