Trust Investment and Allocation Rules: Texas Enters a New Era

by

Gerry W. Beyer

Governor Preston E. Smith Regents Professor of Law
Texas Tech University School of Law
Lubbock, Texas


On January 1, 2004, Texas entered a new era with regard to trust investment and allocation as the Texas versions of the “UPIA twins,” that is, the Uniform Prudent Investor Act and the Uniform Principal and Income Act, took effect. This month’s article reviews these two statutes with emphasis on how they are different from prior law. The reader is warned, however, that not all aspects of these lengthy statutes are discussed. You must read and study the full text of the legislation before relying on it or using it as authority. (All citations in this article are to the Texas Property Code unless otherwise indicated.)

 

I. Investment and Management Standard of Care

 

Until January 1, 2004, the propriety of a trustee’s investments were judged according to the prudent person standard. § 113.056 (Vernon 1995) (prior to amendment). A trustee was required to exercise the degree of care and level of skill that a person of ordinary prudence would exercise in dealing with that person’s own property. The trustee was required to consider three main factors in selecting an investment. First, the trustee examined the safety of the investment. Risky or speculative investments were not allowed. Second, the trustee determined the investment’s potential to appreciate in value. Third, the trustee evaluated the income which the investment was expected to generate. Prior law also contained a portfolio-type provision in that the determination of whether a trustee acted prudently was based on a consideration of how all the assets of the trust were invested collectively rather than by examining each investment individually.

 

The Texas version of the Uniform Prudent Investor Act took effect on January 1, 2004. §§ 117.001-.012. Under this “total asset management” approach, the appropriateness of investments is based on the performance of the entire trust portfolio. A prudent investor could decide that the best investment strategy is to select some assets that appreciate and others that earn income as well as some investments that are rock-solid balanced with some that have a reasonable degree of risk. In selecting investments, the trustee should incorporate risk and return objectives that are reasonably suited to the trust. Different trusts may call for different investment approaches depending on the trustee’s abilities, the trust’s purposes, the beneficiary’s needs, and other circumstances. § 117.004.

 

The new standards apply both to new and existing trusts. With regard to existing trusts, the standards apply only to acts or decisions relating to the trust which occur after December 31, 2003. 78th Leg., R.S., ch. 1103, § 18.

 

A settlor may opt out of the prudent investor rule by including a provision in the trust which imposes a different standard of care on the trustee. § 117.003(b).

 

A. Diversification

 

The new legislation codifies the trustee’s duty to diversify to spread the risk so that if one investment goes bad, the entire trust does not suffer. However, the trustee is not required to diversify if the circumstances demonstrate the purposes of the trust would be better served without diversifying. § 117.005. For example, assume that the settlor created a trust containing the settlor’s heirloom jewelry and a 20,000 acre farm that has been in the settlor’s family for almost 200 years. At the termination of the trust, all remaining trust property passes to the settlor’s children. Should the trustee sell some of this property to create a balanced portfolio of investments? Retaining all trust property in two assets of this type is certainly not a proper diversification. On the other hand, it is reasonable to conclude that the settlor wanted the heirloom jewelry and the farm to remain in the trust so they would pass to the settlor’s children and thus the trustee may retain the assets without diversification.

 

 B. Asset Retention

 

The trustee must review trust assets within a reasonable time after accepting the trust or receiving trust property. The trustee must then bring the trust property into compliance with the prudent investor rule. § 117.006. This is a significant change from prior Texas law which permitted the trustee to retain the initial trust property without diversification and without liability for loss or depreciation. § 113.003 (repealed).

 

C. Loyalty

 

The new legislation codifies the principle that the trustee’s loyalty is to the beneficiaries. § 117.007. Accordingly, social investing may be problematic, especially if the returns from a “politically correct” investment are lower than from other investments. Social investment refers to the consideration of factors other than the monetary safety of the investments and their potential to earn income and appreciate in value. Examples of these types of factors include a company’s handling of environmental matters, whether a company does business with countries with policies that do not protect human rights, whether a company employs and pays substandard wages to workers in foreign countries, and the political party affiliation of the company’s leadership.

 

D. Impartiality

 

The new legislation also codifies the trustee’s duty to act impartially when investing and managing trust assets if the trust has two or more beneficiaries. § 117.008. The trustee must take into account any differing interests which the beneficiaries may have such as whether their interests are concurrent (e.g., multiple income interests) or successive (e.g., life and remainder interests).

 

E. Delegation of Management and Investment Functions

 

The traditional rule regarding delegation of powers is that the trustee may delegate mere ministerial duties but may not delegate discretionary acts. Investment of trust property was deemed a discretionary act and thus not subject to delegation. In 1999, Texas altered this rule and allowed the trustee to delegate investment decisions to an investment agent. §113.060 (repealed). The statute required the trustee to send written notice to the beneficiaries at least 30 days before entering into an agreement to delegate investment decisions to an investment agent. Generally, the trustee remained responsible for the agent’s investment decisions. However, the trustee could have avoided liability for the investment agent’s decisions if all of the relatively strenuous criteria specified in the statute were satisfied.

 

The new legislation takes a very different approach. The trustee may delegate any investment or management decision provided a prudent trustee of comparable skills could properly delegate under the same circumstances. Of course, the trustee must exercise reasonable care, skill, and caution in selecting and reviewing the agent’s actions. In the usual case, the trustee is not liable to the beneficiaries or the trust for the decisions or actions of the agent. § 117.011. The Texas approach is, however, stricter than the Uniform Act. For example, the trustee remains liable if (1) the agent is an affiliate of the trustee, (2) the trustee or a beneficiary of the trust is required to arbitrate disputes with the agent under the terms of the delegation agreement, or (3) the delegation agreement shortens the period for bringing an action by the trustee or a beneficiary of the trust with respect to the agent’s actions from the time period which is normally applicable to trustees under Texas law. § 117.011(c)(1) & (2).

 

F. Language Invoking Prudent Investor Standard

 

Certain phrases in trust instruments are deemed to trigger the prudent investor standard. Note that some of these phrases which invoke the prudent investor standard clearly appear to invoke a much different standard (e.g., “prudent person rule”). § 117.012.

 

 II. Allocation of Receipts and Expenses Between Principal and Income

 

Effective January 1, 2004, the Texas version of the 1997 Uniform Principal and Income Act (UPIA) mandates how a trustee allocates receipts and expenses between principal and income unless the trust instrument provides otherwise. §§ 116.001-.206. This act reflects the most significant change in allocation rules in many decades.

 

The new allocation rules apply to both new and existing trusts. With regard to existing trusts, the rules apply to allocations which occur after December 31, 2003. 78th Leg., R.S., ch. 659, § 4.

 

A. Allocation Methods

 

The trustee has three ways to determine how to allocate receipts and expenses between income and principal. First, the settlor may have provided instructions in the trust instrument. These instructions may state specific allocation rules or may merely give the trustee discretion to make the allocation. § 116.004(a)(1)-(2). An allocation in accordance with the UPIA’s rules by a trustee who has discretionary authority is presumed to be fair and reasonable to all beneficiaries. § 116.004(b). Second, if the instrument is silent, the trustee must apply the rules in Chapter 116. § 116.004(a)(3). Third, if neither the instrument nor the statute specifies the proper method of allocation, the trustee must allocate to principal. § 116.004(a)(4). This last rule is a significant departure from prior law which provided that the trustee must allocate in a “reasonable and equitable” manner if both the instrument and statute were silent. § 113.101(a)(3) (repealed).

 

B. Trustee’s Adjustment Power

 

1. Generally

 

Section 116.005 is the most innovative provision of the 1997 UPIA. Consider the following example: Settlor created a testamentary trust requiring trust income to be paid to Daughter for life with the remainder to Granddaughter. The trust corpus consists primarily of real estate which is appreciating in value at about 15% per year due to its proximity to the edge of a growing city. The land is still subject to a multiple-year lease which Settlor signed with Tenant many years ago. The rent Tenant pays is significantly below market value and is insufficient to support Daughter as Settlor intended. May Trustee sell part of the land and allocate a portion of the profits to income?

 

Under traditional trust rules, Trustee could not allocate any of the profits from the sale of the real estate to income. Granddaughter had a right to the principal and appreciation belonged to the principal. However, § 116.005 grants the trustee the power to adjust between principal and income under specified circumstances and expressly includes the power to allocate a capital gain to trust income. The adjustment power section is quite lengthy and requires the trustee to consider a variety of factors such as (1) the nature, purpose, and expected duration of the trust, (2) the settlor’s intent, (3) the identity and circumstances of the beneficiaries, (4) the needs for liquidity, regularity of income, and preservation and appreciation of capital, (5) the assets held in the trust including whether the asset is used by a beneficiary or whether it was purchased by the trustee or received from the settlor, (6) the trustee’s ability or inability under the terms of the trust to invade principal or accumulate income, and (7) the anticipated tax consequences of an adjustment. In this example, it appears that Settlor established the trust to provide for Daughter and Settlor’s intent would be frustrated if Trustee did not allocate some of the profits to income to provide Daughter with an appropriate level of support.

 

The adjustment power has proven to be an extremely controversial aspect of the 1997 UPIA because of its tremendous departure from traditional law, the fear that trustees may abuse the power, and the potential of a beneficiary suing a trustee if the trustee does not exercise the adjustment power in the beneficiary’s favor. Accordingly, many of the states enacting the 1997 version of the Act have omitted the adjustment provisions or have altered or restricted them in some way.

 

2. When Adjustment Not Allowed

 

Section 116.005(c) prohibits the trustee from making an adjustment in specified situations. For example, the trustee may not make an adjustment if the trustee is also a beneficiary of the trust or if an adjustment would diminish the income interest of a spouse with respect to a qualified terminable interest property trust.

 

3. Notice to Beneficiary Not Necessary

 

Texas follows the uniform version in not requiring the trustee to give notice to the beneficiaries of a proposed adjustment. Some states add this requirement so that the beneficiaries have a statutorily-provided time period in which to object.

 

4. Alteration by Settlor

 

A settlor who does not want the trustee to have this adjustment power must include a specific provision which clearly reflects the settlor’s intent to deny the trustee the power to adjust. A general provision which limits the power of a trustee to make an adjustment between principal and income would not be sufficient. § 116.005(f).

 

5. Court Reversal of Trustee’s Adjustment Decision

 

A court may not order a trustee to change a decision to exercise or not exercise the adjustment power unless the court determines that the decision was an abuse of the trustee’s discretion. A trustee’s decision is not an abuse of discretion merely because the court would have exercised the power differently or would have decided not to exercise the power. § 116.006(a).

 

If the court determines that the trustee did abuse the trustee’s discretion, the court may place the income and remainder beneficiaries in the positions they would have had if the trustee had not abused the discretion. Section 116.006(c) provides the rules the court applies in fashioning the appropriate remedies to restore the beneficiaries’ positions which include ordering the trustee to make additional distributions or withhold distributions, ordering a beneficiary to return a distribution, and requiring the trustee to make payments from the trustee’s own funds to the beneficiaries.

 

6. Court Approval

 

The trustee has the option of seeking court approval of an adjustment between principal and income if the trustee reasonably believes that a beneficiary will object to the manner in which the trustee intends to exercise or not exercise the adjustment power. § 116.006(d). Note that the failure or refusal of a beneficiary to sign a waiver or release is not reasonable grounds for a trustee to believe that the beneficiary will object. If the court deems it appropriate, the court may appoint a guardian ad litem to protect the beneficiary’s interest. The trustee must advance costs incident to the judicial determination from the trust. These costs include reasonable attorney’s fees and costs of the trustee, any beneficiary who retains an attorney, and any guardian ad litem. However, at the conclusion of the proceeding, the court may award costs and attorney fees against the trust, the beneficiary’s interest, or the trustee personally.

 

7. Charitable Trusts

 

The 2003 Legislature established a procedure to permit the trustee of a charitable trust to make adjustments between principal and income within certain parameters. § 113.0211 (Note the unusual effective date provision which provides that this section applies only to a “demand for an accounting” which is made on or after September 1, 2003. The Legislature probably intended this limitation to apply only to § 3 of the bill which deals with accountings.) The Legislature did not correlate this section with the passage of the UPIA which also contains a procedure for making adjustments between principal and income. Accordingly, it is unclear whether charitable trustees are restricted to § 113.0211 or whether they may use the Uniform Act procedure as well.

 

C. Non-Charitable Unitrusts

 

To avoid the accounting hassle of allocating receipts and expenses between the income and remainder interests, as well as to reduce the inherent conflict of interest between current and future beneficiaries, some settlors adopt a unitrust or total return approach. The current beneficiary of a unitrust is entitled to receive a fixed percentage of the value of the trust property annually. The current beneficiary may or may not also be entitled to additional distributions. Under a unitrust, both beneficiaries have the same goal — they want the value of the property in the trust to increase. It does not matter to them whether the increase in value is due to receipts traditionally nominated income (e.g., interest or rent) or principal (i.e., appreciation). All increases inure to the benefit of all beneficiaries. Likewise, all beneficiaries share in the expenses regardless of their usual characterization. Section 116.007 assists unitrusts to qualify for various tax benefits. The UPIA does not contain an equivalent provision. (The Texas provision is not a unitrust conversion statute, that is, it does not permit the trustee to convert a traditional income-principal trust into a unitrust.)

 

D. Interest on Legacy

 

A legacy (cash bequest) in a will earns interest at the legal rate as provided in Finance Code § 302.002. There is currently a conflict regarding the date from which the interest begins to accrue. Probate Code § 378B(f) provides that interest begins running one year after the date the court grants letters testamentary or letters of administration. The 2003 Texas Legislature simultaneously reenacted (with a mere technical amendment) this section while repealing the section as part of the UPIA enactment. Section § 116.051(3)(A) provides that interest is payable beginning on the first anniversary of the date of the decedent’s death.

 

E. Termination of Income Interest

 

Section 116.051 provides guidance to the trustee for determining and distributing net income after (1) a decedent dies or (2) an income interest in a trust ends. The trustee may now allocate interest on estate taxes to either principal or income rather than only against principal. § 116.051.

 

F. Zero-Coupon Bonds

 

The trustee should allocate interest received on money lent (e.g., a certificate of deposit) to income. In a change from prior law, a trustee no longer may allot to income the increase in value of a bond which pays no interest but appreciates in value (e.g., U.S. Series E savings bonds and other zero-coupon bonds) unless its maturity date is within one year after acquisition. §§ 116.163 & 113.105(b) (repealed).

 

G. Insubstantial Allocations

 

Under many circumstances, the new rules free the trustee from the obligation of allocating insubstantial amounts. Instead, the entire amount is allocated to principal. § 116.171. The section, however, does not define “insubstantial.” Thus, a $1,000 receipt could be substantial for some trusts but insubstantial for others depending on the size of the trust corpus.

 

H. Annuity Allocations

 

The new provisions provide guidance for a trustee when allocating receipts from deferred compensation plans, annuities, and similar arrangements such as IRAs. Generally, each year, receipts are allocated to income until they total 4% of the asset’s fair market value. Amounts in excess of 4% are allocated to principal. § 116.172. The Texas version of this section deviates significantly from the UPIA which provides that 10% of each distribution is income with the remaining 90% passing to principal. This change was made to enhance the amounts available to the income beneficiary which was thought to be more in line with carrying out the settlor’s intent.

 

I. Liquidating Asset Allocation

 

A liquidating or wasting asset is one which goes down in value as it is used to produce income beyond what would be considered mere depreciation from normal use and age. Examples of these types of assets include leaseholds, patents, copyrights, and royalties The trustee must now allocate 10% of each receipt to income and the remaining 90% to principal. § 116.173. This allocation is significantly different from prior Texas law which provided that receipts up to 5% of the asset’s value each year were income with any excess being principal. § 113.109 (repealed).

 

J. Oil & Gas Royalty Allocation

 

Traditionally under Texas law, oil and gas royalties were allocated 72.5% to income and 27.5% to principal. These percentages were based on former federal income tax rules which used these percentages for depletion allowances. The UPIA gives only 10% to income with the remaining 90% to principal. (Note how unfair this would be to a beneficiary who is receiving 72.5% and then discovers that the new law cuts the percentage way down to 10%.) Texas deviates from the UPIA by requiring the trustee to allocate these receipts “equitably.” § 116.174. In addition, the trustee may use the prior allocation percentages if the trust owned the natural resource on January 1, 2004.

 

K. Timber Allocation

 

Timber is unlike other natural resources because it is renewable; the trees will grow back. The time it will take the trees to regrow, however, depends on the type of trees. For example, some varieties of pine trees may be ready to harvest in 20 years while other trees such as redwoods may take over a century. Consequently, it is difficult to create a precise allocation rule. The new law explains that receipts are income if the timber removed does not exceed the rate of new growth but receipts become principal if they are from timber in excess of the regrowth rate. § 116.175. This provision provides more guidance than prior law which merely instructed the trustee to do what was reasonable and equitable. § 113.108 (repealed).

 

L. Non-Income Earning Property

 

The trustee should not retain property that does not earn income absent express permission in the trust instrument unless it is prudent to retain it under Chapter 117. Although some nonproductive assets, such as collectible items and unleased land, may have the potential of significantly appreciating in value, the retention of nonproductive property usually would violate the trustee’s duty of fairness to the income beneficiaries. Under prior law, the trustee was required to promptly sell underproductive property which meant property that did not earn at least 1% of its value per year, assuming the trustee was under a duty to sell either according to the terms of the trust or because it was imprudent to retain the property. § 113.110 (repealed). Once the trustee sold the underproductive property, the trustee was often required to allocate a portion of the sale proceeds to income as delayed income to make up for the income the trust should have earned had this portion of the trust been placed in income-producing investments.

The new legislation dispenses with the allocation of delayed income. Now, the proceeds from the sale or other disposition of a trust asset are principal without regard to the amount of income the asset produced. However, the trustee does retain the duty to make property productive for marital deduction trusts to make certain they continue to qualify for favored tax treatment. § 116.176(b).

 

M. Expense Allocation

 

The new legislation makes several significant changes from prior law. First, trustee compensation is now apportioned one-half against principal and one-half income while former law permitted the trustee to allocate compensation on a just and equitable basis. Second, expenses from accountings and judicial proceedings are also allocated equally while under prior law all these expenses were charged against income. §§ 116.201 & 113.111 (repealed). Third, the trustee may make adjustments between principal and income to offset the shifting of economic interests or tax benefits between income beneficiaries and remainder beneficiaries under specified situations. § 116.206.

 

N. Depreciation Allocation

 

A trustee may make transfers from income to principal to compensate for the depreciation of the principal. § 116.203. Under prior law, however, a trustee was required to make a reasonable allowance for depreciation. § 113.111 (a)(2) (repealed).

In publishing this article, the author is not engaged in rendering legal, accounting or other professional service. If legal advice is required, the service of a competent professional should be sought.

 

© 2004 Gerry W. Beyer