Written By: R. Douglas DeNardo
Rothman Gordon, P.C.
Trusts that provide an income stream to a current beneficiary (net income trusts) are very common in estate planning and have been so for the better part of the past century. In fact, a lot of trust that were drafted in the 1950s, 60s and 70s provided a beneficiary with the income only from a trust with no access to the trust principal. Back then, interest rates were much, much higher than they are now and the income from a trust could provide a decent standard of living. Nowadays, however, income is next to nothing.
Since interest rates are at historical lows, net income trusts present a conundrum for trustees who are trying to be fair to both the current beneficiary and the remaindermen. The current income beneficiary will want the trust to be invested in assets that will produce the highest possible income. Unfortunately, these are assets that traditionally do not appreciate in value. Remaindermen, on the other hand, want the assets invested in high growth vehicles that typically do not produce any income. Since the trustee is required to be equitable to both the income beneficiary and the remainderman, this generally results in everyone being a bit unhappy. To rectify this conflict between the needs of the current income beneficiaries and those of the remaindermen, Pennsylvania passed Senate Bill 1014, which became effective in July 15, 2002.
Under that law, the conversion of a net income trust into a four percent (4%) private unitrust. This means that income is redefined as four percent of the value of the trust assets on a three year rolling average rather than the traditional interest and dividend income definition. The conversion may be accomplished at the request of either the income beneficiary or the trustee (without the necessity of going to court) if notice is given to all beneficiaries and no one objects within sixty (60) days of such notice. Your attorney can generate a letter to give such notice.
If any beneficiary objects within such sixty (60) day period, the beneficiary and trustee must then present a petition to the court for approval of the conversion.
Under prior law, the unitrust percentage was applied to the average value of the Trust over the past three years. Rothman Gordon’s estate department generally uses the closing value of the Trust at the end of each year to determine the average value of the Trust assets. The first year of the unitrust distributes an amount equal to four percent (4%) of the value of the Trust as of the close of business of the previous year (generally December 31). For the second year, the average of previous two years is used and in each year thereafter the average of the prior three years is used. Utilizing the average values over a three year period “smooths” the income to the beneficiary and avoids spikes due to upturns or downturns in the market.
Senate Bill 1014 allows conversion of a net income trust to a 4% unitrust.
Senate Bill 53 allows the smoothing period to be changed from three years to three, four or five years.
In addition to stabilizing the income to the current beneficiary, converting the trust to a unitrust also provides an opportunity for the trustee to invest trust assets for “total return.” As discussed above, a trustee of a net income trust would invest a large portion of the assets of a trust in fixed income investments or in securities which produced some income. A small portion, if any, of the trust assets would have been invested in pure growth stocks. This makes the income beneficiary happy since the maximum income is being derived from the trust assets. Although the value of the trust assets may increases lightly under this investment mix, the increase might have been much greater had it been invested for total return that allows a larger portion to be invested in growth securities.
As an added incentive, and another option for those who have already created a unitrust, Pennsylvania Senate Bill 53, allows the changing of the smoothing term from three years to three, four or five years at the discretion of the trustee. (If a beneficiary wants to change the smoothing terms, he or she must petition the Court per 8105(g)(3) to average the valuation of net assets over a period other than three years.) Governor Edward G. Rendell signed the bill into effect on October 27, 2010. To illustrate the advantages, let’s compare a $1,000,000 trust as of December 31, 2005 and compare its value assuming it was based on the S&P 500 value as of that date and the value of the S&P 500 at the end of 2005, 2006, 2007, 2008 and 2009.
|Three-year smoothing||Five-year smoothing|
Calculations are based on the last Friday of each year.
The estate attorneys at Rothman Gordon believe a unitrust is an excellent option for clients who are trying to balance the assets given to the beneficiary with the assets given to the remaindermen. With the recession’s effects still being felt, we believe a unitrust smoothed over five years negates some of the oscillations of the market. If you are interested in more information on either converting an income trust to a unitrust or changing the smoothing term for an existing unitrust in Pennsylvania you may call me directly at (412) 338-1140 or email me at firstname.lastname@example.org.
For more information on Rothman Gordon, please visit the International Society of Primerus Law Firms or www.rothmangordon.com.
We are required by Treasury Regulations to advise that this writing is not intended as a reliance opinion and cannot be used for purposes of avoiding IRS penalties.