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

6-Sep-19

Uniform Fiduciary Income and Principal Act- How It Differs from the UPIA

Take-Away: The Uniform Law Commission approved a year ago the Uniform Fiduciary Income and Principal Act. This Act, if adopted by Michigan, makes some important changes to the 1994 and 1997 versions Uniform Principal and Income Act (UPIA). The earlier UPIA Acts tended to create some dilemmas for a trustee that is charged with prudent investor or total return, investing. Those concerns will presumably be addressed in the new Uniform Fiduciary Income and Principal Act (UFIPA.)

Background: Michigan has adopted the prudent investor rule, along with the imposition of a trustee’s duties of loyalty and impartiality to the trust beneficiaries. [MCL 700.1501 to 1512.] The Michigan Trust Code directs that “The trustee shall act as would a prudent person in dealing with the property of another, including following the standards of the Michigan prudent investor rule. [MCL 700.7803.] The prudent investor rule is a default rule that can be altered, expanded, or eliminated by the terms of a trust. [MCL 700. 1502(2).] Michigan has also adopted the Uniform Principal and Income Act (UPIA) the provisions of which authorize a trustee to adjust between principal and income if the trustee considers that adjustment necessary. [MCL 555.504(1).] The interplay between the prudent investor rule and the UPIA can present problems to a trustee when total return investing, following the prudent investor rule, forces the trustee to exercise the UPIA’s power to adjust. The UPIA would now be replaced with the UFIA in order to provide more flexibility to a trustee that is charged with total return investing.

UFIPA: Some of the UFIA changes are identified in the following paragraphs.

Power to Adjust: The 1997 version of the Uniform Income and Principal Act, adopted in Michigan, gives to the trustee the authority to adjust from income to principal, or from principal to income, but only if three conditions are met. Those three conditions under the 1994 Act are: (i) the trustee invests and manages trust assets as a prudent investor; (ii) the terms of the trust describe the amount that may or must be distributed to a beneficiary by reference to the trust’s income; and (iii) the trustee concludes that it is unable to comply with the requirement of the Act that a trustee administer a trust impartially, based on what is fair and reasonable to all of the trust beneficiaries (both income and remainder beneficiaries.) This inability of the trustee to comply with the requirement of impartiality among all trust beneficiaries creates an administrative dilemma created by the trustee’s total return investing. Example: If no principal can be currently distributed by the trustee, that omission could penalize the trust’s income beneficiaries when the income from trust investments is very low. To address some of the problems encountered with total return investing, the UFIPA makes the following changes to the trustee’s ‘power to adjust.’

  • ‘Assist’: The UFIPA abandons the three conditions, noted above, when the trustee intends to exercise its power to adjust. Instead, the UFIPA requires only that the trustee determine that the exercise of the power to adjust will assist the trustee to administer the trust estate impartially. Example: Assume that the trustee possesses discretion over income and principal distributions. The UFIPA confirms that there is a power to adjust between income and principal, even though the same result might be achieved just by the trustee simply exercising its discretionary distribution authority with regard to trust principal.
  • Optics: This expanded and more flexible power to adjust accomplishes two things: (i) it avoids the anomaly of having trusts that are created with broad trustee discretion over distributions denied the discretion, and the flexibility, of the power to adjust; and (ii) it preserves for the trustee the importance of income, which is easier to explain to trust beneficiaries. When there has been an adjustment between principal and income by the trustee,  and it is described to the beneficiary as  ‘income has been distributed,’ rather than ‘we decided to make an invasion of principal’ which sounds more dramatic (or drastic) even though financially the result is the same to the trust beneficiaries. While this is primarily a matter of optics, it will be helpful for the trustee when it must provide an explanation to all of the trust beneficiaries who have disparate perspectives of the trust’s administration from their different vantage points, e.g. the current beneficiary’s (I need income, now) v the remainder beneficiaries’ (‘the trustee must preserve the purchasing power of principal for our future benefit.’)

Power to Convert to Unitrust: The ultimate adjustment power of a trustee is the power to convert an ‘income trust’ to a unitrust. Instead of focusing on income in the normal sense, distributable income instead is to going to be described as a percentage of the value of the trust’s assets each year, or some other identified period. The 1997 Act did not allow a trust’s conversion to a unitrust due to tax concerns. Those concerns were resolved with final Treasury Regulations in 2002, which acknowledged a state statute that provides that “income is a unitrust amount, if the unitrust amount is no less than 3% or no more than 5% of the fair market value of the trust’s assets.”

  • Michigan: About two-thirds of the states, but not Michigan, have enacted a unitrust statute. Those state statutes usually follow the Regulation’s safe harbor by limiting the converted unitrust rate to 3% to 5% of the value of the trust corpus per year.  Michigan’s statute is limited to the trustee’s power to adjust which must be annually justified by the trustee. [MCL 555.504(1)-power to adjust between principal and income.]
  • Elimination of % Range: The UFIPA does not limit the unitrust rate to a 3% to 5% range. Instead, it provides the fiduciary wide flexibility. Examples:  (i) The converted unitrust distribution provision can determine that the percentage is tied to a published index. (ii) The unitrust provision can limit how high the percentage can go in a year. (iii) The unitrust provision can limit how low the distribution percentage can go in a year. (iv) The unitrust provision can limit how far up, or down, the percentage can move from year-to-year. (v) The unitrust provision can remove hard-to-value assets held in the trust from the need to be annually appraised. (vi) The unitrust provision can state when other trust assets can be excluded from the trustee’s determination the unitrust distribution amount.
  • Special Tax Benefits Limitation: Despite the apparent flexibility now afforded the trustee’s power of conversion to a unitrust, the UFIPA imposes restrictions to this type of flexibility if the trust is intended to achieve a specific tax benefit. Examples of these types of ‘tax benefit trusts’ include annual exclusion gifts, preserving the marital deduction, preserving the eligibility for the trust to be an S corporation shareholder, the preservation of GST exemptions, etc. In these situations, the trustee’s power to convert to a unitrust will be limited to the 3%-5% range in an annual period (which may be subject to extended smoothing adjustments in the determination of the percentage unitrust amount.)

Power to Adjust a ‘Rule of Administration’: The UFIPA acts as a governing law rule of trust administration. Restated, often the question arises if whether the trustee’s power to allocate between principal and income is a rule of trust construction, or a rule of trust administration. The importance of this question is that typically a rule of construction is governed by the law of the place where the trust was originally created. A rule of administration is typically governed by the law of the situs of the trust, which can change from time to time. The distinction between the two rules is that it will affect who receives what from the trust in many situations and, therefore, normally a power to adjust is considered to be a rule of construction, thus controlled by the law where the trust was created. However, the UFIPA specifies that the trust’s governing law will be treated as if it were a rule of administration, thus controlled by the rule of the situs of the trust or the principal place of the trust’s administration, not the settlor’s domicile when the trust became irrevocable.

Judicial Review: The UFIPA revises the UPIA’s provisions that relate to a judge’s review of a trustee’s power to adjust decision. The UFIPA identifies some remedies that a court might impose if it finds that a trustee has breached its duty of impartiality, or the trustee has abused its discretion. Under the 1994 and 1997 UPIA Acts, the sole remedy identified for these breaches was for the court to order the trustee to use the trustee’s own funds to make the beneficiary whole. This only ‘pay-it-back’ remedy is eliminated in the UFIPA. Instead, the UFIPA encourages a judge to first consider other remedies that could be used to correct a trustee’s breach of duty to make the beneficiary whole. Examples of these ‘other remedies’ include court orders that direct: (i) the trustee to not exercise a power to adjust; (ii) the trustee to not convert the income trust to a unitrust; (iii) a distribution, or to withhold future distributions from the trust by the trustee; or (iv) a refund by a trust beneficiary to the trust.

Conclusion: To date, the UFIPA has been adopted in Arkansas, California, Connecticut, Iowa, North Dakota, Oklahoma, Virginia and West Virginia. I am not aware that Michigan is seriously considering the UFIPA’s adoption at this time. That being said, it is possible for a trust instrument in Michigan to include a unitrust distribution provision in keeping with the UPIA that has been adopted in Michigan, and it is possible for the settlor to choose to have the trust governed by the UFIPA even if it has not yet been adopted in Michigan.