Chapter 34 - § 34.15 • REVISED PRINCIPAL AND INCOME ACT

• Jurisdiction: Colorado

§ 34.15 • REVISED PRINCIPAL AND INCOME ACT

In 2000, the Colorado legislature adopted the Revised Uniform Principal and Income Act (the Act) as C.R.S. §§ 15-1-401, et seq. Pursuant to C.R.S. § 15-1-434, the Act became effective July 1, 2001. The Act applies to post-July 1, 2001, estates and trusts then irrevocable. It also applies to pre-July 1, 2001, estates and trusts unless the fiduciary elects by July 1, 2002, to opt out of the Act. As discussed below, the trustee's election to make an adjustment in favor of the income account is an important new concept. Elections once made are irrevocable and notice of the election should be given to the beneficiary.⁴³

Nationally, the Revised Act is intended to supercede both the original 1931 Act and the 1962 Revised Act.

The main purpose of the Act is to provide rules for the allocation of receipts and disbursements in the case of split interest trusts; that is, where the current income interest is in one beneficiary and the ultimate remainder interest is in another beneficiary or beneficiaries. Suppose a trust receives a royalty payment, or an annuity payment, or a payment for the harvest of timber. Is the receipt payable to the current income beneficiary or added to corpus for the benefit of the ultimate remainder beneficiary? These rules also govern the allocation of receipts during the period of probate administration where the residuary beneficiary is itself a trust. Separately, the Act provides rules for dealing with the allocation of receipts and disbursements during probate administration as between pre-residuary pecuniary and specific bequests on the one hand and the residue on the other. The Act also focuses more on non-probate transfers, including revocable trusts as will substitutes and attempts to establish a set of rules that will cover both testamentary and non-probate documents.

There are two core concepts. Initially, the Act provides default rules. It fills gaps not covered in the governing instrument. Where the Act and a trust instrument are inconsistent, the terms of the trust apply.⁴⁴ Therefore, one can draft around or opt out of the provisions of the Act. Note that the "terms of the trust" may be established by spoken words and/or conduct as well as by the writing itself.⁴⁵ Secondly, consistent with the rules of prudence and impartiality, the adjustment and allocation provisions of the Act are to be applied "based on what is fair and reasonable to all of the beneficiaries."⁴⁶

The radical innovation under the Act is the grant of discretionary authority to a trustee to allocate some portion of corpus (presumably realized capital gains, and then unrealized gains) to the income account in cases where the governing instrument limits the life beneficiary's interest to income and does not provide for the invasion of corpus. The Act also authorizes reallocations of income to corpus.⁴⁷ Under the provisions of the Uniform Prudent Investor Act,⁴⁸ a trustee may invest for a total return (i.e., current ordinary dividend and interest income, together with appreciation in the value of the underlying assets), including investing in assets expected to appreciate in value (so as to attempt to keep up with or exceed the expected rate of inflation in the economy). Without an adjustment power, the risk is that the investment in a more growth-oriented portfolio will result in lower current dividends for the income beneficiaries and a disproportionate benefit for the remainder beneficiary. The list of factors relevant to the exercise of discretion under the Principal and Income Act⁴⁹ is similar to those relevant to investment decision-making under the Prudent Investor Rule. Similarly, an adjustment may be appropriate upon the sale of an unproductive or under-productive asset so as to compensate the income account out of the sale proceeds (corpus) for the past deprivation of income.

In 2003, a unitrust amendment was adopted. As an alternative to exercising the power to adjust, a trustee may convert the trust to a total return trust or a unitrust. The conversion may be accomplished either by notice to beneficiaries with no receipt of objection or by court order. The distribution percentage is four percent unless otherwise ordered by the court or by the agreement of the trustee and beneficiaries, but the percentage may not be less than three percent or more than 5 percent.⁵⁰ The amendment is effective May 22, 2003, and applies both to pre-existing and subsequent trusts.

C.R.S. § 15-1-405 contains a notice provision. Before making an equitable adjustment (or deciding not to so act), a trustee may give notice to the current income beneficiaries and those who would be remainder beneficiaries if the trust were then terminated. The notice must provide for a deadline (at least 30 days) to provide the trustee with written objections. If no objection is received, the trustee may proceed without liability risk; if an objection is received, then the trustee may notify the beneficiaries of the decision not to proceed with the adjustment. Either the trustee or beneficiary may petition the court to order that an adjustment be made. The Act protects the trustee from claims by a beneficiary for either proposing or failure to propose an adjustment.⁵¹

Note that the adjustment power will not be applied in the great majority of modern family trust instruments. This is because modern drafting often provides flexibility for the protection of beneficiaries through the grant of discretion in a trustee to invade corpus for the benefit of a beneficiary or class of beneficiaries, usually limited by a standard (often the estate tax protective ascertainable standard of health, education, support, and maintenance). It is only when there is no provision for corpus invasion that the allocation power becomes important.

To protect the integrity of tax-motivated transfers, however, there are certain adjustments that cannot be made. These...