Brief ⁽¹⁾

HB 2501 would enact a revised version of the Uniform Principal and Income Act (UPIA). The purpose of the new Act is to provide procedures for trustees administering an estate in separating principal from income and to ensure that the intention of the trust creator is the guiding principle for trustees.

Major provisions of the bill are the following:

Initial Rule

The express language of the trust instrument, will, or other applicable document will govern, notwithstanding conflict with any statutory rule. The new Act is entirely a default statute that operates only when the governing instrument is silent.

Allocation to Principal or Income

Principal is fundamentally defined as the property held in trust for distribution to a remainder beneficiary when the trust terminates. Income is the current return that any fiduciary receives from an asset that is principal. There is a group of rules that establish what is principal and what is income with respect to specific kinds of assets.

The UPIA refines old rules and provides specific rules for assets that are not accounted for in the earlier acts. An example of the refinement of old rules concerns receipts from an entity. The earlier uniform acts provide for corporate distributions, generally allocating ordinary dividends to income and any other distribution in the form of additional equity to principal. The new Act addresses the broader category of receipts from an "entity." A corporation is an entity, but so is a partnership, a limited liability company, a regulated investment company, and a real estate investment trust. The bill allocates the receipts from all entities in the same manner.

The bill simplifies the allocation question. Any "money" received by a fiduciary is regarded as income, unless it fits certain categories. For example, if money is received as part of a liquidation of the entity, it is principal. If money is received from an investment company (mutual fund) that labels a distribution as capital gain, the receipt is principal. All property received that is not money, i.e., a stock distribution, is principal. In addition, the bill establishes what qualifies as a partial or complete liquidation of an entity. Fiduciaries will be better able to make judgments about receipts that are part of a liquidation. This is a more precise and logical set of rules for making allocations than exists in the earlier uniform acts, making fiduciaries' decisions easier and more certain.

There are certain kinds of assets that the bill provides for that are just not within the scope of consideration in the earlier acts. One of them is derivatives. Another is asset-based securities. Receipts form derivatives, unless a trustee exercises powers available in the conduct of a business held in trust, are principal. Receipts from asset-based securities are either income or principal, depending upon the categorization of the asset backed security's payor.

Apportionment Issues

The beginning point and the ending point of an income interest in an estate or a trust provide particular problems, even though the incoming assets would clearly be income under the rules applied during the life of the income interest. Depending upon the time of receipt, an asset that is otherwise classified as income may have to be apportioned at least in part to principal to balance beneficiary interests. The Act more precisely and simply provides for that apportionment than the earlier acts did.

The UPIA provides, generally, that an income receipt is principal if it is due before a decedent dies in the case of an estate or before an income interest begins in the case of a trust. After death or after an income interest begins, it is classified as income. If there is income that is not distributed at the time the income interest ends, generally it is paid to income beneficiaries. But if the trust is revocable by an income beneficiary at an amount more than 5 percent of the trust's corpus immediately before the income interest ends, the undistributed income allocable to the revocable part, must be added to principal.

Right to Payment

The bill expressly requires distribution of net income and principal receipts to the appropriate beneficiaries when a decedent dies or when an income interest ends. There is discretion given to pay certain expenses out of either principal or income unless there is an adverse effect on estate tax marital deductions or income tax charitable deductions. General expenses of an estate are paid from principal. A specific pecuniary amount required to be paid, is paid from income unless insufficient. The deficiency is paid from principal. If there is any net income after the fact, it is distributed to remainder beneficiaries according to share in principal.

These rules assure orderly distribution of income when the decedent dies or an income interest ends. The earlier uniform acts make no attempt to deal with this distribution problem.

Adjustment Powers

For Prudent Investment. A trustee must use prudent investment rules in any state that has adopted the UPIA or equivalent statute, and in any case governed by the Restatement of the Law of Trusts III. The investment policy governing a trusts' assets depends upon making the appropriate risk/return analysis and investing accordingly. Asset growth can be as significant an objective as income in setting the investment policy for a specific trust. Because a trustee may weight either growth or income significantly in making investment decisions, and because either may be greater or less than anticipated, the trustee may have to rebalance the interests of remainder and income beneficiaries as a result.

The bill allows the trustee to adjust principal and income to the extent made necessary by prudent investment when a trust provides for a fixed income for the income beneficiary. This must be a careful decision before which "a trustee shall consider all of the factors relevant to the trust and its beneficiaries." The express list of factors includes "the nature, purpose, and expected duration of the trust"; and "the intent of the settlor." Adjustments are forbidden in certain circumstances, such as when they diminish "the income interest in a trust that requires all of the income to be paid at least annually to a surviving spouse and for which an estate tax or gift tax marital deduction would be allowed..." or "if the trustee is a beneficiary of the trust..."

The earlier uniform acts did not deal with adjustment as a result of prudent investment. The whole notion of prudent investment, modern portfolio theory, and total return came later than either of the two earlier acts. The Act makes prudent investment work to its full capacity.

For Disbursements during the Administration of a Trust. Expenses and taxes must be paid during the administration of a trust. Generally, the UPIA provides for payment of ordinary expenses out of income, for payment of compensation to the trustee and legal proceedings from principal and income, dividing expenses in two, and payment of expenses peculiar to the reminder interests to principal. A trustee may transfer income to principal to make up for depreciation of an asset or to reimburse principal for disbursements that enhance income, i.e., repairs to assets that are necessary to maintain income. A trustee may make adjustments to principal and income to offset "shifting of economic interests or tax benefits between income and remainder beneficiaries" in certain instances.

During the Conduct of a Business Held in Trust. Under the bill, a trustee who conducts a business held in a trust may separate out the accounting for the business from that for other trust assets. The trustee, also, has the power to allocate net cash receipts to "working capital, the acquisition or replacement of fixed assets, and other reasonably foreseeable needs of the business or activity, and the extent to which the remaining net cash receipts are accounted for as principal or income in the trusts' general accounting records."

The earlier uniform acts treated net profit from a business as income, and losses as principal.

For Tax Purposes. The Act allows a fiduciary to make adjustments between principal and income for tax purposes. Tax liabilities may accrue to either income or remainder beneficiaries. A fiduciary may have to make elections under the tax laws. Imbalances of interests that arise because of taxes can re remedied by the fiduciary.

The earlier uniform acts did not provide such discretion to the fiduciary.

Background

Kansas enacted the original Uniform Principal and Income Act in 1951 and adopted a revised Uniform Act in 1965. This bill updates the current version of the Act by specifying requirements for allocations, transfers, and the principal and interest provisions of trust assets and estates.

An official with the Uniform Law Commissioners appeared in support of the bill and stated the updated version is designed to coordinate with the latest version of the Uniform Prudent Investor Act. According to the conferee, it is essential for the drafting and administration of wills and trusts that the new UPIA be adopted in every state and jurisdiction as soon as possible. Drafting of instruments becomes considerably harder without a modern set of rules that, among other tings, allows adjustment because of prudent investment decisions and because of tax laws. If an instrument is not adequately drafted, trustees will not be able to meet fiduciary obligations. The result will be higher costs for setting up trusts, more conflict between trustees and beneficiaries, and excessive litigation. The new UPIA will make life much easier for personal representatives, trustees, and beneficiaries alike.

The fiscal note indicates no fiscal impact.

1. *Supplemental notes are prepared by the Legislative Research Department and do not express legislative intent. The supplemental note and fiscal note for this bill may be accessed on the Internet at http://www.ink.org/public/legislative/bill_search.html