There isn’t a simple answer to the question of what constitutes the income of a trust.
“Trust income shall be paid to my wife at least annually, and the trust remainder shall be paid to my children at her death.” That common phrase, familiar to generations of trust lawyers, sounds simple, but it is not. What is “income”?
In a traditional trust, income generally consists of interest and dividend payments. Price changes—capital gains and losses—affect the value of principal, and hence the value received by the remainder beneficiaries. For example, assume that a marital deduction trust invests in a technology stock that pays no dividends at all, but it doubles in price in five years. How much income does that create for the surviving spouse? None at all. A spouse who is looking for maximum reliable current income from trust assets likely would favor heavier investment emphasis on bonds and their regular interest payments, or dividend-paying stocks.
However, we have just come off of a period of historically low interest rates, in which an all-bond investing strategy might not yield enough income to satisfy a current beneficiary. What’s more, failure to keep some exposure to equities in the trust portfolio could mean that the assets fail to hold their purchasing power during inflationary periods.
There are several alternatives to the traditional definition of trust income
The example of the charitable unitrust
When Congress became concerned in the late 1960s about a possible mismatch between the charitable deduction and the amounts that a charity actually might receive from a charitable trust, the resolution included a new statutory definition for a charitable income interest. Thus was born the unitrust, in which each year the income beneficiary receives a fixed percentage of the value of the trust assets, regardless of how those assets are invested.
During the 1990s, when interest and dividend rates fell to historically low levels, estate planners began to look to the unitrust model for private trusts as a way to resolve conflicts between income and remainder beneficiaries. At the same time, the Uniform Prudent Investor Act was introduced and began to be adopted around the country. That legislation provides standards by which trustees are measured in the discharge of their fiduciary duties in the investment arena. The new emphasis was less on the appropriateness of each individual trust investment, and more on the adequacy of the total trust return.
Thus was born the total return trust, a trust without a charitable beneficiary that follows the conventions of a charitable trust in determining what the income beneficiary gets.
The first state law authorizing the conversion of existing trusts to the total return format was enacted in June of 2001, and 17 states followed suit within three years. A majority of states also permit “equitable adjustment.” In the earlier example of the no-dividend technology stock, a trustee could use equitable adjustment to allocate a portion of the stock’s capital gains to the income beneficiary. Alternatively, during periods of high interest rates and high inflation, the trustee may allocate some income payments to the principal, to build the trust for the future.
Total return trusts are not a magical solution to investment management issues. They don’t guarantee growth; they don’t prevent losses. But they can ease conflicts among trust beneficiaries and meet beneficiary expectations by providing bright-line definitions of income.
IRS approval
Trusts have tax consequences, and in 2001, the Internal Revenue Service weighed in on total return trusts. Adjustments between income and principal that are consistent with state law will not impair the marital deduction, and a unitrust interest will qualify for the marital deduction if provided for by state law. Generally, the IRS considers that a unitrust interest of not less than 3% and not more than 5% is a reasonable apportionment of the total return of a trust. Existing marital deduction trusts may be converted to total return format under IRS regulations.
When “total return” is not paramount
The rigidity of the total return format may not be appropriate in all cases. See the table below for examples of alternative income definitions that estate planners have developed over the years. Situations in which a traditional trust may be satisfactory:
- Maximum return is not the goal of the trust. Some
grantors are most worried about protection of capital
and controlling investment risk. - The surviving spouse is the primary beneficiary. A traditional trust that also
permits discretionary invasions of principal to meet the spouse’s needs will be
adequate in many situations. - The trust has a short time horizon. Because stock prices tend to be volatile over short time frames, increased equity exposure may not be appropriate for a trust with a short shelf life.
May we tell you more?
As you can see, modern trust design permits flexible trustee response for maximum financial security. If you and your family might benefit from trust-based financial management, we’d be pleased to tell you more about our services. Contact us to make an appointment this month to meet with one of our wealth advisors.
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How should you define “income”?
You can be as flexible or as rigid as you wish in defining the claims of current and future beneficiaries to the assets of the trust that you establish.
| With this kind of trust | The income beneficiary will get |
|---|---|
| Traditional Trust |
The interest and dividend payments
|
| Total Return Trust | A fixed percentage of assets, determined annually |
| Indexed Payout Trust | A fixed dollar amount, adjusted for inflation each year |
| No-drop Unitrust Beneficiaries | A fixed percentage of trust assets, with a floor to protect income |
| Capped Unitrust Remainder Beneficiaries | A fixed percentage of trust assets, with a ceiling to protect |
| Fully Discretionary Trust | Trustee decides each year what is best for all beneficiaries, taking into account their circumstances and financial market conditions. |
With this kind of trust The income beneficiary will get
Traditional trust The interest and dividend payments
Total return trust A fixed percentage of assets, determined annually
Indexed payout trust A fixed dollar amount, adjusted for inflation each year
No-drop unitrust A fixed percentage of trust assets, with a floor to protect income beneficiaries
Capped unitrust A fixed percentage of trust assets, with a ceiling to protect remainder beneficiaries
Fully discretionary trust Trustee decides each year what is best for all beneficiaries, taking into account their circumstances and financial market conditions
Traditional trust The interest and dividend payments
Total return trust A fixed percentage of assets, determined annually
Indexed payout trust A fixed dollar amount, adjusted for inflation each year
No-drop unitrust A fixed percentage of trust assets, with a floor to protect income beneficiaries
Capped unitrust A fixed percentage of trust assets, with a ceiling to protect remainder beneficiaries
Fully discretionary trust Trustee decides each year what is best for all beneficiaries, taking into account their circumstances and financial market conditions
Source: M.A. Co.
© 2021 M.A. Co.
