Total Return Trusts

Most trusts are designed to pay “income” (mainly interest and dividends) to one set of beneficiaries, while the “principal” (the original corpus of the trust plus any undistributed appreciation) accrues to the benefit of another set of beneficiaries. From the time the concept of the trust was first developed until about the 1950s, trust assets tended to produce far more income than capital appreciation. The long-term result was typically that early income beneficiaries fared well, but later income and principal beneficiaries fared poorly. (The decline of the English aristocracy was prominently fueled by this quiet phenomenon.) All that began to change half a century ago, and by the end of the twentieth century many sensibly invested trusts were yielding well under 2 percent. Today, therefore, the problem has reversed itself. Sensibly invested trusts—that is, those with predominantly equity-oriented portfolios—tend to appreciate handsomely over time, but they produce little in the way of current yield in our low-dividend, low-interest-rate environment.

Properly drafted trusts can easily deal with this problem by providing both a floor and a ceiling for payouts to current income beneficiaries. But what about the hundreds of thousands of trusts that were drafted years ago? State legislatures, under pressure from the legal and financial community and from income beneficiaries, have grappled with this issue, and roughly half the states now address it in one of two ways: via the Uniform Principal and Income Act (UPIA) or through unitrust legislation.

The Uniform Principal and Income Act

The UPIA, adopted in 1997, allows trustees to adjust distributable income by transferring principal to income or income to principal as required to achieve fairness between income and principal beneficiaries. The UPIA applies only to trusts that calculate the payout to beneficiaries by reference to net income. The UPIA, or a version of it, has been adopted in 24 states and another three or four have the Act under current review.

Under the UPIA approach, a trustee can invest the trust assets in any manner that is prudent, without regard to how much net income the trust will generate. Then, if the income is so low as to be unfair to the income beneficiaries, the trustee can make an adjustment by transferring principal to income and making a larger income distribution. If the income is so high as to be unfair to the ultimate principal beneficiaries (an unlikely situation these days), the trustee can transfer income to principal and make a smaller distribution. A provision added to the UPIA in 2000 limits trustee liability for making good-faith adjustments.

Unitrust Legislation

Another approach, adopted by fewer states, permits trustees of net-income trusts to convert those trusts to unitrusts. In a unitrust, distributable income is specified as a percentage of the trust assets as those assets appreciate or depreciate annually. Hence, a trustee can invest the trust assets in any manner that is prudent, then pay out a specified percentage of the trust value without regard to whether the payout includes income, principal, or both.

Note that a few states, notably New York, have adopted both approaches, giving trustees the choice of which to pursue.

The IRS View

The Internal Revenue Service has issued proposed regulations that endorse both the unitrust and UPIA models. Hence, the IRS will honor total return approaches to all trusts, including such trusts as marital trusts and generation-skipping trusts, in states that have adopted total return legislation. Importantly, the IRS provides a safe harbor only for total return payouts between 3 percent and 5 percent.

Total Return Trusts in States without Total Return Legislation

Newly drafted trusts can adopt total return approaches regardless of state laws. But what about older trusts domiciled in states that have not adopted total return legislation of any kind? There are two possible solutions for these trusts:

The desire to have a trust managed on a total return basis is, of course, only one of many considerations in judging a trustee's performance. However, my experience has been that trustees who refuse point blank to explore approaches that make simple common sense are likely also to be undesirable from many other points of view.