Trusts enable you to grow assets and provide income for your family. Some trusts provide income to one person for life, with the principal ultimately passing to the next generation. The principal of a trust can consist of stocks, bonds, real estate and other investments which are hopefully generating income. How the trust defines income will determine the amount the beneficiary of the trust receives each month. Trusts which provide for distributions based on accounting income (i.e. – just interest and dividends) can cause tensions among beneficiaries and can seriously prevent the person managing the trust, the trustee, from obtaining the best investment results.
Let’s take an example. Teresa is married to Paul. Paul has two children from his first marriage, Lori and Annelle. Paul wants to provide for Teresa and, at the same time, make sure that his assets ultimately benefit Lori and Annelle. Paul’s lawyer drafts a trust that provides: “The trustee shall distribute all of the income of the trust to Teresa. When Teresa dies, the trustee shall distribute the principal of the trust to Lori and Annelle.” Paul names his business associate, Michael, as trustee. Teresa is the “income beneficiary” of the trust and Lori and Annelle are the “remainder beneficiaries” because they receive the remainder of the assets after Teresa’s lifetime.
Competing Goals Creates Conflicts Between Trust Beneficiaries
Under the language quoted above, Teresa will only receive dividends, interest, rents and similar items. Even though capital gains are taxed as income, all appreciation in the value of the investments will be allocated to principal. If the trust owns stocks, bonds and mutual funds, Teresa will want the trustee to invest to maximize interest and dividends. Lori and Annelle will press for growth-oriented investments. Michael, the trustee, will be caught in the middle.
Traditional Trusts Encourage Sub-par Investment Performance
Unless the trust document directs otherwise (and the vast majority do not), a trustee must balance the interests of the current beneficiary with those of the remainder beneficiaries. Many trustees invest half in bonds for income and half in stocks for growth to satisfy the competing interests. Yet, this “fair” approach results in sub-par investment performance. Only half of the portfolio is generating income and half of the portfolio is positioned for growth. All of the beneficiaries complain and the trustee is criticized for something that the trustee didn’t cause.
Traditional Trusts lead to Unpredictable Distributions
Many trusts are created to give the beneficiary, often a spouse or a child, a reasonably steady and predictable source of support. What can the “income beneficiary” count on? In the 1980s, she might have received 12%. Today her income may be less than 3%. She will have years of feast and years of famine. These fluctuating distributions bear no rational relationship to the beneficiary’s needs.
A Limited Solution: the Principal and Income Act
A statute called the “Principal and Income Act” allows a trustee to make an “adjustment” and augment income returns with an allocation of principal, as long as the trustee acts in a fair and impartial manner. The power to adjust is an excellent way to increase distributions from older trusts. It is not an elegant solution for trusts that we’re creating because control is totally in the trustee’s hands. The trustee could possibly still be criticized and the beneficiary does not have a reliable stream of distributions.
A Better Solution: Total Return Trusts
Total Return Investing
The income-principal distinction found in many trust documents has no relationship to the way people invest their own assets. Most investors look for total return which means they are looking for income AND asset growth. At the same time, the art of investing lies in balancing reward against risk. The most efficient portfolios seek the greatest potential for reward at the least risk. As we have seen, a trustee will have difficulty using this efficient investment paradigm for a traditional trust. We need to look to a trust architecture that is compatible with current investment wisdom.
How Total Return Trusts Can Meet Competing Goals
Studies of investment returns, such as the ones conducted by Vanguard, conclude that, from 1926 to 2016, a portfolio of 60% stocks and 40% bonds can produce an average annual return of approximately 8.7% per year. Because of the inherent conflicts in the administration of traditional trusts, trustees have been prevented from achieving this result.
With a Total Return Trust, the current beneficiary receives a distribution of a specified percentage of the trust’s value each year. The amount of the distribution is based on the value of the trust, not on its income. If the value of the assets increases, the distribution also increases. If the value declines, the distribution decreases. A properly designed Total Return Trust will have a “smoothing provision.” The distributions will be based on a moving average of the trust’s asset value, perhaps based on the preceding three or five years. The percentage to be distributed can be based on the beneficiaries’ needs and the expected investment returns. It need not be one fixed rate throughout the term of the trust.
Examples of a Total Return Trust in action
How a Total Return Trust Provides Income and Growth
Let’s revisit Teresa, Paul, Lori and Annelle. Suppose that Paul creates a Total Return Trust that provides Teresa with a 4% annual distribution. Teresa is young enough that one can reasonably assume a 9% annual total return on investments during her lifetime. Of that 9%, we allocate 2% to pay income taxes, leave 3% in the trust for future growth and distribute 4%. Studies have shown that, in a long-term trust, distributions in the 3.5-4.1% range can be made almost indefinitely while retaining the purchasing power of the trust principal. Now everyone is happy. Teresa will receive distributions that will increase as the fund appreciates. Lori and Annelle see their remainder growing. Michael, the trustee, is free to pursue the most efficient investment policy.
How a Total Return Trust Can Allow for Different Distributions
Tom is a widower with three children, Rachel, Andy and Nathan. He is comfortable leaving Rachel and Nathan their shares outright, but has some concerns about Andy, who is a bit of a spendthrift. Tom wants to provide generously for Andy, but doesn’t think that he could handle an outright distribution of his entire share. He wants Andy to be the primary beneficiary of a trust. Andy is single and has no children. He creates a Total Return Trust that gives Andy a 5% annual distribution. In addition, an independent trustee may make distributions for Andy’s medical care not covered by health insurance. With a 5% annual distribution, it is likely that the fund will eventually be exhausted. However, according to Tom’s financial advisor, the trust for Andy will last a long time.
Some Tax Considerations for Total Return Trusts
Marital Trusts
Most marital trusts require that the surviving spouse receive all of the trust income at least annually. A Total Return Trust can qualify for the marital deduction as long as it contains a specific provision. The surviving spouse must receive the greater of the trust’s income or the distribution percentage.
Turning 37% Income into (for now) 23.8% Capital Gains
In our “income only” trust, the trustee is compelled to realize reasonable income from dividends and interest. Interest income is taxed at rates as high as 37% in 2019. Long term capital gains are currently taxed at 23.8%, including the 3.8% Net Investment Income Tax. In a Total Return Trust, there is no distinction between income and principal. The trustee is able to raise cash for the annual distribution by paring some of the growth. This effectively creates an “income” that is taxed at capital gains rates.
Come see the estate planning attorneys at Cipparone Zaccaro, PC, if you would like to discuss how a Total Return Trust might improve your estate plan.
