When irrevocable trusts include ex-spouses or soon to be ex-spouses as beneficiaries, family law practitioners should be aware that trust distributions can potentially be adjusted. Here’s how that might happen.
By Sharon L. Klein, Family Wealth Strategist, Trusts & Estates Attorney
A trustee must invest assets pursuant to the so-called Prudent Investor Rule. Under that rule, a trustee is required to invest for “total return.” That is, a trustee must invest in a way that benefits both income and principal beneficiaries. However, when beneficial interests clash – as they typically do in a divorce scenario – the source of return becomes critical, and the tension between investing for income and investing for growth can become more pronounced. More specifically, how does a trustee invest without considering whether return is produced from income or from capital appreciation when the income beneficiary (perhaps a second spouse) is pressuring the trustee for more income and the remainder persons (perhaps children from a prior marriage) are pressuring the trustee for more growth?
Powerful Tools for Changing Trust Interests: the Power to Adjust & Unitrust Regimes
Fortunately, there are two regimes that provide trustees with the means to implement the mandate of total return investing: the power to adjust and unitrust regimes. Under a power to adjust regime, the trustee is permitted to make adjustments between income and principal to be fair and reasonable to all beneficiaries. In other words, even if a principal distribution is not permitted under a trust document, or is permissible pursuant only to a very limited standard (like health or education), the trustee can “redefine” a portion of the principal as income, and pay that to the income beneficiary. Under the unitrust regime, the trustee can convert an income beneficiary’s interest into a unitrust payout of a fixed percentage of the trust’s principal. Most states allow a trustee to determine the appropriate unitrust payout within a band of 3-5%. In a few states, the unitrust payment is fixed. In New York, for example, the unitrust payment is fixed at 4%.1
These two regimes are intended to ease the tension between competing income and remainder beneficiaries and align interests so that all beneficiaries benefit from the trust’s growth, wherever that growth may emanate. Every state in the country has enacted one or both of these regimes, and every trustee or advisor should be aware of these powerful tools.
In the matrimonial context, a trustee might consider whether to evaluate existing trust terms in the event of divorce to potentially adjust beneficial interests.
Shifting Beneficial Interests by Opting into a Unitrust Regime
In Matter of Jacob Heller2, the trustees defended a challenge to their determination to opt into the unitrust regime. Jacob Heller created a trust under his will for the benefit of his second wife, who was to receive income for her life. Decedent’s children from a prior marriage were named as remainder beneficiaries, and two of those step-children, the decedent’s sons, became trustees. When Mrs. Heller’s two step-sons became trustees of the trust, Mrs. Heller’s annual trust payment was $190,000, far above a 4% payout. In 2003, the co-trustees opted into the unitrust regime pursuant to New York law to reduce the payment to their stepmother to 4% and opted to make their election retroactive to January 1, 2002 (the date the unitrust regime became effective in New York).
As a result of the unitrust election, Mrs. Heller’s annual income from the trust was reduced from $190,000 to $70,000. As a result of making the election retroactive, Mrs. Heller would have owed the trust $360,000 ($120,000 a year from the date of the 2005 decision, back to each of the three preceding years). Mrs. Heller commenced a proceeding seeking to annul the unitrust election on the grounds that the co-trustees were also remainder beneficiaries of the trust and conflicted from making that decision, and a determination that the unitrust election could not be made retroactive to January 1, 2002.
The court reasoned that the co-trustees owed fiduciary duties to Mrs. Heller as an income beneficiary, but also to all remainder beneficiaries, including the trustees’ siblings. The fact that the remainder beneficiaries’ interests aligned with the interests of the co-trustees did not disqualify them from opting into the unitrust regime. As such, a question of fact remained as to whether the co-trustees were reasonable in their unitrust election, precluding summary judgment on that issue. In addition, since the New York statute allowed a trustee to specify the effective date of a unitrust election, the Court of Appeals held that the co-trustees’ retroactive application of the unitrust election was proper. (Note that in some jurisdictions the unitrust election can only be made prospectively.)
Since the decision in the Heller case, New York law has been revised; a retroactive unitrust election is still possible, but only with court approval.3 A state-by-state analysis is required to determine whether a power to adjust or unitrust election can be made retroactively in any particular state.
The following is a sampling of State statutes regarding changing trust interests:
Changing Trust Interests: State Statutes Examples
Note that even if a divorce action is taking place in one state, a spouse may be a beneficiary of a trust governed by the laws of another jurisdiction, so familiarity with the operation of that other state’s power to adjust or unitrust laws may be important. Typically, the state statutes provide a number of factors for a trustee to consider in determining whether or not to make an adjustment or opt into the unitrust regime.
The Bottom Line: When Changing Trust Interests, Collaboration Early and Often is Key
Clients benefit when matrimonial, trusts & estates, and accounting and investment professionals partner throughout the whole divorce process to integrate considerations that cross disciplines.
1 N.Y. EPTL §11-2.4
2 Matter of Jacob Heller, 800 N.Y.S. 2d 207 (App. Div. 2005), aff’d, 849 N.E.2d 262 (Ct. App. 2006)
3 See, for example, In re Will of Kruszewski, 116 A.D.3d 1288, 984 N.Y.S. 2d 232 (2014)
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Sharon L. Klein is president of Family Wealth, Eastern US Region, for Wilmington Trust. She is a Fellow of the American College of Trusts & Estates Counsel, she chairs the Domestic Relations Committee of Trusts & Estates magazine, and is a member of the New York City Bar Association’s Matrimonial Committee. Beginning her career as a trusts & estates attorney, Sharon has over 25 years’ experience in the wealth advisory arena and is a nationally recognized speaker and author. www.wilmingtontrust.com/divorce
This article is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service or other professional advice. Wilmington Trust does not provide tax, legal or accounting advice. Professional advice always requires consideration of individual circumstances. Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly-owned subsidiary of M&T Bank Corporation (M&T). © 2019 Wilmington Trust Corporation and its affiliates. All Rights Reserved.
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