New Principal and Income Act Provides Greater Flexibility for Trusts

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Estate Planning Bulletin

08.01.2004

William T. Belcher

The North Carolina Principal and Income Act of 2003 (“NCPIA”) was enacted into law on January 1, 2004, and offers the promise of greater investment flexibility to enhance both the current income and future benefits of a trust. The NCPIA applies to all trusts in existence or created on or after January 1, 2004, unless the will or trust agreement clearly provides otherwise. One of the purposes of a principal and income act is to provide rules to define the income of a trust and to allocate trust receipts between income and principal. This can be important, for example, in a trust that provides that income, but not principal, be distributed to the beneficiary. Until the new NCPIA took effect, the applicable North Carolina law (passed in 1973) defined income very traditionally as interest, dividends, rents and similar direct investment returns.

Total Return Investing and NCPIA

However, modern portfolio theory now holds that proper investment management should consider as income not just traditional returns, but also appreciation of the assets. This is called “total return investing.” Adoption of the NCPIA follows the Legislature’s 2000 enactment of another law, The North Carolina Uniform Prudent Investor Act (UPIA), which recognizes total return investing. UPIA provides that the trustee who manages trust assets shall consider the expected total return from income and appreciation of capital. Determining whether the trustee has acted with prudence requires examining the entire portfolio, rather than an asset-by-asset valuation. The total return (income plus capital appreciation) of the whole portfolio at an appropriate risk level, instead of the isolated performance of each investment, is paramount.

In today’s economy, many investments, particularly in stocks, yield very low dividends but can produce significant appreciation in value. Prior to the new NCPIA, such appreciation was typically added to the principal of the trust and often was not distributed to a beneficiary unless a decision was made to invade principal. Thus, a beneficiary who received only income would often receive less money as the yield from interest or dividend income declined, even though there was significant appreciation in the value of trust investments. The Legislature recognized modern portfolio management in light of today’s historically low yields from investments, by passing UPIA and adopting the NCPIA.

The NCPIA now gives the trustee the discretion, unless the trust documents prohibit it, to make adjustments between income and principal. Trustees may now also convert the trust to a “unitrust” format, which will provide a certain percentage distribution to the beneficiary regardless of the income yield of the trust assets. It is important for both trustees and beneficiaries to understand the importance of these changes, as they affect the duties of the trustees and give the beneficiaries the ability to request that the trust be converted into a “unitrust” format.

Discretion Given to Trustees By NCPIA

The NCPIA allows a trustee to comply with the UPIA by granting the trustee the power to perform adjustments between income and principal as needed to make appropriate present and future distributions. The adjustment may go in either direction, recharacterizing income as principal or principal as income, however the trustee believes is necessary to treat beneficiaries impartially. For example, the trustee of an income trust who has realized significant asset appreciation or capital gain while generating little or no income in the form of dividends or interest now has the authority to recharacterize the appreciation in the principal as income. This allows the trust to make a reasonable payment to the income beneficiary.

A trustee who does not wish to make adjustments between income and principal may convert the trust to a unitrust. This means that the unitrust amount, computed as a percentage of the fair market value of the trust, shall become the net income of the trust. This unitrust amount may not be less than 3% or more than 5%. By converting the trust to a unitrust format, the beneficiary will be guaranteed of a distribution regardless of the actual income of the trust. The downside of such a conversion is that if the unitrust amount exceeds the dividends and interest earned by the trust, principal will be reduced. If this continues, the trust could be depleted before the end of its intended term.

The NCPIA provides that the trustee facing the choice of adjusting income and principal or converting to a unitrust must consider the following non-exclusive factors:

The nature, purpose and duration of the trust;
The intent of the creator of the trust;
The identity and circumstances of the beneficiary;
The need for liquidity, regularity of payment, and preservation and appreciation of capital;
The assets held in the trust and their uses by the beneficiary;
The net amount allocated to income under the other sections of the NCPIA and the increase or decrease in the value of the principal assets;
The degree of power, if any, that the terms of the trust give the trustee to invade principal or accumulate income;
The frequency with which the trustee has used this power previously;
The actual and anticipated effect of economic conditions (including inflation and deflation) on principal and income; and
The anticipated tax consequences of an adjustment.

Examples of Trustee Decisions Under NCPIA

The following three examples will help to clarify investment decisions under the NCPIA.

Example 1: ABC Trust Company is the trustee of a trust governed by the laws of North Carolina. The trust pays all its net income to the grantor’s sister, Sarah, during her life, with the remainder to John, who is Sarah’s son. Prior to the enactment of the UPIA and NCPIA, ABC Trust Company had invested the trust assets 40% in stocks and 60% in bonds. The terms of the trust allow the trustee to distribute principal to Sarah for her health care and to support her in her accustomed manner of living after considering Sarah’s other resources, but the trust terms do not otherwise indicate that either Sarah or John should be favored. Sarah, who is retired, is receiving income from Social Security, a pension and her savings, which is more than enough to maintain her accustomed manner of living.

After a full analysis, ABC Trust Company determines that, in order to follow the UPIA, it should realign the portfolio assets so that stocks constitute 80% and bonds 20%. ABC Trust Company recognizes, however, that the trust will receive much less interest income under this approach. ABC Trust Company need not invade principal because Sarah’s standard of living is being maintained by other funds. However, because Sarah is the only income beneficiary of the trust, she is still entitled to receive from it the financial benefits that a sole income beneficiary usually receives. After considering all factors relevant to the trust and its beneficiaries, ABC Trust Company concludes that it should transfer cash from principal to income to boost the current return for Sarah and provide her with the degree of enjoyment to which she is entitled.

Example 2: T is the trustee of a trust governed by the laws of North Carolina that provides income to A for life, with the remainder to B. Historically T has invested the portfolio of financial assets consisting of 20% in stocks and 80% in bonds. Following the UPIA, T determines that a strategy of investing the portfolio 50% in stocks and 50% in bonds has risk and return objectives that are reasonably suited to the trust, but T also determines that adopting this approach will cause the trust to receive a smaller amount of interest income. T may transfer cash from principal to income to the extent T considers it necessary to increase the amount distributed to the income beneficiary.

Example 3: T is the trustee of a trust governed by the laws of North Carolina that requires the trust income to be paid to the settlor’s son C for life, with the remainder to C’s daughter D. In a period of a very high inflation, T purchases bonds that pay double-digit interest. To compensate for the loss of value of principal due to inflation and other factors that T considers relevant, T may transfer part of the interest to principal.

The NCPIA provides significant protection to a trustee who elects to make an adjustment between income and principal. First, a determination by the trustee in accordance with the NCPIA is presumed to be fair and reasonable to all the beneficiaries. Second, a court shall not order a fiduciary to change a decision to exercise or not to exercise a discretionary power unless it determines that the decision was an abuse of discretion.

NCPIA Procedures for Unitrust Conversions

The NCPIA establishes procedures for “interested” and “non-interested” trustees to make conversions to the unitrust format. Interested trustees and their requirements will be defined in a moment. Any other trustee (whether as a single individual, or as a majority of two or more persons acting as trustee) is defined as non-interested and may, in the trustee’s sole discretion and without court approval, take the following steps:

Convert an income trust to a total return unitrust;
Reconvert a total return unitrust to an income trust; or
Change the percentage used to calculate the unitrust amount or the method used to determine the fair market value of the trust.

Step three is conditional upon four very detailed provisions relating to formal documentation and communication. These provisions require that:

1. The trustee adopts a written policy stating that, depending on the conversion,

The future distributions from a trust that was administered as an income trust will be unitrust amounts rather than net income, or
The future distributions from a trust that was administered as a total return unitrust will be net income rather than unitrust amounts, or
The percentage used to calculate the unitrust amount, or the method used to determine the fair market value of the trust, will be changed as stated in the policy;

2. The trustee sends written notice of its intent to take action, along with copies of the ~new written policy, to:

The grantor of the trust, if living,
All the competent beneficiaries who are currently receiving or eligible to receive distributions of income from the trust,
All the competent beneficiaries who would receive principal of the trust if the trust were to terminate at the time the notice is given, and
All persons acting as advisor or protector of the trust;

3. If the trust were to terminate at the time the notice is given, at least one competent beneficiary is receiving or is eligible to receive the principal or distributions of income of the trust; and

4. No one objects within 60 days of receiving this notice.

As noted earlier, interested trustees have their own definition and their own requirement in a conversion. An interested trustee can either be:

An individual trustee who can currently receive the net income or principal of the trust, or who would receive it if the trust were to be terminated and distributed, or
Any trustee who may be removed and replaced by an interested distributee, or
An individual trustee whose legal obligation to support a beneficiary may be satisfied by distributions of income and principal from the trust.

Any such interested trustee, or a majority of all interested trustees if there are more than one, must appoint a disinterested person who acts with sole discretion in a fiduciary capacity to determine three important considerations for the trustee: the percentage used to calculate the unitrust amount; the method used in determining the fair market value of the trust; and which assets, if any, are to be excluded in determining the unitrust amount.

If the disinterested trustee or interested trustee does not wish to exercise discretion to make a unitrust conversion, the trustee may petition the Superior Court for an order that the trustee considers appropriate.

Beneficiaries’ Authority To Request Conversion

The trustee is not the only party to the trust who can initiate its conversion. A competent beneficiary may ask that the trustee:

Convert an income trust to a total return unitrust;
Reconvert a total return unitrust to an income trust; or
Change the percentage used to calculate the unitrust amount or the method used to determine the fair market value of the trust.

If the trustee does not take the action requested, the competent beneficiary may petition the court to order the trustee to take the action.

A number of trusts provide that all of the net income of the trust must be distributed to the surviving spouse for his or her lifetime. These may also allow the trustee to invade the principal of the trust for the benefit of the surviving spouse. If the marital deduction was taken for federal estate tax purposes in the estate of the deceased spouse, the surviving spouse may compel the conversion from an income interest to a unitrust interest, or the reconversion of the trust from a unitrust to an income trust. As with any unitrust, the amount may not be less than 3% or more than 5%.

Summary

All trusts are subject to the NCPIA unless the trust clearly provides otherwise. The combination of the UPIA and the NCPIA allows a trustee to invest the assets of the trust without being torn by the competing interests of the income and remainder beneficiaries. A trust may re-characterize income to principal and principal to income or convert to a total return unitrust. This flexibility benefits both the income and remainder beneficiaries of a trust.

Physical Address: 301 Fayetteville Street, Suite 1900, Raleigh, NC 27601

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08.01.2004