Thompson Coburn LLP
Memorandum
ABA RPPT1 Uniform Acts for Probate and Trust Law Committee
ACTEC2 State Laws Committee
To:
From: Steven B. Gorin
Phone 314-552-6151; Fax 314-552-7151; E-mail SGORIN@thompsoncoburn.com
Date: June 11, 2007
Re:
Distributions from Business Entities to Trust under Uniform Principal & Income Act:
Issues Raised in June 6 Meeting of ABA RPPT Business Planning Group
Attached further below are:

Jim Gamble’s proposed revision to Section 401

Sections 505 and 506 of the Act
Participants favored changing existing Section 401 of the Act.
Jim’s suggested revisions constitute an excellent first draft. We used it as our primary reference,
and the discussion below refers to his suggested revisions rather than the existing version.
However, consideration should be given to the following issues:
Burden on Trustees.
How far should a trustee be required to dig?
subsidiaries. Various thoughts included:
1
2
Many entities have one or more levels of

The first factor to subsection (e), whether the current year’s distributions follow periodic
distributions, might be given greater weight. For example, if an entity made regular
distributions and announced a higher level of distributions that was intended to be
continued indefinitely, perhaps the trustee should have no duty to review the other factors
absent extraordinary circumstances.

If an interest in an entity is a small part of the trust’s assets, then the trustee’s duty to
inquire might be more limited. Conversely, if it’s a large part of the trust’s assets, then
the trustee might be required to spend more time inquiring into the nature of the
distribution.

How does the burden of a trustee’s duties under Section 401 compare with the trustee’s
burden when exercising a power to adjust between income and principal? Jim’s
suggested comments address that issue. Should all exercises of discretion under
The American Bar Association’s Real Property, Probate & Trust Law Section.
The American College of Trust & Estate Counsel.
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Section 401 be put to the same level of scrutiny as a power to adjust, or should some
exceptions apply to reduce the trustee’s burden, considering the above bullet-points?
Income Tax Issues.
Standing alone, Section 401(d) does not make much sense. This is not a flaw in Jim’s drafting
but rather a problem that existed before Jim drafted his suggestions.
Suppose a trust receives a K-1 from a partnership or S corporation reporting $100 of income.
Assuming a 40% overall income tax rate, the entity distributes $40. Section 401(b) says that all
receipts from entities are income unless otherwise provided, so the $40 would be required to be
distributed unless one can find an exception. Section 401(d) allocates to principal only receipts
that exceed tax distributions, so the $40 would be required to be distributed. However, in our
example, the trust needs to retain the entire $40 to pay income taxes. For example, if it
distributed $30, it would have net income of $70 from the entity ($100 minus $30 income
distribution deduction) and be faced with a $28 tax bill ($70 multiplied by the 40% tax rate),
while retaining only $10 ($40 receipt minus $30 distributed). Thus, Section 401(d) should
allocate to principal tax distributions to the extent that trust needs to pay taxes based on a K-1 it
receives from the entity.
We then looked at Section 505(c), which specifically addresses whether income taxes are
allocated to income or principal. That does not solve the problem, either, because in our
example the entire $40 receipt was allocated to income under Section 401. The trust’s other
assets would be required to pay tax on the $60 taxable income it retained. This is especially
problematic if we add a few zeroes to the end of our numbers and the entity is the trust’s only
asset.
We suggest that Section 401 and 505 cross-reference each other and that the language be
changed so that a trustee would use tax distributions from an entity to pay the trust’s taxes on the
entity’s K-1 without that use being considered a deviation classified as an adjustment.
We didn’t consider Section 506. Section 506(a)(3) seems to help. However, it does not require
that result we suggest. The result we suggest should be the general rule; Section 506(a)(3)
should allow deviations from the general rule, but the deviations would be considered to be
adjustments between income and principal.
Distributions of an Entity’s Accumulated Income.
We agreed that Section 401(e)(4), which considers distributions of an entity’s accumulated
income, was an important factor, but we were uncertain how it should cut.
On one hand, it might constitute a significant contraction of the entity, which seems more like a
principal item.
On the other hand, consider the effect of our recommendation regarding tax distributions. In our
example, the entity earns $100 of income, of which it distributes $40 and reinvests $60. The
beneficiary receives nothing, and the trust’s tax basis in its investment has increased by $60
($100 of income increases tax basis, and the $40 distribution reduces tax basis). The beneficiary
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should receive part or all of the $60 income that was reinvested when the entity distributes that
$60 to the trust. Effectively, those who control the entity previously allocated the $60 of income
to principal at the entity level; when they later distribute the $60, they are reallocating it from
principal back to income at the entity level.3
Contradicting this equity in favor of treatment as income is that the trustee might have allocated
other trust principal to income to make up for this reinvestment at the entity level, so that an
allocation to principal of the entity’s contraction should prevail.
Further above, we suggested that not all allocations under Section 401 should receive the same
level of scrutiny as an adjustment between income and principal. However, the allocation of a an
entity’s distribution of many years of accumulated income might need the same level of scrutiny
as an adjustment between income and principal if it is material to the trust’s overall income.
After thinking through the ramifications of our recommendations, my preliminary personal view
is that a flow-through4 entity’s distributions of prior years’ accumulated income from recurring
operations should constitute income. However, this default treatment should be subject to a
power to adjust to principal to take into account adjustments from principal to income the trustee
might have made in prior years (to the extent that the trustee made up to the beneficiary the fact
that no prior distributions from the entity ever reached the beneficiary), as well the usual goals of
making an income/principal adjustment, such as smoothing distributions to try to avoid wild
fluctuations.
Disclaimer.
This memorandum does not constitute the opinion of American Bar Association’s Real Property,
Probate & Trust Law Section. Rather, it is a first step in a discussion of these issues.
3
Partnership agreements, include LLC operating agreements, frequently require distribution of annual cash from
operations. Although these distributions appear mandatory, they really are discretionary, in that the definition of
available cash is adjusted for reserves. By adding to reserves, those in control reduce the cash available for
distribution. Similarly, by reducing reserves, those in control increase the cash available for distribution. Investors
who are not in control frequently negotiate who has authority to determine reserves, which might be the one area
(other than sale of the business) in which otherwise passive investors insist on playing a role in decision-making.
(This footnote is my personal observation, rather than something we discussed.)
4
Entity taxed as a partnership or an S corporation.
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SECTION 401. CHARACTER OF RECEIPTS.
(a)
In this section, “entity” means a corporation, partnership, limited liability
company, regulated investment company, real estate investment trust, common trust fund, or any
other organization in which a trustee has an interest other than a trust or estate to which
Section 402 applies, a business or activity to which Section 403 applies, or an asset-backed
security to which Section 415 applies.
(b)
Except as otherwise provided in this section, a trustee shall allocate to income
money received from an entity.
(c)
A trustee shall allocate the following receipts from an entity to principal:
(1)
property other than money;
(2)
money received in one distribution or a series of related distributions in
exchange for part or all of a trust’s interest in the entity;
(3)
money received in a distribution if and to the extent the trustee determines
the distribution is a return of capital;
(4)
money received from an entity that is a regulated investment company or a
real estate investment trust if the money distributed is a capital gain dividend for federal
income tax purposes.
(d)
A trustee may determine that money is received as a return of capital only to the
extent that all of the money distributed with respect to a taxable year exceeds the total amount of
income tax that a trustee, beneficiary, or both, must pay on their respective shares of the entity’s
taxable income for that year.
(e)
In determining if and to what extent a distribution is a return of capital, the trustee
may rely upon any information reasonably available to the trustee about the source of the money
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from which the distribution was made, including information about the following matters to the
extent that the trustee determines those matters are relevant; the trustee may also determine,
based on the available information, the weight, if any, to give each matter:
(1)
The amount of the distribution in question compared to the amount of the
entity’s regular, periodic distributions, if any, during the year in which the distribution is
made and in prior years.
(2)
If the entity’s primary activity is not an investment activity described in
subsection (e)(3), the amount of money the entity has received from the conduct of its
normal business activities compared to money received from all other sources, including
but not limited to, the sale of all or part of a business conducted by the entity, the sale of
one or more business assets that are not sold to customers in the normal course of the
entity’s business, and the sale of one or more investment assets, in each case including
money representing any gain realized on such a sale.
(3)
If the entity’s primary activity is to invest funds in another entity or in
investment property that it owns directly for the purpose of realizing gain on the
disposition of all or a part of such an investment, the amount of money the entity has
received from the sale of all or part of one or more of those investments, including money
representing any gain realized on such a disposition.
(4)
The amount of money the entity has accumulated over a number of years,
to the extent the entity’s governing body has decided the money is no longer needed for
the entity’s business or investment needs.
(5)
The amount of money the entity has borrowed, whether or not repayment
of the loan is secured to any extent by one or more of the entity’s assets.
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(6)
The amount of money the entity has received from sources described in
Sections 407 (insurance policies), 410 (liquidating assets), 411 (minerals, water, and
other natural resources), and 412 (timber).
(7)
The amount of money the entity has received through one or more levels
of subsidiary entities if one or more of such entities has received money in a transaction
of the kind described in subsections (e)(2) through (e)(6).
(8)
The amount of money the entity has received from a source not described
in this subsection.
(f)
A trustee may determine that money which represents gain upon the sale or other
disposition of property described in subsection (e) is a return of capital.
(g)
If the trustee is in doubt about the portion of a distribution that is a return of
capital, the trustee shall resolve the doubt by allocating to income the amount, if any, the trustee
believes is clearly not a return of capital, and allocating the balance of the distribution to
principal.
(h)
A trustee may rely, without independent investigation, upon the entity’s financial
statements and any other information provided by the entity about the character of a distribution
or the source of funds from which the distribution is made if the entity’s information is provided,
at or near the time of distribution, by the entity’s board of directors or other person or group of
persons authorized to exercise powers to pay money or transfer property comparable to those of
a corporation’s board of directors, but the trustee is not bound by any statement made or implied
by the entity about the extent to which a distribution is or is not a return of capital. If a trustee
receives additional information about the distribution after the trustee has decided the amount
that is a return of capital, the trustee is not required to change that decision.
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Comments
Description of changes. In this revision of Section 401, subsections (a) and (b) have not
been changed. The only change in subsection (c) is in (c)(3), which replaces “money received in
total or partial liquidation of the entity” with “money received in a distribution if and to the
extent the trustee determines the distribution is a return of capital.” All other references in
Section 401 to a liquidation, partial or otherwise, have been removed. Subsection (d) is a
revision of old subsection (e). Subsections (e), (f), and (g) are new, and Subsection (h) is a
revision of the present subsection (f).
The main thrust of the revision is that, when a distribution is received from an entity that
exceeds the amount of the distributions the entity normally makes, the trustee has a discretionary
power to look for the probable source of the distribution, in a manner described in subsection (e),
and to examine relevant circumstances to determine how the distribution should be allocated to
or between principal and income. If the trustee is in doubt, subsection (g) provides that, to the
extent the trustee believes the distribution is clearly not a return of capital, the distribution is
allocated to income; the balance is allocated to principal. “Return of capital” is not restricted to
the amount of capital originally invested in the entity. Under subsection (f), return of capital
includes gain attributable to the portion of a business or asset that is sold.
Reasons for the change. The partial liquidation provision in the 1997 Act has not
worked satisfactorily. The reference in the present Section 401(c)(3) to a “total or partial
liquidation” is a carryover from Section 6(b)(3) of the Revised Uniform Principal and Income
Act (1962), which provides that “... a corporate distribution is principal if the distribution is
pursuant to ... a total or partial liquidation of the corporation, including any distribution which
the corporation indicates is a distribution in total or partial liquidation ....” However, an entity’s
statement about the character of a distribution, or its decision to make no statement, serves only
the entity’s purposes as they relate to generally accepted accounting principles (which do not
apply to this Act) and to the entity’s relations with its owners and with financial analysts. An
entity has no reason to be concerned, or to comment, about how any distribution should be
treated for fiduciary accounting purposes.
The 1997 Act added a provision stating that money is received in partial liquidation “if
the total amount of money and property received in a distribution or series of related
distributions is greater than 20 percent of the entity’s gross assets, as shown by the entity’s yearend financial statements immediately preceding the initial receipt.” Two California cases and a
special dividend paid by Microsoft Corporation in 2004 illustrate several ways in which
Section 401(c)(3) has not served its intended purpose.
In Estate of Thomas, 124 Cal. App. 4th 711 (2004), the court construed the 20% rule to
mean that it applies only if the money received by the trust (instead of the money received by all
of entity’s owners) exceeds 20% of the entity’s gross assets, . This construction causes the 20%
provision to apply only to a trust that owns a major interest by the entity. For example, if the
distribution is slightly more than 20% of the entity’s gross assets, the 20% provision would apply
only to a trust that owns almost 100% of the entity; and if the distribution is 30% of the gross
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assets, the provision would apply only to a trust that owns at least two-thirds of the entity. In
response to Thomas, the California legislature, as an emergency measure, amended its version of
section 401(c)(3) to reject the court’s construction.
In Thomas, the income beneficiary was the decedent’s surviving spouse; sons by prior
marriages were the trustees and remainder beneficiaries. Over several years, the income
beneficiary had paid more than $700,000 on the “phantom” income of a subchapter S
corporation that was the trust’s sole asset. Then the trust received $1.2 million of undistributed
income on which the income beneficiary had paid income tax of $494,000 in prior years; the
parties stipulated that the $1.2 million was accumulated income and did not include the proceeds
from the sale of any corporate asset. Allocating the $1.2 million to principal as a partial
liquidation was correct under the 1997 Act because the total distribution did exceed 20% of the
corporation’s gross assets as shown in the financial statements, but in the eyes of both the trial
and appellate courts, it was an unjust result.
In Estate of Hasso, 148 Cal. App. 4th 329 (2007) the trust owned an interest in entity A,
which owned an interest in entity B, which owned an interest in entity C. Entity B sold its
interest in entity C for $125 million, and distributed a substantial portion of that money to
entity A, which then distributed $33.9 million to the trust and the other stockholders. The prior
year’s financial statements included two values for the corporation’s gross assets. One value was
shown in the balance sheet, the other was in a note to the financial statements. The $33.9 million
distribution was more than 20% of the $133 million shown in the balance sheet, and less than the
$630 million value shown in the note. The trustee notified the beneficiaries that the distribution
would be allocated to principal. The income beneficiary petitioned for a determination that it
should be allocated to income, and the trial court and appellate court agreed. They held there
was no partial liquidation because the “true” value was $630 million, and the 20% test was not
met.
In Hasso, the directors of A were asked to state that the distribution was in partial
liquidation of the corporation, and their response was: “The Board is not capable to say how
such facts should be characterized under the California Probate Code.” 148 Cal. App. 4th 329,
341.
The trustee, whose initial proposal was to allocate the distribution to principal, did not
exercise the power to adjust from income to principal under Section 104(a), despite the following
comment to Section 401:
Other large distributions. A cash distribution may be quite large (for example, more
than 10% but not more than 20% of the entity’s gross assets) and have characteristics that
suggest it should be treated as principal rather than income. For example, an entity may
have received cash from a source other than the conduct of its normal business operations
because it sold an investment asset; or because it sold a business asset other than one held
for sale to customers in the normal course of its business and did not replace it; or it
borrowed a large sum of money and secured the repayment of the loan with a substantial
asset; or a principal source of its cash was from assets such as mineral interests, 90% of
which would have been allocated to principal if the trust had owned the assets directly.
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In such a case the trustee, after considering the total return from the portfolio as a whole
and the income component of that return, may decide to exercise the power under
Section 104(a) to make an adjustment between income and principal, subject to the
limitations in Section 104(c).
Prior to 2003, Microsoft Corporation, which was formed in 1975, paid no dividends to its
stockholders. In March 2003, it paid its first dividend, which was eight cents a share; in
November, 2003, its dividend was sixteen cents a share; and in September 2004, eight cents a
share. In December 2004, it paid a “special dividend” of three dollars a share, which resulted in
a total distribution that was more than 20% of its gross assets as shown in its preceding year-end
financial statements. Allocating the Microsoft special dividend to principal was controversial
among trustees, given Microsoft’s financial history, and reasonable trustees differed about
whether the 20% rule allocating the special dividend to principal produced an appropriate result.
The discretionary power provided for in this revision of Section 401 permits a trustee to
determine whether part or all of such a distribution should be income.
The trustees’ power to determine return of capital. The power to determine the extent
to which a distribution from an entity is a return of capital under the proposed Section 401(e) is a
discretionary power of administration. As such, it is subject to Section 103(b), which requires a
fiduciary, “in exercising a discretionary power of administration regarding a matter within the
scope of this Act, ... to administer a trust or estate impartially, based on what is fair and
reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will
clearly manifest an intention that the trust shall or may favor one or more of the beneficiaries.”
It is also a discretionary power to which Section 105 (Judicial Control of Discretionary Powers)
applies in those states that have adopted Section 105.
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SECTION 505. INCOME TAXES.
(a)
A tax required to be paid by a trustee based on receipts allocated to income must
be paid from income.
(b)
A tax required to be paid by a trustee based on receipts allocated to principal must
be paid from principal, even if the tax is called an income tax by the taxing authority.
(c)
A tax required to be paid by a trustee on the trust’s share of an entity’s taxable
income must be paid proportionately:
(1)
from income to the extent that receipts from the entity are allocated to
income; and
(2)
from principal to the extent that:
(A)
receipts from the entity are allocated to principal; and
(B)
the trust’s share of the entity’s taxable income exceeds the total
receipts described in paragraphs (1) and (2)(A).
(d)
For purposes of this section, receipts allocated to principal or income must be
reduced by the amount distributed to a beneficiary from principal or income for which the trust
receives a deduction in calculating the tax.
Comment
Electing Small Business Trusts. An Electing Small Business Trust (ESBT) is a creature
created by Congress in the Small Business Job Protection Act of 1996 (P.L. 104-188). For years
beginning after 1996, an ESBT may qualify as an S corporation stockholder even if the trustee
does not distribute all of the trust’s income annually to its beneficiaries. The portion of an ESBT
that consists of the S corporation stock is treated as a separate trust for tax purposes (but not for
trust accounting purposes), and the S corporation income is taxed directly to that portion of the
trust even if some or all of that income is distributed to the beneficiaries.
A trust normally receives a deduction for distributions it makes to its beneficiaries.
Subsection (d) takes into account the possibility that an ESBT may not receive a deduction for
trust accounting income that is distributed to the beneficiaries. Only limited guidance has been
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issued by the Internal Revenue Service, and it is too early to anticipate all of the technical
questions that may arise, but the powers granted to a trustee in Sections 506 and 104 to make
adjustments are probably sufficient to enable a trustee to correct inequities that may arise
because of technical problems.
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SECTION 506. ADJUSTMENTS BETWEEN PRINCIPAL AND INCOME BECAUSE
OF TAXES.
(a)
A fiduciary may make adjustments between principal and income to offset the
shifting of economic interests or tax benefits between income beneficiaries and remainder
beneficiaries which arise from:
(1)
elections and decisions, other than those described in subsection (b), that
the fiduciary makes from time to time regarding tax matters;
(2)
an income tax or any other tax that is imposed upon the fiduciary or a
beneficiary as a result of a transaction involving or a distribution from the estate or trust;
or
(3)
the ownership by an estate or trust of an interest in an entity whose taxable
income, whether or not distributed, is includable in the taxable income of the estate, trust,
or a beneficiary.
(b)
If the amount of an estate tax marital deduction or charitable contribution
deduction is reduced because a fiduciary deducts an amount paid from principal for income tax
purposes instead of deducting it for estate tax purposes, and as a result estate taxes paid from
principal are increased and income taxes paid by an estate, trust, or beneficiary are decreased,
each estate, trust, or beneficiary that benefits from the decrease in income tax shall reimburse the
principal from which the increase in estate tax is paid. The total reimbursement must equal the
increase in the estate tax to the extent that the principal used to pay the increase would have
qualified for a marital deduction or charitable contribution deduction but for the payment. The
proportionate share of the reimbursement for each estate, trust, or beneficiary whose income
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taxes are reduced must be the same as its proportionate share of the total decrease in income tax.
An estate or trust shall reimburse principal from income.
Comment
Discretionary adjustments. Section 506(a) permits the fiduciary to make adjustments
between income and principal because of tax law provisions. It would permit discretionary
adjustments in situations like these: (1) A fiduciary elects to deduct administration expenses that
are paid from principal on an income tax return instead of on the estate tax return; (2) a
distribution of a principal asset to a trust or other beneficiary causes the taxable income of an
estate or trust to be carried out to the distributee and relieves the persons who receive the income
of any obligation to pay income tax on the income; or (3) a trustee realizes a capital gain on the
sale of a principal asset and pays a large state income tax on the gain, but under applicable
federal income tax rules the trustee may not deduct the state income tax payment from the capital
gain in calculating the trust’s federal capital gain tax, and the income beneficiary receives the
benefit of the deduction for state income tax paid on the capital gain. See generally Joel C.
Dobris, Limits on the Doctrine of Equitable Adjustment in Sophisticated Postmortem Tax
Planning, 66 Iowa L. Rev. 273 (1981).
Section 506(a)(3) applies to a qualified Subchapter S trust (QSST) whose income
beneficiary is required to include a pro rata share of the S corporation’s taxable income in his
return. If the QSST does not receive a cash distribution from the corporation that is large enough
to cover the income beneficiary’s tax liability, the trustee may distribute additional cash from
principal to the income beneficiary. In this case the retention of cash by the corporation benefits
the trust principal. This situation could occur if the corporation’s taxable income includes capital
gain from the sale of a business asset and the sale proceeds are reinvested in the business instead
of being distributed to shareholders.
Mandatory adjustment. Subsection (b) provides for a mandatory adjustment from
income to principal to the extent needed to preserve an estate tax marital deduction or charitable
contributions deduction. It is derived from New York’s EPTL § 11-1.2(A), which requires
principal to be reimbursed by those who benefit when a fiduciary elects to deduct administration
expenses on an income tax return instead of the estate tax return. Unlike the New York
provision, subsection (b) limits a mandatory reimbursement to cases in which a marital deduction
or a charitable contributions deduction is reduced by the payment of additional estate taxes
because of the fiduciary’s income tax election. It is intended to preserve the result reached in
Estate of Britenstool v. Commissioner, 46 T.C. 711 (1966), in which the Tax Court held that a
reimbursement required by the predecessor of EPTL § 11-1.2(A) resulted in the estate receiving
the same charitable contributions deduction it would have received if the administration expenses
had been deducted for estate tax purposes instead of for income tax purposes. Because a
fiduciary will elect to deduct administration expenses for income tax purposes only when the
income tax reduction exceeds the estate tax reduction, the effect of this adjustment is that the
principal is placed in the same position it would have occupied if the fiduciary had deducted the
expenses for estate tax purposes, but the income beneficiaries receive an additional benefit. For
example, if the income tax benefit from the deduction is $30,000 and the estate tax benefit would
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have been $20,000, principal will be reimbursed $20,000 and the net benefit to the income
beneficiaries will be $10,000.
Irrevocable grantor trusts. Under Sections 671-679 of the Internal Revenue Code (the
“grantor trust” provisions), a person who creates an irrevocable trust for the benefit of another
person may be subject to tax on the trust’s income or capital gains, or both, even though the
settlor is not entitled to receive any income or principal from the trust. Because this is now a
well-known tax result, many trusts have been created to produce this result, but there are also
trusts that are unintentionally subject to this rule. The Act does not require or authorize a trustee
to distribute funds from the trust to the settlor in these cases because it is difficult to establish a
rule that applies only to trusts where this tax result is unintended and does not apply to trusts
where the tax result is intended. Settlors who intend this tax result rarely state it as an objective
in the terms of the trust, but instead rely on the operation of the tax law to produce the desired
result. As a result it may not be possible to determine from the terms of the trust if the result was
intentional or unintentional. If the drafter of such a trust wants the trustee to have the authority
to distribute principal or income to the settlor to reimburse the settlor for taxes paid on the trust’s
income or capital gains, such a provision should be placed in the terms of the trust. In some
situations the Internal Revenue Service may require that such a provision be placed in the terms
of the trust as a condition to issuing a private letter ruling.
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