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George F. Bearup, J.D. Senior Legal Trust Advisor

24-Jul-17

A Trustee’s Power to Adjust – Useful But It’s A Lot of Work

Take-Away: Michigan’s version of the Uniform Principal and Income Act (UPAIA or Act) [recently renamed the Fiduciary Principal and Income Act] gives a Trustee the authority to classify principal as income in order to treat all trust beneficiaries (life and remainder) impartially and invest trust assets for a total return. This authority is critical to consider in a period of low income yet rapidly appreciating investments, where the desire may be to shift more investments to growth but at the expense of generating less income for the lifetime beneficiary of the trust. However,  there is a lot of ‘behind the scenes’ work by the Trustee before the power to adjust can be exercised, which leads to more costs and time. Moreover,  not all Trustees may hold the power to adjust under the Act.

Background: Michigan has adopted the Uniform Principal and Income Act.  MCL 555.501 et seq. That Act gives to the Trustee a power to adjust. MCL 555.504(1) In addition, one of the express default powers conferred on a Trustee under the Michigan Trust Code is the power to adjust. Specifically that statutory trust power is: “to allocate an item of income or expense to either trust income or principal, as permitted or provided by law.” MCL 700.7817(u) That ‘law’ is the Act, specifically MCL 555.504(1).

  • Purpose of Power to Adjust: One court provided a helpful overview for the purpose of the Act and the Trustee’s power to adjust. “The comments to the Principal and Income Act establish that the primary purpose for the adjustment provision is to free trustees from the traditional obligation to invest in a minimum threshold of income-producing assets and to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio’s total return in the form of traditional accounting income, such as interest, dividends, and rents.” In re Orpheus Trust 179 P.3d 562 (2008). Thus, the primary purpose of the Act’s power to adjust is to address the tension between the prudent investor rule which requires a Trustee to invest for total return and the traditional, albeit competing,  interests of the income and remainder beneficiaries which requires the Trustee to invest assets to generate current income.
  • Trustee Discretion: The Act provides three instances in which a Trustee possesses discretion to adjust between income and principal. (i) The Trustee may use income to reimburse principal in the case of an extraordinary expense that is payable from principal but which should be borne by both income and principal beneficiaries- section 504; (ii) The Trustee may, and in some situations must, adjust between income and principal to offset the shifting economic benefits of certain tax elections- section 506; and (iii) The Trustee may adjust between income and principal to enable the Trustee to fulfill its various duties to the beneficiaries and to invest trust assets prudently- section 104, in Michigan MCL 555.504.  Section 504’s  authority  is the most important, since it controls the income that is available for distribution from the trust to the income beneficiary, the tax treatment of distributions from the trust, and it carries the potential to affect the tax liability of the trust beneficiaries.
  • Power to Adjust Authority: The Act clearly says that a Trustee ‘may adjust between principal and income to the extent the trustee considers necessary”  if: (i) the Trustee acts as a prudent investor as to the investment and management of trust assets; (ii) the trust instrument provides the amount that may or must be distributed to a beneficiary by referring to the trust’s income; and (iii) the Trustee determines that it is unable to administer the trust impartially under the terms of the trust and applicable law. MCL 555.504. In effect, this authority given to the Trustee to adjust  overrides other provisions of the UPAIA that provide for the default allocation of certain items of income or principal or expenses in a trust’s administration. In short, the power to adjust gives the Trustee the authority to distribute trust principal to the lifetime beneficiary of the trust and treat it as part of an income distribution.
  • ‘Must Consider All Relevant Factors’: This is where the Trustee’s work really begins if it contemplates making an adjustment. In order to exercise the statutory power to adjust, the Act directs the Trustee to consider all factors relevant to the trust and its beneficiaries. The Trustee’s consideration of all of the factors then needs to be documented by the Trustee in anticipation that the decision to adjust is later called into question by a trust beneficiary. The Act provides a non-exhaustive list of factors the Trustee must consider when it makes the determination  to adjust and treat principal as income, or vice versa. That list includes: (i) the nature, purpose and expected duration of the trust; (ii) the settlor’s intent or material purpose for the trust; (iii) the identity and circumstances of all the beneficiaries (income and remainder); (iv) the need for liquidity, the regularity of income, and the preservation and appreciation of capital assets held in the trust; (v) the nature and character of the assets held in the trust, e.g. closely held businesses, intangible property, real estate, or assets to the extent that they are actually used by the trust beneficiaries, e.g. use of a cottage; (vi) whether assets were received from the settlor or purchased by the Trustee; (vii) the net amount allocated to income under other sections of the Act, and the increase or decrease in estimated appreciation of trust assets; (viii) to what extent, if any, the trust instrument gives the Trustee the power to invade principal, or prohibits the Trustee from invading principal, and the extent to which the Trustee has actually exercised its  principal invasion power in the past; (ix) the actual and anticipated effect of economic conditions on principal and income and the effects of inflation or deflation; and (x) the anticipated tax consequences of an adjustment. UPAIA 104(b)
  • Limitations: The Act provides a couple of helpful limitations imposed on a Trustee’s power to adjust, which are  intended to protect tax-sensitive trusts, called savings provisions. For example, the Trustee is precluded from exercising the power to adjust where the adjustment would reduce the actuarial value of the income interest in the trust that is intended to qualify for the federal gift tax annual exclusion, or with respect to amounts that are set aside for charitable purposes. Similarly, the Trustee may not exercise the power to make adjustments if it would have adverse tax consequences that would  the disqualify the trust from either the marital or charitable deductions.

Disinterested Trustees: A surprise to many is that not all Trustees possess the power to adjust, despite the discretion provided by the Act. Specifically, the Trustee who exercises the power to adjust must be disinterested, which is defined in the Act. If the Trustee is a beneficiary of the trust, or if the Trustee is not a beneficiary but the proposed adjustment would in some manner benefit the Trustee, directly or indirectly, then the Trustee cannot exercise the power to adjust. Consequently, a Trustee who is also a remainder beneficiary or an income beneficiary cannot exercise the Act’s power to adjust.

Much less clear, however, is whether a family member of an income beneficiary or a remainder beneficiary, like a spouse or child, who acts as  Trustee, can exercise the power to adjust. Are those family members sufficiently remote such that an adjustment would not benefit that individual directly or indirectly? A grandparent acting as trustee for a grandchild’s trust might be sufficiently remote, but probably not a parent acting as Trustee of a trust for their own children.

If an individual serves as co-Trustee of the trust with an independent or impartial co-Trustee, then the power to adjust decision can be made by the independent co-Trustee. If there is no independent Trustee, then an independent Trustee will have to be appointed if there is a perceived need to exercise the power to adjust.

Unitrust Conversion:  Michigan’s version of the Act does not authorize a unitrust conversion by the Trustee, where a ‘pay all income’ trust is converted to a ‘pay a percentage of the trust estate value each year’ which avoids tying distributions solely to the income earned by the trust. However many states [31 to be exact] have tacked onto their adoption of the APAIA a separate unitrust conversion statute. Michigan’s surrounding states, e.g. Indiana, Illinois, Wisconsin have all adopted a unitrust conversion add-on statute. Delaware, of interest to us at Greenleaf Trust,  has also adopted a unitrust conversion statute. Most of the add-on statutes permit a conversion where the income interest of the beneficiary is converted to a unitrust annual distribution amount that ranges from 3% to 5% of the value of the trust’s assets. The unitrust conversion permits the Trustee to invest for the total return of the trust assets, as opposed to being concerned about maximizing the return to the income interest, or constantly balancing that annual income return with the principal beneficiary’s interest in the same trust. The perceived benefit from a unitrust conversion is that the Trustee makes that conversion decision once, as opposed to the annual exercise of a power to adjust  where the relevant factors considered by the Trustee must be documented each year the decision to adjust is made.

Can A Unitrust Conversion Occur in Michigan?: What if a Michigan Trustee wanted to convert an income-only trust, like a credit-shelter trust, to a unitrust to permit the Trustee to pursue a total return approach to the investment of the trust’s assets? How might the Trustee proceed? There are a couple of possibilities, but as is often the case, there are no guarantees:

  • Common Law: The Restatement (Third) of Trusts, Section 111, comment c (2012) claims that there is a common law right held by a Trustee to convert an income trust to a unitrust. But many probate judges tend to look at the Restatement (Third) of Trusts skeptically since it was primarily written by a bunch of law professors, aka ivory-tower egg-heads,  who tend to be more proactive as to what they think the law should be, and not actually summarizing in their Restatement what the common law on trusts actually is.
  • Petition the Court: The UPAIA anticipates that a Trustee may obtain a judicially authorized conversion of an income only trust to a unitrust with fixed percentage distribution terms following an established procedure. UPAIA 105(d). The Trustee’s petition for a conversion to convert to a unitrust is not  considered an abuse of discretion. Under the authorized procedure the court must enter the order that authorizes the unitrust conversion unless a beneficiary challenges the proposed conversion and the beneficiary, not the Trustee,  meets the burden of proof that such a conversion would result in an abuse of the Trustee’s discretion.
  • Implied Power of Conversion: One of the principal drafters of the UPAIA, the late Jim Gamble from Michigan, suggested that the power to convert is inherent in the Act itself. This personal belief shows up in one of his official comments to the UPAIA:

“A fiduciary has broad latitude in choosing the methods and criteria to use in deciding whether and to what extent to exercise the power to adjust in order to achieve impartiality between income beneficiaries and remainder beneficiaries, or the degree of partiality for one or the other that is provided for by the terms of the trust or the will. For example, in deciding what the appropriate level or range of income should be for the income beneficiary, and whether to exercise the power, a trustee…may consider the amount that would be distributed each year based on a percentage of the portfolio’s value at the beginning or end of an accounting period, or the average portfolio value for several accounting periods, in a manner similar to a unitrust, and may select a percentage that the trustee believes is appropriate for this purpose and use the same percentage or different percentages in subsequent years.” UPAIA 105 comments.

  • Beneficiary Budgeting: Many beneficiaries prefer a unitrust established for their benefit as opposed the distributions that they receive under an income only That is because at the beginning of each calendar year the Trustee can inform the beneficiary exactly how much unitrust distributions that the beneficiary will receive during that coming calendar year, because the unitrust amount is based on a snapshot of the value of trust assets determined at the beginning of that year. Accordingly, since the beneficiary knows exactly how much to expect in the way of distributions from the trust for that calendar year, it is much easier for the beneficiary to prepare a budget on which to live for that  year, as opposed to hoping that enough income will be generated throughout the year to meet their  expenses.

Advantages of a Power to Adjust (or Convert to Unitrust): There are a variety of situations where a Trustee’s exercise of a power to adjust may provide a significant benefit to all trust beneficiaries.

  • Duty of Impartiality: By permitting balanced investments for a total return, the Trustee that exercises  a power to adjust  is in a much better position to administer the trust in an impartial manner for all trust beneficiaries (current and remainder beneficiaries.)
  • Retention of Particular Assets: Some trust settlors direct that an asset be retained in the trust, even if the asset does not generate income, e.g. the legacy family cottage; a large tract of undeveloped land. The power to adjust permits the Trustee to retain these non-income producing assets as directed by the settlor, despite their inability to generate income, without being forced to sell the asset in order to reinvest the cash to provide for the income beneficiary’s needs.
  • Distribute Capital Gains: Due to the recent change in federal estate tax exemptions (and portability) there is a renewed emphasis on saving income taxes, more so than estate taxes. An irrevocable trust generally pays capital gains taxes at the 20% rate, and it quickly must deal with the net investment income tax (3.8%) once the trust’s accumulated income exceeds $12,500 in the year. If the Trustee can distribute capital gains to a trust beneficiary through a power to adjust, as distributable net income (DNI),  the beneficiary might pay much lower income taxes on the distribution {capital gains at the 15% rate, and not expose the capital gain distribution to any NIIT 3.8% tax.) In short, distributing capital gains to the beneficiary might result in an income tax savings of 8.8% a year {from 23.8% for the trust down to 15% for the beneficiary} just by having the beneficiary pay the capital gain tax and not the trust.
  • Basis Step-Up:  Consider a conventional credit-shelter type of trust that is established for a surviving spouse. Perhaps it was set up when  the settlor was  more worried about saving  federal estate taxes than saving federal income taxes. Now, with the paradigm shift to saving income taxes,  the Trustee  sees appreciation in some of the credit shelter trust’s assets, which assets will someday be owned by the remainder beneficiaries of the credit shelter trust- but exposing those assets to capital gain taxes upon the asset’s ultimate liquidation by the remainder beneficiaries. If the Trustee of the credit shelter trust exercises a power to adjust, and distributes assets from the trust to the surviving spouse, those assets, now owned by the survivor after the distribution,  will receive a step-up in basis on the death of the survivor. IRC 1014. Of course, the down-side to this tax basis planning is that the same assets that are distributed to the surviving spouse using the Trustee’s power to adjust will now be exposed to creditor claims of the surviving spouse.

Conclusion: The power to adjust gives the Trustee considerable latitude to administer an irrevocable trust and flexibility in how the trust’s assets are invested. It is particularly useful when it is a challenge for Trustees to find income producing assets to adequately provide income for the lifetime beneficiary of the trust. Hopefully more trusts will be drafted in the future, especially those which tend to be more dynasty-trust like, that gives to the Trustee the right to convert the income-only trust to a unitrust whenever the Trustee determines the circumstances warrant  such a conversion, without the need to petition the probate court to seek  permission for that conversion. In the absence of that right granted in the trust instrument, a Trustee will either go through the time-consuming annual ritual of exercising its power to adjust under the Act, thus documenting the reasons for that exercise, or the Trustee will follow the UPAIA’s formalized court procedure to convert the income-only trust to a unitrust, but with expense and time incurred for that effort.