Estate Planning Council of Delaware By: Joseph V. Falanga, CPA, AEP Sharon H. Goodman, Esq.

1. Estate Planning Council of Delaware By: Joseph V. Falanga, CPA, AEP Sharon H. Goodman, Esq.

2. The Uniform Principal and Income Act (and relevant state statutes that have adopted the Act or the unitrust methodology in some form) controls allocations between principal and income and “who gets what”. The Act has absolutely no significance where the governing instrument gives the fiduciary sufficient discretion to distribute principal, allocate between income and principal and make tax elections. Then, the governing instrument controls. This presentation touches on some of the more pressing issues and complications resulting from certain provisions of the Act and the unitrust methodology. These complications and issues point to the fact that the controlling documents should be well crafted to give the fiduciary the ability to act impartially without having to rely on the Act or state law. In light of the downturn in the economy, where expectancies of beneficiaries will be thwarted, it is essential that, should the governing instrument not provide the flexibility needed to insure impartiality, the practitioner understand the intricacies of the Act and adjustment and unitrust powers under relevant state law. Introduction 1

3. The UPIA was revised in 1997 and in 2004, amendments were made to the Code Section 643(b) definitions of income. Factors which played a role in the revisions and amendments include: New forms of investment Modern portfolio theory of investing for total return replaced the traditional income and principal approach The traditional approach generally focused on investing to produce income The total return approach diminished the ordinary income available for distribution to the income beneficiary In 2004, in response to the changes to the UPIA, amendments were made to Code Section 643(b) and the accompanying Regulations. The amendments to Code Section 643(b) changed the definition of income to reflect modern investment theory. Historical Overview of the Revised Uniform Principal and Income Act (UPIA) and Amendments to Code Section 643(b) 2

4. The provisions of the old UPIA historically provided rules regarding the determination of what constituted a trust’s net income. Over the past few decades, there have been substantial differences between actual versus assumed investment returns: The 1970’s and early 1980’s produced high inflation. In more recent years, there has been low to negligible inflation, and now there is talk of a recession. Concurrently, the investment model evolved from the prudent man standard to an investment philosophy that encompasses the portfolio’s total return. Total return looks to capital appreciation as well as the annual return on the investments. The result of these changes to investment theory generally had a negative impact on income beneficiaries who saw a reduction in the income that could be distributed to them under the traditional theory of what constituted “net income”. 3

5. The revisions to the UPIA and amendments to Code Section 643(b) have brought complications and confusion in a number of areas. Historically, the trust’s net income consisted of income, dividends and rents, but excluded capital gains. The total return concept impacted negatively on what the income beneficiary could receive from the trust in situations where the trustee did not have flexibility in distributing principal to the income beneficiary. While the total return concept of investing might have increased the overall value of the trust, interest and dividend income was dramatically reduced. These factors moved the National Commissioners to issue the 1997 revisions to the UPIA. The UPIA and Code Section 643(b) revisions brought some new and innovative concepts, including Giving the fiduciary the power to adjust between principal and income under certain circumstances (and vice versa), and The unitrust concept. 4

6. Fiduciaries now must confront major challenges in dealing with the interaction of : (1) the power to adjust between principal and income, (2) the unitrust method of determining income and (3) the final Treasury Regulations which define trust income. It is essential to understand that the power to adjust controls the income available for distribution. This is because the Subchapter J definition of income, which establishes the tier distribution system, provides that “income” when not modified by such terms as gross, distributable net or undistributed net is determined under applicable state law. Challenges to Fiduciaries – What is Net Income? 5

7. The only exception to this rule is if the governing instrument provisions depart fundamentally from traditional principles of what is income versus what is principal; in such case, IRS will not respect the governing instrument definitions of income and principal. The UPIA defines income as “money or property a fiduciary receives as current return from a capital asset …[and it] includes a portion of the receipts from a sale, exchange or liquidation of a principal asset, to the extent provided in [Article] 4.” This is in effect gross income. Under the UPIA, “net income” is defined as “the total receipts allocated to income … minus the disbursements made from income” during the accounting period. Significantly, the definition provides that receipts and disbursements include items transferred to or from income. The comments to the UPIA under Section 102 explain that transfers to or from income include, among other items, the power to adjust under Section 104(a). 6

8. Section 104(a) of the UPIA for the first time gives the fiduciary the ability to make transfers from principal to income (and vice versa). The power to adjust affects various classes of trust beneficiaries and also affects the tax treatment of distributions and potentially impacts the beneficiary’s tax liability, especially under the rules enacted by Code Section 643(b) and Regulation 1.643(b)-1. Under modern portfolio theory, an investment that is made solely in growth stock under the prudent investor standard and which, accordingly, produces virtually no dividend income, is the subject of the adjustment power. In effect, there is a charge to principal and credit to income. The discussion which follows below is based on the UPIA issued by the Uniform Commissioners. (Note: Many states have adopted the UPIA with certain modifications so it is essential to review and understand the local controlling law before taking any action). Under Section 104 of the UPIA, the fiduciary is given the power to adjust when the governing instrument is silent. Note: The terms of the governing instrument controls and will override the UPIA provisions. Power to Adjust 7

9. When a trustee adopts a total return investment policy, rather than a policy which expressly addresses the income and principal rights of the beneficiaries, the trustee is permitted to transfer amounts from principal to income (and from income to principal). The trustee’s decision must recognize: What is fair and reasonable to all beneficiaries. The trustee’s duty of impartiality. Note: Impartiality does not mean equality. It means that the trustee must treat the beneficiaries equitably in light of the purposes and terms of the trust. The power to adjust becomes operative when the trust instrument: Fails to contain adequate discretionary administrative powers, and Does not clearly show an intention that the trustee must or may favor a particular beneficiary. In effect, the power to adjust is a default provision: It gives the trustee the ability to override other provisions of the UPIA regarding allocations between income and principal. It is operative when the power to adjust is necessary to allow the trustee to accomplish its duties and responsibilities. So, if the governing instrument is silent in regard to the determination of what is income and what is principal, the power to adjust under the UPIA applies. The power to adjust is not a power to transfer capital gains from principal to income. In determining the amount to adjust, the amount of realized capital gain is irrelevant. Code Section 643 and the Regulations sets forth the income tax treatment of the adjustment. 8

10. Section 104 of the UPIA says that the trustee must consider the following factors when considering use of the power to adjust: The nature, purpose and expected duration of the trust. The intent of the settlor. The identity and circumstances of the beneficiaries. The need for liquidity, regularity of income and preservation and appreciation of capital. The assets held by the trust, their nature and the extent they are used by a beneficiary and whether the asset was transferred to the trust by the settlor or acquired by the trustee. The net amount allocable to income under other provisions of the UPIA and the increase or decrease in the value of the principal assets. Whether and to what extent the trustee is given the power to invade principal or accumulate income, or is prohibited to do so under the terms of the trust agreement and the past history in regard to the use of the adjustment power. The actual and anticipated effect of economic conditions on principal and income and the effects of inflation or deflation, and The anticipated tax consequences of the adjustment. Factors which must be considered under the UPIA when determining if the Power to Adjust should be exercised 9

11. In certain situations, the fiduciary is explicitly prohibited from exercising a power to adjust. The power to adjust may not be exercised when such exercise would have a negative tax impact, including causing the loss of part or all of: (1) a federal or state gift tax exclusion, (2) an income, gift or state charitable deduction, or (3) an inheritance deduction otherwise available. The power to adjust is also precluded when exercise of the power would: diminish an income interest in a marital trust. reduce the actuarial value of an income interest in a transfer intended to qualify for gift tax exclusion. change the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust’s assets. affect any amount permanently set aside for charitable purposes. cause an individual to be treated as the owner of the trust for income tax purposes. cause all or part of the trust assets to be included in the gross estate of an individual who has the power either to remove or appoint a trustee. allow the trustee to make an adjustment for his/her direct or indirect benefit, including the satisfaction of a legal obligation. Note: A disinterested trustee may make an adjustment that benefits another trustee. When the Trustee cannot exercise a Power to Adjust 10

12. The power to adjust may not be exercised if the governing instrument clearly bars the trustee from exercising an adjustment power. The comments to Section 104 provide certain examples of the power to adjust: Investment advisors convince the trustee to shift to a total return investment policy that involves solely growth stocks. The change results in a reduction of dividend and interest receipts from $100,000 in the prior year (and the average of the past five years) to $10,000. As a result of the portfolio change, principal value increased by $300,000. These results indicate to the trustee that it should exercise its power to adjust by transferring $90,000 from principal to income. Accordingly, the income beneficiary receives $100,000, the determination of trust accounting income after the adjustment. Adjustments can also be made from income to principal where a very high interest return is obtained in a period of substantial inflation where part of the interest return is a principal return in an economic context that represents loss of principal value due to inflation. Example 2 of the Section 104 comments illustrates this: Inflation returns, and the trustee invests $1 million in U.S. government bonds with a 14% coupon. The inflation rate is 8%, so the trustee decides to adjust by transferring $80,000 from income to principal, an amount the trustee considers an appropriate adjustment (other fiduciaries may choose a larger or smaller adjustment) to make up for the loss in value due to inflation and $60,000 is distributed to the income beneficiary. 11

13. Applying the adjustment power may be difficult and problematic when the governing instrument is an old trust document that does not provide the flexibility built into more recent documents. The comments to Section 104 gives the following example (Example 4): When the irrevocable trust was formed and funded, the state law did not contain the prudent investor rule. The trust document required all income to be distributed to a named beneficiary. The trustee was provided with very narrow principal invasion powers “for dire emergencies only,” and over the term of the trust the aggregate principal invasion was limited to 6% of the trust’s initial value. The state of the trust’s situs then changed its law by adding the prudent investor rule. As a result, the trustee changed the asset allocation from 50/50 percentages for stocks and bonds to 90/10 percentages for stocks and bonds. This change in the portfolio reduced the annual income from dividends and interest, but it significantly increased the total return. This example in the UPIA concludes that the trustee may adjust by a transfer from principal to income, but only if the transfer is exclusively from the capital appreciation resulting from the switch in the asset allocation. Even so, the adjustment will be prohibited if the trustee cannot determine, or inadequate records exist to assist the trustee in ascertaining, the application of the 6% invasion cap. 12

14. Additional examples of circumstances of when the power to adjust can be used: Trust gives A income for life with the remainder going to B. The settlor funded the trust with a portfolio consisting of stocks and bonds in a 20/80 ratio. In accordance with his fiduciary duties, the trustee determines that suitable risk and investment return objectives indicate that the portfolio should be invested 50/50 in stocks and bonds. This investment strategy results in a decrease in ordinary income. The trustee is authorized, after considering the factors listed above, to make an adjustment between principal and income to the extent it considers it necessary to increase the amount payable to the income beneficiary. Settlor creates a trust that provides income is paid to the settlor’s sister, S, for life, with the remainder payable to charity. The trust terms allow the trustee to invade principal to provide for S’ health and to support her in her accustomed manner of living but does not otherwise indicate if the trustee should favor S or the charity. S is a retired schoolteacher, with no children. Her income from various sources is more than enough to provide for her accustomed standard of living. In applying prudent investor standards, the trustee determines that the portfolio should be invested entirely in growth stocks which provide virtually no dividend income. While it is not necessary to invade principal to maintain S’ accustomed standard of living, she is entitled to receive the degree of beneficial enjoyment accorded to a person who is the only income beneficiary of the trust. The trustee has the power to adjust between principal and income to provide S with that degree of enjoyment. 13

15. The UPIA does not preclude a state from adopting a unitrust provision. The unitrust concept is not part of the UPIA. The unitrust concept is a provision that allows trust income to be computed by using a fixed percentage of the value of the trust’s assets (the unitrust amount) to compute “income”. The IRS allows the unitrust amount to range from 3% to 5%. Reg.1.643(b)-1. The unitrust concept permits an income beneficiary to receive a fixed percentage of the trust’s assets (the valuation base), revalued annually. The fixed percentage may be applied to the valuation base on an annual basis, or as adopted by some states in a form that uses a three year moving average of the fair market value of the assets. Use of the unitrust methodology eliminates the need for Trustees to wrestle with the determination of accounting income and principal. If the unitrust concept is elected state law may preclude the trustee from using a power to adjust. The Unitrust Rules 14

16. Once elected (unless otherwise directed by the Court) state law may provide that the unitrust methodology must be used in subsequent years. This mandatory rule make the use of the unitrust less flexible than the power to adjust. It is a separate fiduciary accounting income distribution system and is operative only if a state independently enacts a unitrust provision. If state law adopts a unitrust provision, as a general rule, the trustee must obtain court approval to use the unitrust methodology if the governing instrument does not allow for the use of the unitrust methodology. 15

17. When the UPIA was revised in 1997 giving the trustee the power to adjust or ability to convert to a unitrust, there were questions as to whether the IRS would allow trustees to exercise such powers (and thereby increase or decrease accounting income) without, for example: jeopardizing the marital deduction, causing any gift tax ramifications and jeopardizing grandfathered generation-skipping transfer trusts. The Regulations that were effective as of January 2004 answered these concerns in a positive manner. If the trustee’s actions fall within the Regulations parameters, using a power to adjust or converting the trust to a unitrust will not: Cause the loss of a federal marital deduction Cause a taxable transfer for gift tax purposes Cause a taxable sale or exchange Undo the grandfathered status of a generation-skipping transfer tax trust The new Regulations generally will respect the trustee’s determination of income made in accordance with the trustee’s power to: (1) adjust between principal and income (and vice versa) granted under local law, (2) convert to a unitrust granted under local law and (3) allocate capital gain to fiduciary accounting income. The Final Income Tax Regulations Under Code Section 643(b) 16

18. The Regulations allow for the conversion of an existing trust into a unitrust and the use of a power to adjust when such powers are granted under state law. Generally, federal tax law follows local state law with respect to the definition of income. State law definitions of income which provide for a reasonable apportionment between the income and principal beneficiaries of the total return of the trust for the year will be respected. The final Regulations define “income” as the amount of income of an estate or trust for the taxable year determined under the terms of the governing instrument and controlling local law. The final Regulations retain the previously existing rule that trust provisions that depart from traditional principles in regard to the characterization of income and principal will generally not be recognized for federal tax purposes. 17

19. The Regulations say that allocations between principal and income pursuant to local law will be respected if the local law provides for a reasonable apportionment between the income and principal beneficiaries of the trust’s total return for the year. Total return includes ordinary and tax-exempt income, capital gains and appreciation. For the allocations to be respected, the Regulations mandate that the controlling state law specifically authorize the power to equitably adjust and/or provide a unitrust definition of income. For the unitrust provision to be respected for federal purposes, the state statute must define the unitrust amount as being between 3% to 5% of the trust’s fair market value. The preamble to the Regulations clarifies that if no statutory law exists, other actions, such as a decision by the state’s highest court enunciating a general principle of law applicable to all trusts administered in the state may constitute applicable state law. A court order applicable only to the specified trust does not constitute applicable state law for such purposes. 18

20. In regard to the power to adjust, the Regulations require that such adjustment power be expressly allowed under state law and that such law describe the circumstances under which the power to adjust may be used. Generally, adjustments are allowed when the trustee invests under the prudent investor model, the trust describes the amounts that can be distributed to the beneficiary by referring to trust income and the trustee, after applying the local state rules in regard to the allocation of principal and income, is not able to administer the trust impartially. In certain situations the trustee is expressly prohibited from using the power to adjust. IRS will generally recognize an allocation of all or part of a capital gain to income if the allocation is made pursuant to: the terms of the governing instrument and local law, or a reasonable and impartial exercise of a discretionary power granted to the fiduciary under the governing instrument or pursuant to local law, if not prohibited by applicable law. The final Regulations dramatically changed the rules concerning the inclusion of capital gains in distributable net income (DNI). The old rule was that generally capital gains were not included in DNI. The premise under the new Regulation is that capital gains are included in DNI. Reg. Section 1.643(a)-3(b). 19

21. Capital gains are included in DNI to the extent they are: required to be included under the terms of the governing instrument and local law, or allowed to be allocated to DNI pursuant to a reasonable and impartial exercise of the fiduciary’s discretion in accordance with a power granted to the fiduciary by the governing instrument or local law if not prohibited by local law: allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitust amount over the amount of DNI); allocated to corpus but treated consistently by the fiduciary on the trust’s books, records and tax returns as part of the distribution to the beneficiary; or allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to the beneficiary. The Preamble to the Regulations says that the power to adjust does not have to be exercised consistently as long as it is exercised reasonably and in an impartial manner. If however the unitrust provisions are used, the power must be exercised on a consistent basis. 20

22. The Regulations contain some useful illustrations showing when capital gains are included in DNI. They show that a pattern is established with the first act or the first failure of the trustee to act where the governing instrument gives the trustee discretionary power. Two of the illustrations showing the tax treatment when the fiduciary has discretionary power are: Example 1: Under the terms of Trust’s governing instrument, all income is to be paid to A for life. Trustee is given discretionary powers to invade principal for A’s benefit and to deem discretionary distributions to be made from capital gains realized during the year. During Trust’s first taxable year, Trust has $5,000 of dividend income and $10,000 of capital gain from the sale of securities. Pursuant to the terms of the governing instrument and applicable local law, Trustee allocates the $10,000 capital gain to principal. During the year, Trustee distributes to A $5,000, representing A’s right to trust income. In addition, Trustee distributes to A $12,000, pursuant to the discretionary power to distribute principal. Trustee does not exercise the discretionary power to deem the discretionary distributions of principal as being paid from capital gains realized during the year. Therefore, the capital gains realized during the year are not included in distributable net income and the $10,000 of capital gain is taxed to the trust. In future years, Trustee must treat all discretionary distributions as not being made from any realized capital gains. What does all of this mean and when can Capital Gain be Included in DNI? 21

23. Example 2: The facts are the same as in Example 1, except that Trustee intends to follow a regular practice of treating discretionary distributions of principal as being paid first from any net capital gains realized by Trust during the year. Trustee evidences this treatment by including the $10,000 capital gain in distributable net income on Trust’s federal income tax return so that it is taxed to A. This treatment of the capital gains is a reasonable exercise of Trustee’s discretion. In future years Trustee must treat all discretionary distributions as being made first from any realized capital gains. The Regulations also provide illustrations in the unitrust context: Example 11: The applicable state statute provides that a trustee may make an election to pay an income beneficiary an amount equal to four percent of the fair market value of the trust assets, as determined at the beginning of each taxable year, in full satisfaction of that beneficiary’s right to income. State statute also provides that this unitrust amount shall be considered paid first from ordinary and tax-exempt income, then from net short-term capital gain, then from net-long term capital gain, and finally from return of principal. Trust’s governing instrument provides that A is to receive each year income as defined under state statute. Trustee makes the unitrust election under state statute. At the beginning of the taxable year, Trust assets are valued at $500,000. During the year, Trust receives $5,000 of dividend income and realizes $80,000 of net long-term gain from the sale of capital assets. Trustee distributes to A $20,000 (4% of $500,000) in satisfaction of A’s right to income. Net long-term capital gain in the amount of $15,000 is allocated to income pursuant to the ordering rule of the state statute and is included in distributable net income for the taxable year. 22

24. Example 12: The facts are the same as in Example 11, except that neither state statutes nor Trust’s governing instrument has an ordering rule for the character of the unitrust amount, but leaves such a decision to the discretion of Trustee. Trustee intends to follow a regular practice of treating principal, other than capital gain, as distributed to the beneficiary to the extent that the unitrust amount exceeds Trust’s ordinary and tax-exempt income. Trustee evidences this treatment by not including any capital gains in distributable net income on Trust’s Federal income tax return so that the entire $80,000 capital gain is taxed to Trust. This treatment of the capital gains is a reasonable exercise of Trustee’s discretion. In future years Trustee must consistently follow this treatment of not allocating realized capital gains to income. Example 13: The facts are the same as in Example 11, except that neither state statutes nor Trust’s governing instrument has an ordering rule for the character of the unitrust amount, but leaves such a decision to the discretion of Trustee. Trustee intends to follow a regular practice of treating net capital gains as distributed to the beneficiary to the extent the unitrust amount exceeds Trust’s ordinary and tax-exempt income. Trustee evidences this treatment by including $15,000 of the capital gain in distributable net income on Trust’s Federal income tax return. This treatment of the capital gains is a reasonable exercise of Trustee’s discretion. In future years Trustee must consistently treat realized capital gain, if any, as distributed to the beneficiary to the extent that the unitrust amount exceeds ordinary and tax-exempt income. 23

25. The illustrations show that the controlling factor is if there is a defined ordering rule, either under the applicable state law or governing instrument, which determines the character of the unitrust amount. In the absence of an ordering rule, the trustee’s discretion is considered. If the trustee has a discretionary power over the decision, capital gains can be included in DNI, but the discretion must be exercised consistently. This means that the way the return is filed in year 1 is the way future returns must be filed. Note: In all cases, capital gains cannot be included in DNI to the extent that they exceed the unitrust amount. For example, if the total net income of the trust was $100,000, including $25,000 of capital gains, then capital gains could not be included in DNI if the unitrust amount was less than or equal to $75,000. If the unitrust amount was $100,000 all of the capital gains could be included in DNI. If there is not an ordering rule and the trustee has no discretion over the decision, capital gains cannot be included in DNI. 24

26. The Regulations do have a major shortcoming – they do not include examples that illustrate the inclusion of capital gains in DNI when the trustee exercises a power to adjust. Treasury refused to provide examples and maintained that there were too many potential variations in the circumstances and ramifications of exercising the power to adjust under the applicable state laws. While the regulations do not provide guidance in the context of a power to adjust, some commentators believe that the unitrust examples provide analogies for guidance and suggest that the exercise of a power to adjust will result in the inclusionof capital gains in DNI when: 1) state law ordering rules allow (or are silent regarding) inclusion of such gains in DNI, 2) the trustee determines that inclusion is appropriate and equitable, 3) Form 1041 reflects this tax approach and 4) the tax treatment is followed consistently in subsequent years. If state law precludes an ordering that includes capital gains, and the trust document is silent or it precludes ordering as well, then capital gains cannot be included in DNI. Some commentators maintain that since the Regulations provide no guidance regarding the inclusion of capital gains in the power to adjust context, the best course is to obtain a private letter ruling. 25

27. Trusts often own interests in flow-through entities such as partnerships, LLCs and S corporations. More often than not these entities show K-1 income reportable by the trust which differs from the amount of cash or other property distributed to the trust. There are many situations where the cash distribution made from the flow-through entity to the trust as owner of an interest in the entity is less than the taxable income allocated to the fiduciary. If applicable state law gives the trustee the power to adjust, the trustee may decide to transfer from principal to income an appropriate amount to be reflected as “net income” and thus become distributable. Application to Ownership Interests in Flow-Through Entities 26

28. For accounting purposes, the trustee must keep an income account and a separate principal account to reflect the interest of the two classes of beneficiaries. For income tax purposes, no distinction is made between receipts and disbursements that the trustee allocates to principal and income. All taxable receipts, and all deductible expenses, in both the income and principal accounts, are combined to determine the trust’s taxable income for the year. Distributions to beneficiaries generally will reduce the trust’s taxable income. Caveat: Under traditional concepts, capital gains are not included in distributable income for tax purposes. To the extent tax is paid by the Trustee, it is allocated to the income and principal accounts under Section 505 of the UPIA. Trust income, taxable income and distributable net income are usually different. Distributions from Flow Through EntitiesTrust Accounting and Tax TreatmentUPIA Section 505 27

29. Example: A Trust that receives dividends of $25,000 and pays a trustee commission of $3,000, $1,000 of which is allocated to income under state law has trust accounting income of $24,000 ($25,000 less $1,000) but taxable income of $22,000 ($25,000 - $3,000). Unless the governing instrument provides otherwise, trust accountings are made on a cash receipt and disbursement basis. A trust’s share of a partnerships taxable income may be more or less than the partnership’s distribution to the Trust. The accounting income only includes the amount received from partnership income. The trust’s share of the partnership’s taxable income is irrelevant for trust accounting purposes. Distributable Net Income (DNI): Places a ceiling on the income distribution deduction Determines the amount includable in the beneficiary’s income Determines the character of the distribution to the beneficiary The distribution deduction, and the amount taxable to the beneficiary, is never larger than DNI. If the trust’s DNI for the year is less than the trust income that is distributed or required to be distributed the portion of the income that exceeds DNI is not taxable to the income beneficiary. 28

30. UPIA Rules: A cash distribution from the partnership is allocated to income under Section 401(b) if the distribution is not a partial liquidation Section 401 (d) of the UPIA allocates money received in a partial liquidation to principal. Among other definitions, the UPIA provides that money is received in partial liquidation if the total amount of property and money is received in a distribution or series of related distributions is greater than 20% of the entity’s gross assets as shown by the entity’s year-end financial statements immediately preceding the initial receipt. UPIA Section 401 (d) (2). Comments made by various professional organizations including the ABA, the AICPA, and ACTEC suggest that the 20% rule contained in Section 410 (d)(2) be eliminated. The belief is that such section as written allows a change in the character of the return on an investment simply by placing the investment in a single member LLC. For example, a trustee could transfer an investment portfolio into a single member LLC in order to dispose of certain highly appreciated assets followed by a distribution of the proceeds, not in excess of 20% of the entity’s gross assets, and change the character of the proceeds from principal to income through the use of the entity. “Net income” means total receipts allocated to income during an accounting period minus disbursements from income during the period, plus or minus transfers under the UPIA to or from income during the period. UPIA Section 102(8) How is the trust’s income tax obligation calculated when the trust owns a partnership interest? 29

31. Income taxes a trustee must pay on the trust’s share of the partnership’s taxable income are paid from income or principal under the rules of UPIA Section 505(c) Section 505(c) provides: “A tax required to be paid by a trustee on the trust’s share of an entity’s taxable income must be paid proportionately” From income to the extent the receipts from the entity are allocated to income; and From principal to the extent that (A) receipts from the entity are allocated to principal; and (B) the trust’s share of the entity’s taxable income exceeds the total receipts described in paragraph (1) and (2)(A) If the amount distributed from the partnership exceeds the trust’s share of partnership taxable income, and if all of the distribution must be paid to the income beneficiary, the trust will not bear any tax. If the amount distributed from the partnership is less than the trust’s share of partnership taxable income, the trust must bear some or all of the amount allocated to the trust’s income and perhaps from principal. 30

32. UPIA Sections 505 (c) and (d) pertain to how the trustee should allocate income tax on the trust’s share of a flow-through entity’s taxable income. The interplay between Sections 505 (c) and (d) produces different tax results depending upon the order in which the provisions of such sections are applied. The AICPA’s comments regarding certain proposed changes to various sections of the UPIA illustrates this dynamic. As pointed out in the AICPA’s comments, it is not clear if Section 505(c) is applied first or if 505(d) is applied first. James Gamble, co-reporter of the UPIA, apparently believes that Section 505(c) is applied first. Under Gamble’s interpretation, the trust’s tax on its share of the entity’s taxable income is calculated and then the tax is subtracted from income receipts from the entity. To the extent the trust receives an income distribution deduction for paying cash received from the entity to the beneficiary, the trustee in turn increases its payment to the income beneficiary to the extent of its tax savings under UPIA Section 505(d). 31

33. On the other hand, as reported in the AICPA’s comments, the AICPA’s Fiduciary Accounting Income Task Force takes the opposite approach. The Task Force believes Section 505(d) should be applied first. Under the Task Force’s interpretation, receipts from the entity would be reduced by the amount for which the trust receives an income distribution deduction. Then, the trustee would apply 505(c) by calculating the trust’s tax on taxable income from the entity reduced by the deductible payments to the beneficiary and allocating the tax proportionately between a) the reduced income receipts and b) reduced principal receipts plus the trust’s share of the entity’s undistributable taxable income. Under the above interpretation, as pointed out in the AICPA’s comments, no taxes would be allocated to the income beneficiary if all income receipts from the entity would be deductible by the trust because income receipts would be zero. The rule supported by Gamble that requires that the tax be computed first involves a circular calculation. The is because the trust's tax depends on the amount paid to the beneficiary for which the trust receive an income distribution deduction. But the amount paid to the income beneficiary depends on the trust’s tax liability attributable to those receipts. The computation can be solved by using an algebraic formula to determine the net amount due to the income beneficiary. 32

34. The formula is: D=(C - R* K) / (1 – R) D = Distribution to Income Beneficiary C = Cash Paid by the Entity to the Trust R = Tax Rate on Income K = Entity’s K-1 Taxable Income AICPA’s comments provide the following illustrations concerning the above concepts: “ABC Trust receives an IRS Schedule K-1 from the Partnership reflecting taxable income of $1 million. Partnership distributes $500,000 to the trust. The Partnership represents that the distribution is income and so the trustee initially allocates the entire $500,000 to income. The trust is in the 35 percent tax bracket. Note: The above formula and solution would become more complicated if the state also had an income tax. In the above example, the partnership distribution exceeds the trust’s $350,000 ( i.e., $1 million x 35% tax rate) tax liability on the IRS Schedule K-1 income by $150,000). The excess is income that the trustee is required to distribute and for which it receives a distribution deduction. But the distribution deduction reduces the trustee’s tax, which increases the beneficiary’s income and so on. 33

35. As illustrated below, the trustee must pay $230,769 to the income beneficiary so that after deducting the payment, the trust has exactly enough to pay its tax on the remaining taxable income from the entity. Taxable Income per K-1 $1,000,000 Payment to Beneficiary 230,769* Trust Taxable Income $769,231 (35 % Tax = 269,231) Partnership Distribution $500,000 Tax Allocated to Income (269,231) Payable to Beneficiary $230,769 D=(C - R* K) / (1 – R) = (500,000) [Cash Paid by Entity to the Trust] – 350,000 *[Tax on $1,000,000 K-1 Income at 35% Rate / (1-.35) [ 1- tax rate] = 230,769 [Payable to Beneficiary] 34

36. The above circular calculation occurs ONLY when the entity distributes an amount that is more than enough to pay the tax on the trust’s taxable income but which is less than its total taxable income. When the entity distributes less than a sufficient amount to pay the tax on the trust’s share of the entity’s taxable income, the trust has to retain the entire distribution to pay the tax. In this situation, the income beneficiary gets nothing. When the distributions from the entity to the trust are equal to or exceed the K-1 taxable income, the tax treatment is simple and straight forward. When the entity distributes more than its taxable income, the trust’s tax liability attributable to its share of the entity’s taxable income is zero. This is because the trustee can pay enough to the income beneficiary to get a full income distribution deduction which reduces the trust’s tax to zero. As shown in the AICPA’s comments, the result is much different if Section 505(d) is applied first. The amount payable to the income beneficiary would increase to $500,000. If Section 505(d) is applied first, the trustee would allocate taxes on the entity’s taxable income between income and principal based on receipts, reduced by payments to the beneficiary for which the trustee is entitled to a deduction. Thus, receipts in the allocation formula are first reduced by amounts that the trustee can deduct when paid to the beneficiary. So, the trustee would first reduce income receipts by amounts for which the trust receives an income tax deduction. To the extent this reduce income receipts to zero, no tax would be allocated to income receipts. 35

37. Illustration (Assume same facts as above – Taxable Income $1,000,000; Distribution to Trust $500,000) Taxable Income per K-1 $1,000,000 Payment to Income Beneficiary 500,000 Trust Taxable Income $500,000 (35 % Tax = $175,000) Partnership Distribution $500,000 Tax Allocated to Income (0) Payable to Beneficiary $500,000 The above alternate construct could leave the trustee in the position of not having sufficient cash to pay the tax on the entity’s undistributable income. Another situation which could prove troublesome is where the entity makes a distribution precisely for the amount of federal income tax that is payable on income reflected on Form K-1. Suppose the trust has a mandatory distribution requirement. Unless the fiduciary takes further action, the “tax reimbursement” is distributable to the income beneficiary, depriving trust principal of the ability to discharge the tax liability from funds received in the distribution. Here, the fiduciary could use the power to adjust and allocate the distribution to principal. 36

38. Relying on UPIA provisions will not secure the marital deduction. IRA’s are unique Income is taxable to the beneficiary when distributed Upon the account owner’s death, the account is a principal asset to the fiduciary Nature of IRA has caused concern among practitioners in regard to securing marital deduction when funding a marital trust with an IRA Securing marital deduction is complicated by Code’s minimum distribution requirement (RMD) Funding a Marital Trust with an IRAor Defined Contribution Plan*Note: All such plans will be referred to for simplicity as an IRA. 37

39. UPIA Provisions: UPIA includes models of how marital deduction could be secured Section 409 (c) 10 % Rule – If no part of payment from an IRA is characterized as interest, dividend or an equivalent payment, and all or part of the payment is required to be distributed currently, the trustee must allocate 10% of the payment to income and 90% to principal If no part of the payment is required to be paid currently, the entire payment must be allocated to principal UPIA recognized that above provisions could jeopardize the marital deduction: Q-TIP provisions require payment of net income to surviving spouse to secure deduction Section 409 (c) mandated classifications bear no relationship to IRA’s actual income In an attempt to insure the marital deduction, UPIA requires an additional allocation to income if necessary to secure the marital deduction (Section 409 (d)) 38

40. Even with Section 409 (d) savings clause, practitioner's were concerned that UPIA retirement plan allocation rules were problematic in marital deduction situations – they were right! Revenue Ruling 2006-26: Answers question of how adoption of UPIA affects the determination of what is IRA income in marital deduction situations The Revenue Ruling is of critical importance in obtaining the marital deduction for amounts held in an IRA when the beneficiary is a Q-TIP Trust and the applicable state law is the UPIA with power to adjust and/or power to define income as unitrust amount Ruling provides three illustrations showing how IRA income should be computed to satisfy marital deduction requirements The three illustrations address the requirement for income distributions in the context of states which: have adopted the UPIA’s power to adjust and UPIA Sections 409 (c) and (d) Have a unitrust definition of income, or Have not adopted the UPIA’s power to adjust nor a unitrust definition 39

41. The Ruling acknowledges that each of the below three methods could produce a sufficient amount of income to secure the marital deduction: Power to Adjust under UPIA section 104 (c), (Caution Reliance on UPIA Sections 409 (c) and (d) will not secure the marital deduction) Determination on unitrust basis Determination under traditional state law principles All three illustrations are based on the same basic facts: The Q-TIP Trust gives the spouse power to require the trustee to make withdrawals from the IRA in an amount equal to all income and to distribute such income to spouse. The trustee elects to take distributions over the spouse’s life expectancy. The spouse has the right to require that the IRA be invested in productive assets. The remaindermen are the account owner’s children. No person other than the spouse and children have a beneficial interest in the trust. Illustration 1: Applies where state laws allows adjustments between principal and income and the power to adjust is exercised to administer the trust fairly State law also has adopted Section 409 (c) 10% rule and 409 (d) savings clause Trustee determines total return for all trust assets other than the retirement plan and allocates between principal and income in accordance with UPIA Section 104 (a) Trustee separately determines the total return for the plan assets and allocates in accordance with Section 104 (a) 40

42. This latter allocation is made “without regard to, and independent of, the trustee’s determination with respect to trust income and principal” In other words, the allocation of a payment from the IRA to trust income or principal under UPIA Section 409 (c) is irrelevant to the determination of trust income from non-plan assets and to the determination of trust income from the IRA In summary, the Trustee determines income from Non IRA assets IRA assets The above two components together constitute the income which must be distributed to the spouse, or in the case of IRA income, subject to the spouse’s power to force distribution It is critical to note that the method of computing income sanctioned by IRS entirely ignores the UPIA rules for allocation of IRA distributions to income and principal The ruling explicitly states that the 10% allocation rules of Section 409 (c) does not satisfy the Q-TIP rules. The 10% rule: Does not reflect a reasonable apportionment of the total return between the income and remainder beneficiaries Does not represent IRA income under applicable state law without regard to a power to adjust 41

43. The ruling adds that the savings clause of Section 409 (d) might not save the marital deduction Note that even if Section 409 (d) effectively requires that the entire distribution be allocated to income this still does not insure that the surviving spouse will actually receive all of the IRA’s annual income The RMD in any year is unrelated and is not equal to the IRA’s income So, the annual income requirement of Code Section 2056 is just not met under Sections 409 (c) and (d) Illustration 2: Applies where income is defined as a unitrust amount in accordance with state law The Trust is governed by state law which permits income to be a 4% unitrust amount if: The governing instrument so provides, or The interested parties consent The Trustee determines the 4% unitrust amount independently for the IRA and non-IRA assets The Trustee of the Q-TIP Trust distributes the unitrust amount from the trust to the surviving spouse each year Although the Revenue Ruling found this methodology to be reasonable note that the surviving spouse had the right (under the universal fact pattern described above) to demand that the trustee withdraw the IRA’s annual income and distribute it to him/her 42

44. Illustration 3: Applies where the trust is governed by the law of a state that has not adopted the UPIA As in Illustrations 1 and 2, the trustee determines income separately for the IRA and non-IRA assets The allocations between income and principal are made using traditional allocation principles This methodology would also be permissible in a state that has adopted a power to adjust under the UPIA if the trustee decides not to use the power to adjust As in the two other illustrations, the surviving spouse’s power to demand and receive all IRA income annually saved the marital deduction In the Revenue Ruling, IRS noted that in a state that has adopted the power to adjust and power to define income as a unitrust amount it would be permissible for the trustee to determine income for non-IRA assets using the power to adjust and income for IRA assets as a unitrust amount, or vice versa. 43

45. Application of the Revenue Ruling is prospective It applies to taxable years beginning on or after May 30, 2006. So, marital trusts which were properly drafted but not administered in accordance with Revenue Ruling 2006-26 before the effective date will not be adversely effected. Note that the provisions of the UPIA cannot be exclusively relied on to secure a marital deduction when an IRA is payable to a Q-TIP Trust: The governing provisions must conform to Code Section 2056, as illustrated in Revenue Ruling 2006-26 Without specific non-UPIA language in the governing instrument, a marital deduction will not be available with respect to the IRA in the three illustrations discussed in Revenue Ruling 2006-26 In the fact pattern of Revenue Ruling 2006-26: The Q-TIP Trust and the IRA were considered to be separate marital deduction trusts for the purposes of allocating income and principal and determining if each qualified for the marital deduction. The surviving spouse had the right to mandate that the Q-TIP and IRA assets be made productive. 44

46. The governing instrument or state law had to provide that the determination of income and principal for the Q-TIP Trust and the IRA had to be made separately. The surviving spouse had the absolute right annually to require that: the Q-TIP trustee withdraw all income from the IRA, and all of the withdrawn income be distributed to him/her It is this power to withdraw and right of distribution that is essential to the allowance of the marital deduction. Securing the marital deduction depends on proper drafting. Some of the provisions which should be included is language which: gives the spouse the power to demand income from both the trust and the IRA requires the trustee of the Q-TIP trust to withdraw the greater of income and the RMD overrides UPIA Section 409 (c) mandates that income of the Q-TIP Trust and IRA is to be computed separately gives the surviving spouse the power to require the trustee to make the Q-TIP Trust property and IRA productive 45

47. Proposed Changes to Section 409 In light of Revenue Ruling 2006-26 which rejected the 10% rule of Section 409 (c) in the context of securing the marital deduction when a Q-TIP Trusts holds an IRA or certain other retirement plans, recommendations have been made to revise Section 409 to secure the marital deduction The recommendations suggest adding provisions to Section 409 to include an “income allocation provision” and “mandatory distribution provision” The AICPA comments note that IRA accounts generally fall into two categories Where underlying earnings are ascertainable, such as mutual funds Where underlying earnings are not ascertainable, such as annuity contracts Where earnings are ascertainable the trustee should be able to determine the amount of income and allocate so much of the required distribution that represents this amount to income and the balance to principal Where earnings are not ascertainable, AICPA recommended the adoption of a unitrust approach allowing the trustee to allocate an amount ranging from 3% to 5% of the IRA’s fair market value to income and the balance to principal 46