Trust Design and Investment Strategy for the
Next Millennium:
Pulling the Plug on Income Rule Trusts
By David A. Diamond, Esq.*
Premise
The income rule trust is on life support. This condition results from two statutory changes, the Uniform Prudent Investor
Act1 and the Uniform Principal and Income Act.2 As we approach the next millennium, it is time for the estate planning bar
to “pull the plug” on income rule trusts.
We should confess that we have been mired in archaic theories and have largely ignored the realities of the modern
investment marketplace. As a consequence, we have set up trustees for failure and beneficiaries for disappointment. 3 In order
to minimize the potential for conflict between trustees and beneficiaries, we should adopt the “total return trust,” or what I
call the Prudent Return Unitrust (PRU), as the default standard for drafting trusts.
Income Rule Trusts
The “income rule trust” is the conventional trust model. It is characterized by the bifurcation of a trust’s value into two
components, income and principal, where the income is paid to a current beneficiary for a period of time (term of years, life,
etc.), with the principal passing to a remainder beneficiary (or beneficiaries) at the end of the trust term.
In its most basic form, an income rule trust would provide: “Pay income to A for life, remainder to B.” The metaphor one
might use when explaining such trusts to clients is the “tree and the fruit.” The income beneficiary is entitled to the yearly
harvest, but does not own the tree; when the income beneficiary dies, the trust terminates and ownership of the tree, along
with all future harvests, passes to the remainderman.
As the foregoing metaphor suggests, income rule trusts are a reflection of our agrarian roots. They mirror the simplistic
investment strategy propounded by our Depression-era parents, grandparents, and clients: invest conservatively, live off the
income, and do not touch the principal. This is an example of what Professor Joel Dobris calls a “heuristic,” which he defines
as “a rule of thumb that is not necessarily correct and is not verifiable, but that gives comfort in the face of uncertainty and
complexity.”4
We are all familiar with the common variations on the basic income rule trust model. Typical examples include credit
shelter (bypass) trusts and marital deduction (QTIP) trusts (income to spouse, remainder to children), as well as generationskipping trusts for the benefit of children (income to children, remainder to grandchildren). Quite often, such trusts will also
grant the trustee discretion to make distributions of principal to the current beneficiary. 5
The trusts described above, especially the “pay net income to spouse” bypass trust, have become ubiquitous. However,
when compared to the alternative PRU model described herein, income rule trusts do not measure up. 6 The reason is that the
trustee has a fiduciary duty under state trust law to balance the interests of the income beneficiary (who wants to maximize
income and will therefore prefer fixed income investments, i.e., bonds) with the interests of the remainder beneficiary (who
wants to maximize growth and will therefore prefer equity investments, i.e., stocks).7 The trustee thus finds herself between
the proverbial rock and hard place.
As attorney Robert B. Wolf points out in a recent article, as of early 1998, with dividend yield on the S&P 500 below
1.5% and the intermediate government bond index yielding 5.5%, producing a 5% return after administration expenses would
have required the trustee to allocate the trust portfolio 95% to bonds and 5% to stocks. 8 A 50%-50% allocation, which might
at first glance appear attractive to a trustee concerned with the duty of impartiality, would have generated only a 3.16% return
to the income beneficiary.9 Such an allocation would likely disappoint both the current and remainder beneficiaries, exposing
the trustee to potential lawsuits.
Skeptics might be tempted to dismiss the foregoing as nothing more than an academic exercise. 10 From experience, we
know that the most common irrevocable trusts we will encounter in our daily practice are credit shelter trusts established for a
surviving spouse where the surviving spouse is the sole trustee. As a general rule, the children are not going to sue Mother
because she invested in bonds rather than stocks, although there will always be dysfunctional families that create unfortunate
exceptions to this rule.
So why worry about asset allocation and the duty of impartiality when dealing with these run-of-the-mill bypass trusts?
First, from a liability perspective, the high rate of divorce, multiple marriages, and blended families have made it far more
likely that the surviving spouse–trustee will be a step-parent rather than a natural parent of the remainder beneficiaries. The
filial devotion that may discourage litigation where the trustee is the parent of the remainderman may be seriously lacking
where the trustee is a step-parent. In fact, the step-children may be looking for any excuse to commence litigation as an outlet
for venting their frustration over their delayed inheritance. 11 Questionable asset allocation decisions by the surviving spousetrustee may be just the spark needed to ignite the litigation fuse.
Second, from an economic perspective, it is short-sighted to focus only on the trustee liability issue and disregard the
empirical evidence that clearly demonstrates the superiority of the PRU model. 12 One can make a compelling case that
drafting trusts that encourage a total return investment strategy is not only consistent with recent statutory developments, but
will vastly improve the economic results for every generation of the family.
Prudent Return Unitrusts
Also known as “total return trusts” or “private unitrusts,” the PRU is a relatively new concept in trust design, at least in the private trust arena.
Actually, it is an old concept borrowed from the charitable trust arena and applied in a new, non-charitable way.13
In its most basic form, such a trust might provide: Pay A x% of the value of the trust each year, remainder to B. In this
drafting paradigm, the tension between current yield (favored by the current beneficiary) and long-term growth (favored by
the remainder beneficiary) is muted. Rather than worrying about balancing investment performance between current income
and long-term growth, the trustee of a PRU is free to pursue a single, cohesive investment objective: total return. After all, as
a matter of economic reality, a dollar is a dollar, no matter whether you characterize it as “income” or “principal.”14
Consistent with this economic reality, trustees of PRUs are not handcuffed by the archaic principal/income dichotomy.
The beauty of the PRU approach is in its simplicity. If the trust grows, the current beneficiary’s annual distributions will
grow (because distributions are based on the same percentage slice of a larger pie) and the share left over for the remainder
beneficiary will grow as well. If the trust contracts, the current beneficiary’s distributions will be reduced, as will the size of
the remainder interest. In the latter case, both classes of beneficiaries may be unhappy, but at least they will not blame each
other and, more importantly, they will not blame the trustee (provided he or she has been investing for total return consistent
with the Prudent Investor Rule).
Thus, the total return trust approach is more likely to foster a harmonious relationship among the trustee, the income
beneficiary, and the remainder beneficiary because they are all in the same investment boat (whether that boat is riding the
crest of a bull market wave or falling into the depths of a bear market trough). That means fewer lawsuits (good news for
trustees) and the opportunity for better overall investment performance (good news for all beneficiaries).
The total return unitrust model has been the subject of several academic articles in recent years, which articles are cited
throughout this paper and in the attached bibliography (Appendix A). But the concept is also making its way into the
mainstream press.15 Even if you are not ready to discard your old trust forms, you may find your clients starting to ask
questions about total return trusts. Consider this fair warning to be prepared!
Keeping up with the Law
Income rule trusts are on their deathbed because of two recent statutory developments: the Uniform Prudent Investor Act
(effective January 1, 1996) and the Uniform Principal and Income Act (effective January 1, 2000).
Uniform Prudent Investor Act
The Prudent Investor Act has been the subject of recent articles in the Quarterly, and I will not undertake an extensive
review of that statute here.16 A few comments are in order, however, to support the premise of this article.
The key to understanding the Prudent Investor Act is to keep in mind that what matters as far as trustee compliance and
potential liability is concerned is the process, not the product. In effect, the Act incorporates Modern Portfolio Theory (MPT)
into California law.17
The lynchpin of MPT (and hence the Prudent Investor Act) is the correlation of risk and return. In general, risk and return
are directly correlated, i.e., the greater the risk, the greater the potential return, and the lower the risk, the lower the potential
return. The goal of a trustee-investor under the Act is to achieve an acceptable rate of return with the least amount of risk
based on the facts and circumstances applicable to the particular trust in question, taking into account the factors enumerated
in Probate Code § 16047 (general economic conditions, inflation, taxes, total return, liquidity, costs, etc.).
MPT demonstrates that diversification is essential to risk management. 18 Thus, as a general rule, the Prudent Investor Act
requires a trustee to diversify a trust’s investments.19 The trustee is therefore duty-bound to reduce risk through
diversification without creating a significant negative impact on the portfolio’s expected return. Stated another way, given the
universe of investment opportunities, if the trustee can achieve greater return without increasing risk, the trustee should do so.
Conversely, if the trustee can lower risk without reducing the rate of return, the trustee should do so.
Therefore, and this is key, the trustee faces liability exposure not only where the trustee takes undue risk with no
corresponding increase in return, but also where the trustee gives up the opportunity for greater returns through the exercise
of excess caution. In my experience, the latter type of liability exposure is pervasive in the typical bypass trust, especially
where an older, more conservative surviving spouse serves as sole trustee.
How would a PRU approach reduce this type of liability exposure? Because the surviving spouse’s distributions from the
bypass trust would not be based on traditional concepts of net trust accounting income, but rather as a stated percentage of the
value of the trust estate, it would be easier for the surviving spouse’s legal and financial advisors to demonstrate (applying
MPT) the direct economic benefits to the surviving spouse of an asset allocation strategy that includes at least some
equities,20 ideally a mix of broad-based index mutual funds.
Uniform Principal and Income Act
The second statutory development that will ultimately lead California trust drafters to discard the income rule trust in
favor of the private unitrust model is the recently enacted Uniform Principal and Income Act. 21 The new Act, which
implements the California Law Revision Commission’s recommendation22 to adopt the Uniform Principal and Income Act
approved by the National Conference of Commissioners on Uniform State Laws in 1997 (with some revisions), replaces the
California Revised Uniform Principal and Income Act.23
According to the CLRC Report, “[t]he proposed law would also make needed revisions in principal and income rules for
consistency with the prudent investor rule embodied in the Uniform Prudent Investor Act (Prob. Code §§ 16045–16054),
which was enacted in California in 1995. Existing principal and income rules, which focus on trust accounting principles, can
conflict with the overriding duty of a prudent investor to invest trust assets as a portfolio.” 24 Furthermore, one of the primary
purposes of the new Act “is to provide a means for implementing the transition to an investment regime based on principles
embodied in the Uniform Prudent Investor Act, especially the principal of investing for total return rather than a certain level
of ‘income’ as traditionally perceived in terms of interest, dividends, and rents.” 25
The foregoing comments make it clear that the Uniform Law Commissioners and the California Law Revision
Commission recognize that we have already entered the era of total return investing for trusts, leaving income rule trusts in
the dust. The Principal and Income Act is a logical extension of the Prudent Investor Act, and there should be little doubt
about the impact of these statutory developments on trust drafting techniques. It is now up to the drafters of estate planning
documents to catch up with the law.
The Principal and Income Act contains a host of changes to the existing statutory regime; however, an exhaustive
treatment of same is beyond the scope of this article. Instead, I will focus on one particular provision of the new Act that is
recognized as the most controversial, and one that will dramatically impact the way lawyers draft and administer trusts. This
is the so-called “adjustment provision.”
New Probate Code § 16336 gives the trustee authority to make adjustments between principal and income if three
conditions are satisfied: (1) the trustee invests and manages trust assets under the prudent investor rule; (2) the trust describes
the amount that shall or may be distributed to a beneficiary by referring to the trust’s income; 26 and (3) the trustee determines,
after applying the rules in subdivision (a) of Section 16335, and considering any power the trustee may have under the trust
to invade principal or accumulate income, that the trustee is unable to comply with subdivision (b) of Section 16335. 27
If the trustee of a traditional income rule trust believes that investing in a manner consistent with the Prudent Investor Rule
tends to favor the current beneficiary over the remaindermen, or vice versa, the trustee may make adjustments in order to
treat what would otherwise be income as principal, or vice versa. In the current investment marketplace (i.e., a bull market
with low dividend yields), a trustee would most likely exercise this authority by re-characterizing what would otherwise be
principal (capital appreciation) as “income.” In other words, the trustee of an income rule trust subject to the Uniform
Prudent Investor Act (i.e., virtually all trustees in California, since that Act has retroactive effect) who is investing for total
return, but who believes this approach is short-changing the income beneficiary, may use this provision to “even things out”
by reallocating principal to income and distributing more to the current beneficiary. 28
Based on academic research, including the work of Wolf and others (see Bibliography), some commentators suggested the
adoption of a 4% “safe harbor”—in other words, a rule that a trustee’s adjustment of an income rule payout to a 4% unitrust
payout would not be subject to challenge. However, the CLRC rejected this approach out of fear that the 4% figure would become both a ceiling and
a floor, reducing needed flexibility.29 Instead, the CLRC opted to recommend a “notice of proposed action” approach.30
While helpful in theory, there are several restrictions on the exercise of the adjustment power that will hinder its
usefulness in the real world. First and foremost is the rule that a trustee who is also a beneficiary of the trust cannot exercise
the power.31 This exception will eliminate the vast majority of bypass trusts where the surviving spouse (or child) occupies the dual
position of income beneficiary and trustee. However, this restriction can be circumvented by naming a disinterested co-trustee (or perhaps a “special” cotrustee) with authority to exercise the power of adjustment.
While controversial and untested, the new adjustment provision of the Uniform Principal and Income Law will essentially
allow trustees of traditional income rule trusts to adopt other distribution methodologies, including a private unitrust
distribution rule, if certain requirements are met and certain procedures are followed.
Suggested Drafting Solutions
At the drafting stage, there are at least five potential approaches32 to dealing with the friction created by the inadequacies
of the traditional income rule trust and the adoption of Modern Portfolio Theory mandated by the Uniform Prudent Investor
Act and the new Uniform Principal and Income Act:
1. Keep drafting income rule trusts and ignore recent developments;
2. Keep drafting income rule trusts with discretionary distribution of principal provisions and rely on the trustee’s power
to make discretionary distributions of principal to “make up” for the short-fall in current yield.33
3. Keep drafting income rule trusts, but override the Uniform Prudent Investor Act.34
4. Keep drafting income rule trusts and name an independent trustee, co-trustee or special trustee, who will be able to
exercise the power of adjustment under the new Uniform Principal and Income Act as needed to rebalance the interests
of the income and remainder beneficiaries.35
5. Abandon the income rule trust and adopt the PRU as the default model.
In my opinion, the fifth option shines above the rest. Although past performance is not a guarantee of future results, Mr.
Wolf and others make a compelling argument for the superiority of the total return unitrust model based on historical stock
market data. From a liability perspective, the PRU model allows the trustee to satisfy the duty of impartiality while
complying with the Uniform Prudent Investor Act. From an economic perspective, the PRU model encourages trustees to
invest in a manner consistent with Modern Portfolio Theory rather than focusing on an archaic principal and income
dichotomy, which should achieve better results for all classes of beneficiaries. The primary impediments to widespread
adoption of the PRU model are our reluctance to change and the challenge of explaining this new form of trust to our
clients.36
Improving on a Great Idea
Once we understand and accept the premise of this article, that it is time to abandon our income rule trust forms and adopt
the Prudent Return Unitrust as the default standard, we can begin to develop some creative alternatives to make the basic
model work even better. As the work of Mr. Hoisington and Mr. Wolf demonstrates, as a starting point, we will generally
want to set the unitrust payout at between 3% and 5%. 3% will tend to favor the remaindermen while 5% will tend to favor
the income beneficiary. 3.5% to 4% seems to be a happy medium and should produce reasonably fair results, particularly if
discretionary distributions are permitted if necessary to support the income beneficiary.
Smoothing Rule. Mr. Wolf recommends, and I have adopted in my own forms, a three-year rolling average approach to
determining the unitrust payout as a way of smoothing out income flow in periods of high volatility. 37 In other words, the
unitrust payout in a given year would be the average of the December 31 values for the three years preceding the year of
payout. Of course, in the first two years of a trust’s existence, you would have to use a single year’s valuation or the average
of two years’ valuations, respectively.
“Give Me Five” Unitrust. Jerold I. Horn proposes a form of unitrust that does not require a unitrust payout, but gives the
beneficiary the right to withdraw up to the unitrust payout amount in a given year.38 He suggests that this type of trust makes
particular sense for a credit shelter trust where the surviving spouse has adequate resources for his or her support and would
rather let the credit shelter trust accumulate and grow for the remainder beneficiaries. To avoid gift tax and estate tax
problems, the withdrawal percentage should not exceed the greater of 5% or $5,000, and the period during which the power
is exercisable should be limited to a narrow window. Mr. Horn suggests that the power be exercisable only if the beneficiary
holding the power is alive “immediately before the end of the calendar year.” 39
I believe that this “give-me-x%” model would also be appropriate for an optional disclaimer bypass trust or for a
generation-skipping trust where the child would have the option to leave the unitrust amount in the trust to accumulate and
grow for the benefit of the child’s children.
Mr. Horn discusses at length some of the transfer and income tax problems raised by the “give-me-x%” formulation and
some suggested solutions. Anyone considering using this form of unitrust should read his article carefully.
Marital Trusts. Extra care must be exercised when adapting a Prudent Return Unitrust to the QTIP rules of Internal
Revenue Code § 2056. The QTIP rules reflect an income rule trust bias by providing that the surviving spouse must be
entitled to receive all of the net income of the trust at least annually if the trust is to qualify for QTIP treatment. Thus, in order
to draft a QTIP trust as a PRU, the trust must provide that the Trustee will pay to the surviving spouse the greater of net trust
accounting income or the unitrust amount. Such a trust should meet the QTIP requirements because the surviving spouse will,
in all events, receive not less than the entire net income of the trust. At least in today’s investment climate, if the trustee
invests for maximum total return (which would include a healthy allocation to equity instruments), a unitrust rate of 3% to
5% will almost always exceed net trust accounting income. If the PRU model becomes widely used, perhaps the QTIP
requirements will be amended to permit unitrust payout options.
The “Flip-PRU” Plan. In this variation on the standard bypass/marital trust combination, the marital trust (QTIP) would
provide for payment of a 3% to 5% unitrust amount or net accounting income, whichever is greater, to the surviving spouse,
and allow discretionary distributions of principal for the surviving spouse’s health, education, maintenance and support. The
credit shelter trust would be a “give-me-x%” unitrust (see discussion above) unless and until the marital trust is exhausted, at
which time the credit shelter trust would “flip” to a mandatory unitrust payout. This scheme encourages exhaustion of taxable
(at second death) assets before tapping into the non-taxable bypass trust.
The “345” PRU. This variation might be used in a generation-skipping tax exempt trust for a child. Distributions would be
entirely discretionary until age 30, with an independent trustee. At age 30, the child would become the trustee, and the trust
would convert from a fully discretionary trust to a PRU with a 3% annual payout during the child’s 30s, a 4% payout during
the child’s 40’s, and a 5% payout beginning at age 50 and continuing at that rate until the child’s death. The smaller payout
rate during the early years combined with the “miracle of compounding” would make the distributions in later years much
greater. This plan is consistent with the wishes of most settlors who prefer small payouts while their beneficiaries are younger
and larger payouts as the beneficiaries mature.
The “10% Solution.” A somewhat more elegant version of the “345” model, and one that I have been using with
increasing frequency, would be a trust that is completely discretionary until the child reaches age 25 or 30 and would then
convert to a PRU with a payout equal to the child’s age divided by 10, with a maximum payout percentage of 5% beginning
at age 50. In other words, the payout would be 3.0% in the year immediately following the year the child reached age 30,
3.1% the next year (age 31), and so on, so that the distribution percentage gradually increases with the child’s age. Such a
provision might provide:
In each tax year of the Exempt Trust during the lifetime of the beneficiary, commencing with the first tax year that begins
after the beneficiary has attained 30 years of age, the Trustee shall pay to or apply for the benefit of the beneficiary, in
annual, quarterly or more frequent installments, an amount (hereinafter “distribution amount”) equal to a percentage
determined by dividing the beneficiary’s age as of the beneficiary’s most recent birthday (i.e., birthday immediately
preceding the last business day of the calendar year with respect to which such distribution is made) by ten (10) (for
example, 3.1% if the beneficiary most recently turned 31 years of age, 3.2% if the beneficiary most recently turned 32
years of age, and so on), but not to exceed five percent (5%), of the average of the fair market values of the trust as of the
close of the last business day of the trust’s three previous tax years (or such lesser number of tax years as are available for
the first three tax years of the trust).
Either the “345” PRU or the “10% Solution” PRU could be modified to be a “give-me-x%” withdrawal type trust rather
than a mandatory payout trust, setting a maximum on the amount that could be paid out, but no minimum, which might be
advantageous for a GST exempt trust where the child-beneficiary is willing to rely on his or her independent resources.
As noted above, each of the trust models described above would also likely be supplemented by a provision authorizing
discretionary distributions of principal in addition to the unitrust amount (subject to an ascertainable standard if the
beneficiary is also the trustee).
Why Change?
Despite the compelling arguments for adopting the PRU drafting model, some practitioners may question the need to
change. Unfortunately, resistance to change in the face of the Uniform Prudent Investor Act and the new Uniform Principal
and Income Act is a liability trap for the trustee and the trustee’s professional advisors. Consider the following hypothetical:
Doug dies on January 1, 1999, with a typical A-B revocable living trust funded with $1 million of community property.
Doug is survived by two adult children from a prior marriage and Stephanie, his second wife, whom he married when his
children were already adults and at a time when he had minimal assets. Doug’s $500,000 estate (his half of the community
property) passes to a credit shelter trust that provides for “income to Stephanie for life and principal for her health,
maintenance, and support in her accustomed manner of living; remainder at Stephanie’s death to Doug’s then living
descendants by right of representation.”
Stephanie is named sole trustee of the credit shelter trust. She instructs her stock broker to invest in government bonds
because “stocks are too scary, bonds pay higher income than stocks, and, besides, Doug always invested in government
bonds and what was good enough for Doug is good enough for me.” The broker carries out this instruction without
discussion. The lawyer who represents Stephanie in the administration of the trust after Doug’s death and who makes
minor changes to Stephanie’s own estate plan over the ensuing years never discusses the Uniform Prudent Investor Act
with Stephanie. The CPA who prepares the fiduciary returns for the credit shelter trust as well as Stephanie’s personal
returns every year never raises the issue of her investment strategy.
Years later, Doug’s children become curious about the trust and hire a lawyer who requests an accounting from
Stephanie. The trust estate is worth only slightly more than the original $500,000. The average rate of return on the S&P
500 during this period holds at the historical 1926 to 1998 rate of approximately 12% per annum. Even allowing Stephanie
a reasonable 4% payout rate, the children want to know why the trust principal has not increased significantly in value.
The children sue Stephanie for breach of trust. Stephanie in turn sues her financial advisor, lawyer, and CPA. If the trust
had been drafted as a PRU rather than as an income rule trust, the financial advisor, lawyer, or CPA might have been able
to convince Stephanie to make a different asset allocation based on the fact that she would be entitled to a percentage of an
increasing pie, which would not only increase her annual return, but also reduce her exposure to lawsuits by Doug’s
children.
Closing Comments
Although my enthusiasm for the PRU model is obvious, in all fairness it should be pointed out that this enthusiasm is not
shared by all. In a recent article, James P. Garland presents a criticism of the private unitrust model, expressing his preference
for a spending rule based on “real interest from bonds plus dividends from stocks.” 40 One of Mr. Garland’s principal
criticisms is that the unitrust model is based on market value, which is unpredictable and uncontrollable. He believes that,
paradoxically, the unitrust model will lead to more conservative investment allocations, out of a fear that a bear market will
create a rush out of equities and into fixed income securities in order to protect the beneficiaries.
Although many of Mr. Garland’s points are well taken and deserve consideration, I nevertheless disagree with his
conclusion. The advantages of a long-term investment strategy that includes a substantial allocation to diversified equities,
and that limits erosion of principal through transaction costs and taxes by minimizing turnover, are firmly established by the
historical market data. In the short term, a bear market may reduce a unitrust beneficiary’s annual payout significantly.
However, if the trust is properly drafted to include a discretionary distribution provision over and above the unitrust amount,
the trustee will be able to maintain the beneficiary’s standard of living. Moreover, it is incumbent upon the trustee’s
professional advisors to help the trustee stay disciplined and ride out the storm of a bear market. At least historically, any
short-term losses should be recouped within a few years, although there is certainly no guarantee.
Moreover, the goal of the typical settlor is not to create the perfect distribution rule (i.e., one that distributes only the real
“income” to the current beneficiary and the real “principal” to the remaindermen), but simply to achieve a reasonable degree
of fairness between the income beneficiary (e.g., the surviving spouse) and the remainder beneficiaries (e.g., the children). In
my opinion, the unitrust model accomplishes this goal in a format that is easy to understand and easy to apply, while at the
same time reducing the trustee’s liability exposure, at least where the trustee acts in accordance with the Prudent Investor
Rule.
Modern Portfolio Theory has been woven into the fabric of California trust law through enactment of the Uniform Prudent
Investor Act and the Uniform Principal and Income Act. Estate planners who ignore these statutory developments do so at
their own peril, and to the detriment of the trustees and beneficiaries they serve. As we enter a new era in trust investment
law, it is time to throw out our outmoded trust forms. It is time to adopt the Prudent Return Unitrust as the default standard
for drafting trusts.
*Napa, California.
Endnotes
1. California Probate Code § 16045 et seq.
2. Chapter 145, Statutes of 1999 (A.B. 846 [Ackerman]), signed into law by Governor Davis on July 21, 1999, implements the California Law Revision
Commission’s recommendation (February 1999) to adopt the Uniform Principal and Income Act, replacing the California Revised Uniform Principal
and Income Act (Prob. C. §§ 16300–16315). The new law makes several minor and technical corrections to the Uniform Act. (Full text available online
in
PDF
format
at
http://www.leginfo.ca.gov/pub/bill/asm/
ab_0801-0850/
ab_846_bill_19990722_chaptered.pdf).
3. Robert B. Wolf, “Defeating the Duty to Disappoint Equally—the Total Return Trust,” Real Property, Probate and Trust Journal, Vol. 32, No. 1
(Spring 1997) (hereinafter cited as “Wolf I”).
4. Joel C. Dobris, “Why Trustee Investors Often Prefer Dividends to Capital Gain and Debt Investments to Equity—a Daunting Principal and Income
Problem,” Real Property, Probate and Trust Journal, Vol. 32, No. 2, p. 266.
5. Of course, where the income beneficiary is also the trustee, discretion over principal distributions should be limited to an “ascertainable standard” (e.g.,
health, education, maintenance, and support) in order to avoid including the trust estate in the beneficiary-trustee’s taxable estate. Internal Revenue
Code § 2041(b)(1)(A).
6. I do not take credit for the private unitrust concept, but rather consider myself merely an apostle of the ideas put forth by William J. Hoisington, Robert
B. Wolf and others. My first introduction to the private unitrust approach was Bill Hoisington’s presentation at the 1997 Heckerling Institute at Miami.
Mr. Hoisington wrote, “The drafters of private trusts should immediately stop the practice of defining the interests of the current trust beneficiary in
terms of a right to receive all accounting income. This traditional formula is almost certain to result in second-rate and ill-suited investment
performance and a steady decline in the market value of the trust property when adjusted for inflation. There are vastly superior alternative trust
architectures, many of which are much less complicated in their administration than the traditional ‘pay all net income to….’ model.” William J.
Hoisington, “Modern Trust Design: New Paradigms for the 21st Century,” Thirty-First Annual Philip E. Heckerling Institute on Estate Planning,
University of Miami School of Law, January 1997, at p. 5-5.
7. The trustee’s duty of impartiality is expressed in California Probate Code § 16003 as follows: “If a trust has two or more beneficiaries, the trustee has a
duty to deal impartially with them and shall act impartially in investing and managing the trust property, taking into account any differing interests of
the beneficiaries.”
8. Robert B. Wolf, “Total Return Trusts—Can Your Clients Afford Anything Less,” Real Property, Probate & Trust Journal, Vol. 33, No. 1, Spring
1998, at p. 136 (hereinafter cited as “Wolf II”).
9. Wolf II, supra, at p. 136. The trend of low dividend yields on stocks continues. For 1998, the dividend yield on the stocks that make up the Standard &
Poor 500 was 1.68%. (Source: Ibbotson Associates, Inc., Stocks, Bonds, Bill and Inflation, 1999 Yearbook.)
10. As my former law partner, David B. Gaw, might have said, “Diamond, you’re dancing on the head of a pin.”
11. “If Mom/Dad had not married that %$#@!, I would have had my inheritance by now!”
12. See, generally, Wolf I and Wolf II.
13. You are probably familiar with charitable remainder unitrusts, which provide, in essence, “pay x% of the trust value annually to non-charitable
beneficiary, remainder to charity at non-charitable beneficiary’s death.” Such trusts are creatures of the Internal Revenue Code and allow the settlor to
deduct the remainder value for income, gift, and estate tax purposes. PRUs use the same concept to define the current beneficiary’s income stream, but
have no charitable component.
14. Except of course for income taxes, in which case a dollar of principal growth is arguably worth more than a dollar of income, because (1) you don’t
have to pay tax on principal growth until you realize it by selling an asset, and (2) capital gain rates are lower than ordinary income rates.
15. Dan Rottenberg, The Inheritor’s Handbook: A Definitive Guide for Beneficiaries, Bloomberg Press, 1999, at p. 65: “Another way your parents can
eliminate possible conflicts over investment objectives—for example, whether the trust assets should be invested for maximum immediate income or
maximum long-term growth—is to avoid the conventional “income trust” approach (in which the trust’s income goes to one beneficiary and the
remaining principal goes to another) in favor of a “total return” concept (sometimes called a “unitrust” model). Under this approach, the trustee invests
the assets for maximum long-term growth—and then the income is distributed each year to beneficiaries based on a percentage of principal. Under this
model, income beneficiaries and remainders alike benefit from the growth of the trust’s principal—and since all beneficiaries share this common goal,
the trustee isn’t caught in the middle.”
16. See Hartog and Sanderson, “A Trustee’s Crime and Punishment: Managing Fiduciary Liability under the California Uniform Prudent Investor Act,”
4 Cal. Tr. & Est. Q., Summer 1998, at p. 4.
17. Nobel prize winner Harry M. Markowitz is widely recognized as the father of Modern Portfolio Theory. (Markowitz, Harry M., Portfolio Selection:
Efficient Diversification of Investments, John Wiley & Sons, 1959.) Modern Portfolio Theory or “MPT”includes such concepts as the so-called
“efficient frontier,” the correlation of risk and return, the effects of diversification among asset classes, and the efficient market hypothesis.
18. This relationship is often expressed graphically in the form of the familiar “efficient market frontier” curve. The points on the curve represent the
optimum level of return for a given level of risk. See William J. Bernstein, The Efficient Frontier: An Online Journal of Practical Asset Allocation,
1999 (http://www.efficientfrontier.com).
19. California Probate Code § 16048.
20. In my experience, there is a strong temptation, especially among older surviving spouse-trustees, is to invest 100% in government bonds, certificates of
deposit and other “non-risky” investments.
21. Chapter 145, Statutes of 1999 (A.B. 849 [Ackerman]), effective January 1, 2000.
22. Uniform Principal and Income Act, 29 Cal. L. Revision Comm’n Reports, 245 (1999) (http://www.clrc.ca.gov/ftp/Printed-Reports/REC-UPAIA.pdf)
(hereinafter cited as “CLRC Report”).
23. California Probate Code §§ 16300–16315, repealed effective January 1, 2000.
24. CLRC Report, supra, at p. 249.
25. CLRC Report, supra, at p. 252.
26. In otherwords,anincomeruletrust;thepowerofadjustmentdoesnotapplytotrustsdraftedastotalreturnunitrusts(seealsoproposedSection16336(b)(3)).
27. Section 16335(b) restates the rule that in allocating receipts and disbursements to income or to principal the trustee must administer the trust
impartially.
28. The CLRC Report describes the purpose of proposed Section 16335 as follows: “The Act…helps the trustee who has made a prudent, modern
portfolio-based investment decision that has the initial effect of skewing return from all the assets under management, viewed as a portfolio, as
between income and principal beneficiaries. The Act gives that trustee a power to reallocate the portfolio return suitably. To leave a trustee constrained
by the traditional system would inhibit the trustee’s ability to fully implement modern portfolio theory.” CLRC Report, supra, at p. 255.
29. CLRC Report, supra, at p. 255.
30. Under new Section 16337, a trustee may mail notice of a proposed reallocation to all adult beneficiaries who are receiving, or are entitled to receive
income, and to those beneficiaries who would be entitled to receive principal if the trust were terminated at the time notice is given. The notice must
31.
32.
33.
34.
35.
36.
37.
38.
39.
40.
describe the action and give beneficiaries at least 30 days to object. The trustee is exonerated from liability to a beneficiary for making a reallocation if
the trustee mails the notice to the beneficiary and does not receive a written objection. Likewise, if no written objection is made by any beneficiary to
whom notice is given, the trustee is not liable to any current or future beneficiary with respect to the proposed action.
New Probate Code § 16336(b)(7)).
Mr. Hoisington and Mr. Wolf, supra, also discuss other drafting options such as “fully discretionary trusts” and “indexed annuity trusts” (i.e., inflationadjusted annuity trusts), further treatment of which is beyond the scope of this article. However, in my opinion, fully discretionary trusts are not a
viable option for the most common irrevocable trust, the bypass trust with the surviving spouse serving as sole trustee, because of the ascertainable
standard requirement (to avoid estate tax inclusion in the surviving spouse’s estate), and because of the inherent conflict of interest in making
discretionary distributions to oneself, which may only invite litigation if the remainder beneficiaries are the step-children of the surviving spouse.
This might work in a congenial family situation. However, in an unfriendly situation, do you want the income beneficiary-trustee, who has independent
resources, to have to prove that a disbursement of principal was for “health, support and maintenance”? Additionally, while less common, there are
trusts that provide for distribution of net income only, with no provision whatsoever for discretionary distributions of principal.
The Uniform Prudent Investor Rule was promulgated by the American Law Institute, adopted by the Uniform Law Commissioners, recommended by
the California Law Revision Commission, and passed by the California legislature for valid reasons. In my opinion, it is somewhat presumptuous for
the estate planner to decide, without a full discussion of the issues and the client’s informed consent, that his or her clients should sidestep the
application of the Prudent Investor Rule.
This solution takes the burden off the attorney and places it squarely on the shoulders of the trustee, who may or may not feel comfortable making such
decisions. In fact, the banking industry lobbied against the adoption of the adjustment provision because they did not want this power. This “I’ll just
rely on the adjustment provision if I need it” approach also leaves the door open to potential disputes if a beneficiary who receives a notice of proposed
action objects to the adjustment. Moreover, implementation can get tricky where the current beneficiary is also the trustee and cannot exercise the
power himself or herself.
In my experience, clients understand the unitrust model as well (or perhaps it would be more accurate to say as little) as they understand the traditional
income rule model.
Wolf I, supra, at p. 75–76
Jerold I. Horn, “Prudent Investor Rule, Modern Portfolio Theory, and Private Trusts: Drafting and Administration Including the “‘Give Me Five’
Unitrust,” Real Property, Probate & Trust Journal, Vol. 33, No. 1 (Spring 1998).
Horn, supra, at pp. 46–47.
James P. Garland, “The Problem with Unitrusts,” The Journal of Portfolio Management, Vol. I, No. 4 (Spring 1999).