How Does the Revised Uniform Principal & Income Act Affect Unitrusts?

To begin with, several states have adopted or are in the process of adopting the Revised Uniform Principal & Income Act, which was established in 1997.  As of June 2000, the Act has been adopted in Arkansas, California, Connecticut, Iowa, North Dakota, Oklahoma, and Virginia, and was recently introduced in Hawaii, Kansas, Michigan, Nebraska, and Vermont.

The principal and income act of each state contains trust accounting rules that are especially important for the administration of net-income with makeup Unitrusts (NIMCRUT), net-income Unitrusts (NICRUT) and flip Unitrusts.  In many states which have adopted the Act, the new rules apply to trusts already in existence.

Trustee Reallocation Power

In Section 104 of the Act, trustees are granted the power to "... adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor..."  This power allows trustees to invest for a total return, a portion of which may come from capital appreciation of trust assets rather than traditional income items such as interest and dividends.  Therefore, the trustee is now allowed to allocate trust principal to the income beneficiary (or to reallocate a portion of the trust income to principal), even if no provision exists in the trust document allowing the trustee to do so.  So, a trustee can allocate to the income of a NIMCRUT or NICRUT all or a portion of a realized capital gain, even though capital gains are allocated to principal under the normal rules, if the trustee determines that the allocation is necessary to balance the interests of the beneficiaries in the trust.

However, the power to reallocate is not unlimited.  The Act lists situations in which the trustee is prohibited or restricted from exercising the power.  A significant limitation prohibits the trustee from exercising the reallocation power if the trustee is a beneficiary of the trust.  This limitation will not only prevent reallocation where the trustee is the grantor and income beneficiary of the trust but also where the trustee is the charity which is the remainder beneficiary of the trust.  Unless a power to reallocate is specifically written into the reallocation power if the trustee is a beneficiary of the trust.  This limitation will not only prevent reallocation where the trustee is the grantor and income beneficiary of the trust but also where the trustee is the charity which is the remainder beneficiary of the trust.  Unless a power to reallocate is specifically written into the trust, the Act empowers only independent trustees to exercise the power.  To achieve the benefits and flexibility afforded by the reallocation power, it may be necessary to appoint a special trustee to exercise the power or to modify provisions of the NIMCRUT and NICRUT concerning the removal and replacement of trustees.  New NIMCRUTs and NICRUTs can include the reallocation power into the accounting provisions of the trust, making it clear that the power may be exercised by a trustee even if the trustee is also a beneficiary of the trust.

Mutual Fund Distributions

The Act distinguishes between different types of distributions from mutual funds.  The general rule is that distributions from any type of entity, including a mutual fund, are income. Excluded from this general rule are long-term capital gain distributions, which are principal. But mutual funds often distribute both long-term and short-term capital gains, and short-term capital gains dividends now remain subject to the general rule -- they are allocated to income.

Please note that under the Act, when a trustee elects to reinvest mutual fund dividends in additional shares of the mutual fund, the shares purchased through dividend reinvestment are principal, not income, whether they are ordinary or capital gain dividends. Additionally, the trustee remains subject to the fiduciary duty to balance the interests of income and remainder beneficiaries of the trust. To the extent that too large a portion of mutual fund distributions receipts would be allocated to income, due to the treatment of short-term capital gains, or too little, due to the reinvestment of those distributions, the trustee, under the Act, must exercise the power to allocate to balance the interests of the beneficiaries.

Zero Coupon Bonds

Unlike regular bonds, zero coupon bonds pay no interest at all -- they are issued at a discount from face value and the holder realizes the equivalent of interest in the form of accrued bond discount when the bond is sold or matures and is redeemed for the full face value. Since the accrued bond discount is the investor's equivalent of interest, it is treated as interest for income tax purposes. However, now the default treatment under the Act is that the realized bond discount is treated as principal.

Zero coupon bonds have been a popular income timing device for NIMCRUTs, with which deferred income can be accrued at a predictable rate for future distribution when the bonds are sold or redeemed. To give the trustee the flexibility to pursue this investment strategy, include a specific provision in the trust document's accounting rules allocating realized bond discount to income.

The Importance Of Trust Language

Since the Act now covers a broader array of categories of trust receipts and disbursements, it's important for new NIMCRUTs, NICRUTs and flip Unitrusts to include the desired accounting rules, at least to the extent that the desired result is different from the Act's default rules. The default restrictions may be overridden by a specific provision in the trust authorizing the trustee to allocate between principal and income in the manner provided in the Act, even if the trustee is also a beneficiary of the trust.

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