New Rules For Trustees In New York

by Michael S. Kutzin Goldfarb Abrandt Salzman & Kutzin LLP

On September 4, 2001, Governor Pataki signed into law 2001 N.Y. Laws 243, which made substantial changes to the Estates Powers and Trusts Law. The two most important changes to the EPTL are the powers to make adjustments between principal and income, and the ability to compute income using a “unitrust” computation.

Power to Adjust.

Under the new rules, a Trustee is given the power to make discretionary allocations between income and principal. New EPTL 11-2.3 (b) (5). In deciding whether to make a discretionary allocation, a Trustee “may” consider the following factors in making or declining to make a discretionary allocation between income and principal:

  1. The intention of the Settlor as expressed in the governing instrument;
    1. Your spouse, if not legally separated from you, or your domestic partner.
    2. Your spouse, if not legally separated from you, or your domestic partner.
    3. Your spouse, if not legally separated from you, or your domestic partner.
  2. The assets held in the trust;
  3. The extent to which they consist of financial assets, interests in closely held businesses, tangible, intangible or real property;
  4. The extent to which an asset is used by a beneficiary;
  5. Whether the asset was received from the Settlor or purchased by the Trustee;
  6. The net amount allocated to income and the increase or decrease in the fair market value of principal assets;
  7. The powers given to the trustee to invade principal or accumulate income, and the extent to which the Trustee has exercised such powers.

New EPTL 11-2.3 (b)(5)(B). While the statute says “may,” a Trustee who may be called upon to defend the decision should be prepared to document how these and other pertinent factors were taken into account.

The Trustee is prohibited from exercising the power:

  1. If it would diminish an income interest in a trust that qualifies for the marital deduction;
  2. If it diminishes the actuarial value of an income interest to which a person transfers property intending to qualify for a gift tax exclusion (e.g., charitable lead trust);
  3. In a manner that would change the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of trust assets;
  4. If it would take property from any amount permanently set aside for charitable purposes, unless the income is also permanently set aside for charitable purposes;
  5. If having the power or exercising it would result in the Trustee being treated as the owner of the trust under the Grantor Trust rules, assuming that the Trustee would not otherwise be so treated;
  6. If having the power or exercising it would result in the inclusion of all or part of the trust assets as being includible in the gross estate of the Trustee for Federal Estate Tax purposes;
  7. If the Trustee is a current beneficiary or a presumptive remainderman of the trust;
  8. If the adjustment would otherwise benefit the Trustee directly or indirectly; or
  9. If the trust is a “Medicaid trust” and the adjustment power would result in either additional income or principal to be treated as available income or available resources (contrast to unitrust rules).

New EPTL 11-2.3(b)(5)(C). A co-Trustee may exercise the adjustment power that another Trustee is prohibited from exercising if the co-Trustee is not himself prohibited from exercising that power, either by statute or under the terms of the Trust. New EPTL 11-2.3(b)(5)(D).

Lawyers, trust settlors and trustees must bear in mind that boilerplate language that limits the Trustee’s power to make adjustments between principal and income is not deemed to override the powers given to a Trustee by EPTL 11-2.3(b) unless “it is clear from the terms of the trust that the terms are intended to deny the trustee the power of adjustment conferred by [EPTL 11-2.3] (b)(5)(A).” New EPTL 11-2.3(b)(5)(D).

EPTL 11-2.3-A sets forth, in a perfunctory manner, a standard for judicial oversight of this power of adjustment. A Trustee cannot be found to have abused his discretion by the exercise or nonexercise of a power of adjustment merely because the court would have come to a different conclusion as to whether to so exercise. EPTL 11-2.3-A(a). In other words, a court cannot merely substitute its judgement for that of a Trustee. It can only reverse the determination of the Trustee if it finds an abuse of discretion.

If a court finds that a Trustee has abused his discretion, the court can make a necessary adjustment to make a beneficiary whole by either requiring a distribution, requiring a holdback from one or more future distributions, requiring a beneficiary to return some or all of a distribution, or, if neither will make the wronged beneficiary whole, AND the Trustee was was dishonest, arbitrary or capricious in the exercise of discretion, the Trustee can be required to make the beneficiary whole out of his own funds. EPTL 11-2.3-A(c).

Preemptive Determination Request.

A Trustee can petition the court for a determination of whether the exercise or nonexercise of the adjustment power would be an abuse of discretion (in effect, an advise and direction proceeding in this realm). If the Trustee describes the proposed adjustment with sufficient detail to inform the beneficiaries with the reason for the proposal, and the facts that the Trustee relies upon , and how the income and remainder beneficiaries will be affected, an objecting beneficiary bears the burden of establishing that the proposed exercise or nonexercise of the adjustment power is an abuse of discretion.

The effective date for power to adjust between principal and income is January 1, 2002.

Unitrust Computation for Income.

Section 11-2.4 was added to the EPTL to provide for an optional computation of income using a unitrust amount rather than the standard amount provided under the Uniform Principal and Income Act (as it was reenacted under new Article 11-A of the EPTL).

While this new optional unitrust computation becomes available on January 1, 2002, the election to use this unitrust computation may be made for trusts in existence prior to this date, as well as to trusts subsequently established. For any trust established prior to 1/1/02, this optional methodology for computing trust income may be chosen if, on or before 12/31/05, the Trustee, either with the consent of all persons interested in the trust, or in the Trustee’s own discretion, elects to have the unitrust provisions apply to the trust. EPTL 11-2.4(e)(1)(B)(I).

For any trust not in existence on 12/31/01, the election to have the unitrust provisions apply to the trust must be made by the Trustee, with or without the consent of all persons interested in the trust, on or before the last day of the second full year of the trust beginning after assets become subject to the trust. EPTL 11-2.4(e)(1)(B)(II).

The election is made by delivering an executed and acknowledged instrument to the grantor of the trust (if living), to all persons interested in the trust, their representatives, and to any court that has jurisdiction over the trust. EPTL 11-2.4(e)(1)(B)(III).

The statute provides factors to be taken into account in determining whether the optional unitrust provisions should be applied to a trust:

  1. Nature, purpose and duration of trust;
  2. Intention of grantor of trust;
  3. Identity and circumstances of beneficiaries;
  4. Needs for liquidity, regularity of payment, and preservation and appreciation of capital;
  5. The assets held in the trust;
  6. The extent to which they consist of financial assets, interests in closely held businesses, tangible, intangible or real property;
  7. The extent to which an asset is used by a beneficiary; and
  8. Whether the asset was received from the Settlor or purchased by the Trustee.

EPTL 11-2.4(e)(5)(A).

The unitrust provisions will also apply if the governing instrument specifically provides that the unitrust provisions will apply to the trust. EPTL 11-2.4(e)(1)(B)(a).

Unlike the discretionary adjustment rules, the new unitrust provisions contain NO restrictions about when they can be elected. It does not matter whether the power to make such an election would have deleterious tax consequences, or whether the availability of the election could render some or all of the assets of a “Medicaid proof” trust as available resources.

It should be noted, however, that Proposed Treasury Regulations published on February 15, 2001, if finally promulgated, would eliminate the potential problem of the election or nonelection of the unitrust provisions by a non-spouse trustee of a QTIP, power of appointment or estate trust as possibly disqualifying the trust for the marital deduction. Prop. Treas. Reg. §20.2056(b)-5(f)(1) provides that a spouse’s entitlement to income is based upon state law’s reasonable apportionment between principal and income . Reasonable apportionment includes unitrust payments and equitable adjustments. Prop. Treas. Reg. §1.643(b)-1.

Judicial Review of Election of Unitrust Provisions.

A trustee or beneficiary can petition a court with jurisdiction over the trust on notice to all persons interested in the trust to direct that either the unitrust provisions or the Uniform Principal and Income Act should apply to the trust. EPTL 11-2.4(e)(2)(A) and (B). There is a rebuttable presumption in any such proceeding that the unitrust provisions should apply to the trust. EPTL 11-2.4(e)(5)(B).

Note that there are no standards for how to remedy an abuse of discretion, unlike the provisions for a discretionary adjustment between income and principal.

Effectiveness of Election or Judicial Review.

If the governing instrument provides for applicability of unitrust provisions, an election is made, or a judicial determination is made that the unitrust provisions should apply, the unitrust provisions are applied as of the first year of the trust in which assets became subject to the trust (i.e., retroactively), unless

  1. The governing instrument or court order provides otherwise, or
  2. The election is expressly made effective as of the first day of the first year of the trust commencing after the election is made. EPTL 11-2.4(e)(4)(A).

If a court determines that the Uniform Principal and Income Act should apply to the trust rather than the unitrust provisions, the unitrust provisions cease to apply as of the first day of the year beginning after the decision of the court becomes final, unless the court decision says otherwise. EPTL 11-2.4(e)(4)(B).

The Mechanics of the Unitrust Provisions.

The election is to have “net income” defined as 4% of the net fair market value of the trust principal. For the first three years of the trust, the unitrust amount for the trust is 4% of the net fair market value of the trust on the first business day of the current valuation year. EPTL 11-2.4(b)(1). For years four and thereafter, the unitrust amount is 4% of the average of the net fair market value of trust assets for the current valuation year and the preceding two years. EPTL 11-2.4(b)(2); (c)(2) and (c)(3).

In other words, the unitrust amount after the first three years becomes a three year moving average, so that the unitrust value does not increase or decrease as precipitously as it does in a charitable remainder unitrust.

The unitrust amount is to be “proportionately reduced” for any distribution to beneficiaries that are mandated by the terms of the trust, and “proportionately increased” for the receipt of additional property to the trust (not including any return on investment). EPTL 11-2.4(b)(3). Any mandatory distribution to beneficiaries or receipt of additional trust property that results in proportionate reduction or proportionate increase in the unitrust amount is reflected by reducing or increasing the net fair market value for each of the preceding two years as of the first day of such prior years. EPTL 11-2.4(b)(4).

“Net fair market value” is defined as the fair market value of all assets held in and included in the trust for valuation purposes, minus any “outstanding interest-bearing obligations of the trust, whether allocable to a specific asset or otherwise.” EPTL 11-2.4(c)(5).

Residential or tangible personal property that, as of the first business day of the valuation year, one or more “current beneficiaries” had the right to occupy, possess or control (other than in a fiduciary capacity) is not included as an asset of the trust for purposes of determining the unitrust amount. Distribution or receipt of such property, however, results in an adjustment in the unitrust amount. EPTL 11-2.4(c)(6)(A).

The unitrust computation is made on a calendar year basis. EPTL 11-2.4(c)(4). In the event of a short year, the Trustee must prorate the unitrust amount on a daily basis. EPTL 11-2.4(b)(5).

Commissions from a trust where income is defined using the unitrust provisions are paid directly from principal after the payment of the unitrust amount, rather than the usual 1/3 – 2/3 split between income and principal. SCPA 2308(3), 2309(3) and 2312(5) as amended.

Highlights of new Uniform Principal and Income Act (New Article 11-A of the EPTL).

Aside from the new powers to adjust between principal and income and the optional right to compute trust income on a unitrust basis, the changes to the EPTL that were enacted on September 4th include a new Uniform Principal and Income Act (“UPIA”). The following discussion contains highlights of changes made to the UPIA in New York, and is not meant to be comprehensive in scope:

New Default Rule for Allocation of Principal and Income.

If a trust or will is silent regarding an allocation between principal and income, the governing instrument does not give a Trustee the discretion to allocate such an item, and the new statute is silent regarding the allocation, the Trustee must allocate to principal. EPTL 11-A-1.3(a)(4).

The rule under the prior UPIA called for a “reasonable and equitable” allocation based on the facts and circumstances under the prudent man standard. EPTL 11-2.1(a)(1).

Satisfaction of Outright Pecuniary Interest from Income.

The new UPIA calls for payment of pecuniary interest to be paid out of income first, and if inadequate, from principal. EPTL 11-A-2.1(3).

Change in Allocation of Stock Dividends.

The New UPIA eliminates the allocation of 6% of a stock dividend to income – all distributions in property other than money are allocated to principal. EPTL 11-A-4.1.

Elimination of “Underproductive Asset” Rule.

Under the prior UPIA, upon the sale of an asset that did not generate an average of at least 1% in fiduciary accounting income each year that was not traded on a national securities exchange or trade over-the-counter (a so-called underproductive asset), 5% per year held (simple interest) of the sales proceeds had to be allocated to income. The new UPIA does not have such a rule per se, but instead provides for up to 10% of receipts from certain assets to be characterized as income, as will be discussed below.

Addition of Concept of “Liquidating Asset” (e.g., patent, copyright, royalty).

Calls for allocation of 10% of receipts to income and balance to principal. EPTL 11-A-4.10.

Deferred Compensation, Annuities and Similar Payments.

Provides that if no part of payment is allocable to interest or dividends, must allocate 10% of payment to income. EPTL 11-A-4.9.

Derivatives and Options.

To extent that derivative trading is not treated as a business activity of the fiduciary, all receipts are allocable to principal. EPTL 11-A-4.14(b). Similarly, a Trustee is required to allocate an amount for option granted or exercised to principal. EPTL 11-A-4.14(c).

Asset-backed securities.

If the underlying assets paying interest or provide “other current return,” allocate such interest or current return to income and the rest to principal. EPTL 11-A-4.15(b). If the trust instead receives one or more payments in exchange for entire the interest in the asset-backed security in one accounting period, a trustee must allocate all payments to principal. EPTL 11-A-4.15(c). However, if the payment is one of a series of payments that will result in liquidation of trust’s interest in the security over more than one accounting period, there Trustee again must allocate 10% of the receipts to income and the rest to principal.

Conclusion.

While the changes to the New York Estates Powers and Trusts Laws provide greater potential equity between income and principal beneficiaries, the added discretion provides potential controversy over the exercise of discretion and the impact, expected and unexpected, on the trust beneficiaries.

Any trustee of a trust governed under New York law must become familiar with these new rules or retain attorneys who understand them. Similarly, any person who would create such a trust, either during his or her lifetime or, through a will, at death, should work with counsel who has a real understanding of the new rules and the potential impact that they may have on someone’s estate planning.