A traditional trust can sometimes create a conflict among the lifetime and remainder beneficiaries. This makes it more difficult for your estate plan to achieve its objectives and places your trustee in a difficult position. A total return unitrust (TRU) may offer a solution.
What are the trustee’s challenges?
When a trust is designed to provide benefits for two classes of beneficiaries, often in different generations, it presents a difficult challenge for the trustee. Consider this example: Adam’s will establishes a trust that pays all of its income to his wife, Kristen, for life (the “lifetime beneficiary”), and then divides the trust assets equally among his three children from his first marriage (the “remainder beneficiaries”). The trust names Adam’s friend, Roger, as trustee. Kristen outlives Adam by 10 years.
Roger has a fiduciary duty to act in the best interests of all the beneficiaries, but traditional trust design makes it difficult for him to be impartial. Suppose Adam leaves $2 million to the trust. To provide Kristen with a steady income stream, Roger places the trust assets in fixed-income investments that generate a 5% return. Kristen receives income of $100,000 per year, and when she dies the trust’s principal — still $2 million — is distributed to Adam’s children. Not a bad inheritance, but its value has been eroded by 10 years of inflation.
Suppose, instead, that Roger invests the trust assets in growth stocks that earn a 9% annual return. Ten years later, the trust’s value has appreciated to more than $4.7 million. That’s good news for Adam’s children, but this approach likely generates little or no income for Kristen.
In an effort to make everyone happy, Roger compromises: He invests half of the assets in growth stocks and the other half in fixed-income vehicles. The $1 million in fixed-income investments generates $50,000 per year for Kristen, and at the end of the trust term the principal is just under $2.7 million.
How can a TRU help?
The advantage of a TRU is that it frees the trustee to employ investment strategies that maximize growth (total return) for the remainder beneficiaries without depriving lifetime beneficiaries of income. Rather than pay out its income to the lifetime beneficiary, a TRU pays out a fixed percentage (typically between 3% and 5%) of the trust’s value, recalculated annually, regardless of the trust’s earnings.
Going back to our previous example, suppose Adam’s trust is designed as a TRU that makes an annual payout to Kristen equal to 3.5% of the trust’s value, recalculated annually. Roger, relieved of the duty to generate income for Kristen, invests all of the trust assets in a diversified portfolio of growth stocks that yield a 9% annual return. Kristen’s payments from the trust start at $70,000 and grow steadily over the trust’s term, reaching more than $113,000 by year 10.
At the same time, the value of the trust principal grows to more than $3.4 million, which is distributed to Adam’s children at the end of year 10. Thus, the lifetime beneficiary and the remainder beneficiaries are better off with a TRU than they would have been under the compromise approach described earlier.
Can you convert an existing trust into a TRU?
If you’re concerned that an existing, irrevocable, income-only trust may be unfair to certain beneficiaries, it may be possible to convert it into a TRU. In order to do so, however, such a conversion must be permitted by applicable state law.
An IRS private letter ruling clarifies that converting a trust into a TRU according to state law shouldn’t have any negative tax implications. It doesn’t cause the trust to lose its grandfathered status for generation-skipping transfer (GST) tax purposes. (For example, GST tax doesn’t apply to irrevocable trusts in existence on Sept. 25, 1985, so long as no additions, actual or constructive, are made to the trust after that date.)
Issues to consider when creating a TRU
If you’re considering implementing a TRU, it’s important to plan carefully. Ask a financial advisor to project the benefits your beneficiaries will enjoy under various scenarios, including different payout rates, investment strategies and market conditions. Keep in mind that, for a TRU to be effective, it must produce returns that outperform the payout rate, so don’t set the rate too high.
Be sure to investigate your state’s trust laws. Some states disallow TRUs. Also, many states establish payout rates (or ranges of permissible rates) for TRUs, so your flexibility in designing a TRU may be limited. Finally, if a trust is required to pay out all of its income to a current beneficiary, be sure that unitrust payouts will satisfy the definition of “income” under applicable state and federal law.
Is a TRU right for you?
By aligning your beneficiaries’ interests, a TRU can relieve tension among your loved ones and allow your trustee to concentrate on developing the most effective investment strategy. Contact Holbrook & Manter today to learn whether a TRU is right for your family’s situation. We would be happy to assist you with all of your trust and estate planning needs.