[A] The Prudent Investor Act introduced new standards for investment performance. It de-emphasizes the importance of accounting income and instead measures a trustee's performance in terms of total return (income plus growth) to the trust portfolio.
[B] But, the 1995 Prudent Investor Act created a problem for trustees of net income trusts. That is, trusts whose payout to current beneficiaries is measured by reference to trust accounting income.
[C] The solution was the passage of the UPAIA (2000). This act, and its "adjustment power" provision, was necessary to enable trustees to comply with their enhanced investment duties under the Prudent Investor Act, and to treat both income beneficiaries and remaindermen impartially. It was also necessary because the investment world had changed so much since the old 1962 Principal and Income Act requirements.
[D] While the Prudent Investor Act and the UPAIA were a big step forward, there still was a problem with the taxation of distributions from trusts managed to comply with the Prudent Investor Act and the UPAIA. One problem though raised its head. Could a trustee, for example, using the adjustment power to permanently change the payout of a net income trust such that the income beneficiary receives a fixed percentage of the value of the trust corpus each year, thereby converting the trust to the equivalent of a unitrust?
[E] There was some question of whether the capital gains that were allocated to income pursuant to an exercise of the adjustment power would be included in distributable net income (DNI) of the trust as necessary for the trust to claim a deduction under I.R.C. section 661 for distribution of such gains to the income beneficiary. If capital gains were to be taxed to the trust under these circumstances, taxable income that had been distributed would be trapped at the trust level for income tax purposes, and trust principal would end paying tax on income that would be in the hands of the income beneficiary rather than the trustee.
[F] In 2003 the U.S. Treasury Department issued new regulations [effective 2004] under I.R.C. section 643(b) concerning the definition of income that allowed the inclusion of capital gains in DNI, but the Regulations appeared to do so only if the state statute specifically authorized the trustee to define trust income as a unitrust amount
[G] Thus was born the new provisions to the California Probate Code [section 16336.4 and 16336.5] that created the unitrust conversion provisions effective in 2006. It provided for income to be defined as between 3% and 5% of the trust corpus.
[H] From a U.S. Treasury standpoint you can't switch back and forth between a unitrust and an income trust and retain the benefits of washing out capital gains through DNI. You can switch back and forth under the California statute and the trust is still valid, but you would lose the benefit of I.R.C. section 643 (b).
Published April 12, 2007
David G. Mackenzie is a Fiduciary Consultant who limits his consulting practice to providing expert witness testimony in Trust & Estate Litigation Cases. He has represented either trust beneficiaries or trustees who are either plaintiffs or defendants.
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