Investment performance is measured, in large part, by total return on investment under modern portfolio theory. For most, not much thought is given to whether the return on investment is dividend/interest income or growth. However, the difference is critical when it comes to income-only trusts.
A staple of estate planning for married couples involves the division assets between a survivor’s trust and a decedent’s trust after the first spouse’s death. Most decedent’s trusts grant the surviving spouse a right to all income from the decedent’s trust. In fact, recent changes in law strongly favor such a right. Namely, portability of the estate tax exemption amount under the 2012 American Taxpayer Relief Act and the dramatic increase in the estate tax exemption amount under the recently-passed Tax Cuts and Jobs Act, have encouraged couples to qualify for the marital deduction and receive a second “step-up” in tax basis for the decedent’s trust assets upon the surviving spouse’s death. In a nutshell, the prevalence of income-only trusts is on the rise.
The major downside of income-only trusts is that it pits the interests of the surviving spouse against the interests of the deceased spouse’s remainder beneficiaries – in many cases, stepparent vs. stepchild(ren). The surviving spouse obviously wants the trust to invest in income-producing assets. However, assets with strong income performance usually have poor total investment performance.
Under California law, a trustee can make a unitrust conversion by following certain steps codified in the California Probate Code or, failing that approach, by petitioning the local probate court. The unitrust conversion permits that trustee to pay the income beneficiary of the trust a payout rate based on the net asset value of the trust. The rate ranges from 3-5%. To make the unitrust conversion without court approval, the trustee must first provide the income and remainder beneficiaries with a “notice of proposed action.” If the proposed action seeks to convert the trust to a unitrust that pays the lifetime beneficiary at a rate 4%, then the conversion can be made if no beneficiary objects. However, if the proposed action seeks a rate of 3% or 4%, the trustee must obtain written consent from the beneficiary adversely affected by the proposed action. For example, if the trustee seeks to apply a rate of 5% to the unitrust, the written consent of all remainder beneficiaries must be obtained. Conversely, if the trustee seeks to apply a rate of 3% of the unitrust, the written consent of the current beneficiary must be obtained.
Consider the following scenarios where a unitrust conversion may be appropriate:
- A trust gives the surviving spouse a right to all income. The trust holds a portfolio of $1,000,000 worth of high-performing equities that grow in value every year but produce little income. Since the deceased spouse died many years ago, these equities cannot be sold and used to buy a more diverse mixture of assets without incurring capital gains income taxes. The trust produces $10,000 of income for the surviving spouse per year, but she needs an additional $30,000 from the trust to maintain her customary standard of living. Either the trustee or the surviving spouse (if not one and the same) could seek a unitrust conversion to increase income for the surviving spouse. The remainder beneficiaries would be unlikely to object for fear that the high-performing equities will be replaced.
- A trust gives the surviving spouse a right to all income. The trust owns farmland in Central California with a lease arrangement that yields an extraordinary amount of income – close to 10%. The surviving spouse has vast wealth from her first marriage. The trustee or the remainder beneficiaries could use a unitrust conversion to limit the income paid to the surviving spouse to 4% to allow the excessive income to accumulate for the remainder beneficiaries.
The clear advantage of the unitrust conversion to the trustee is that it allows the trustee to take a total investment return approach without fear of being accused of favoring income beneficiaries or remainder beneficiaries. The unitrust can also relieve tension between income beneficiaries and remainder beneficiaries and provide an income beneficiary on a budget with more stability and certainty.
The disadvantage to the unitrust conversion most commonly confronted is the requirement for annual appraisals in order to determine the net asset value of the trust. This is not a big deal for trusts that hold financial assets with readily ascertainable market value; however, it can be a costly endeavor to obtain real estate and business appraisals and appraisals for unmarketable assets.
Ideally, a well-crafted estate plan will avoid the need for conversions in petitions. However, if a unitrust conversion makes sense for you – whether as the result of careless planning or changed circumstances – please gives us a call.