The typical trust arrangement provides for a beneficiary who receives all the income, usually in the form of interest and dividend during a set period (often his or her life). Thereafter the assets in the trust are paid over to a “remainderman.” As a fairly generic but interesting example, suppose that Husband’s will makes a provision for all or part of his estate to flow into a trust in which income is to go to Wife (his second) for her life, with, thereafter, the remainder passing to his Son (from husband’s first marriage).
Forgetting for a minute the issues that may arise from the two-marriage aspect of this problem, the more universal problem with this arrangement is that the beneficiary Wife will want the trustee to invest in high income bearing investments (in a word, bonds, with maybe the admixture of some high dividend stocks). Meanwhile remainderman Son will want the trustee/investor to invest in investments that appreciate in value (in a word, stocks). The trustee is left in a quandary-he has constituencies with opposing goals and, unless the trust gives him clear instruction on whom to favor, he is in for complaints, headaches and even possible claims that he is mismanaging the trust assets. This last is called a “surcharge” claim and could be brought, for example, by the wife if she is only getting a small return on the money. To return to our mixed family hypothetical, the conflict might have added tension. Remainderman Son may have no problem taking a back seat to his own mother, but when his step-mother is collecting enough income to support what he perceives as an opulent lifestyle, he may be more likely to think about the effects this investment philosophy has on his future nest egg.
A tool has appeared to address this problem. About twenty years ago the “unitrust” began its rise to popularity. A unitrust requires that the trustee pay out to the life beneficiary a fixed percentage of the fair market value of the trust. The general idea is that now the interests of the life beneficiary and the remainderman beneficiary are aligned. Both benefit from an increase in value of the trust assets; the lifetime beneficiary is no longer limited to income paid; and, in theory at least, the conflict in interest has disappeared. The trustee is freed-up and his new goal is simply to make investments that maximize the trust’s fair market value. In years when the income on those assets is less than the percentage to be paid out to the beneficiary, the trustee will have to sell assets and apply those capital gains to the payments. In years when the income exceeds the trust percentage payout, that excess gets added to trust principal.
Unitrusts are created in two ways. Either the Settlor sets the trust up at the start as a unitrust or, at some point in time, the trustee elects to convert an ordinary trust to a unitrust. For unitrusts converted under Pennsylvania law, unless otherwise allowed by the Court, the requirement is a 4% payout rate applied to the “smoothed” three year average of the trust’s fair market value for the prior three years. Departure from these default rules may be ordered by the Court if one or more beneficiaries petition for it at the time of conversion.
— Rod Fluck