Conversion to Total Return Unitrust
Unless specifically prohibited by the governing instrument, PEF Code §8105 authorizes the trustee to convert a conventional “income” trust to a unitrust. In order to convert to a unitrust, the trustee must determine that the conversion will enable the trustee to better carry out the intent of the settlor or testator and the purposes of the trust. The trustee must give written notice of the intention to convert to all sui juris beneficiaries who are currently entitled to receive income and who would receive principal if the trust terminated immediately before notice was given. See PEF Code §8105(a). There must be at least one (1) adult and competent beneficiary in both categories. If no beneficiary receiving notice objects to the conversion within sixty (60) days of the notice, the trustee may make the conversion. If a beneficiary does object or if there is not a representative in each of the categories listed above, the trustee may seek Court approval of the conversion. In addition, if after a beneficiary requests a conversion a trustee refuses to make the conversion, the beneficiary may request the Court to direct that the conversion be made if the Court determines that it is consistent with the intent of the settler or testator. See PEF Code §8105(b). Once a trust is converted to a unitrust, it cannot convert back without Court approval.

In deciding whether to exercise the power to convert to a unitrust, the trustee may consider the factors under PEF Code §8105(c), including the size of the trust, how long the trust is expected to last, the liquidity requirements of the trust, the need for regular distributions and for the preservation and growth of principal, expected tax consequences of an adjustment, the source and type of assets held by the trustee, the needs of the beneficiaries to the extent reasonably known, whether the governing instrument permits the trustee to invade principal or to accumulate income, and the effect of inflation and deflation and other economic conditions, actual and anticipated. Once the trustee decides to convert to a unitrust, the trustee has the discretion to determine, among other things, the effective date of the conversion, the provisions for prorating the unitrust distribution in a short year, the frequency of unitrust distributions throughout the year, whether to value the trust’s assets annually or more frequently, and what valuation dates to use. See PEF Code §8105(e).

Upon conversion, the trustee must follow an investment policy seeking a total return for the investments held by the trust. The word “income” as used in the trust will thereafter be defined as a specified percent of the annual value of the trust, which the statute sets at four (4%) percent, valued on a three (3) year rolling average. See PEF Code §8105(d). The trustee can petition the Court to approve a percentage payout of more or less than four (4%) percent or to average the valuation over a period of other than three (3) years. See PEF Code §8105(g). Expenses which would be deducted from income if the trust were not a unitrust may not be deducted from the unitrust distribution. Unless otherwise provided by the governing instrument, the unitrust distributions are ordered, first from net income, then if necessary short term capital gains, then long term capital gains and finally principal. See PEF Code §8105(f).

The trustee is prohibited from converting the trust to a unitrust where: (i) the adjustment would diminish the income interest in a trust that requires that all of the income be distributed annually to a spouse that qualifies for the marital deduction; (ii) the trust is a unitrust or annuity trust, (iii) the trust is a split interest trust with a charitable income or remainder beneficiary; (iv) the power to adjust would make the trust a grantor trust as to the trustee; (v) the power to adjust would result in the trustee holding a general power of appointment; or (vi) the trustee is a beneficiary. However, if there is more than one trustee, a co-trustee to whom these provisions do not apply, may convert the trust unless prohibited by the governing instrument. See PEF Code §8105(i).

The federal income tax consequences of conversion to a total return unitrust are set forth in IRC Reg. §1.643(b) and related regulations effective for taxable years that began on or after January 2, 2004.



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