by Hon. C. Raymond Radigan
In order to compliment and implement the new Prudent Investor Act, EPTL 11-2.3, the EPTL-SCPA Legislative Advisory Committee, which I Chair, recommended to the legislature the enactment of a new uniform Principal and Income Act which was enacted by L.2001, CH243, (EPTL Article 11-A) effective Jan. 1, 2002, as well as to amend the Prudent Investor Act to provide for a trustee’s ability to adjust between principal and income.
As a result of tax regulations and comments made by various bar associations, bank associations, the insurance industry and others, the advisory committee determined that there ought to be a technical correction bill as well as other substantive changes in the Principal and Income Act. The committee is presently reviewing the proposed substantive changes. However, we have submitted, after approval from many organizations, a technical corrections bill to the New York State Senate (S4704) which is also awaiting introduction in the Assembly.
Definition of Income
While the advisory committee was preparing its Fifth Report concerning the Principal and Income Act, it also attempted to bring to the IRS and the Treasury Department our recommendations regarding the definition of income. That is, whether or not it would be permissible for a fiduciary to make adjustments concerning income by way of allocating a portion of the income to principal or having principal added to income, or to permit a unitrust. Our main concern was the safeguarding of the marital deduction. Therefore, we prepared a brief and went to Washington to meet with the IRS and Treasury to discuss the issue and ultimately, new regulations were enacted defining income. The final regulations were issued on Dec. 31, 2003 (treas. dec. 9102; 69FR12). Primarily, the regulations comport the definition of income with the modern portfolio theory of investing for total return and provide for payouts to income beneficiaries that is also equitable as to remainderman.
Attorney Jon L. Schumacher, a member of the advisory committee, has prepared an excellent article entitled “Final Regulations Defining Income,” dated April 21, 2004. This article was prepared in order to aid the committee in studying the Principal and Income Act as well as advising other organizations of his views since he worked very closely on the issues involved.
Mr. Schumacher, in summarizing the suitable definition of income, indicates that a state or governing instrument defining income may not depart too far from traditional concepts of income and principal, but the regulations have been amended to take into consideration the new concept of unitrust and the power of a trustee to adjust.
As a result of Matter of Bosch, 87 SCt 1776, which provides that the federal government is not bound by a lower state court’s findings, we felt it advisable to provide, via statute, a definition of income since the federal government will recognize state statutes defining what income is. We also sought a ruling from the IRS regarding whether or not our recommendations to the legislature regarding the definition of income would be acceptable.
Rather than give a trustee the power to adjust under the Principal and Income Act, we recommended and the legislature enacted EPTL 11-2.3(b)(5), which under the Prudent Investor Act grants the trustee the power to make adjusting transfers between principal and income. Where after allocating principal and income under the usual methods, the trustee may deem it advisable to adjust in order to permit making appropriate present and future distributions taking into consideration the risk and return objectives reasonably suited to the entire portfolio that will be fair to all beneficiaries both present and future.
Under the Uniform Principal and Income Act, the power to adjust refers to impartiality between the present beneficiaries and the remainderman. New York did not incorporate the power to adjust under its Principal and Income Act but rather placed it under the Prudent Investor Act and does not mention impartiality. The advisory committee determined that it would be appropriate to incorporate within the provisions dealing with the power to adjust the word “impartiality” to avoid the possibility of any audit agent raising an issue. The committee’s technical correction bill makes clear that any adjustments made by a fiduciary will be limited to cases requiring impartiality and not favoring either the income or remainder interest.
The Fifth Report provided the legislature with a memorandum in support of the proposed legislation, together with the proposed legislation and its commentary. We have added Mr. Schumacher’s article of April 21, 2004 as an appendix to the Fifth Report. (This will appear under Warren’s Heaton on Surrogate’s Courts Sixth Edition Revised, Volume 14. The technical corrections bill and its covering memo can also be found in that volume.)
Other Technical Corrections
There are other technical corrections to the Principal and Income Act that may be necessary because of changes in rules and regulations and by trusts and estates specialist who feel that there should be further amplification or changes. In this article, I will cover four of the sixteen proposed changes.
1. Prerequisites to a trustee’s making an equitable adjustment between principal and income. [bill § 1] EPTL 11-2.3(b)(5)(A) states that the prudent investor standard authorizes the trustee to adjust “if the trustee determines, after applying the rules in article 11-A, that such an adjustment would be fair and reasonable, so that current beneficiaries may be given such use of the trust property as is consistent with preservation of its value.” The italicized phrases have raised two issues.
As to the first phrase, Trustees have expressed concern that the word “after” can or must be read to specify that no adjustment can be made until after the 11-A rules have been applied to the actual receipt/expense facts to determine the trust’s 11-A income – that is, not till after the close of the year when all such facts have finalized. That was not the intention of the Act. It would be a serious inconvenience to income beneficiaries to receive insufficient payments throughout a year, waiting for a large make-up payment early in the next year. Trustees are accustomed to planning a year’s net income flow based on prospective estimates of the year’s receipts and expense. Examples in the Uniform Commissioners’ commentary must be read as contemplating that trustees will apply the 11-A rules prospectively, by estimation and re-estimation throughout the year. Presumably, the courts will not permit a trustee to delay the adjustment decision based on an argument as to the meaning of “after.” Nevertheless, the committee believes that the language should be corrected, to remove the possibility of such an argument, and to allay any trustee concern about the proper process for making adjustments. The language is amended to provide that the adjustment decision must be made in light of the investment decisions and the expected income that will result from such investments under the rules of article 11-A.
The second phrase was placed in the statute at a time when it was unclear whether the Federal government would accept an adjustable income under the “all income” requirement of the marital deduction rules. The language was taken from the deduction regulations, to show that equitable adjustment would be consistent with the regulation’s definition of what would constitute adequate income. It is now clear from proposed regulations that the government has committed itself to recognize the adjustment power method of determining income. The phrase can therefore safely be removed. And it should be. The treasury regulation in which the quoted language appears was not drafted with total return investing or the Prudent Investor Rule in mind. One could argue from the language that the current payout consistent with preservation of capital value is the greatest such amount, mathematically set at the amount deemed necessary to preserve capital based only on a mechanical formula (this year’s total return rate, less this year’s inflation rate equals current payout rate). That would be quite inconsistent with the “fair and reasonable to all of the beneficiaries” and the “appropriate present and future distributions” tests, which constitute the real underpinning of adjustment power use. The amendment excises the phrase.
2. Gift tax annual exclusion limitation on trustee’s adjustment power. [bill § 2] EPTL 11-2.3(b)(5)(C)(ii) states that a trustee may not make an adjustment . . . “that reduces the actuarial value of the income interest in a trust to which a person transfers property with the intent to qualify for a gift tax exclusion.” The provision was taken directly from the proposed Uniform Act text. However, the provision presents numerous difficulties. It is true that there are certain trusts which use the actuarial value of their income interests to base a donor’s gift tax annual exclusion, and the provision may be effective to protect that donor. However, the number of such specialized trusts is quite small, and all require a drafts person of some sophistication. That makes it fair to expect that if annual exclusion is desired for the initial gift, the trust will be drafted to provide its own protection. If annual exclusion is desired for continuation of a gift pattern to an existing trust, that trust can in most cases be frozen and replaced by a protective new trust. As to existing trusts that once received a donor’s gift with probable intention to take an exclusion, it is doubtful whether anything done by the trust today could revert an adverse effect back to the gift event, but the present language would prohibit the adjustment power even as to those. The provision is overbroad in its coverage. It does not limit its reach to those few trusts where actuarial value is what counted. Rather, it seems to cover any trust if the donor subjectively intended to claim an annual exclusion. That seemingly includes thousands of “Crummey” insurance trusts and “2503(c)” infant trusts, all of which were designed to give donors their annual exclusions. Denial of the adjustment power to all these trusts over their entire terms, often because of only one donor’s one-time annual exclusion, is unwarranted. For these reasons, the Committee believes that the entire limitation should be deleted and the subsequent paragraphs renumbered accordingly.
3. Adjustment power prohibited if the trustee is a beneficiary. [bill § 2] EPTL 11-2.3(b)(5)(C)(vii) states that a trustee may not make an adjustment if he or she is a current or remainder beneficiary. There is no automatic reason why a trustee should not be able to exercise the adjustment discretion if the exercise is not in favor of that trustee. Nor should it be implied that the presence of an implicated trustee should prevent use of the adjustment power if there is an independent trustee to exercise the discretion. Whether there is a gift tax issue for a trustee’s exercise that is adverse to himself is something the trustee should consider, but preventing use of this important power in all cases, including rational use where adverse or neutral to the trustee’s own interest, is not warranted. The amendment limits the prohibition to cases where the exercising trustee would benefit from the exercise.
4. “Direct or indirect benefit” from trustee’s adjustment power. [bill § 2] EPTL 11-2.3(b)(5)(C)(viii) states that a trustee may not make an adjustment . . . “if the trustee is not a current beneficiary or a presumptive remainderman, but the adjustment would benefit the trustee directly or indirectly.” The banking community has expressed deep concern that this provision could be interpreted as denying the adjustment power because of an adjustment’s incidental effect on computation of the trustee’s commissions. An adjustment from income to principal would increase the amount of principal on hand that could eventually qualify for a 1 percent termination commission.
The provision was not intended to cover such a minuscule side effect of a trustee act having such high independent significance as its achievement of a proper overall investment strategy through the use of the adjustment power. In clear cases of possible direct benefit to a trustee, EPTL 10-10.1 will prevent the exercise of discretion if there is no independent co-trustee to do it. And in any event, under general equitable principles, it should still be expected and permitted that trustee acts can be tested by the apparent balance between their independent significance, benefits to the trust, and benefits flowing directly or indirectly to the trustee.
What would make sense, here, however, is to replace this overbroad provision with a narrower savings clause directed at the rule that the trustee will be subject to tax if he or she acts in a way that will satisfy his or her obligation of support or other legal obligation. The amendment makes this substitution.
In the next article, I will follow up on additional technical corrections that the advisory committee to the legislature deems appropriate which can be found in the appendix to our Fifth Report.
C. Raymond Radigan is former surrogate of Nassau County and of counsel to Ruskin Moscou Faltischek. He also is chairman of the advisory committee to the Legislature on estates powers and trust law and the Surrogate’s Court Procedure Act. Frank J. Gobes, an associate at Ruskin Moscou, assisted in the preparation of this article.
Reprinted with permission from the Wednesday, July 21, 2004 issue of the New York Law Journal (c) 2004, ALM Properties, Inc.