|Mark W. Williamson is a partner in the Boston law firm of Casner & Edwards and is chairman of the Probate Law Section.
Early trustees were constrained to follow the "prudent man" theory of investment. Based on an historically agrarian economic model, the prudent man theory was designed to save the farm and the seed corn - i.e. preserve the principal at all costs. One could invest for income to the extent that such investment did not jeopardize the trust corpus. With each investment viewed separately as to performance, and low current returns considered an acceptable consequence of "prudence," such a strategy would be considered anachronistic today.
Modern portfolio theory relies upon investment diversification to balance the competing concerns of acceptable risk and expected return. Current thinking holds that enlightened management utilizing the precepts of modern portfolio theory can result in a better ratio of performance to risk, thus tending to increase both income and principal growth in a given risk profile.
As interest and dividend rates fluctuate over time, so does the pace of capital appreciation, and these fluctuations do not occur in lockstep. During certain periods, income will see greater performance, and at other times income opportunities will all but disappear while equities grow explosively. Diversification of investment can ameliorate the effects of these short-term trends, lowering volatility for the entire trust while allowing for more predictable returns over time.
In order to manage assets utilizing modern portfolio theory, a necessary first step is to scrap the prudent man theory, in favor of the "prudent investor rule," - essentially allowing the trustee to invest for the best total return for the entire portfolio, regardless of the microperformance of certain asset classes at any given time.
A trustee, however, has equal fiduciary obligations to both the income beneficiaries and the remaindermen, and utilizing the modern portfolio theory may negatively impact one class of beneficiaries while disproportionately benefiting another over certain periods. Thus, modern portfolio theory is fundamentally at odds with the realities of exercising trustee investment discretion in a fair and equitable manner.
The tension between income beneficiaries and remaindermen is often manifested in the world of marital deduction trusts. The marital deduction is often sought for transfers to trusts in which the decedent spouse wishes to control the ultimate disposition of the transferred assets upon the death of the surviving spouse. To qualify for the unlimited estate tax marital deduction, such a trust, known as a "qualified terminable interest property" (QTIP) trust, must provide that all income be distributed to the surviving spouse. If the decedent wishes to retain the most possible control over the ultimate disposition of the assets, such a trust would provide that the income - and only the income, be made available to the surviving spouse. But a trust that provides income only may be grossly unfair to a surviving spouse if the trustee, utilizing modern portfolio theory, correctly surmises that the total portfolio performance will be improved if income-producing investments are foregone in favor of equity appreciation opportunities.
Furthermore, provisions (which are required in such trusts) granting the surviving spouse authority to direct the trustee to invest in income-producing assets might have a very deleterious effect on the entire trust fund, if the surviving spouse exercised such authority during an economically inappropriate period.
The Uniform Principal and Income Act, which has not yet been adopted in Massachusetts, allows trustees to address this problem by giving them the ability, in certain circumstances, to reallocate gains (which would normally increase principal) to income and to distribute such gains to the income beneficiary. However, such reallocation is subject to numerous limitations and considerable scrutiny as to whether such action comports with the donor's intent, the beneficiary's circumstances, the need for liquidity, etc.
In light of the generally conservative nature of trustees as a group, many trustees would not choose to exercise their discretion to reallocate, even if it were appropriate to do so. Furthermore, institutional trustees might consider such reallocation of gains to income as being antithetical to their own interests. Since their fees are usually based upon the value of assets under administration, distributions of principal gains would tend to negatively impact such fees, at least in the short run (although one would assume that proper integration of a diversified investment strategy coupled with the right to reallocate gains to income would be healthy for the portfolio, over the long term).
To deal with these issues, and allow the trustee to invest for total return without regard for the stringent requirements of current income generation and the preservation of principal, a number of states, such as Delaware, New York, Missouri, New Jersey, Pennsylvania and more every day, have passed legislation to allow the conversion of an income trust to a unitrust or vice-versa.
A unitrust is a trust that provides that the income beneficiary receive a certain percentage of the trust assets each year. Although the percentage would be fixed, the actual amount of the distribution would be redetermined annually, as the trust increases or decreases in value. The distributive unitrust amount could be generated from income or principal or any appropriate combination of the two. Such a system allows the trustee great flexibility to invest over a variety of asset classes and respond to changes in the investment climate as circumstances require.
The states that have adopted legislation to allow conversion of an income trust to a unitrust generally require that notice be given to both the current and the remainder beneficiaries, whom may then raise objections if desired. Generally, if no objection is raised within the legally provided period, the change can then be made without the requirement of court approval.
The laws generally provide that the unitrust interest must be in a range of between 4 percent and 6 percent, although there is variation among the states as to what is permitted. In order to ensure the IRS would consider the unitrust as qualified terminable interest property, usually statutes provide that the greater of all of the income or the unitrust amount be distributed to the current beneficiary.
Proposed legislation in Massachusetts would allow a disinterested trustee (or a majority of disinterested trustees, if there is more than one) to convert an income trust to a total return unitrust or vice versa (multiple times, if needed). The disinterested trustee(s) could also change the percentage used to calculate the unitrust amount (in a range of between 3 percent and 5 percent) and/or the method used to determine the fair market value of the trust. To do so, the trustee must adopt a written policy for the trust that provides the following: The trustee must provide written notice (including the technical requirements of the law and the trust's provisions) to the grantor (if living), the current beneficiaries and the remaindermen and anyone acting as an adviser or trust protector.
All of the interested parties would have an opportunity to object, and if there are objections, the disinterested trustee would be able to petition the court to allow the conversion notwithstanding. If there is no disinterested trustee, the court can be petitioned (or act on its own initiative) to appoint a disinterested person to provide the court with the necessary information to determine whether such a conversion would be warranted. To not run afoul of the IRS requirements for qualification for the marital deductions, the unitrust amount cannot be less than the net income of the trust, if a marital deduction has been taken for federal tax purposes.
Following the conversion of an income trust to a total return unitrust, the trustee treats the unitrust amount as if it were net income. With regard to distributions from the trust, the actual net income is utilized first, then short-term, then long-term gain.
The proposed law also provides, among other provisions, that if a marital deduction has been taken, the spouse otherwise entitled to receive the net income of the trust shall have the right to compel the reconversion during his or her lifetime of the trust from a total return unitrust to an income trust.
Conversion to a unitrust would not be allowed if the governing instrument reflects an intention that the current beneficiary or beneficiaries are to receive an amount other than a reasonable current return from the trust, and that the income beneficiary has a power of withdrawal over the trust that is not subject to an ascertainable standard or that can be exercised to discharge a duty of support he or she possesses; or the governing instrument expressly prohibits such conversion.
It will be interesting to see whether the legislature acts to enact unitrust legislation. It should be noted that unitrust provisions may be utilized in your trust drafting without any change in the present law, and with proper safeguards a trust drafted with such provisions would be available for the marital deduction (i.e., the requirement that the distributed amount be the greater of the unitrust amount or the net income, the ability of the surviving spouse to require the trustee to invest the funds in income-producing assets and the prohibition of the trustee to make distributions to any other beneficiaries but the surviving spouse during the spouse's overlife).
Furthermore, an income-only trust with a spousal non-cumulative right to demand 5 percent of the trust on an annual basis may provide greater flexibility for the trustee and the beneficiaries than would a unitrust, because the surviving spouse would be not required to receive the unitrust amount each year. By foregoing the right to demand the principal distributions, the surviving spouse could benefit the remainder beneficiaries by not forcing the untimely liquidation of assets to fulfill the unitrust distribution requirements.
The value of the proposed legislation does not arise because unitrusts are otherwise unavailable to the estate planner, but rather because such legislation provides an extrajudicial remedy when an existing trust, either created by a decedent or otherwise irrevocable, does not contemplate the difficulties that "income only" provisions can cause. As such, such remedial legislation could prove quite useful to the income beneficiary hard pressed by these low-interest economic times, and to the trustee caught between the needs and desires of income beneficiaries and the remaindermen waiting in the wings.