Pennsylvania Trustee Mistake Part 5
Failing To Conform To The Principle And Income Act
The Principle and Income Act applies to all Pennsylvania trusts unless the language of the trust instrument specifically exempts the trust from its provisions. The Act contains three main sections.
So, this act applies to most trusts and you might have been named as a trustee.
The first section specifies what is "principal" and what is "income" for trust purposes. On the face of it, this sounds simple. But in reality it can be complicated. Interst seems to be income and income might go to a surviving spouse. But what about capital gains from the sale of stock? Should they go to the income beneficary or should they build up and go to children? It is important that there be no confusion over what belongs to who.
The second part of the Act covers the "power to adjust," which allows trustees to re-categorize "principal" as "income" or vice versa to achieve fairness as between income and principal beneficiaries. This is an important breakthrough in allowing trusts to be properly managed on a total return basis. Under the Act's total return approach, a trustee must decide on each occasion whether or not to re-characterize principal or income.
To help with this problem part three of the Act offers another option, to convert the entire trust to a "unitrust." Under this technique, the trustee decides one time to operate the trust as a unitrust, and thereafter the distinction between income and principal no longer matters for payout purposes.
Unitrusts are a new way that a trust creator can balance the needs of multiple beneficiaries-like a second spouse and his or her children from a prior marrige. And, the act has made this process clearer and more flexible.
Before the Principle and Income Act the traditional rules required the trustee to adjust trust investments to conform to the income needs of the beneficiaries. Now the Act allows a trustee to decide either to equitably adjust amounts between principal and income or convert to a unitrust that annually pays the income beneficiaries a fixed 4 % of the trust's net fair market value. These two new alternatives provide the trustee with much more flexibility when deciding what type of investment strategy to follow.
Now that you have a brief understanding of the alternatives the Principle and Income Act have created for you, the trustee, you must be aware that to utilize the benefits the Act has to offer through re-characterizing principle or income or converting the trust to a unitrust there are many rules that need to be followed. The trustee must determine that the conversion will enable it to better carry out the intent of the creator of the trust. The trustee must also give notice to the beneficiaries of its intent to convert to a unitrust and must specify how the unitrust would operate. It is easy for a trustee to see the value of utilizing the alternatives laid out in the Act but fail to follow all the rules that govern the ability to use those alternatives. As a trustee do not make this mistake. Understand what the alternatives mean and the steps you must follow to legally utilize them.
See all ten of our articles on How To Avoid The Most Common Mistakes Trustees Make:
David M. Frees III
Representing trustees and executors throughout the region, from Exton, Malvern and West Chester to Phoenixville Pennsylvania