The New Alchemy: Hasso v. Hasso and Converting Principal to Income Under the Revised Upia

• Publication year: 2008
• Author: By Andrew Zabronsky, Esq. and Claudia J. Lowder, Esq.

THE NEW ALCHEMY: HASSO V. HASSO AND CONVERTING PRINCIPAL TO INCOME UNDER THE REVISED UPIA

By Andrew Zabronsky, Esq. and Claudia J. Lowder, Esq.^*

I. INTRODUCTION

In recent years, estate planners have increasingly utilized limited partnerships, LLCs and other entities to gather client assets and pass wealth to younger generations. As part of this planning, the client will usually transfer interests in these entities to irrevocable trusts. Often overlooked amid the enthusiastic discussion about such devices, however, are certain side effects that can seriously undermine basic expectations of settlors and trust beneficiaries.

The 2007 case of Hasso v. Hasso¹ illustrates one such side effect, in the area of trust income and principal allocations. There, the question was the proper allocation of trust receipts generated from a $125 million sale of stock by a subsidiary of a corporation owned by the trust. Over time, the receipts amounted to nearly half the corporation's net worth.² Yet the income beneficiary asserted that receipts should all be allocated to income and paid out to her. Such a wholesale transfer of the principal value of a trust to the income beneficiary would surely conflict with the desire and expectation of most settlors. There is also no question the same receipts would have to be treated as principal had the trust owned the shares directly. According to the Court of Appeal, however, because the shares were owned indirectly through entities, the opposite rule applied, and a major portion of the trust's value had to be paid out to the income beneficiary.

Although the result in Hasso may contradict traditional notions of income and principal, it was for the most part dictated by recent revisions to the rules in the Uniform Principal and Income Act ("UPIA"), which treats very differently receipts generated from assets owned directly by the trust and those owned indirectly through an entity. Under rules adopted in 2000, receipts from an entity, unless they fit within rigidly defined exceptions, must be allocated all to income. As a result, receipts that would traditionally be considered principal, e.g., proceeds of the sale of a major principal asset, may be allocated to the income beneficiary, and receipts that would traditionally be considered income, e.g., proceeds of an income reserve, may be allocated to principal.

It is unlikely estate planners intend to fundamentally alter the rules allocating receipts between income and remainder beneficiaries when they use closely held entities as estate planning devices. Likewise, settlors and beneficiaries are likely to view a trust holding assets through, e.g., a family limited partnership as similarly situated to a trust holding the same assets directly. The authors believe these situations should not be treated as disparately as they are under the UPIA, and urge the Executive Committee of the Probate and Trust Section (TEXCOM) to study the matter and propose reform.

At a minimum, estate planners ought to be aware of the potential effects of the use of entities for estate planning purposes, and draft accordingly.

II. CALIFORNIA'S UNIFORM PRINCIPAL AND INCOME ACT

A. The Law Prior to the 2000 UPIA

The traditional, common law rule for allocating trust receipts was that gains from the use of trust property (e.g., interest and rents) were income, while substitutes for or changes in the form of original trust property (e.g., proceeds from a sale or collection of a debt) were principal.³ Although the peculiar nature of corporate stock, in which the stockholder has no right to corporate assets or earnings until the corporation makes a distribution, presented certain allocation problems,⁴ the common law generally strove to treat distributions from an entity in accordance with the traditional rule applicable to assets owned directly by the trust. Thus, there was general consensus under the common law of the various states that ordinary cash dividends were income and that dividends on a partial or total liquidation of a corporation were principal, at least to the extent they represented a return of capital.⁵

Similarly, under the first two iterations of the UPIA,⁶ which California adopted in 1941 and 1967, respectively,⁷ distributions from a corporation's sale or liquidation of assets were generally treated as principal.⁸ Moreover, in applying the rule, a trustee was given the flexibility to "rely upon any statement of the distributing corporation ... concerning the source or character of dividends or distributions of corporate assets."⁹

Effective January 1, 2000, however, this flexibility and fidelity to traditional notions of income and principal gave way to a desire, through bright-line rules, to "'mak[e] fiduciaries' decisions easier and more certain.'"¹⁰

B. The 2000 UPIA

In 1999, the Legislature enacted the current UPIA, effective January 1, 2000.¹¹ California's UPIA is based largely on the Uniform Laws Commission's 1997 Uniform Principal and Income Act, but with some divergences,¹² including the provision on the allocation of distributions from a corporation.¹³

Section 16350 of the UPIA provides for the allocation of receipts from "entities," defined in Section 16350(a) to include corporations, partnerships, LLCs, and other such organizations in which a trust may have an interest. Under Section 16350(b), a trustee must allocate "money received from an entity" to income unless it falls within one of several exceptions identified in

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Section 16350(c). If an exception applies, the receipt is principal. If no exception applies, the receipt is income.

Among these exceptions is the exception analysed in Hasso: "[m]oney received in total or partial liquidation of the entity."¹⁴ Section 16350(d)(1) provides that money is received in partial liquidation "(A) to the extent that the entity, at or near the time of a distribution, indicates that it is a distribution in partial liquidation" (the "entity indication exception") or "(B) if the total amount of money and property received by all owners, collectively, in a distribution or series of related distributions is greater than 20 percent of the entity's gross assets, as shown by the entity's yearend financial statements immediately preceding the initial receipt" (the "20 percent exception").

Section 16350(e) provides that "a trustee may rely on a statement made by an entity about the source or character of a distribution if the statement is made at or near the time of distribution by the entity's board of directors" or by others who are "authorized to exercise powers to pay money or transfer property" comparable to the board's.

The Legislature's stated goal in enacting Section 16350 was to simplify allocation decisions by providing clear tests for what is principal and what is income. "'Fiduciaries will, thus, be better able to make judgments about receipts that are part of a liquidation. This is a more practical and logical set of rules for making allocation than existed in the earlier uniform acts, making fiduciaries' decisions easier and more certain.'"¹⁵ As will be seen, the drafters have not so much made trustees "better able to make judgments" as taken "judgment" out of the equation altogether. As to whether the new rules are "more ... logical," that is subject to substantial doubt.

C. The Thomas Case

The first case to point to problems with Section 16350 was the 2004 decision of Estate of Thomas.¹⁶

In Thomas, the issue was whether a distribution from a subchapter S corporation was a "partial liquidation" of the corporation and hence allocable to principal. Although the distribution to all shareholders represented over 50 percent of the corporation's gross assets, the court ruled that the distribution to the trust had to be allocated to income because that distribution was not over 20 percent of the corporation's gross assets. The court reasoned that the plain language of the statute—which at that time referred simply to money "received in a distribution"—had to be construed in this manner and that the Legislature, if it intended otherwise, could have expressly referred to the total amount paid to all shareholders.¹⁷ The court rejected the argument that its holding would lead to the "absurd" result that the same corporate distribution would be a partial liquidation for some trusts but not for others.¹⁸

The Thomas decision provoked an immediate outcry since it came out just as Microsoft Corporation was preparing to issue a $32 billion special dividend that represented some 35 percent of its gross assets. Institutional trustees had been preparing to allocate the special dividend to principal under the 20 percent exception, and Thomas sent them into a tizzy about what to do. Exercising their clout, the bankers pushed through emergency legislation amending Section 16350 to clearly provide that the 20 percent threshold for determining whether a partial liquidation has occurred is calculated based on "the total amount ... received by all owners, collectively."¹⁹

Although this amendment was surely right, one cannot help but sympathize with the Thomas court, which, having based its construction on the plain meaning of Section 16350, was then criticized by the drafter of the section (the Legislature) for being "excessively literal."²⁰

III. HASSO V. HASSO

A. Introduction

In Hasso, the issue was whether funds distributed by a corporation to a shareholder-trust constituted income or principal. At stake were the competing interests of the trustor's widow, the income beneficiary, and his children, the remainder beneficiaries. The Court of Appeal, construing Section 16350 of the UPIA, held that the distribution, being "money received from an entity" and not subject to the entity indication exception or the 20 percent exception, represented trust income payable to the widow. As will be seen, although Hasso may have correctly applied Section 16350, the result was absurd—the transfer of millions of dollars of principal to income on the grounds...