Total Return Trusts

A Thoroughly Modern Approach

Trust income shall be paid to my wife at least annually, and the trust remainder shall be paid to my children at her death.” That common phrase, familiar to generations of trust lawyers, sounds simple, but it is not. What is “income”?

In a traditional trust, income generally consists of interest and dividend payments. Price changes—capital gains and losses—affect the value of principal, and hence benefit the remainder beneficiaries. For example, assume that a marital deduction trust invests in a technology stock that pays no dividends at all, but it doubles in price in just five years. How much income does that create for the surviving spouse? None at all. A spouse who is looking for maximum reliable current income from trust assets likely would favor heavier investment emphasis on bonds and their regular interest payments.

However, we have just come off a period of historically low interest rates, in which even an all-bond investing strategy might not yield enough income to satisfy a current beneficiary. What’s more, failure to keep some exposure to equities in the trust portfolio could mean that the assets fail to hold their purchasing power during periods of significant inflation.

There are several alternatives to the traditional definition of trust income.

The example of the charitable unitrust

When Congress became concerned in the late 1960s about a possible mismatch between the charitable deduction and the amounts that a charity actually might receive from a charitable trust, the resolution included a new statutory 

definition for a charitable income interest. Thus was born the unitrust, in which each year the income beneficiary receives a fixed percentage of the value of the trust assets, regardless of how those assets are invested.

During the 1990s, when interest and dividend rates fell to historically low levels, estate planners began to look to the unitrust model for private trusts as a way to resolve conflicts between income and remainder beneficiaries. At the same time, the Uniform Prudent Investor Act was introduced and began to be adopted around the country. That legislation provides standards by which trustees are measured in the discharge of their fiduciary duties in the investment arena. The new emphasis was less on the appropriateness of each individual trust investment, more on adequacy of the total trust return.

Thus was born the total return trust, a trust without a charitable beneficiary that follows the conventions of a charitable trust in determining what the income beneficiary gets.

The first state law authorizing the conversion of existing trusts to the total return format was enacted in June of 2001, and 17 states followed suit within three years. Most states have such legislation today. A majority of states also permit “equitable adjustment.” In the earlier example of the no-dividend technology stock, a trustee could use equitable adjustment to allocate a portion of the stock’s capital gains to the income beneficiary. Alternatively, during periods of high interest rates and high inflation, the trustee may allocate some income payments to principal, to build the trust for the future.

Total return trusts are not a magical solution to investment management issues. They don’t guarantee growth; they don’t prevent losses. But they can ease conflicts among trust beneficiaries and meet beneficiary expectations by providing bright-line definitions of income.

IRS approval

Trusts have tax consequences, and in 2001 the Internal Revenue Service weighed in on total return trusts. Adjustments between income and principal that are consistent with state law will not impair the marital deduction, and a unitrust interest will qualify for the marital deduction if provided for by state law. Generally, the IRS considers that a unitrust interest of not less than 3% and not more than 5% is a reasonable apportionment of the total return of a trust. Existing marital deduction trusts may be converted to total return format under IRS regulations that were finalized in 2004.

When “total return” is not paramount

The rigidity of the total return format may not be appropriate in all cases. See the table below for examples of alternative income definitions that estate planners have developed over the years. Situations in which a traditional trust may be satisfactory:

• Maximum return is not the goal of the trust. Some grantors are most worried about protection of capital and controlling investment risk.
• The surviving spouse is the primary beneficiary. A traditional trust that also permits discretionary invasions of principal to meet the spouse’s needs will be adequate in many situations.
• The trust has a short time horizon. Because stock prices tend to be volatile over short time frames, increased equity exposure may not be appropriate for a trust with a short shelf life.

May we tell you more?

As you can see, modern trust design permits flexible trustee response for maximum financial security. Might you and your family benefit from trust-based financial management? We’d be pleased to tell you more about our services. Why not make an appointment this month to meet with one of our officers?