The historical distinction between income and principal has become less important over the last few decades for two reasons. First, unless the terms of the trust prohibit it, many trustees now employ modern portfolio theory to invest for the maximum total return, regardless of whether that return comes in the form of income or growth of principal. The 1997 Uniform Principal and Income Act revision added a section allowing the trustee to adjust between income and principal as necessary to allow for total-return investing. Second, many modern trusts are drafted with flexible terms that give the trustee discretion to disburse either income or principal to beneficiaries if doing so furthers the purposes of the trust. If a trustee has discretion to invade principal and accumulate income, it matters less how receipts are allocated in the first place.
In July 2018, the ULC approved a major revision of the act, retitling it as the Uniform Fiduciary Income and Principal Act to distinguish it from its predecessor acts rooted in the previous century. As an added benefit, the new name shortens to UFIPA (pronounced “yoo-FIP-uh”), an acronym that will no longer be confused with the closely related acronym for the Uniform Prudent Investor Act (UPIA).
One major benefit of UFIPA compared to its predecessors is the inclusion of a unitrust conversion provision. Unitrusts go hand in hand with total-return investing. Simply put, a unitrust arrangement allows a trustee to disburse a fixed percentage of the net trust assets to beneficiaries who are entitled to receive trust income.
An example will illustrate the concept. Settlor creates a trust naming settlor’s spouse and children as beneficiaries. The spouse is entitled to receive all trust income, and after the spouse’s death, the children are entitled to receive the trust corpus. This creates an inherent conflict between the spouse and the children. If the trustee invests the corpus mostly in income-producing assets, the spouse’s income will be greater but the corpus will not grow much, leaving the children with a smaller inheritance. By contrast, if the trustee invests the corpus mostly in growth stocks that generate capital gain, the spouse will have less income, but the corpus will grow more over time. Any investment decision the trustee makes threatens to benefit one side at the expense of the other, often creating family tension in the process.
Now assume the trust is converted to a unitrust that pays 4 percent of the net trust assets to the spouse annually, regardless of the amount of actual income received. After conversion, the financial interests of the spouse and children are aligned—they both benefit from growing the corpus. The trustee can invest for the greatest total return without worrying about being partial to one beneficiary over another. It’s easy to see why trustees and beneficiaries alike often welcome the unitrust option.
The committee that revised the Uniform Principal and Income Act in 1997 did not include a unitrust conversion option. At the time, the US Treasury Department had not issued guidance on the tax treatment of unitrusts, and there was some doubt as to how the definition of “income” in the IRC would apply in the unitrust context. Under those circumstances, the committee instead created the fiduciary’s “power to adjust” between income and principal and relied on trustees to determine how an adjustment would affect a trust’s tax liability.
Then in 2001, the Treasury Department issued proposed regulations for unitrusts, and those regulations were finalized in December 2003. Under the federal regulations, a unitrust payout from three percent to five percent to the income beneficiary pursuant to a local law is deemed reasonable, and the trust is not disqualified from receiving a tax benefit because of the unitrust structure. Treas. Reg. § 1.643(b)-1.
Once the IRS blessed unitrusts they proved very popular, and states began to enact unitrust conversion statutes to take advantage of the ruling. Today about 30 states have adopted some sort of unitrust conversion statute, but there is little uniformity. Some states permit a unitrust rate from three percent to five percent, some require a four percent rate specifically. The procedures for conversion also differ from state to state. In hindsight, if the drafters of the 1997 Uniform Principal and Income Act had included a unitrust conversion provision, there would be greater uniformity between the states today.
The UFIPA drafters wanted to correct this omission and simultaneously improve on existing state unitrust laws. Consequently, the unitrust provisions contained in UFIPA Article 3 are very flexible. If a trust qualifies for a “special tax benefit” (as defined in the act), then the unitrust rate must fall within the three percent to five percent safe harbor indicated in the federal regulations. However, UFIPA expressly permits variable rates determined using a formula based on a market index or other published data and blended rates based on longer-term averages to smooth the rate curve.
For trusts that do not qualify for a “special tax benefit,” the upper and lower limits do not apply. UFIPA makes it possible to choose a unitrust rate outside of the three percent to five percent range tailored to the specific goals of the settlor, the individual needs of the beneficiaries, and the current market environment. Variable and blended rates are again expressly permitted.
In summary, the unitrust provisions of UFIPA provide greater flexibility than any current state statute. Trustees will still have the option to use a simple unitrust rate, say four percent, for ease of administration when appropriate. But the additional flexibility built into UFIPA will allow creative estate planners to design a unitrust rate suited to each client’s individual needs.
UFIPA has other benefits as well. A new section on governing law clarifies which state’s income and principal rules will apply. For example, assume a company distributes an extraordinary dividend equal to 50 percent of the company value. How the trustee allocates the dividend between income and principal may depend on the state’s default law. If the trust was originally created by a settlor living in State A but is administered by a trustee in State B, the settlor now resides in State C, and all of the beneficiaries are in State D, which state’s allocation rules apply? UFIPA settles the question by providing a rule that the law of the trust’s principal state of administration governs (State B in the example), unless the trust document specifies a different jurisdiction. The act is also restructured and some sections have been rewritten for clarity.
UFIPA is available now for consideration by state legislatures. See www.uniformlaws.org/UFIPA.aspx.