Annual Exclusion Amount Increased to $11,000/New York Changes its Principal and Income Act

Client Advisory

January 14, 2002

The Taxpayer Relief Act of 1997 indexed for inflation various tax thresholds, one of which was the annual exclusion amount. That has increased from $10,000 to $11,000 effective January 1, 2002. This means that any individual can now give up to $11,000 each year ($22,000 if his or her spouse agrees to split the gift) to anyone without the transfer being treated as a taxable gift.

New York Changes its Principal and Income Act

This is very important news to anyone who is a trustee or a beneficiary of a New York trust, as well as to anyone who creates a trust in New York.

Why? Because the Principal and Income Act is what defines the term "income" in trusts and in so doing helps determine the amount distributed to the income beneficiary.

A brief history may be helpful here. New York's existing Principal and Income Act generally defines income to mean rents, interest (taxable and non-taxable) and dividends, with special provisions for certain royalties, growing crops and distributions from depleting natural resources (1). When dividend and bond yields were higher, this definition could provide the income beneficiary of a trust with a satisfactory return. As dividend and bond yields have decreased, trustees have placed a significant percentage - often as much as one half - of a trust's portfolio in fixed income assets to assure the income beneficiary the appropriate stream of "income" that the creator of the trust wanted the beneficiary to enjoy.

Five years ago New York changed its trust investment rules and adopted the Uniform Prudent Investor Act. The new rules follow "total return" investment concepts and require a trustee to develop an investment strategy that enables it to make appropriate present and future distributions in accordance with risk and return objectives that are reasonably suited to the entire portfolio. This encourages investment for growth, and could result in an even greater proportion of non- or low-income producing assets in the trust's portfolio. To assure that the income beneficiary still receives adequate distributions, the definition of income also had to be changed.

The new Principal and Income Act is that change. In addition to making a number a technical changes (e.g. all stock dividends, not only those in excess of 6%, are principal under the new Act, and the old law's underproductive property section has been eliminated in all but a few instances), the new Act creates two distinct but parallel opportunities for a trustee to provide fairer treatment for both the income beneficiary and the remaindermen.

First, the Act gives to a trustee the power to adjust between income and principal, if the adjustment "would be fair and reasonable to all of the beneficiaries, so that current beneficiaries may be given such use of the trust property as is consistent with the preservation of its value."

Second, and as an alternative to the power to adjust, the trustee can elect to convert the trust to a four percent unitrust, deeming that an amount equal to four percent of the fair market value of the trust principal is "income" each year, and ignoring actual receipts of dividends, interest, and rents.

These two options will revolutionize how trusts are administered in New York.

The Power to Adjust

The power to adjust is granted to all trustees unless the trust instrument specifically prohibits it or the trust is a unitrust (more about this later). Suppose, for example, that the decedent created a trust under his will to provide income to his wife, and the trust is funded largely with stock that has been appreciating at 10% a year but only pays a 1% dividend. The trustee, using the power to adjust, can allocate a portion of the principal to income, giving the widow a fair and reasonable return. If the stock continues to appreciate over time, both the widow and the remaindermen will benefit.

The standard to be applied is that any adjustment must be "fair and reasonable" to all beneficiaries, so that the income beneficiary is given use of the trust property consistent with preservation of its value. The power of adjustment need not be exercised in one direction only; the trustee may determine that the trust has too much "income" in the ordinary sense, and may allocate a portion of that income to principal, in order to preserve the value of the trust principal in times of inflation.

The statute directs the trustee to consider numerous factors when making an adjustment, including:

  • the intent of the creator of the trust, as expressed in the instrument;
  • the nature of the trust's assets;
  • the extent to which an asset may be used by a beneficiary (a home held in the trust, for example);
  • the increase or decrease in value of the trust principal;
  • whether or not the trustee has a power under the instrument to invade principal;
  • the distribution requirements of the instrument;
  • general economic conditions;
  • tax consequences, and
  • the income and other resources of the beneficiaries.

The trustee cannot use the power to adjust if it would create certain adverse tax consequences. For example, the trustee cannot diminish the surviving spouse's income in a trust that qualifies for the marital deduction, nor can the trustee exercise the power if he or she is also a current beneficiary or presumptive remainderman of the trust.

The beneficiaries are given a limited right of redress in the courts if they believe that the power has been unfairly applied. The court cannot simply second-guess the trustee and interfere with the trustee's decision unless it determines that the trustee abused its discretion. If the court does find an abuse of discretion, it can reverse the adjustment. A trustee can also go to the court prospectively, and seek advance approval of a planned adjustment.

The Unitrust Option

As an alternative the power to adjust, the trustee can convert any New York trust into a four percent unitrust. With a unitrust, the traditional distinctions between income and principal become meaningless, as "income" is defined by the statute to mean the unitrust amount.

With the unitrust option, each year the trustee determines the fair market value of the trust's assets, and four percent of that value is "income" distributable to the income beneficiary. There is a "smoothing" rule that provides that after the first three years income is four percent of an amount determined by averaging the fair market value of the trust as of the beginning of the trust year and the two prior years. This will moderate severe market fluctuations, and will have the effect of "underpaying" the beneficiary in a rising market, and "overpaying" the beneficiary in a declining market. Once converted to a unitrust, a trust cannot return to a normal income and principal trust without a court order.

In determining the fair market value of the trust's assets, "use" property, such as a residence that is held in the trust for the use of the beneficiary, is ignored. The trustee has authority to determine the value of hard to value assets without the need for a formal appraisal, and the trustee's determination is binding unless objected to promptly.

The statute authorizes the trustees of existing New York trusts to elect to become unitrusts by making a written formal election and delivering it to all persons interested in the trust prior to December 31, 2005. For new trusts, the trustee has two years after the trust is first funded within which to make the election. A court may also convert the trust to a unitrust upon the petition of the trustee or any person interested in the trust in a proceeding, notice of which is given to all persons interested in the trust. As indicated, a court can also approve a return of the trust to a normal principal and income trust.

Tax Implications

The tax implications of an exercise of the adjustment power or of the unitrust are not entirely clear, but the Treasury Department has issued proposed regulations which say that if state law redefines "income", as the New York Act does, that redefinition will be honored. The proposed regulations also say that if the state law defines a unitrust amount as income, and the unitrust amount is within a reasonable range (suggested to be between 3 and 5 percent), then such a trust will qualify for the estate or gift tax marital deduction, both of which require that all income be paid to the surviving spouse. Much remains unclear, however, about how these regulations will operate, and whether or not the final regulations will reflect significant changes from those proposed regulations.

Other States

New York's new Principal and Income Act is derived from the revised Uniform Principal and Income Act, which has been adopted in several states. New York's version of the Act modifies the Uniform Act in that it adds the unitrust option which is not part of the Uniform Act. New Jersey, Connecticut and other states have adopted the Uniform Act without this addition, keeping only the basic Act with a form of the power to adjust. Delaware has incorporated its own version of the Uniform Act, but has deleted the power to adjust and has added its own unitrust option, leaving it to the trustee to fix the unitrust percentage.

Planning Strategies

We often recommend that trustees be given a broad power to invade principal for the benefit of the income beneficiaries. Where that has been done, there may be little need for the trustee to exercise the power to adjust or the power to convert to a unitrust. If there is antagonism between the beneficiaries and the trustee, or strong differences between the income beneficiary and the remaindermen, then the unitrust can provide a clear amount for the income beneficiary, minimizing arguments about investments (although perhaps not about investment performance).

Trusts can also be drafted as unitrusts with a payout other than the four percent provided in the statute. Additionally, instruments often give the income beneficiary a "5 & 5" power; that is, the non-cumulative power to withdraw the greater of $5,000 or 5% of the trust assets in each year. Trusts can be drafted with a power to withdraw less than five percent, and that may be a desirable alternative to a statutory unitrust.


The changes wrought by this new law are far ranging, and all of their implications are not yet apparent. The clear goal is to give trustees flexibility to deal with differing investment returns, and this goal may be attained in different ways. It has already been addressed in many existing trust instruments, but creators of new trusts, as well as trustees of existing trusts, must keep in mind the new options that are now available.

1."Income" for trust purposes is not synonymous with "income" for tax purposes - for example, the latter includes capital gains and excludes non-taxable interest.

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2018 Carter Ledyard & Milburn LLP.
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