California passed legislation, effective January 1, 2006, which allows a trustee of an irrevocable trust (either a living trust or testamentary trust), to convert the trust from a “net payment of income” to a unitrust, without a court order, under certain conditions. This can stabilize and increase the income paid to the trust beneficiary and make the administration of the trust easier for the trustee.
Trustees of California trusts should carefully examine their trusts to see if they meet these new requirements and if conversion should be considered.
Payments of income from a trust, whether coupled with discretionary payments of principal or not, frequently lead to problems. For example, the trust beneficiary receives the “net income” from the trust and desires the highest amount of income possible. The “income” consists of dividends on stock, interest and net rental income. Capital gains from the sale of trust assets are “principal” and not part of the income paid to the trust beneficiary.
The trust remainder persons, who receive the principal on the beneficiary’s death, may desire the greatest appreciation of assets, with little or no concern regarding income. With the dividends paid by stock companies, as a percentage of the price of a stock, falling over the years, and with interest rates declining in the last five years, the “net income” available to a trust beneficiary has fallen.
To compensate for this, the California legislature, in 1999, amended the Probate Code dealing with what is “income” and “principal” under provisions of the California Uniform Principal and Income Act (Probate Code sections 16320-16375). This Act, which dates from 1962, defines in great detail what is income and principal and what expenses are charged to each. Trustees are obligated to keep detailed records reflecting income and principal accounts for each trust.
The 1999 changes to this Act allowed a trustee, under certain conditions, to make adjustments in the income paid to a trust beneficiary by allocating some capital gains (normally principal) to income or increasing the income in other ways. While the changes were useful, this adjustment provision could not be used if a trust beneficiary, such as the spouse, was the trustee. Unless there was a co-trustee who was not a beneficiary of the trust or a bank acting as the sole trustee, this provision could not be used.
In 2003 the Internal Revenue Service issued trust income tax regulations (IRS Reg.1.643(b)-1) which provided that if a state statute provided that net income is a unitrust amount of no less than 3% or more than 5% of the fair market value of the trust assets, determined annually, or averaged over a multiple year basis, this would be taxed as “net income.” These regulations allowed capital gains to be taxed to a trust beneficiary instead of to the trust, when the gain was distributed to the beneficiary.
Although California had an adjustment provision in the Probate Code, as mentioned above, it did not have any provisions for a “unitrust.” The California Uniform Principal and Income Act was therefore amended, by amending Probate Code sections 16328-16338 and adding Probate Code sections 16336.4-16336.7, to allow a method of conversion of a trust to a unitrust.
A unitrust is a trust where the assets are valued, usually annually, and the trust beneficiary then receives a predetermined percentage of this value for the following year.
If a trust had $1,000,000 in value on December 31st, the annual valuation date, and the trust paid a unitrust amount of 4% per year, the beneficiary would receive $40,000 the following year, or $3,333 per month. The next December 31st the trust would again be valued and, based on the value, the trust beneficiary would receive 4% of that value for the next year, usually paid on a monthly basis.
Factors to Consider When Converting
Under a number of conditions, California law now allows a trustee to convert a trust to a unitrust, whether it is a testamentary trust under a will or a living trust. California Probate Code sections 16336.4-16336.7 were added, effective January 1, 2006, and define the conversion process and steps which must be undertaken to legally convert a trust.
California Probate Code section 16336(g) sets forth a non-exclusive list of factors that the trustee may consider when deciding whether to convert an existing trust to a unitrust. These factors are as follows:
- The nature, purpose, and expected duration of the trust.
- The intent of the trustor.
- The identity and circumstances of the beneficiaries.
- The needs for liquidity, regularity of income, and preservation and appreciation of capital.
- The assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the trustor.
- The net amount allocated to income under other statutes and the increase or decrease in the value of the principal assets (which the trustee may estimate for assets which do not have readily available market values).
- Whether and to what extent the trust gives the trustee the power to invade principal or accumulate income or prohibits the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income.
- The actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation.
- The anticipated tax consequences of an adjustment.
Converting a trust
Unless prohibited by the governing instrument, a trustee or trustees of a trust may convert a trust, under Probate Code section 16336.4(b), to a unitrust if all of the following provisions apply:
- The three conditions set for in Probate Code section 16336(a) apply;
- None of the express prohibitions in Probate Code section 16336.4(h) applies;
- The unitrust is administered, under conditions as set forth in Probate Code section 16336.4(e); and
- The prescribed notice to trust beneficiaries is given and no beneficiary makes timely written objections.
All of the three conditions in set forth in Probate Code section 16336(a) must be met. They include the following:
- The trustee invests and manages the trust assets under the Prudent Investor Rule (California Uniform Prudent Investor Act -Probate Code sections 16045-16054). Most trusts operate under this rule;
- The trust describes the amount that shall or may be distributed to a beneficiary by referring to the trust’s income; and
- The trustee determines, after applying the rules for allocation of receipts and disbursements that are mandated by Probate Code section 16335(a), and considering any power the trustee may have under the trust to invade principal or accumulate income, that the trustee is unable to treat all classes of beneficiaries impartially, under Probate Code section 16335(b).
Conditions 1 and 3, above, are generally easy to satisfy. Condition 2, above, is only a problem if the beneficiary or beneficiaries do not receive the net income but receive a fixed amount or some other described amount. Personal residence trusts, charitable remainder trusts, and some other trusts will not qualify for the conversion.
Prohibitions regarding the conversion of a trust
A trustee may not convert a trust to a unitrust under Probate Code section 16336.4(h) in any of the following circumstances:
- If payment of the unitrust amount would change the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets.
- If the unitrust distribution would be made from any amount that is permanently set aside for charitable purposes under the governing instrument and for which a federal estate or gift tax deduction has been taken, unless both income and principal are set aside.
- If possessing or exercising the power to convert would cause an individual to be treated as the owner of all or part of the trust for federal income tax purposes, and the individual would not be treated as the owner if the trustee did not possess the power to convert.
- If possessing or exercising the power to convert would cause all or part of the trust assets to be subject to federal estate or gift tax with respect to an individual, and the assets would not be subject to federal estate or gift tax with respect to the individual if the trustee did not possess the power to convert.
- If the conversion would result in the disallowance of a federal estate tax or gift tax marital deduction that would be allowed if the trustee did not have the power to convert.
The above prohibitions will generally not apply to most regular net income trusts. Unlike the inability of a trustee/beneficiary to use the adjustment powers mentioned earlier, a trustee who is also a beneficiary of the trust can legally convert a trust to a unitrust.
Once the trustee decides to convert, without obtaining a court order, the trustee must give a notice of proposed action under Probate Code sections 16500-16504 to all trust beneficiaries, including minors and incapacitated adults. Then, at least 45 days must elapse before making the conversion provided no beneficiary files a written objection to the proposed conversion.
In mailing notice, under Probate Code section 16336.4(c), the trustee must include with the notice all of the following:
- A statement that the trust shall be administered in accordance with the provisions of section 16336.4(e) (the unitrust amount and accounting year of the trust) and the effective date of the conversion.
- A description of the method to be used for determining the fair market value of trust assets.
- The amount actually distributed to the income beneficiary during the previous accounting year of the trust.
- The amount that would have been distributed to the income beneficiary during the previous accounting year of the trust had the trustee’s proposed changes been in effect during that entire year.
- The discretionary decisions the trustee proposes to make as of the conversion date, pursuant to section 16336.4(f), which covers the following:
(a) The effective date of a conversion to a unitrust.
(b) The frequency of payments in satisfaction of the unitrust amount.
(c) Whether to value the trust’s assets annually or more frequently.
(d) What valuation dates to use.
(e) How to value nonliquid assets.
(f) The characterization of the unitrust payout for income tax reporting purposes. The trustee’s characterization shall be consistent.
(g) Any other matters that the trustee deems appropriate for the proper functioning of the unitrust.
- A copy of Probate Code sections 16336.4-16336.
- Notice must be provided to all income beneficiaries and to “a beneficiary who would receive a distribution of principal of a trust if the trust were terminated at the time notice is given.”
Required terms of the unitrust
After a trust is converted to a unitrust all of the following rules must apply unless a court orders otherwise or all of the trust beneficiaries agree in writing to other terms, as provided in Probate Code section 16336.4(e):
1. The trustee shall make regular distributions in accordance with the governing instrument construed in accordance with the provisions of this section.
2. The term “income” in the governing instrument shall mean an annual distribution, the unitrust amount, equal to 4 percent, which is the payout percentage, of the net fair market value of the trust’s assets, whether those assets would be considered income or principal under other provisions of this chapter, averaged over the lesser of:
A. The three preceding years, or
B. The period during which the trust has been in existence.
3. During each accounting year of the trust following its conversion into a unitrust, the trustee shall, as early in the year as is practicable, furnish each income beneficiary with a statement describing the computation of the unitrust amount for that accounting year.
4. The trustee shall determine the net fair market value of each asset held in the trust no less often than annually. However, the following property shall not be included in determining the unitrust amount:
A. Any residential property or any tangible personal property that, as of the first business day of the current accounting year, one or more current beneficiaries of the trust have or have had the right to occupy, or have or have had the right to possess or control, other than in his or her capacity as trustee of the trust, which property shall be administered according to other provisions of this chapter as though no conversion to a unitrust had occurred.
B. Any asset specifically devised to a beneficiary to the extent necessary, in the trustee’s reasonable judgment, to avoid a material risk of exhausting other trust assets prior to termination of the trust. All net income generated by a specifically devised asset excluded from the unitrust computation pursuant to this subdivision shall be accumulated or distributed by the trustee according to the rules otherwise applicable to that net income pursuant to other provisions of this chapter.
C. Any asset while held in a testator’s estate or a terminating trust.
5. The unitrust amount, as otherwise computed pursuant to this subdivision, shall be reduced proportionately for any material distribution made to accomplish a partial termination of the trust required by the governing instrument or made as a result of the exercise of a power of appointment or withdrawal, other than distributions of the unitrust amount, and shall be increased proportionately for the receipt of any material addition to the trust, other than a receipt that represents a return on investment, during the period considered in paragraph (2) in computing the unitrust amount. For the purpose of this paragraph, a distribution or an addition shall be “material” if the net value of the distribution or addition, when combined with all prior distributions made or additions received during the same accounting year, exceeds 10 percent of the value of the assets used to compute the unitrust amount as of the most recent prior valuation date. The trustee may, in the reasonable exercise of his or her discretion, adjust the unitrust amount pursuant to this subdivision even if the distributions or additions are not sufficient to meet the definition of materiality set forth in the preceding sentence.
6. In the case of a short year in which a beneficiary’s right to payments commences or ceases, the trustee shall prorate the unitrust amount on a daily basis.
7. Unless otherwise provided by the governing instrument or determined by the trustee, the unitrust amount shall be considered paid in the following order from the following sources:
A. From the net taxable income, determined as if the trust were other than a unitrust.
B. From net realized short-term capital gains.
C. From net realized long-term capital gains.
D. From tax-exempt and other income.
E. From principal of the trust.
8. Expenses that would be deducted from income if the trust were not a unitrust may not be deducted from the unitrust amount.
The trustee can deviate from the above required terms under Probate Code section 16336.5(a). The default rule for payment is 4%, but can be any percentage from 3-5%. The trustee can also list assets to be excluded from the unitrust computation (other than listed in section 16336.4(e)(4)), and decide that certain assets be valued less frequently than annually, and that certain expenses be paid out of the unitrust amount. If any deviation occurs the trustee must obtain the written consent of all trust beneficiaries or a court order.
Administrative matters determined by the trustee
The trustee is required, under Probate Code section 16336.4(f), to determine all of the following matters as they relate to the administration of a unitrust.
1. The effective date of a conversion to a unitrust.
2. The frequency of payments in satisfaction of the unitrust amount.
3. Whether to value the trust’s assets annually or more frequently.
4. What valuation dates to use.
5. How to value nonliquid assets.
6. The characterization of the unitrust payout for income tax reporting purposes. However, the trustee’s characterization shall be consistent.
7. Any other matters that the trustee deems appropriate for the proper functioning of the unitrust.
Court order for conversion
In lieu of notice, or upon the timely written objections of a beneficiary when he or she receives notice, a trustee may petition the court to convert a trust to a unitrust. Any trust beneficiary may also petition the court for such conversion. The court shall approve the conversion to a unitrust if all the provisions of section 16336(a) are satisfied and the court determines that the conversion will enable the trustee to comply with section 16335(b), which provides the trustee shall administer the trust impartially. The court may not change the percentage payout below 3% or for more than 5%.
Reconversion or change in percentage payout
Once converted to a unitrust, a trust can be converted back to a “net income” trust or the percentage payout can be changed pursuant to Probate Code section 16336.6(a) provided the following conditions apply:
1. At least three years have elapsed from the conversion of the trust;
2. The trustee determines that the reconversion of change in percentage would enable the trustee to better comply with section 16335(b) (administering the trust impartially for all classes of beneficiaries); and
3. Written notice to all trust beneficiaries has been made with no timely objections.
While a trustee may not reconvert a trust or change the percentage payout for three years, a trustee can petition the court at any time, even within the three year period, to make these changes.
Discretionary principal payments from trust
If the trust document provides for discretionary payments from a trust (health, support, maintenance and education), the trustee is still free to make such payments even though the trust has been converted to a unitrust.
Exculpatory provisions regarding trustee converting or not converting a trust
The trustee has no legal obligation to adjust or convert a trust and is not liable for not considering any adjustment or conversion. In any legal proceedings regarding an adjustment or conversion to a unitrust, the sole remedy is to obtain a court order directing the trustee to covert the trust to a unitrust, to reconvert from a unitrust, to change the distribution percentage, or to order an administrative procedure which the court considers appropriate. The court can make adjustments but can not award a party damages because adjustments were not made.
Every trustee of a California trust that may legally be converted to a unitrust should review the trust document and determine if the trust can legally be converted to a unitrust. If so, the trustee should determine the current annual income payments to the beneficiary or beneficiaries as well as what amount 4% of the trust value would produce.
The trustee should then carefully review whether the trust should be converted to a unitrust or not.
If a trustee decides to make a conversion, it is important to very carefully follow the Probate Code provisions on the conversion to avoid problems at a later date.
© Milton Berry Scott, 2006-2016.