Introduction – Out with the Old, and In with the New

On April 11, 2022, Governor Glenn Youngkin signed into law House Bill 370, which adopts the Uniform Fiduciary Income and Principal Act (“UFIPA”) into the Virginia Code and repeals the Uniform Principal and Income Act (“UPIA”). In doing so, Virginia became the sixth state to adopt the UFIPA, following Utah, Washington, Kansas, Colorado, and Arkansas.

Besides the new acronym, this article provides an overview of the changes that the UFIPA brings. To provide context for these changes, this article examines the history and prior versions of the UPIA, looks at how the UFIPA adapts to the continued modernization of trusts, and concludes with planning recommendations for practitioners.

History: the Uniform Principal and Income Acts.

Traditionally, beneficiaries of trusts were typically either entitled to receive: (1) income derived from trust investments; or (2) a subsequent, remainder share of the trust principal. This created an inherent conflict between the interests of the income and remainder beneficiaries. This conflict extended beyond whether the trustee should invest more heavily in income-producing assets (benefiting the income beneficiaries) or growth assets (benefiting the remainder beneficiaries) to the manner in which receipts and expenditures are allocated to income or principal.

The Uniform Principal and Income Act (Prior to 1997).

Prior to 1931, the law regarding the allocation of receipts and expenses between the principal and income of a trust had been almost entirely made by court decisions. These holdings were to a large extent harmonious, except that a sharp division had occurred between the courts of Massachusetts and Pennsylvania regarding corporate distributions, such as dividends. 1 The National Conference of Commissioners on Uniform State Laws (“Conference”) codified the subject as an attempt to create uniform treatment among the states when allocating receipts and expenses between principal and income. The UPIA was prepared and approved by the Conference in 1931 and updated in 1962 (“1962 UPIA”) to reflect changes in law and business practices that had taken place.

The 1994 Uniform Prudent Investor Act and the 1997 Revised Uniform Principal and Income Act

In the decades following the 1962 UPIA, there was a major shift in the investment practices of fiduciaries. This shift occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as “modern portfolio theory.” The modern portfolio theory posits that any given investment’s risk and return characteristics should not be evaluated alone but rather by how it affects the overall portfolio’s risk and return.

The Conference responded to this shift to the modern portfolio theory by preparing and approving the Uniform Prudent Investor Act in 1994 (“Prudent Investor Act”). The Prudent Investor Act altered the former criteria for prudent investing by providing that the standard of prudence to be applied to any investment should be reviewed as a part of the total portfolio, rather than to the individual investments themselves. On the heels of the Prudent Investor Act came the 1997 UPIA, which modified the 1962 UPIA to reflect the adoption of the modern portfolio theory approach by the Prudent Investor Act. The most significant change in the 1997 UPIA was the addition of Section 104, captioned “Trustee’s Power to Adjust.” This section provides that a trustee may adjust between principal and income to the extent the trustee considers necessary if: (1) the trustee invests and manages trust assets as a prudent investor; (2) the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income; and (3) the trustee determines that the trustee is unable to comply with the requirements of the 1997 UPIA that a trustee administer a trust or estate impartially based on what is fair and reasonable to all of the beneficiaries. The purpose of Section 104 is to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio’s total return in the form of traditional trust accounting income (such as interest, dividends, and rents).

The 2018 Uniform Fiduciary Income and Principal Act – More than just a Change in Name

Similar to the previous updates of the UPIA, the Uniform Law Commission released the UFIPA with the primary purpose to adapt to changes in the design and usage of trusts over the preceding decades. The modernization of trusts in the decades following the 1997 UPIA included: (1) increased use of very long-term trusts; and (2) the increased use of totally discretionary trusts – that is, trusts in which income, as well as principal, is distributable to beneficiaries during the term of the trust not as a matter of right but solely in the discretion of the trustee. Even in trusts with income distributions mandated by requirements of tax law (such as the estate tax marital deduction), the modern trend is for the trustee to have discretion to supplement such income distributions by the invasion of principal.

The UFIPA reflects the modernization of trusts with major updates including: (1) an expansion of the use of the power to adjust between income and principal; (2) the addition of unitrust provisions; and (3) a simplifying change in governing law for purposes of distinguishing income and principal. Each of these updates is discussed below.

1. Trustee’s Power to Adjust

As the modern trend moves towards the totally discretionary trust, historical distinctions between income and principal become less important as a technical matter in some cases. Discretionary accumulation of income has the effect of treating income as principal to the extent of the accumulation, and, similarly, the discretionary invasion of principal has the effect of treating principal as income to the extent of the invasion. The UFIPA recognizes that despite the increase in discretionary trusts, the difference between income and principal remains important to impartial trustees and beneficiaries alike.

The UFIPA operates on the premise that the trustee should be able to determine a standard for adjusting between income and principal that are reasonable under the circumstances, and to update those standards from time to time. Because of this, the UFIPA retains and expands the trustee’s authority to make adjustments between income and principal from year to year (introduced as Section 104 of the 1997 UPIA). This authority is found in new Section 203 of the UFIPA.

New Section 203 (codified as Code of Virginia §64.2-1038) eliminates the three conditions necessary under the 1997 UPIA’s Section 104 for the trustee to adjust between principal and income. Under Section 203, the trustee may adjust between income and principal simply if the trustee determines the exercise of the power to adjust will assist the trustee to administer the trust or estate impartially.

One of the most important ways Section 203 expands the authority to adjust from the 1997 UPIA is by eliminating the precondition that the trust distributions are constricted by the concept of “income” in a way that economic results from year to year could arbitrarily affect. This prevents the odd result where the trustee of a purely discretionary trust has less flexibility to adjust between income and principal than a trustee of a less flexible income trust.

2. Unitrust

Article 3 of the UFIPA (Code of Virginia §§64.2-1039 – 1047) adds the authority for a trustee to convert to or from a unitrust or change a unitrust. A “unitrust” is a trust in which the current income beneficiary receives a periodic payment determined with reference to the net value of trust assets, regardless of how much income is produced by the trust assets or the growth of the trust assets. As the value of the trust assets increases, the unitrust amount increases, and vice versa. Thus, there is a unity between the “income” and “principal” beneficiaries because both benefit from an increase in asset values.

There are several potential advantages to the unitrust approach: (1) the “unity” of interest between the current income beneficiaries and successor beneficiaries enable the trustee to invest for long-term growth to benefit all beneficiaries; (2) to the extent that the unitrust approach obviates discretionary invasions of principal, the trustee is protected against challenges by the remainder beneficiaries that any discretionary principal distributions were excessive; and (3) similarly, the unitrust approach eliminates the need to make adjustments between income and principal under Section 203 and thus avoids or minimizes controversy over whether such adjustments are proper.

The 1997 UPIA did not allow for the conversion to a unitrust, largely because there was concern about the tax consequences. However, much of the concern was cleared up with the release of final Treasury Regulation § 1.643(b)-1, which provides, in relevant part:

an allocation of amounts between income and principal pursuant to applicable local law will be respected if local law provides for a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary and tax-exempt income, capital gains, and appreciation. For example, a state statute providing that income is a unitrust amount of no less than 3% and no more than 5% of the fair market value of the trust assets, whether determined annually or averaged on a multiple-year basis, is a reasonable apportionment of the total return of the trust.

Following the release of this final regulation, Virginia enacted a unitrust statute that followed the 3-to-5-percent safe harbor found in the final regulation. The Virginia statute required the fair market value of the trust to be determined at least annually, using such valuation date or averages of valuation dates as deemed appropriate.2 While Virginia already had a unitrust statute prior to the UFIPA, the new unitrust statute under the UFIPA takes a more expansive approach.

The new Article 3 of the UFIPA does not, with the exception discussed below, limit the unitrust amount to 3-to-5-percent, but provides much broader latitude for the fiduciary to determine the unitrust percentage and also the period used to determine the values. The market value may be determined based on a rolling average of values for periods other than years, such as twelve quarters. Other flexibilities that Article 3 adds include the ability to put a cap on the size of fluctuation on the unitrust amount from period to period and to put a floor and/or ceiling on the unitrust payout amount.

Under UFIPA, trusts that are intended to qualify for a “special tax benefit” are denied much of the expanded flexibility of Article 3, and the unit rate is limited to 3–5 percent, and the period used for calculation is limited to a calendar year. “Special tax benefits” include the annual gift tax exclusion, eligibility of a qualified subchapter S trust (QSST), an estate or gift tax marital deduction, or exemption from generation-skipping transfer tax.

One change that practitioners should be aware of is that the UFIPA changes the waiver language of the repealed unitrust statute.3 The UFIPA unitrust statute provides that the statute is applicable to an income trust, “unless the terms of the trust expressly prohibit use of this article by a specific reference to this article or an explicit expression of intent that net income not be calculated as a unitrust amount.” Given that Virginia had already enacted a unitrust statute, the addition of Article 3 in the UFIPA is less of a major change for Virginia than it is for the UFIPA (compared to the 1997 UPIA). The new Article 3 of the UFIPA does significantly expand the prior unitrust statute’s ability to utilize the unitrust provisions; however, a QTIP or other trust with a “special tax benefit” will largely remain subject to the prior 3-to-5 percent safe harbor.

3. Governing Law

New Section 104 of the UFIPA, found at Code of Virginia § 64.2-1035, clarifies that the income and principal rules of the state that is the principal place of administration of the trust will be the governing law. This may be superseded by the terms of the trust.

Typically, a “rule of construction” is governed by the law of the place where the trust was created and a “rule of administration” is governed by the law of the situs of the trust.4 There is some uncertainty over which category includes an income and principal act, but because income and principal allocations often determine “who gets what,” it is likely to be deemed a rule of construction, which would be governed by the law where the trust was created. The UFIPA overrides this result, determining that having such allocations governed by the current place of administration is the most workable approach.

Takeaways for Practitioners

The passage of the UFIPA should not fundamentally shift the drafting or administration of most trusts in Virginia. It does, however, continue to show Virginia’s commitment to maintaining statutes consistent with the modernization of trusts. In addition to the UFIPA, Virginia offers many of the features that one would expect in a modern trust jurisdiction, such as: the availability of a directed trust, a domestic asset protection trust statute, and an option to waive the rule against perpetuities for trusts not holding real property.

The UFIPA provides a flexible default statute for the allocation of principal and income which reflects the current structure and usage of trusts. The settlor may override these default provisions in the trust agreement, and the passage of the UFIPA should serve as a reminder for practitioners to review their boilerplate language and ensure their trust documents reflect the developments in trusts over the preceding decades. Specifically, practitioners should examine and consider provisions relating to the allocation of receipts and expenditures to either income or principal, the ability to convert to unitrust, and the governing law relating to such provisions in relation to the default provisions of the UFIPA.

(Endnotes)

1. See Restatement (Second) of Conflict of Laws § 268, comment h (1971).
2. See Talbot v. Milliken, 221 Mass. 367, 108 N.E. 1060 (1915) and Appeal of Smith, 140 Pa. 344, 21 Atl. 438 (1891). The Massachusetts court made the allocation of corporate distributions on the basis of the form of the distribution, under the general theory that dividends payable in stock should go to capital and cash dividends to income. The Pennsylvania court held that the remaindermen are entitled to so much of a distribution as is necessary to preserve the book value of the trust’s stock as it was when the trust obtained the stock, with the remainder of the distributions credited to income. The UPIA took the Massachusetts approach.
3. See Code of Virginia § 64.2-1003 (repealed).
4. Prior to the UFIPA, the Virginia unitrust statute provided that such section applied to a trust unless “the governing instrument expressly prohibits use of this section by specific reference to this section or expressly reflects the grantor’s intent that net income not be calculated as a unitrust amount. A provision in the governing instrument that ‘The provisions of § 64.2-1003, Code of Virginia, as amended, or any corresponding provision of future law, shall not be used in the administration of this trust,’ or ‘My trustee shall not determine the distributions to the income beneficiary as a unitrust amount,’ or similar words reflecting such intent shall be sufficient to preclude the use of this section.”