Trusts typically distinguish between principal, the assets they hold, and income, such as dividends, interest, and rents they receive. Trusts often have different beneficiaries for each. For instance, a trust may provide that the income is paid to one beneficiary during their life with the principal to be distributed to so-called “remainder” beneficiaries upon the income beneficiary’s death.
In such instances, the income and remainder beneficiaries have somewhat different interests in how the trust funds are invested, since the income beneficiary would want the funds to produce as much income as possible while the remainder beneficiaries would want them to grow in value instead. Most trustees steer a middle course, investing conservatively for modest growth.
Most trusts include a provision that permits the trustee to decide what is income and what is principal. This may appear odd because the distinction between income and principal should be obvious in most cases. Yet, the provision is included in trusts primarily to protect the trustee from unreasonable challenges to accounting decisions and to permit them to make adjustments when investments that benefit the trust overall favor some beneficiaries over others.
In addition, the Massachusetts Principal and Income Act (MPIA) provides trustees power to adjust between principal and income if the trustee deems it necessary and sets out the standards for making such a determination.
In the case of In the Matter of the Trusts Under the Will of Helyn W. Kline (SJC-13579, November 5, 2024), the Massachusetts Supreme Judicial Court considers a challenge to an adjustment made by a trustee.
Background
Denise Jo Levy is the income beneficiary of a trust created under her mother’s will. The will also allowed for principal distributions to her under “extraordinary circumstances.” Levy’s three sons are the remainder beneficiaries of the trust and the trustees are Levy, herself, and Robert Friedman.
The trust was invested for long-term growth. As a result it did not produce as much income as it might have with a different investment approach. Robert Friedman in an affidavit stated that the trust might have modified the investment strategy to produce more income, but that would have involved selling investments. That, in turn, would have produced capital gains, resulting in taxes that would otherwise not have been due. Instead, he made an adjustment shifting $90,000 from principal to income to distribute to Levy.
One of Levy’s sons, Peter Judson, then challenged this adjustment, arguing that the MPIA did not give the trustee the power to take this step because his grandmother’s will bars distributions of principal to Levy except in cases of emergency. The probate court rejected his challenge and he appealed.
The Decision
In considering the remainder beneficiary’s appeal, the SJC explains that the purpose of the MPIA is to permit the trustee to invest trust assets for total return without being overly concerned as to whether it produces income or growth of principal:
One of the act’s central purposes is to address the “vexing problem” faced by trustees saddled with the sometimes-conflicting aims of the duty to invest trust assets under the prudent investor rule, on the one hand, and the duty to administer the trust impartially so as to treat fairly both current beneficiaries entitled to distributions from net income and future beneficiaries entitled to distributions of principal, on the other.
In particular, a prudent investment strategy may counsel investing to maximize the trust’s total return but may result in growth in principal without a comparable growth in income. Such a strategy may comply with the prudent investor rule, but it may improperly favor remainder beneficiaries over income beneficiaries.
Similarly, an investment strategy that maximizes traditional trust accounting income such as interest, dividends, and rents may result in a lopsided win for the income beneficiary at the expense of the remainder beneficiary. The rigid characterization of investment returns as “income” or “principal” limited a trustee’s ability to take advantage of an over-all investment strategy that maximized the expected total return of the trust’s assets.
The MPIA solves this conundrum by permitting a trustee who pursues a prudent investment strategy to maximize the trust’s total return without regard to the characterization of that return as “principal” or “income” to adjust trust assets between principal and income to administer the trust impartially based on what is fair and reasonable to all of the beneficiaries. [Citations omitted.]
The Court then considers and rejects Mr. Judson’s argument that that will’s provision that principal be distributed only in “extraordinary circumstances” when “necessary for any emergency affecting” Ms. Levy bars the trustee from recharacterizing principal as income. It rules that an adjustment between income and principal is not the same as a distribution.
Mr. Judson also argued that the trustee was barred under the MPIA from making the adjustment because Ms. Levy is a co-trustee of the trust. The Court points out that the MPIA permits a co-trustee who is not a beneficiary to make the adjustment, which is what occurred in this case. Further, while “the will bars a trustee ‘who is also a beneficiary [from] participat[ing] in any decision relating to any discretionary distributions of income or principal,’ it neither restricts the other trustee from acting nor prohibits Levy from asking the trustee for distributions.”
The moral of the case: The law permits trustees to make reasonable decisions, including in this case sticking to an investments strategy that reduces taxes for the trust and adjusting the interests of beneficiaries accordingly.