April 2, 2014
Authored by: Tiffany McKenzie and Doug Stanley
Originally posted on bryancavefiduciarylitigation.com
It is uncommon to see modern trusts that require distribution of all income but preclude distribution of any principal to a beneficiary. Since the characterization of income and principal can be subject to multiple interpretations, precluding any distribution of principal often can lead to legal disputes. In Favour v. Favour (not for publication), the Arizona Court of Appeals disagreed with an Arizona superior court’s ruling that “the income beneficiary of [a] Martial Trust is entitled only to the annual ‘distributable net income (“DNI”)… reported on the federal income tax return, and no more than that.” The Will also specified that it was intended to qualify as “qualified terminable interest property” (“QTIP”) for which an election could be made under Section 2056(b)(7).
The decedent, Mr. Favour, left a testamentary trust for the benefit of his wife, Susan. Susan was named as trustee, and the Will directed that she was to receive “the entire net income” from the trust for the rest of her life. Mr. Favour specifically directed that, as trustee and beneficiary, Susan would have no right to invade the principal of the trust. Nonetheless, upon Mr. Favour’s death, Susan began automatically transferring $3,000 per month from the trust to her personal checking account, regardless of how much income the trust produced. She did not maintain a checking account for the trust, did not generate monthly or annual financial statements for the trust, and did not provide full or complete accountings of the Trust to the other beneficiaries.
Among other things, such as failing to keep beneficiaries abreast of the trust’s administration, using trust assets for personal benefit and failing to keep accurate accountings and records, the superior court of Arizona ruled that Susan breached her duties as trustee by invading the principal of the trust. The Arizona Court of Appeals affirmed most of the superior court’s findings, but disagreed about how much Susan should have been entitled to receive from the trust.
The superior court judge had ordered Susan to return everything she received above the DNI of the trust and the Court of Appeals held that such a calculation was incorrect. The Court of Appeals relied on the definition of “net income” from the Revised Uniform Principal and Income Act and held that DNI under the Internal Revenue Code is a different concept from that of net income. DNI is not synonymous with net income owed to income beneficiaries. See I.R.C. § 651(b) (acknowledging that income required to be distributed under a trust may exceed DNI). The Court held that the terms of the testamentary instrument govern and here the trust mandated distribution of “the entire net income” to Susan – a clear directive inconsistent with the reliance on a tax code concept of DNI which possibly could diminish the income distributions to Susan as beneficiary. Further, the Court held that the QTIP status of the trust was not jeopardized merely by distributing sums in excess of DNI to Susan. The surviving spouse will have a qualifying income interest in a QTIP merely if he or she “is entitled to all the income from the property, payable annually or at more frequent intervals, or has a usufruct interest for life in the property.” See I.R.C. § 2056(b)(7)(B)(ii)(I).
Therefore, the superior court erred by using DNI as the measure for income distribution to Susan and by concluding that distributions in excess of DNI were per se invasions of Trust principal. However, the Court remanded the dispute to the trial judge for further hearings to calculate the amount that Susan owed back to the trust and directed the judge to consider whether legal fees could be paid from the principal of the trust.