71 J. Kan. Bar Assn. 6, 51-61 (2002). An Accounting Primer for Estate Planning, Probate and Trust Counsel (The New Kansas Uniform Principal & Income Act).

AuthorBy C. David Newbery and D. Thad Sullivan

Kansas Bar Journals

Volume 71.

71 J. Kan. Bar Assn. 6, 51-61 (2002).

An Accounting Primer for Estate Planning, Probate and Trust Counsel (The New Kansas Uniform Principal & Income Act)

Kansas Bar Journal71 J. Kan. Bar Ass'n, June/July 2002, 51-61 (2002)An Accounting Primer for Estate Planning, Probate and Trust Counsel (The New Kansas Uniform Principal & Income Act)C. David Newbery and D. Thad Sullivan, An Accounting Primer for Estate Planning and Turst Counsel (The New Kansas Uniform Principal & Income Act), J. Kan. Bar Ass'n, June/July 2002, 51-61By C. David Newbery and D. Thad SullivanI. Introduction

Effective July 1, 2000, Kansas adopted the revised 1997 Model Uniform Principal and Income Act (Act) with minor modifications.[1] This Act, which replaces the Kansas Uniform Principal and Income Act, sets forth the accounting procedures and related duties and powers of executors and trustees in administering Kansas estates and trusts.

Like the prior Act, the new Act sets forth an extremely detailed set of default rules that apply to all estates and trusts in virtually all situations. As default rules, they can be overridden by the terms of a will or trust. Consequently, an estate planner who drafted a will or a trust without any knowledge of the Act has blindly adopted a list of rules to which the client may or may not be amenable.

Because the new Act is very detailed and extensive, it is not possible to discuss and analyze in detail all of its provisions in this article. Instead, this article is intended to provide an introduction to, and summary of, the new Act for those who have a limited understanding of fiduciary principal and income accounting concepts.

This article will first explain the substantial changes that have occurred in estate planning practices and in the investment, financial and business world since the last Model Act was adopted more than 37 years ago. Next, the article will review the purpose and scope of the Act within the context of several examples involving common fact patterns. Finally, the article will present a brief introduction to some (but not all) of the many esoteric provisions in the Act that only the most fervent and studious tax and accounting enthusiast would care to explore.

  1. Real World Changes Reflected in the New Act

    This section explains the genesis of the major changes in the new Act. Each of these changes will be more fully described in later sections of this article.

    1. Revocable Living Trust as Will Substitute

      Perhaps the most significant development in the estate planning field over the past twenty years has been the growing popularity of the revocable living trust as a will substitute. The prior Act provided extensive accounting rules that applied during estate administration, but provided no guidance for the administration of a revocable living trust following the death of the trust grantor. The new Act not only updates and clarifies the accounting rules that apply during estate administration, but also provides that these rules apply to the administration of a revocable living trust after the death of the grantor. These rules are set forth in Part 2 of the new Act .[2]

    2. "Prudent Investor" Standard Replaces "Prudent Man" Rule

      The second significant change giving impetus to the new Act is the recent imposition of more onerous investment standards on fiduciaries. Prior to 1992 a fiduciary in Kansas was subject to the "Prudent Man" standard. For example, where a trust provided an income stream to an income beneficiary, the trustee's job was to generate income for the income beneficiary while preserving the principal for the remainder beneficiary. Today, fiduciaries are generally subject to the more stringent "Prudent Investor" rules, and under modern portfolio theory, are expected not only to provide income-to-income beneficiaries, but also to grow the principal for the benefit of the remainder beneficiaries. The new Act recognizes this greater burden placed upon fiduciaries by providing trustees and executors more flexibility and discretion in making allocations and adjustments between income and principal beneficiaries' accounts. The new Act generally permits the fiduciary to discretionarily transfer amounts between income and principal when the fiduciary determines that such transfer or adjustment is necessary to meet the requirements of the "Prudent Investor" rule.[3]

    3. Popularity of "Pass-through" Entities

      The third significant real world change requiring an update to the prior Act is the pervasive use of "pass-through" entities. When the 1965 Model Act was promulgated, most small businesses were conducted by C corporations, which generally returned investment income to investors through dividends. In recent years, the entity de jure for nonpublicly traded businesses has become the S Corporation, followed closely by the limited liability company and its distant cousins, the limited liability partnership and the limited partnership. The new Act recognizes the increased use of these entities by completely revamping the accounting rules that apply to receipt of dividends or other distributions from business entities.[4]

    4. New Investment Vehicles Such as Derivatives and Asset-Backed Securities

      The fourth real world change compelling changes to the new Act has been the advent of new investment vehicles, most notably derivatives and asset-backed securities,[5] such as interest rate swaps, forward and option contract pools, and mortgage and other debt pools.

    5. Other Impetus for Change

      There are a substantial number of other changes in the new Act designed to correct deficiencies and to answer questions that have arisen over the 37-year history of the prior Act.

  2. Purpose and Scope of the Act

    Like the predecessor law, the new Act provides a set of rules for allocating receipts and disbursements between income and principal. This distinction between income and principal is important in two different situations. First, the distinction is obviously important where the income beneficiaries of an ongoing trust or estate are different than the principal beneficiaries. Under the new Act, principal beneficiaries are called "remainder beneficiaries" and are defined as persons entitled to receive principal when an income interest terminates.[6]

    The second situation concerns an estate or trust "winding-down" and there typically are no income beneficiaries per se. In this situation, a trustee or executor is concerned not only with accounting for income and principal, but also with determining who is entitled to the income.

    To illustrate the importance of these accounting rules, consider the following examples:

    Example 1. Assume G establishes a trust for A and B by transferring investment assets to T, trustee. The trust agreement requires T to pay all income to A for ten years after which the trust is to terminate with principal to be paid to B. Each time T receives any cash or property during the ten-year term, T must decide whether to credit that receipt to the account of A, the income beneficiary, or to the account of B, the remainder beneficiary, or partially to each. Likewise, T must decide for each trust disbursement, whether to reduce A's account (the income beneficiary) or B's account (the remainder beneficiary).

    To illustrate further, assume that G initially transfers to T a corporate bond that pays interest quarterly. Assume further that, at the time of transfer, one month has passed since the last interest payment date. The first bond interest payment received by the trustee (two months after inception) will therefore have two components: a) one month of interest income that was earned (accrued) prior to creation of the trust; and b) two months of interest income that was earned while T held the bond. Most reasonable persons would agree that the two months of bond interest earned after trust creation should be credited to A, the income beneficiary. But who should be allocated the income earned or accrued prior to inception of the trust?

    Example 2. Same facts as Example 1, except that G also purchases ABC stock for $100 and immediately transfers it to T to be held as part of the trust. Five years later, T sells the ABC stock for $175, generating a $75 taxable long-term capital gain. Should the taxable $75 gain be allocated to A's account (income beneficiary) or to B's account (remainder beneficiary)?

    Example 3. The executor(E) of Bob's estate is directed to distribute Bob's assets as follows:

    Farm to son Ed.

    Rental properties to son John.

    $50,000 to daughter Jane.

    50 percent of the balance each to wife, Vera, and the XYZ Church.

    During the course of estate administration, the estate earns substantial income from investments, the farm and rental properties. Upon final distribution, to whom should E distribute the income?

    The new Act directs T to four sources of authority, in priority order, with which to make these decisions.

    First, the new Act requires T to follow the terms of the trust or will. Therefore, if the trust document (or will) provides direction as to how to allocate accrued bond interest at trust inception, capital gains, and/or estate income, then T must follow such directive.[7]

    Second, if no specific direction exists in the trust agreement, but if the trust agreement (or will) grants T discretion in allocating receipts and disbursements, then T may exercise such discretion and allocate receipts and disbursements to either principal or income.[8] However, in exercising such discretion, T must act...

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