Trustees constantly deal with the characterization of receipts and disbursements for the purposes of calculating fiduciary accounting income. Fiduciary accounting income is not the same as taxable income; taxable income is used to determine the payment of taxes to the government. Fiduciary accounting income is determined by the trust document and state law and is used to determine income or principal for the purpose of distribution to the beneficiaries. The law governing the allocation between income and principal is the Colorado Uniform Principal and Income Act (“UPIA”).
The UPIA directs the trustee to allocate first according to the trust terms, second according to any discretionary powers under the trust instrument, and third according to the UPIA. C.R.S. § 15-1-403(1). If the trust grants the trustee discretion to allocate between income and principal, then an allocation consistent with the UPIA is presumed to be reasonable. C.R.S. § 15-1-403(2).
The UPIA provides specific guidance on how to allocate receipts and disbursements depending on type. For example, professional fees are allocated 50/50 to income and principal. C.R.S. § 15-1-426. Royalty payments from oil and gas assets are allocated 10% to income and 90% to principal. C.R.S. § 15-1-421. The UPIA provides that anything not specifically addressed in the trust or in the act shall be allocated to principal. C.R.S. § 15-1-403.
If the allocation under the trust or the UPIA does not suffice for the trustee to meet the duty of impartiality, then the trustee can adjust between principal and income in a manner that allows the trustee to meet its fiduciary duties (“Power to Adjust”). C.R.S. § 15-1-404. The purpose behind the Power to Adjust is to avoid the conflict between acting as a prudent investor with due regard for both current and reminder beneficiaries and following the UPIA.
When determining whether to exercise the Power to Adjust, the trustee should consider, among other things, the nature of the trust and settlor intent, circumstances of the beneficiaries, the regularity of the income from the assets held by the trust and the nature of the assets held in trust. C.R.S. § 15-1-404.
The trustee could also consider a unitrust conversion, which allows an income interest to convert to a 3-5% annual distribution of the total value of the trust. C.R.S. § 15-1-404.5. A trustee can convert to a unitrust unless it is explicitly prohibited by the terms of the trust. This allows the trustee to invest the assets of the trust for a total return, instead of having to balance income and growth. It also helps control beneficiary expectations and reduces trustee exposure for exercising discretionary distribution decisions. When converting to a unitrust, trustees should consider the tax ramifications, particularly when dealing with a marital trust or GST exempt trust, as well as asset protection ramifications.
The most common claims involving the UPIA include breach of the duty of impartiality and breach of the duty of prudent investment. Specifically, beneficiaries may claim that the trustee is not investing in a way that produces enough income versus enough growth. To best protect a trustee, the trustee can obtain beneficiary consent and/or court approval for decisions involving allocation of income or principal.