Estate Planning

Uniform Prudent Investor Act
Under the Uniform Prudent Investor Act, which was enacted in 1995 and advocates investments designed to generate a “total return” (adopted by many states, including California), the determination of “trust accounting income” according to traditional rules often resulted in dramatic shifts in the interests held by income beneficiaries of a trust, as opposed to the remainder beneficiaries of that trust. In an effort to treat the competing interests of the income beneficiaries and the remainder beneficiaries more equitably, a new Uniform Principal and Income Act (“new UPIA”) was developed and has been adopted by many states, including California (effective January 2000).

The New Uniform Principal and Income Act (“new UPIA”)
The new UPIA re-characterizes items traditionally viewed as “principal” as “income” under certain specified circumstances, such as the determination of “income” under a “unitrust” approach in states such as New York, the grant of equitable adjustment powers in states such as California (Prob C §16336), and the ability to apply special accounting rules to businesses or “other activities” (Prob C §16352). Further, the new UPIA can cause items which have been traditionally viewed as “income” to be re-characterized as “principal”, such as 90% of all royalty payments (Prob C §16362) (Note: prior to the new UPIA the entire royalty payment could have been treated as income), and 100% of the amount received from the sale, redemption or other disposition of an obligation which occurs more than one year after it is purchased or acquired by the trustee (Prob C §16357(b)) (Note: prior to the new UPIA, adjustments could be made to reflect “discounts” and “premiums” in purchase and sales prices). Since the prior regulations issued by the IRS in connection with IRC §643(b) dealt with the concepts of “income” and “principal” under principal and income acts that preceded the new UPIA, those regulations needed to be altered to reflect the “new realities” of “income” and “principal” for trust accounting purposes.

New Treasury Regulation Section (“Reg §”) 1.643(b)-1
New Treasury Regulation Section (“Reg §”) 1.643(b)-1 states that provisions for the determination of trust accounting income which depart fundamentally from traditional principles of income and principal will generally not be recognized. It now provides an example of such a provision—“if a trust instrument defines ordinary dividends and interest as principal.” More importantly, the new regulation provides that the determination of “trust accounting income” under a state statute calling for a “unitrust” approach, or a state statute permitting adjustments between income and principal to fulfill the trustee’s duty of impartiality to income and remainder beneficiaries (commonly referred to as an “equitable adjustment power”; Prob C §16336), will be respected. Moreover, the new regulation provides that while a switch between methods for determining trust accounting income authorized by state statute will not constitute a taxable sale, exchange, etc. for income tax purposes and will not result in a taxable gift by the grantor or any of the trust’s beneficiaries, any switch in methods which is not specifically authorized by state statute may cause such tax consequences, based upon the applicable facts and circumstances. Finally, the new regulation provides that in circumstances where trust accounting income is not determined under a “unitrust” approach, a discretionary power to allocate capital gains to income does not need to be exercised “consistently”, so long as it is exercised “reasonably and impartially.”

Impact of the New Rules
Although not directly related to the determination of “taxable income”, “trust accounting income” will impact certain areas of income, gift, estate and generation skipping transfer taxation. Those areas and the impact upon them of the new rules governing the determination of trust accounting income are as follows:

Income Taxation of Simple Trusts: The determination of what constitutes “trust accounting income” will affect whether a trust is considered a “simple trust” for income tax purposes, as well as the amount of the distributions which must be made from the “simple trust”. A “simple trust” is a trust, which makes no distributions of principal during the taxable year and the terms of which require all trust accounting income to be distributed currently (not less frequently than annually) and do not direct any payments to be made to one or more charities. (IRC §§651 and 652) To the extent a trust makes a distribution from principal in any taxable year, it will be a complex trust for income tax purposes in that year. (IRC § 661).

In order to reflect the new concepts of “trust accounting income”, Reg §1.651(a)-2(d) has been revised to provide (i) if the trust does not distribute trust assets in excess of the amount determined to be income, as defined in IRC §643(b), the distribution of what might otherwise constitute “principal” will not cause the trust to lose its status as a simple trust; and (ii) to the extent property is distributed “in-kind” to satisfy the requirement that the trust distribute all of its income currently, that “in-kind” distribution will be treated, for income tax purposes, as if the trust sold the property for its fair market value on the date of distribution. Reg §1.643(a)-3(b)(1) has also been updated to provide that for trusts determining income other than under the “unitrust” approach, capital gains which are allocated to trust accounting income, including gains attributable to the deemed sale of the property distributed in-kind, will be included in the “distributable net income” (“DNI”) of the simple trust under IRC§643(a). In addition, if the “unitrust” approach is used, such capital gains will be included in DNI if the trustee exercises the discretionary power to allocate gains to income “consistently.”

Application of Rules to Complex Trusts: “Trust accounting income” will also impact the amount which must be distributed from a complex trust to beneficiaries who, under the terms of the trust instrument, must receive current distributions of “trust accounting income”. A “complex trust” is any trust which is not a “simple trust” and will include trusts which may and/or do make distributions to charities, are not required to distribute all of the net trust accounting income currently and/or make distributions of principal during the taxable year (IRC §§661 and 662). The determination of “trust accounting income” will also have an impact on whether capital gains realized by the trust during the taxable year must be included in the DNI of the complex trust under IRC § 643(a). In order to reflect the new concepts of “trust accounting income”, Reg §1.661(a)-2(f) has been revised to provide that to the extent property is distributed “in-kind” to satisfy the requirement that the trust distribute income, as defined under IRC §643(b), that “in-kind” distribution will be treated, for income tax purposes, as if the trust sold the property for its fair market value on the date of distribution. Further, as discussed above with respect to the determination of DNI for simple trusts, Reg §1.643(a)-3(b)(1) provides that for trusts determining income other than under the “unitrust” approach, capital gains which are allocated to income will be included in the DNI of the complex trust under IRC § 643(a). In addition, if the “unitrust” approach is used, such capital gains will be included in DNI if the trustee exercises the discretionary power to allocate gains to income “consistently.”

Application to Pooled Income Funds: Capital gains realized by a pooled income fund will not qualify for the income tax charitable deduction afforded under IRC §642(c) unless and except to the extent those gains have been permanently set aside for exclusive distribution to the charity which will be receiving the fund at the expiration of the non-charitable lead interest. However, concern was expressed that to the extent the “income” distributable from the pooled income fund could include capital gains under the application of the new UPIA, the fund could not claim the charitable deduction for capital gains received by the fund, since there was no assurance that those gains would not be paid to the non-charitable lead beneficiary as “income” determined under the new UPIA.

To deal with this issue, Reg §1.642(c)-2(c) has been revised to provide that capital gains shall not be considered as permanently set aside for charitable purposes if, under the terms of the governing instrument and applicable local law, the trustee has the power, whether or not exercised, to distribute a “unitrust” amount as income or to distribute any amount which includes unrealized appreciation in the value of assets held by the fund, or to distribute as “income” proceeds realized from the sale or exchange of any assets contributed to the fund by the donor or from the sale of any assets purchased by the fund, at least to the extent of the fair market value of assets contributed to the fund by the donor as determined on the date of contribution (see Reg §1.642(c)-5(a)(5)(i)). These new limitations will apply only for taxable years beginning after January 2, 2004, and the regulations do permit the reformation of existing pooled income funds to comply with these new limitations, provided a court reformation proceeding is commenced or a non-judicial reformation, which is valid under applicable state law, is completed within 9 months of January 2, 2004. (Reg §1.642(c)-2(e)).

Net Income Charitable Remainder Uni Trusts (NICRUTs and NIMCRUTs): IRC §§664(d)(2) and (d)(3) permit the creation of a charitable remainder unitrust which provides for the distribution of an amount equal to the lesser of a fixed percentage of the fair market value of trust assets, determined annually on the valuation date (“unitrust” amount) or net income earned by the trust during the year (NICRUT) and may also provide that if in any year, the net income earned by the trust exceeds the unitrust amount for that year, that excess income may also be distributed to the beneficiary if, in one or more of the previous taxable years of the trust, the beneficiary received amounts which were less than the unitrust amounts, as determined on the valuation date for each such year, with the excess amount which may be distributed to the beneficiary not in excess of the aggregate of the deficiencies from all of the prior years (NIMCRUT). Obviously, the determination of trust accounting income is critical to the operation of NICRUTs and NIMCRUTs. However, applicable legislation provides that the unitrust amount that must be paid from a CRUT to a beneficiary may not be less than 5%. (IRC §664(d)(2)(A)).

To the extent a state (such as New York) has adopted a definition of income determined under the unitrust approach, the definition of income as a unitrust amount of less than 5% of the fair market value of trust assets, could circumvent the requirement of IRC §664(d)(2)(A). To prevent this occurrence, Reg §1.664-3(b)(3) now makes it clear that trust income may not be determined by reference to a fixed percentage of the annual fair market value of trust property, notwithstanding any contrary provision of applicable state law.

In addition, the IRS has already addressed its concerns about provisions in the trust instrument which permit capital gains to be treated as income for purposes of determining trust accounting income. The regulations have provided and continue to provide that only post-contribution capital gains may be included in the definition of income under the terms of the governing instrument or applicable local law. However, under Reg §1.664-3(b)(3), as revised, the trustee may be given a discretionary power to allocate capital gains to income, but only to the extent the state statute permits the trustee to make adjustments between income and principal to treat the beneficiaries impartially (such as Prob C § 16336).

Trusts Qualifying for Gift and Estate Tax Marital Deduction: In order for a trust to qualify for the customary federal gift and/or estate tax marital deduction, that trust must be either a “general power of appointment” (“GPA”) trust (IRC §§2523(e) and 2056(b)(5)) or a “qualified terminable interest property” (“QTIP”) trust (IRC §§2523(f) and 2056(b)(7)). With respect to a surviving spouse who is not a US citizen, a special form of marital deduction will be available for assets passing to a “qualified domestic” trust (“QDOT”). However, in order to qualify for the marital deduction as a GPA trust, a QTIP trust or a QDOT, the trust must require that all of the trust accounting income earned by the trust be distributed to the spouse, currently.

Reg §§20.2056(b)-5, -7 and –10, 20.2056A-5 and –13, 25.2523(e)-1 and 25.2523(h)-2 have been revised to incorporate the new rules governing the determination of trust accounting income.

Grandfathered Generation Skipping Trusts: The regulations provide that to the extent a modification to a trust, which is otherwise exempted from the application of the generation skipping transfer tax imposed under Chapter 13 of the IRC because it predates the effective date of Chapter 13 (“grandfathered trust”), will result in the shift in beneficial interest to a younger generation beneficiary, that modification will result in the loss of exempt status for the grandfathered trust. However, to the extent the modification is administrative in nature, and only indirectly increases the amount transferred to a younger generation beneficiary, it will not result in the loss of exempt status for the grandfathered trust. Concern was expressed regarding whether the determination of trust accounting income under applicable local law that defines income under the unitrust approach or permits an equitable adjustment between income and principal could result in the loss of exempt status by a grandfathered trust.

Reg §26.2601-1(b)(4)(D)(2) now makes clear that administration of a grandfathered trust in conformance with applicable local law permitting income to be determined under a unitrust approach, or permitting the trustee to adjust between income and principal to fulfill the trustee’s duty of impartiality to the income beneficiaries and remainder beneficiaries of a total return trust, and meets the new rules developed in Reg §1.643(b)-1, will not result in the loss of exempt status. In addition, the change of the situs of a grandfathered trust from a state with a more traditional definition of income and principal to a state permitting income to be determined under a unitrust approach or permitting equitable adjustments between income and principal, will not affect the exempt status of the grandfathered trust; nor will a change of situs in the opposite direction. (Reg §26.2601-1(b)(4)(E), Examples 11 and 12).

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California Decedent Estate Practice, Volumes 1 and 2
The first two volumes of an authoritative set covering both the basics and the complexities of decedent estate practice.
Volumes 1 and 2: 1205 pages, 2 looseleaf volumes, updated 5/03
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The third volume in an authoritative set covering both the basics and the complexities of decedent estate practice.
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