When interest rates are high and the equity markets are growing, the trustee is better able to realize both a high level of income to the income beneficiaries and report to the remainder beneficiaries an increase in the equity of the portfolio. However, when interest rates are low and equity markets are stagnant or declining – like current markets – the trustee faces a dilemma. The Act provides a method by which the trustee may balance the competing interests of the income and remainder beneficiaries. The Act provides an alternative “unitrust” distribution arrangement, whereby the trustee may distribute from the trust a fixed percentage amount between four and six percent of the trust assets each year, without regard to whether the distribution amount is considered to be principal or income. This allows the trustee the flexibility to distribute a sufficient amount currently while allowing the assets of the trust to remain invested in the equity markets, thereby providing the potential for long-term growth for remainder beneficiaries. Long-term growth may also be enhanced by a unitrust distribution arrangement because the trust (or the beneficiaries) need not constantly incur capital gains taxes when the trustee rebalances the trust portfolio by selling appreciated equity assets to convert them into income producing assets in order to maintain a balanced portfolio.
While existing trusts can be amended by the trust’s grantor to allow the trustee to take advantage of the Act, trusts that are irrevocable, or have become irrevocable because the grantor died, may also take advantage of the Act. A trust may become subject to the Act in one of three ways: (1) the trustee acting alone may convert the trust to a total return trust; (2) the beneficiaries and the trustee may agree to convert the trust; or (3) either the trustee or a beneficiary may seek approval of the court to convert to a total return trust. The Act provides protection to the trustee for converting and not converting a trust to a total return trust provided the trustee acts in good faith while considering the interests of the beneficiaries. There are a number of other provisions in the Act which will protect the trustee from lawsuits by the beneficiaries. The Act provides the conversion of a trust will not limit any right given in a trust agreement to a surviving spouse or other beneficiary to withdraw principal, and a grantor may state within the trust agreement that it may not be converted to a total return trust.
Every trustee should consider whether a trust under his or her control would benefit from conversion to a total return trust. However, the trustee’s decision should be made only after a thorough consideration of all the relevant factors regarding conversion, the grantor’s desires, the beneficiaries’ respective needs and interests, and the tax implications. Please do not hesitate to telephone us if you would like to further discuss the Act or conversion of a trust to a total return trust.