Robert B. Wolf, Esq.

Article Courtesy Leimberg Information Services, Inc. (http://www.leimbergservices.com)

You may have breezed by it.  It’s understandable.  A regulation changing the federal income tax definition of trust accounting income to comport with state law changes might seem, at a very quick glance, to be another unimportant, ho hum, highly technical fix of interest only to academics and legal scholars. 

BUT, take it from me, TO ESTATE PLANNING PRACTITIONERS AND OUR CLIENTS, REG-106513-00 MAY BE THE SINGLE MOST IMPORTANT REGULATORY CHANGE OF THE DECADE!

REG-106513-00 may well signal nothing less than a sea change in trust planning - and may have arrived at the very time (the increase in unified credit exemptions, gradual lowering of the top rates,  and possible repeal of the estate tax) when it is needed most by life insurance agents and advisors.  The long term implications of this proposed regulation must be understood and should not be underestimated by any estate planning attorney, CPA, trust officer, life insurance agent, or financial planner!

So what is the story?

Somewhere, in a galaxy far, far away, some years ago, the world of total return investing collided with the age-old trust concept of “invest to maintain the principal and produce income”. The world of Total Return Investing survived and thrived. The age-old concept of principal and income was mortally wounded, and has been dying ever since.

The Proposed Regulations revising the definition of income under 643(b) of the Internal Revenue Code provide confirmation of the “death” of the old, and the birth of the new.  Like all of such events that we see in space, the “collision” occurred many years ago.  But due to the distance, the light from the event is just now reaching our eyes. Perhaps we would have seen it sooner, but for the glare of death taxes, which kept us from seeing the obvious.

But with the future of federal estate taxes currently much in doubt, it is interesting, encouraging, and even exciting to observe that the Treasury is one of the first, rather than one of the last, to recognize the event, and adapt itself sensibly to new investment realities.

ALREADY IN A THEATER NEAR YOU!

A total of 13 states have adopted the new Uniform Principal and Income Act with the Power to Adjust between Principal and Income, with 8 introductions in 2001. A total of 5 states (New York (Passed by Legislature-waiting for Governor to sign), Missouri (Now Law), Pennsylvania (Bill Form), New Jersey (Passed by the legislature--waiting for Governor to sign) and Delaware (Now Law) have enacted or are close to enacting legislation to allow a unitrust definition of income as an additional alternative to the power to adjust.  Clearly, REG-

106513-00 will provide significant impetus to accelerate the adoption of such laws.

REGS VERY POSITIVE!

The Treasury department has placed its blessing on both the power to adjust and the unitrust with the Proposed Regulations, and in doing so, is providing guidance precisely when it is needed, rather than after it has been needed for a long time.

            “The proposed changes to the regulations will permit trustees to implement a total return investment strategy and to follow the applicable state statutes designed to treat the income and remainder beneficiaries impartially.”  (Explanation of Provisions, Federal Register at 10397)

SPECIFIC IMPACT OF PROPOSED REGS:

What DO these proposed regulations do in connection with these state law changes?

*          They bless a state law unitrust interest and a principal and income act with the power to adjust as qualifying for the marital gift and estate tax deduction. A conforming change is made in the QDOT regulations.

*          They allow the use of an ordering rule by the governing instrument or by state law, which includes short and long term capital gains in DNI.

*          They allow the administration of a trust that was GST grandfathered to retain its exempt status where such trust is converted to a unitrust pursuant to a state statute which defines income as a unitrust amount or which permits the power to adjust.

What DON’T the regulations do in connection with these state law changes?

*          They do not allow the charitable deduction in a pooled income fund for capital gains if the income beneficiary’s rights to income may be satisfied by a unitrust amount.

*          They do not allow for purposes of a net income charitable remainder unitrust for the income to be defined as a unitrust amount. The trust must have its own definition of income.

DRAFTING IMPLICATIONS:

What are the implications of these proposed regulations on the drafting of trusts and on state legislatures considering the passage of laws affecting the definition of income under the proposed new Uniform Principal and Income Act?

C                   The promulgation of these Proposed Regulations indicates that Treasury views the sea change in the definitions of income and the way distributions are described in trusts as inevitable and sensible. They are facilitating, if not actually encouraging, these changes, which are, in the final analysis, tax neutral and helpful.

C                   The marital deduction can only be ensured in the context of a unitrust payout or the power to adjust where there is a conforming state law change, so that it meets the definition of income under the new regulations 1.643(b).  Without the state law change, the unitrust would have to be an “income or unitrust interest, whichever is the greater.”  Please note:  The power to adjust could never be placed in the governing document without a conforming state law!

C                   Changes in GST grandfathered trusts are only safe in the context of a state law change. A court modification to a unitrust payout without the state law change would require an income or unitrust, whichever is greater approach.

C                   The regulations specifically mention a unitrust amount of between 3 and 5%

 as being a reasonable allocation of return between the current and remainder  

 beneficiaries. Legislatures are likely to be encouraged to enact laws within these limits, to be sure that they are coloring inside the critical tax lines.

MAJOR DISTINCTIONS IN TAX TREATMENT BETWEEN “DO” and DON’T STATES!

It’s obvious that states which have the new principal and income act and which also have an elective unitrust option will benefit trustees and beneficiaries of existing trusts which may otherwise be locked into the dysfunctional income and principal distinctions.  As importantly,  new trusts in those states can be drafted more effectively with more certain and beneficial tax effect than in those states which hang back from enacting legislative relief.

Why is this distinction so important?  States which do promptly enact such statutes now have a significant competitive edge in the attraction and preservation of trust business within their borders.

WHAT I’D LIKE TO SEE ADDED TO THE REGULATIONS:

What is missing from these regulations? Well, first, let me say that there is always something missing.  But these regulations reflect an extraordinary effort on the part of the Treasury and IRS to facilitate beneficial change that does not conflict with valid tax policy.

But there is always something missing. That is why they call them PROPOSED regulations.

Here is my WISH LIST:

1.      Virtually everyone who has considered these matters, and all of the state legislatures of which I am aware considering a unitrust definition of income, is providing for or allowing a “smoothing rule”, whereby the unitrust amount is multiplied times an average of the last three years’ ending market values or the like. The smoothing rule is a strictly economic and beneficiary-oriented feature to avoid excessive volatility in the distribution. It would be helpful to add a smoothing rule to Example 9.

2.      With respect to the ordering of ordinary income, short and long term capital gain Example 9 refers to state law providing the ordering rule. Example 10, reflects the situation in which “neither State law nor Trust’s governing instrument has an ordering rule for the character of the unitrust amount, but leaves the decision to the discretion of the trustee.” There is no example in which state law is silent but the governing instrument has a consistent ordering rule. I would assume that this is O.K., since the Explanation of Provisions  states  that capital gains are includible in DNI  to the extent they are “pursuant to the terms of the governing instrument OR local law” allocated to income. This is somewhat important simply because it will be awhile before all of the states have addressed these issues, and in the meantime, drafters in the slower states will still want to be able to draft for tomorrow today.

3.      On a similar but broader note, what about other types of total return trusts, like index payout trusts, as Bill Hoisington has suggested, or TRUCAP index trusts (indexed for inflation but with a unitrust cap), as I have suggested, or graduated unitrusts (3% at 30, 4% at 40 and 5% at 50) as David Diamond has suggested, or the Planned Income Trust (an index payout trust with a 3% minimum increase each year as Frank Croak has suggested)?  If the governing document has a consistent ordering provision, such as the one quoted in the proposed regulations, there seems little reason for Treasury to be concerned with their application.

4.      The use of an ordering rule simply allows the drafter to be sure of the tax assumptions that may impact the proper choice of payout. Otherwise, the ordering rule or a consistently applied trustee’s discretionary power will give predictability to the situation while remaining essentially tax neutral.

5.   In the exceptions prescribed for the NIMCRUT and Pooled Income Trust, we are reminded that the original rules concerning charitable split interest trusts evolved at a

time when interest rates were high and the concern initially was that payouts from charitable trusts to the charities would be unfairly low or even  inconsequential, and that therefore the charitable goals could not be achieved. Enigmatically, perhaps simply to provide parity in the rules, the same rules requiring a 5% minimum payout to the charities were also applied to the non-charitable beneficiaries.

Today, in an ordinary CRUT, now that we are required to have at least 10% of the actuarial value passing to the charity, it is difficult to draft a CRUT for a young person, because the 5% mandatory payout typically makes their interest too big and the charity’s interest too small. If we were allowed to use a lower percentage for the CRUT (down to 3% for example) these important charitable vehicles would not be arbitrarily limited to those 26 years of age and older.

In the long run charities would profit by this expansion, because the 5% limitation impedes the use of these valuable charitable vehicles for a parent and child or grandchild. The 10% minimum on the charitable interest will protect the policy concerns adequately without arbitrarily limiting the use of  these valuable trusts. This would be an ideal time for Treasury to reconsider their position on minimum payouts generally and perhaps Section 4942 also, now that they have wrestled with the major changes in the concept of income.

WHERE CAN I LEARN MORE?

For articles and outlines on TRUs by David Diamond, Michel Nelson, Mark Edwards, Bob Wolf, Patti Spencer, Jim Dam, and from Forbes, go to http://www.leimberg.com and look on the far right hand side under TRUs. (And be sure to search Leimberg Information Services archives for more).  Multi disciplinary practitioners will find “Proposed Regs. On the Definition of Trust Income: The Best Thing for Life Insurance Since Sliced Bread!, Estate Planning Magazine (May 2001). Also, don’t miss Estate Planning Magazine (July 2001, Vol. 28, No. 7, Pg. 308) where you’ll find Laura Howell-Smith’s comprehensive and well presented analysis, “How Prop. Regs. On the Definition of Income Affect Total Return Trusts which analyzes tax consequences of TRUs.  The latest article published in the popular press can be found in Bloomberg News, Friday, July 13^th entitled, “The TRU Takes Off”.