| EXECUTIVE SUMMARY |
Albert D. Spalding, CPA, JD, is associate professor at the School of Business Administration, Wayne State University, Detroit, Michigan. His e-mail address is aspaldi@aspaldi.com. |
The Uniform Laws Commission (see box) has introduced two new model statutes that change the statutory responsibilities of trustees and fiduciaries. The first is the Uniform Prudent Investor Act, which 36 states have enacted into law and others are currently considering.
(See exhibit 1) The second, a new Uniform Principal and Income Act, was approved by the commission on July 31, 1997 (UPIA-97). Several states already are considering adopting it.
The Uniform Prudent Investor Act raises the standard of care for trustees and other fiduciaries by requiring them to incorporate modern portfolio theory into their investment management strategies. UPIA-97 unlinks a trustee's investment strategy from its traditional impact on allocating principal and income. A trustee subject to the Uniform Prudent Investor Act, for example, might shift some trust investments out of the stock market during times of high volatility and invest the proceeds in bonds. While this would increase interest income, UPIA-97 allows the trustee to reallocate some of that income to principal beneficiaries so income beneficiaries do not enjoy a windfall triggered solely by the trustee's compliance with the Uniform Prudent Investor Act.
From the CPAs perspective, both laws have some important features, which are discussed here. CPAs themselves occasionally serve as executors and trustees, but even more frequently they provide tax, accounting and investment advice to clients who are acting as executors and trustees. CPAs can play an important role in helping clients understand and properly respond to the changes these laws have made. And still more CPAs have clients who are the beneficiaries of trusts or estates where a knowledge of these laws may prove helpful in preparing personal tax returns or doing investment planning.
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PRUDENT INVESTOR RULE
In the past, trustees were concerned about a trusts accounting
income, on one hand, and the avoidance of capital losses on the other.
When trustees investment activities were challenged by beneficiaries,
those trustees traditionally were held accountable by the courts on an
asset-by-asset basis. A trusts accounting income included dividends,
interest and the like. Stock splits, capital gains and losses and
other capital transactions were stated separately and accounted for as
part of principal rather than income.
The prudent investor rule, as implemented by the Uniform Prudent Investor Act, changes this protocol dramatically. Trustees now are accountable for a trusts overall performance; less consideration is given to how a specific asset performs. Net capital gains are part of the total performance return. For these reasons, the reporting needs of trustees under the Uniform Prudent Investor Act include measuring overall portfolio performance, inclusive of traditional accounting income plus net capital gains.
Approved by the Uniform Laws Commission in 1994, the Uniform Prudent Investor Act also requires fiduciaries to adopt the modern portfolio theory concept of investment practices. Included in the prudent investor rule of the American Law Institutes 1992 Restatement (Third) of Trusts 227 , that concept allows for substance to rule over form in managing, and accounting for, estates and trusts.
This means that in determining whether a fiduciary has met his or her duty of prudence, a beneficiary, for example, should examine the overall investment performance of the total portfolio of trust assets, not just that of specific assets. Investments should be viewed in the context of the entire portfolio, not as individual, isolated units for which the trustee is separately liable.
While the rules provide trustees with some relief on individual investments, trustees are held to a higher standard in the factors and variables they must consider when making investment decisions. For example, a trustee must take into account economic conditions (including inflation and deflation), tax consequences, the role each investment plays in the beneficiary's overall portfolio strategy, the anticipated income and capital return, liquidity and cash flow needs and the diversity of investments for risk management purposes. So, while a trustee is not necessarily in breach of the prudent investor rule if a particular investment performs poorly, he or she must be able to show how each investment meets specific risk and return objectives.
UPIA-97 AND ITS PREDECESSORS
In 1931, the Uniform Laws Commission approved its first Uniform
Principal and Income Act (UPIA-31). Originally enacted by 24 states,
and still in effect in 7 of them, UPIA-31 was intended to help
trustees resolve difficult technical questions that arose during the
discharge of their fiduciary duties and to help them make decisions.
The 1931 act also was intended to resolve many of the conflicting
opinions about fiduciary accounting matters in the courts of various
jurisdictions.
As the use of trusts increased in the years after 1931due in part to increased uniformity after UPIA-31 was enacted, the problems of allocating sums between principal and income became more acute. As business practices, corporate structures and economic conditions changed after World War II, parts of UPIA-31 began to appear inadequate. In response, a committee of the Uniform Laws Commission revised the 1931 law, resulting in the Revised Uniform Principal and Income Act (RUPIA-62), which was completed in 1962; 36 states have enacted some version of it. Its primary objective was to give more weight to the expressed intent of the settlor (or grantor) of a trust. RUPIA-62 also resolved some issues of allocation among trust beneficiaries, with an eye to administrative convenience.
| The National Conference of Commissioners on Uniform State Laws, commonly known as the Uniform Laws Commission, is made up of more than 300 lawyers, judges and law professors appointed by the 50 states as well as the District of Columbia, Puerto Rico and the U.S. Virgin Islands. The commissions charge is to draft proposals for uniform and model laws and work toward their enactment in state legislatures. Since its inception in 1892, the commission has developed more than 200 laws, including such bulwarks of state law as the Uniform Commercial Code, the Uniform Probate Code and the Uniform Partnership Act. |
Years of change. Since 1962, the business of trust management has continued to change for all concerned, including CPAs. More sophisticated investment vehicles, including derivatives, options and asset-backed securities, have become available. This, in turn, influenced the prudent investor rule and the Uniform Prudent Investor Act described above. The use of revocable living trusts by U.S. taxpayers also increased dramatically, prompted in part by the Economic Recovery Tax Act of 1981 and the tax laws that followed. Other changes affected the use of trusts, including the enactment of superfund legislation that affects trust investments in real estate, more widespread use of S corporations and limited liability companies and the increased use of buy-sell agreements, including agreements funded by life insurance and the consequential purchase of business interests by a trustee. In the last 36 years, the tax laws have become more complicated and the interrelationships among fiduciary income taxation (including the tax elections a trustee must make), estate taxation and fiduciary accounting have become more intricate.
Responding to change. UPIA-97 represents an effort by the Uniform Laws Commission to update state laws. The primary change in UPIA-97 is its coordination with the Uniform Prudent Investor Act and the modern portfolio approach to investment management.
At the outset, UPIA-97 retains a traditional approach to allocating principal and income, providing CPAs with definitions for each that reflect the fiduciary accounting theories of the earlier uniform statutes. Trustees who find the effect of using a modern portfolio theory approach on income and principal somewhat skewed may reallocate the portfolio return so both income and principal beneficiaries are treated fairly.
This is a significant change. Under UPIA-31 and RUPIA-62, the nature of receipts determined the rights of income and principal beneficiaries to those receipts. Capital gains, for example, were typically allocated to principal and ordinary dividends, to income. Under modern portfolio theory, however, an investments total return, yield plus growth over time, is more important than the respective yield-growth components. However, fiduciaries and their CPAs guided by UPIA-31 and RUPIA-62 were unable to maximize overall investment performance by adopting a modern portfolio theory investment strategy because of the old statutory requirement to balance a portfolio between income-oriented investments (for the sake of income beneficiaries) and growth-oriented investments (for the sake of principal beneficiaries). The result? Hampering of the aggregate return of trust investments. For example, fiduciaries did not have the flexibility to move large blocks of trust assets back and forth between equity investments (during stock market upsurges) and income-oriented investments (during times of rising interest rates).
UPIA-97 grants fiduciaries the power and discretion to reallocate investment returns to income and principal, irrespective of whether that return was derived primarily from capital gains, ordinary dividends or interest. The goal of this provision is to allow fiduciaries to make aggregate investment decisions that maximize overall return and then to reallocate that return among principal and income beneficiaries in a reasonable manner.
Exhibit 2, shows some of the other significant changes UPIA-97 makes. For example, the act draws a distinction between sole proprietorships and other unincorporated businesses. For sole proprietorships, the new rules discard RUPIA-62s concept of cashing out book income. Instead, the fiduciary is allowed to determine a business's cash flow needs and to distribute only the excess cash to income beneficiaries. Corporations, partnerships, limited liability companies, regulated investment companies, real estate investment trusts and other estates or trusts can, under UPIA-97, use a cost method approach. Only distributions from such entities are recorded as income.
HOW IT ALL WORKS
The following examples reflect the changes UPIA-97 and the
Uniform Prudent Investor Act brought about.
Example 1. Allen is the trustee of a trust that provides income to the settlor's surviving spouse for life, with the remainder to the settlor's children. Allen received a portfolio of investments from the settlor comprising 95% bonds and certificates of deposit and 5% stocks. Under UPIA-31 and RUPIA-62, Allen would account for interest and dividends as income and capital gains as principal. Under UPIA-97, however, Allen would consider whether to allocate a portion of the interest income to principal as a return of capital. In making this determination, Allen would consider the loss of principal value due to inflation and other factors.
Example 2. Assume the same facts as in example 1 except trustee Allen decides to balance the trust portfolio by liquidating some of the bonds and CDs and investing the proceeds in a combination of stocks, growth mutual funds and equity mutual funds. While this results in greater diversification and more growth in the portfolios value over time, it also reduces the overall yield of dividends and interest. Under UPIA-31 and RUPIA-62, Allen's CPA would continue to account for interest and dividends as income and capital gains (including capital gain dividends) as principal. Under UPIA-97, however, Allen would consider whether to instruct his CPA to allocate to income a portion of the capital gains realized by stocks and stock mutual fund investments.
In deciding whether and to what extent to make allocations between principal and income, trustees, according to section 104(b) of UPIA-97, must consider the
- Nature, purpose and expected duration of the trust.
- Intent of the settlor.
- Identity and circumstances of the beneficiaries.
- Need for liquidity, regularity of income and preservation and
appreciation of capital.
- Assets held in the trust; the extent to which they consist of
financial assets, interests in closely held enterprises, tangible
and intangible personal property or real property; the extent to
which an asset is used by a beneficiary; and whether an asset was
purchased by the trustee or received from the settlor.
- Net amount allocated to income under other sections of the act and
the increase or decrease in the value of the principal assets, which
the trustee may estimate for assets without readily available market
values.
- Extent, if any, to which the terms of the trust give the trustee
the power to invade principal or accumulate income or prohibit the
trustee from invading principal or accumulating income and the
extent to which the trustee has exercised a power from time to time
to invade principal or accumulate, income.
- Actual and anticipated effect of economic conditions on principal
and income and the effects of inflation and deflation.
- Anticipated tax consequences of an adjustment.
UPIA-97 specifically prohibits a trustee from making any adjustment
- That diminishes the income interest in a trust requiring all
income to be paid at least annually to a spouse and for which an
estate tax or gift tax marital deduction would be allowed, in whole
or in part, if the trustee did not have the power to make the
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.
- That changes the amount payable to a beneficiary as a fixed
annuity or a fixed fraction of the value of the trust assets.
- From any amount permanently set aside for charitable purposes
under a will or the terms of a trust unless both income and
principal are set aside.
- If possessing or exercising the power to make an adjustment causes
an individual to be treated as the owner of all or part of the trust
for income tax purposes and the individual would not be treated as
the owner if the trustee did not possess the power to make an
adjustment.
- If possessing or exercising the power to make an adjustment causes
all or part of the trust assets to be included for estate tax
purposes in the estate of an individual who has the power to remove
a trustee or appoint a trustee, or both, and the assets would not be
included in the estate if the trustee did not have the power to make
an adjustment.
- If the trustee is a beneficiary of the trust.
- If the trustee is not a beneficiary but the adjustment would benefit the trustee directly or indirectly.
PRIMACY OF THE DOCUMENT
Despite the changes UPIA-97 promulgated, one concept has not
changed: the primacy of the written instrument. The statute retains
the predominance of the trust document or will in prescribing
accounting methods that are inconsistent with the statute, providing
that a fiduciary shall administer a trust or estate in accordance with
the terms of the trust or the will, even if there is a different
provision in this [act]. Each testator or settlor is therefore granted
the power to override any or all of the accounting rules the Uniform
Law Commission developed.
UPIA-97 also retains the power of the testator or settlor to grant discretion to her or his trustee in adopting accounting periods and methods, providing that a fiduciary may administer a trust or estate by the exercise of a discretionary power of administration given the fiduciary by the terms of the trust or the will even if the fiduciary exercises that power in a manner different from a provision of this [act]. Many, if not most, trust documents include this type of discretion in the list of trustee powers.
Settlors always have had the right to override statutory principal and income provisions by prescribing specific accounting and allocation methods. For example, under UPIA-31, settlors sometimes called for a charge to depreciation against rental income, so a depreciation reserve, to be used for major repairs and improvements, is accumulated on behalf of the principal beneficiary. On the other hand, under RUPIA-62, settlors sometimes proscribed depreciation, so most of the net cash flow from rental property is distributed to the income beneficiaries.
UPIA-97 does not change the settlor's ability to customize the document in an effort to preempt state law. In jurisdictions that have enacted UPIA-97, settlors might, on the advice of their CPA, choose to override the statute and reinstate traditional principal and income concepts.
Example 3. Wanda wants income from specific assets, rental real estate property, to accrue to the benefit of a specific beneficiary, her surviving spouse, George. Under UPIA-97, Wanda's CPA recommends she limit the trustees power to reallocate such income (that is, to treat a portion of the income as a return of capital) by denying the trustee the power to make an adjustment with regard to the net rental income from that property.
Example 4. Morton chooses to simplify the management of the trust he creates by requiring that traditional income items, such as interest and ordinary dividends, be allocated to the income beneficiary and traditional principal items, such as capital gains, be allocated to the principal beneficiary. Under UPIA-97, Morton may deny the trustee the power of adjustment altogether.
IMPACT ON FIDUCIARY TAXATION
The statutes described here will affect the relationship between
fiduciary accounting and fiduciary taxation in two ways:
- Fiduciary accounting or book income (reported as accounting income
on line 10 of schedule B on Form 1041, Fiduciary Tax Return
) serves as a ceiling or limitation on distributable net
income. With the trustee's power to make allocations (such as
capital gains to income beneficiaries or interest income to
principal beneficiaries) for fiduciary accounting purposes, it is
likely the differences between book income and taxable income will
become more pronounced. This may require the trustees CPA to produce
more complex tax workpapers.
- UPIA-97 allows the trustee to take into account tax costs and tax benefits when making allocations between beneficiaries. Before making such an allocation, a trustee will need tax impact information from his or her CPA, further increasing the CPAs involvement in trust management.
HELPING IN NEW WAYS
In addition to sometimes serving as trustees themselves, CPAs
traditionally assist trustees with identifying and selecting
accounting methods, producing fiduciary accounting statements for
distribution to beneficiaries and preparing forms 1041 for fiduciary
tax compliance purposes. In addition, more CPAs are also providing
advice on selecting investments. (See exhibit 3, for a list of
the traditional and expanded roles CPAs play in helping testators and
settlors.) With the advent of the Uniform Prudent Investor Act and
UPIA-97, CPAs may be called on to assist trustees in new ways and may
be asked to produce fiduciary accounting information that helps users
understand the trustee's compliance with these standards.
When clients have wills and trusts drafted or updated by their attorneys, they often ask their CPAs advice. In this advisory role, CPAs traditionally help clients (and often clients' attorneys) prescribe accounting methods, allocate assets to trusts and similar matters. (See exhibit 4, for the expanded role of CPAs in assisting trustees.) In jurisdictions where the new uniform acts are being legislated into law, CPAs also must be prepared to help settlors, testators and grantors decide whether to adopt the new approaches or to override the new laws with language in new or updated trusts that retains the traditional approach. For example, CPAs might suggest the trust document of a client whose estate consists primarily of a sole proprietorship provide that after his or her death the trustee can continue to use the same accounting methods, including depreciation, as were used before the clients death.
AN ADVISORY ROLE
Exhibit 1 lists the
version of the UPIA in effect in each state as this issue of the
Journal goes to press. CPAs in all states who practice in
tax, financial and estate planning or who work with trustees must
familiarize themselves with the Uniform Prudent Investor Act. As
states consider that act and begin to adopt UPIA-97, CPAs should
become familiar with these provisions as well. These new statutes
change the duties, and therefore the reporting needs, of trustees and
the CPAs who advise them. They also expand the opportunities for CPAs
to serve in an advisory role at the time clients are having trust
documents drafted or updated. In particular, CPAs should carefully
examine client trust documents in light of these new statutes. CPAs
can then decide if the documents would be improved with the addition
of detailed accounting and investment instructions. In this way,
trustees would be guided by clients' wishes rather than by the
trustees' interpretations of increasingly complex state laws.
