Accountants’ Handbook Special Industries and Special Topics 10th Edition_17 pot

The lection and the distribution of income are incidental to the main function of the estate’s fiduciary.Whenever an estate accounting is prepared, a reconciliation of the gross estate as

EGTRRA has modified the income tax rules relating to the step-up in basis discussed above ginning in 2010 To make up for the loss of revenue from the estate tax repeal, a new “carryoverbasis” regime will become effective Under this regime, property acquired from a decedent will have

be-a bbe-asis eqube-al to the lesser of the decedent’s bbe-asis or the fbe-air mbe-arket vbe-alue of the property on the dbe-ate

of the decedent’s death A total $4.3 million of property may, however, still qualify to use the currentstep-up in basis rules Up to $3 million of property passing to a surviving spouse, plus up to an ag-gregate of $1,300,000 of property passing to any beneficiaries will qualify for a step-up in basis.These new rules sunset after 2010, resulting in the modified carryover basis rules ending and the cur-rent step-up in basis rules being reinstated in 2011 So just in case, we should all start keeping betterrecords in order to accurately reflect our tax basis in the assets we hold currently

Estates must now make quarterly estimated tax payments in the same manner as individuals, cept that an estate is exempt from making such payments during its first two taxable years Accord-ingly, the penalties for underpayment of income tax are applicable to fiduciaries

ex-Some states also tax the income of estates, and the representative must see to it that such statestatutes are complied with

41.2 ACCOUNTING FOR ESTATES

(a) GOVERNING CONCEPTS The general concepts governing the accounting for decedent’s

es-tates are for the most part similar to those applicable to trusts, but there are some differences The derlying equation expressing the accounting relationship is assets⫽ accountability However, the

un-representative is concerned not with the long-term management of property for beneficiaries, but rather

with the payment of debts and the orderly realization and distribution of the estate properties The lection and the distribution of income are incidental to the main function of the estate’s fiduciary.Whenever an estate accounting is prepared, a reconciliation of the gross estate as finally deter-mined for estate tax purposes should be made with the schedule of principal received at the date bythe representative Every difference should be explainable

col-(i) Accounting Period The accounting period of the estate is determined by the dates set by the

fiduciary or by the court for intermediate and final accountings; nevertheless, the books must beclosed at least once a year for income tax purposes

(ii) Principal and Income Unless otherwise provided for, the rules outlined below for the

trustee should generally be followed by the representative in the allocation of receipts and bursements to principal and income Such distinctions, although not called for under the will, arefrequently mandated by requirements of estate, inheritance, and income tax laws and regulations

dis-(iii) Treatment of Liabilities The representative picks up only the inventory of assets of the

decedent at the inception of the estate Claims against the estate, after presentation and review, arepaid by the representative and are recorded as “debts paid.” The payment of such debts reduces inproportion the accountability of the representative

(b) RECORD-KEEPING SYSTEM No special type of bookkeeping system is prescribed by law,

but a complete record of all transactions must be kept with sufficient detail to meet the requirements

of the courts and of the estate, inheritance, and income tax returns Much of the information may be

in memorandum form outside of the formal accounting system

The federal estate tax law requires information regarding assets beyond those ordinarily under thecontrol of the representative (e.g., real estate) Such information must be assembled in appropriateform by the representative, who has responsibility for the estate tax return

(i) Journals A single multicolumn journal is usually sufficient It should incorporate cash

re-ceipts, cash disbursements, and asset inventory adjustments Further, it is important to note and keeptrack of the distinction between principal and income

(ii) Operation of a Going Business. If the decedent was the individual proprietor of a goingbusiness and if the court or the will instructs the administrator or executor to continue the oper-ation of the business, the bookkeeping procedure becomes somewhat complicated The books ofthe business may be continued as distinct from the general estate books, or the transactions ofthe business may be combined with other estate transactions in one set of records The best pro-cedure, if the business is of at least moderate size, is to keep the operations of the business in aseparate set of books and to set up a controlling accounting in the general books of the executor

or administrator

As soon as the representative takes charge of the business, the assets should be inventoried andthe books closed, normally as of the date of death The liabilities should be transferred to the list ofdebts to be paid by the representative, leaving the assets, the operating expenses and income, and thesubsequently incurred liabilities to be recorded in the books of the company An account should beopened in the books of the business for the representative that will show the same amount as the con-trolling account for the business in the books of the representative

(iii) Final Accounting The “final” accounting is the report to the court of the handling of the

es-tate affairs by the representative, if required It presents, among other things, a plan for the tion of the remainder of the assets of the estate and a computation of the commission due therepresentative for his services If the court approves the report, it issues a decree putting the propos-als into effect

distribu-(c) REPORTS OF EXECUTOR OR ADMINISTRATOR The form of the reports of the fiduciary

will vary according to the requirements of the court and to the character of the estate In general,however, the representative “charges” himself with all of the property received and subsequently dis-covered plus gains on realizations, and “credits” (or discharges) himself with all disbursements fordebts paid, expenses paid, legacies distributed, and realization losses Each major item in the chargeand discharge statement should be supported by a schedule showing detailed information At anytime during the administration of the estate, the excess of “charges” over “credits” should be repre-sented by property in the custody of the fiduciary It may be necessary to show the market value ofproperty delivered to a legatee or trustee at the date of delivery, in which case the investment sched-ule will show the increase or decrease on distribution of assets, as well as from sales The incomeschedule, when needed, should be organized to show the total income from each investment, the ex-penses chargeable against income, and the distribution of the remainder

Exhibit 41.2 is typical of the charge-and-discharge statement, each item being supported by

a schedule

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND

(a) NATURE AND TYPES OF TRUSTS The trust relationship exists whenever one person holds

property for the benefit of another The trustee holds legal title to the property for the benefit of the

beneficiary, or cestui que trust The person from whom trust property is received is known as the

grantor, donor, settler, creator, or trustor

An express trust is one in which the trustee, beneficiary, subject matter, and method of tion have been explicitly indicated An implied trust may be created whether language of an instrumentindicates the desirability of a trust but does not specify the details or when the trust relationship is as-sumed in order to prevent the results of fraud, breach of trust, or undue influence The terms “con-structive,” “resulting,” and “involuntary” trust are sometimes applied to such situations

administra-A testamentary trust is one created by a will administra-A living trust, or trust inter vivos, is created to take

effect during the grantor’s lifetime Trusts are sometimes created by court order, as in the case of aguardianship

A private trust is created for the benefit of particular individuals, while a public or charitable trust

is for the benefit of an indefinite class of persons Charitable trusts are discussed in Chapter 33

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 19

A simple trust directs the trustee to distribute the entire net income of the trust to the named ciary A complex trust gives the trustee the discretionary authority to distribute or accumulate the trustnet income to or on behalf of the named beneficiary In some instances, the trust may start off as com-plex and then convert to a simple trust upon the happening of a specified event, that is, the beneficiary’sattainment of age 21 or 25.

benefi-A grantor trust exists when both the grantor and beneficiary are the same individual benefi-A grantortrust may be implied if the grantor retains sufficient rights or controls over disposition of trust in-come and/or principal

When a grantor establishes an irrevocable trust inter vivos and transfers assets to it, the

grantor has made a completed gift of the property transferred for income, gift, and estate taxpurposes Should the grantor retain any of the rights enumerated in IRC Sections 671 to 679,however, the grantor will be continue to be treated as the grantor or owner of the trust propertyfor income tax purposes only The grantor will be taxed on the income of the trust instead of thetrust or trust beneficiaries (even if they receive a distribution of this trust income) This is re-

ferred to as an intentionally defective grantor trust (IDGT) and can be used as an effective estate

and financial planning tool

ESTATE OF JOHN SMITH Charge and Discharge Statement

A L White, Executor From April 7, 20XX, to December 15, 20XX First, as to Principal:

The Executor charges himself as follows:

With amount of inventory at the date of death, April 7, Schedule A $xxx

With amount of assets discovered subsequent to date of death,

$xxxThe Executor credits himself as follows:

With amount paid for funeral and administrative expenses,

With amount paid on debts of the estate, Schedule F xxx

xxx

Second, as to Income:

The Executor charges himself as follows:

The Executor credits himself as follows:

With amount of administrative expenses chargeable to income,

With distribution of income to legatees, Schedule I xxx xxx

Balance of principal and income to be distributed to those entitled

thereto, subject to the deduction of the Executor’s commissions,

legal fees, and the expenses of this accounting, Schedule K

Exhibit 41.2 Sample charge and discharge statement.

A trust may include a spendthrift clause that prohibits the beneficiary from assigning his interestbefore receiving it or prevents creditors from enforcing their claims against the income or principal

of a trust fund, or both

Trusts are often used for business purposes, as when property is transferred by a deed

of trust instead of a mortgage, when trustees are appointed to hold title and perform other functionsunder a bond issue, or when assets are assigned to a trustee for the benefit of creditors Bankruptcyand insolvency are discussed in Chapter 43

(i) Limitations on Private Trusts A public trust may be established for an indefinite period, but a

trust may not suspend indefinitely the power of anyone to transfer the trust property The commonlaw rule, otherwise known as the Rule against Perpetuities, limits the duration of a private trust to 21years after the death of some person who is living when the trust is created Another common limita-tion in certain states is “two lives in being” at the origin of the trust

Accumulation of the income of a trust is also restricted by state law A common provision, for ample, is that in the case of a trust created for the benefit of a minor, the income can be accumulatedonly during the minority of the beneficiary Even the income of a charitable trust cannot be accumu-lated for an “unreasonable” period

ex-(ii) Revocation of Trusts A completed trust cannot be revoked without the consent of all the

ben-eficiaries unless the right to revoke has been expressly reserved by the grantor Trusts are thereforesometimes classified as “revocable” or “irrevocable.”

(b) APPOINTMENT AND REMOVAL OF TRUSTEES. In general, anyone competent tomake a will or a contract is competent to create a trust The trustee must be one who is capable

of taking and holding property and who has the legal capacity and natural ability to execute the trust

(i) Choice of Trustee The decedent’s will usually names the trustee for a testamentary trust A

grantor who is establishing an inter vivos trust will usually appoint one or more of the following toact as trustee: a relative; his professional adviser, that is, attorney, accountant, broker; a business as-sociate; or an institutional entity, such as a bank or trust company Each type of trustee has its prosand cons; however, the most important concern is not to choose a trustee that will cause adverse in-come tax consequences

(ii) Methods of Appointment Seven of the means by which trustees are appointed are:

1 By deed or declaring of trust The creator of the trust names the trustees in the instrument.

2 By will The same person may be both executor and trustee under a will, but this dual capacity

should be clearly indicated

3 By agreement.

4 By the court The court will appoint a trustee when a trust may fail for lack of a trustee, when

a trustee refuses to serve or has died, or when a vacancy from any cause exists and no othermeans have been provided for filing the vacancy

5 By implication of law.

6 By self-perpetuating boards When vacancies occur, they are filed by the remaining members

of the board

7 By the exercise of a power of appointment The instrument creating the trust may give the

remaining trustees, beneficiaries, or any other person the power to appoint a trustee to fill

a vacancy Specific instructions should be included in the instrument as to the situationestablishing a vacancy, the persons who may be appointed, and the manner of makingthe appointment

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 21

(iii) Acceptance or Disclaimer Acceptance of an appointment as trustee may be made by

posi-tive statement, by qualifying as executor if the appointment is by will, by the acceptance of property

of the trust, or by other acts from which acceptance may be presumed An individual may refuse toaccept an appointment as a trustee and should execute and deliver a disclaimer expressing rejection

of the appointment

(iv) Resignation of Trustee. According to the Restatement of the Law of Trusts 2d (1 TrustsA.L.I 234):

A trustee who has accepted the trust cannot resign except (a) with the permission of a proper court;

or (b) in accordance with the terms of the trust; or (c) with the consent of all the beneficiaries, ifthey have capacity to give such consent

(v) Removal of Trustee The court has power to remove a trustee and appoint a successor under

certain circumstances Scott cites, among others, the following six grounds upon which trustees havebeen removed:

1 Failure to exercise discretion

2 Self-dealing

3 Failure to keep proper accounts, and mingling with trustee’s own funds

4 Incompetency and neglect of duty

5 Conversion of trust property

6 Refusal to obey orders of the court5

(c) POWERS AND DUTIES OF TRUSTEES. The powers of trustees are obtained both from theprovisions and implications of the instrument creating the trust and from the general laws pertain-ing to the trust relationship The instrument may either expand or restrict the general powers, ex-cept that it may not relieve the trustee from liability for gross negligence, bad faith, or dishonesty.The powers of a trustee may be either (1) imperative or mandatory or (2) permissive or discre-tionary In other words, they must either be exercised definitely and positively within a givenlength of time or upon the occurrence of some contingency, or they may be exercised at the dis-cretion of the trustee

(i) General Powers The nine general powers of a trustee, which include all necessary incidental

powers, are:

1 To take and retain possession of the trust property

2 To invest trust funds so as to yield a fair income

3 To sell and reinvest when necessary

4 To sell and convey real estate when necessary to carry out the provisions of the trust

5 To release real estate so that it may earn income

6 To pay for repairs, taxes, and other such expenses in connection with trust property

7 To sue or defend suits when necessary

8 To make contracts that are necessary to carry out the purposes of the trust

9 To pay over and distribute the trust property to those entitled to it

5A W Scott, The Law of Trusts, 4th ed (Little Brown, 1987), 1995 Supplement.

The trustee secures possession of the trust property and holds title in his own name All debtorsshould be notified of the change in ownership of claims against them in order to hold them directlyliable to the trustee All debts due the trust estate should be collected promptly Trust property must bekept separate from the property of anyone else The trustee will be liable for any loss occurring as a re-sult of their mingling of funds or other property An exception is usually made when a trust company isacting as trustee; it may deposit cash in trust funds with itself or may mingle various trust funds and de-posit same with designated depositories.

(ii) Duties The 14 duties of the trustee are outlined by Scott as follows:

1 To administer the trust as long as he continues as trustee

2 To administer the trust solely in the interest of the beneficiary (the duty of loyalty as a

fiduciary)

3 Not to delegate to others the performance of acts which the trustee sought personally to

perform

4 To keep clear and accurate accounts

5 To give to beneficiaries upon their request complete and accurate information as to the

admin-istration of the trust

6 To exercise such care and skill as a man of ordinary prudence would exercise in dealing with

his own property; and if the trustee possesses greater skill than that of an ordinary prudent man,

he must exercise the skill he has

7 To take reasonable steps to secure control of trust property and to keep control of it

8 To use care and skill to preserve the trust property The standard of care and skill is that of a

man of ordinary prudence

9 To take reasonable steps to realize on claims which he holds in trust and to defend claims of

third persons against the trust estate

10 To keep the trust property separate from his own property and separate from property held

upon other trusts; and to designate trust property as property of the trust

11 To refrain in ordinary circumstances from lending trust money without security

12 To invest trust funds so that they will be productive of income

13 To pay the net income of the trust to the beneficiary at reasonable intervals; and if there are two

or more beneficiaries he must deal with them impartially

14 Where there are several trustees, it is the duty of each of them, unless otherwise provided by

the trust instrument, to participate in the administration of the trust, and each trustee must usereasonable care to prevent the others from committing a breach of trust6

(d) PROPER TRUST INVESTMENTS The trustee is under a duty to invest funds in such a way as

to receive an income without improperly risking the loss of the principal The only general rule as toinvestment is that the trustee is under a duty to make such investments as a prudent man (the “pru-dent man” rule or “Massachusetts” rule) would make of his own property, having primarily in viewthe preservation of the estate and the amount and regularity of the income to be derived In somestates (“legal-list” states), the legislatures tell trustees in what they must or may invest funds unlessthe terms of the trust otherwise provide

Eight kinds of investments that are almost universally condemned are summarized by Scott

as follows:

1 Purchase of securities on margin

2 Purchase of speculative shares of stock

3. Purchase of bonds selling at large discount because of uncertainty of repayment at maturity

4 Purchase of securities in new and untried enterprises

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 23

6Id

5 Use of trust property in the carrying on of a trade or business, even though it is not an untried

enterprise

6 Purchase of land or other things for the purpose of resale, unless authorized by the terms of the trust

7 Purchase of second and other junior mortgages

8 Making unsecured loans to individuals or firms or corporations7

Three types of investments that are almost universally permitted include:

1 Bonds of the United States or of the state or of a municipality thereof

2 First mortgages on land

3 Corporate bonds of a high investment grade

In 1990, the American Law Institute adopted the Uniform Prudent Investor Act (the UPIA) and

published it in the Restatement of the Law of Trusts, 3rd ed The UPIA incorporates a new Prudent

Investor Rule that has since been adopted by a significant majority of the states in a form that is ilar to, or somewhat comparable to, the scope of these new rules The Restatement embodies threemain themes:

sim-1 Although it is thought that a trustee may not delegate any of his duties, other than certain

minis-terial duties, this position is relaxed in that a trustee should, or even must, delegate investmentauthority to skilled professionals should they lack the required expertise or experience toproperly manage the assets within the trust

2 The costs incurred by the trustee in performing his duties must be reasonable.

3 A trustee is now charged with the responsibility for maintaining the trust portfolio so as to

keep pace with inflation In other words, trustees should invest for the maximum total return

on investment without regard for distinctions between principal and income This is referred

to as modern portfolio theory, permitting trustees to invest for capital appreciation as well ascurrent income in the form of interest, dividends, rents, and so forth

(e) TRUSTEE’S PERSONAL LIABILITIES AND LIABILITY FOR ACTS OF CO-TRUSTEE A

trustee is liable to the beneficiary for failure to fulfill his duties under the statutes, general rules of uity, or the provisions of the trust indenture

eq-A trustee must be particularly circumspect in all matters affecting his own property or benefit

He is personally liable for torts committed by himself or his agents and, unless his agreement statesotherwise, is personally liable on all contracts made on behalf of the trust

A trustee is not responsible for loss by theft, embezzlement, or accident if he has taken all the cautions that a careful businessman takes in guarding his own property, and if he is strictly following hisline of duty as a trustee If a trustee is not insolvent and mixes trust property with his own, the beneficiarymay take the whole, leaving the trustee to prove his own part If the trustee is insolvent, the beneficiaryshares with the other creditors unless definite property can be identified as belonging to the trust Interestwill be charged against a trustee who has mingled trust funds with his own If bank deposits are made inthe individual name of the trustee, he will be treated as a guarantor of the solvency of the bank, eventhough he uses care in his choice of the bank and has not in any way misused the funds

pre-In general, a trustee is not liable for losses caused by the default or negligence of a co-trustee less he has cooperated with the trustee who is at fault, or has known of the trustee’s misconduct andhas not taken any steps to prevent it If, however, each trustee should have interested himself in thematter in question, such as the proper investment of funds, each would be responsible even though hetook no part in or knew nothing of the misconduct All trustees should act together in handling thetrust property and should apply to the court for instructions in case they cannot agree Unanimity is

un-7Id

usually required for all important decisions in the case of private trusts, but a majority of a board oftrustees may act for a charitable trust.

In certain circumstances, a trustee may become personally liable for the unpaid estate taxes

of a decedent under the theory of transferee liability Ordinarily, the beneficiary of an estate ortrust is ultimately liable for any unpaid estate or gift taxes due on the transfer The liability isequal to the value of the property received by the recipient as of the date of transfer A review ofIRC Sections 6324 and 6901, primarily, is in order For example, the trustee of an inter vivostrust that is included in the gross estate for estate tax purposes could result in the trustee beingpersonally liable, as opposed to the beneficiaries, for payment of any attributable estate taxes.Certain trust distributions trigger the GSTT, discussed in Subsection 41.1(l), requiring the trustee

to pay this tax As a result of this possibility, a trustee should consider maintaining a reserveuntil he is satisfied that all such taxes are satisfied Upon making distributions, the trusteeshould also consider requesting that the beneficiaries indemnify him for any taxes that may beassessed against him

(f) GUARDIANS If a person is incompetent to manage his own property because of a disability

such as infancy or mental incompetency, a guardian will be appointed by the probate or other priate court The court must approve the appointment of a guardian by will A guardian is a trustee inthe strictest sense of the term He is directly under the supervision of the court If possible, only theincome from the property should be used for the maintenance and education of the beneficiary; per-mission must be granted by the court before the principal can be used for this purpose Any sale ofreal estate must be authorized by the court A guardian should have the authorization of the court orthe direction of a will before paying money to a minor or to anyone for the minor; otherwise he may

appro-be compelled to pay the amount again when the minor appro-becomes of age

(g) TESTAMENTARY TRUSTEE The work of the trustee appointed by a will begins when the

ex-ecutor sets aside the trust fund out of the estate assets One person may serve as both exex-ecutor andtrustee under a will

The testamentary trustee has slightly more freedom in handling the funds than does theexecutor, and his responsibility may be made less rigorous by provisions of the will He holds,invests, and cares for the property, and disposes of it or its income as directed by the will Atrustee should have specific authority of a will or the court, or the consent of everyone inter-ested, before carrying on a business If there are several executors, one can act alone, buttrustees must act jointly

(h) COMPENSATION OF TRUSTEES Trustees are usually allowed compensation for their

work, either by provision of the trust instrument or by statute The statutory provision is usually agraduated percentage of the funds handled

A trustee is entitled to be repaid expenditures reasonably and properly incurred in the care of trustproperty The compensation is usually allocated to principal and income in accordance with the spe-cific provision of the indenture or as provided by statute or rules of law

(i) RIGHTS OF BENEFICIARY The beneficiary has an equitable title to the trust property, that is,

he can bring suit in a court of equity to enforce his rights and to prevent misuse of the property by thetrustee Unless the instrument by which the trust is created provides otherwise, the beneficiary, if ofage, can sell or otherwise dispose of his equitable estate in the property

The beneficiary has the right to inspect and take copies of all papers, records, and data bearing onthe administration of the trust property and income that are in the hands of the trustee The benefi-ciary may have an accounting ordered whenever there is any reason for suspicion, or any failure toallow inspection or to make satisfactory reports and statements Whenever it seems advisable, a court

of equity will order an accounting

The beneficiary may have an injunction issued to restrain the trustee from proceeding with anyunauthorized action, if such action will result in irremediable damage The beneficiary may present a

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 25

petition to the court for the removal of a trustee but must be able to prove bad faith, negligence, lack

of ability, or other such cause for the removal The trustee is entitled to a formal trial

The beneficiary can, if it is possible to do so, follow the trust property and have it subjected tothe trust, even if a substitution has been made for the original property, unless it comes into thehands of an innocent holder for value If the trust property cannot be traced or is in the hands of aninnocent holder for value, the beneficiary may bring action against the trustee in a court of equityfor breach of trust

If the beneficiary is of age and mentally competent, he may approve or ratify acts of the trusteethat would otherwise be a violation of the trustee’s duties or responsibilities

(j) DISTINCTION BETWEEN PRINCIPAL AND INCOME Probably the most difficult problem

of the trustee is to differentiate between principal (corpus) and income The intention of the creator

of the trust is binding if it can be ascertained, but in the absence of instructions to the contrary thegeneral legal rules must be followed

The life tenant (the present beneficiary) is entitled to the net income and the remainderman (the ture beneficiary) to the principal, as legally determined The principal is the property itself that consti-tutes the trust fund, and the income is the accumulation of funds and other property arising from theinvestment or other use of the trust principal Increases or decreases in the value of the assets that con-stitute the trust fund affect only the principal The income determined under these rules is not alwaysthe same as taxable income or income as determined by generally accepted accounting principles(GAAP) The life tenant is entitled to receive only the net income from all sources for the entire term

fu-of his tenancy He is not allowed to select the income from only those investments that are lucrative.The existing rules regarding principal and income are based on the Uniform Principal and In-come Act of 1962 (UPAIA) These rules are, to a great extent, at odds with a trustee’s ability tocomply with the modern portfolio theory contained in the Uniform Prudent Investor Act describedearlier As one commentator noted,8the incompatibility of the UPIA and UPAIA were reconciled

in 1997 by the National Conference of Commissioners on Uniform State Laws The revisedUPAIA accomplishes:

this result by way of an adjustment power conferred upon trustees, pursuant to which the trustee isempowered to allocate traditional trust accounting income (e.g., interest, dividends, rents) to prin-cipal and perhaps more importantly, to allocate to income what is typically considered principal.Thus, a trustee can increase the amount currently distributable to a beneficiary, for example, by al-locating capital appreciation to income Some states (New York, New Jersey, Delaware, and Mis-souri) added an alternative approach to their respective adoptions of the new UPAIA: an optionalunitrust provision Instead of being limited to the annual accounting income actually realized bythe trust in any year, the current beneficiary of a unitrust is entitled to an amount equal to a fixedpercentage of the value of the trust’s assets determined annually As a result, the trustee is free toinvest for total return absent the need to produce sufficient income to satisfy the current benefi-ciary By adopting the unitrust alternative, the trustee is relieved of the obligation to determineeach year whether an equitable adjustment is warranted In addition, the unitrust approach pro-vides the current beneficiary with the certainty of knowing what he or she is entitled to each yearinstead of having to await the trustee’s possible exercise of its discretionary adjustment power.All of the statutes give testators and grantors the ability to opt out of the statutory language bydefining how they want principal and income to be recognized and charged The UPAIA in effect

in a given state is operative only if the trust document or will is silent The U.S Treasury ment and Internal Revenue Service have recognized this new trend in trust accounting and have is-sued Proposed Treasury Regulation Section 1.643(a) through (d)

Depart-8The commentator is Linda B Hirschon, Esq., of Greenberg Tauig LLP, New York, in an updated

ver-sion of her article “The Unitrust Alternative, A Framework for Total Return Investing,” Tax ment Memorandum, Vol 42, No 23 (November 5, 2001) The updated version of the article appeared

Manage-in a NYS Bar Association CLE publication entitled, “New York’s New PrManage-incipal and Income Act, thePower of Adjustment Between Principal and Income and the New 4% Unitrust Option.”

The following describes the principal and income rules under the UPAIA of 1962 Trusteesare advised to seek to professional counseling to determine whether the 1962 or 1997 revisedrules are in effect in their respective state.

(i) Receipts of Principal The following ten receipts of cash or other property have been held to

be part of the corpus of the trust and therefore to belong to the remainderman or persons entitled tothe corpus:

1 Interest accrued to the beginning of the trust Bond coupons are not apportioned in the

ab-sence of a statute providing for such a division

2 Rent accrued to the beginning of the trust Under the common law, rent was not apportioned

according to the time expired

3 Excess of selling price of trust assets over their value in the original inventory or over its

pur-chase price Appreciation, in general, belongs to the trust corpus

4 The value of assets existing at the time the original inventory was taken but not included in

the inventory

5 Dividends (see discussion below).

6 Proceeds of the sale of stock rights.

7 Profit from the completion of executory contracts of a decedent.

8 Profits earned prior to the beginning of the trust on the operations of a partnership or sole

proprietorship

9 Insurance money received for a fire that occurred prior to the date of the beginning of the

trust, or after that date if the property is in the hands of the trustee for the benefit of the trust

in general

10 If trust property is mortgaged, the proceeds may be said to be principal assets, although there

is no increase in the equity of the remainderman

(ii) Disbursements of Principal The following 12 payments, distribution, and exhaustion of

as-sets have been held to be chargeable to the corpus:

1 Excess of the inventory value or purchase price of an asset over the amount realized from

its sale

2 Payment of debts owed, including accruals, at the date of the beginning of the trust.

3. Real estate taxes assessed on or before the date of the beginning of the trust In the case ofspecial assessments made during the administration of the trust, the remainderman maypay the assessment and the life tenant may be charged interest thereon annually during thelife of the trust, or else some other equitable adjustment will be made between them

4 Any expenditures that result in improvements of the property, except those made voluntarily

by a life tenant for his own benefit, and all expenditures on newly acquired property that arenecessary to put it into condition to rent or use

5 Wood on the property that the life tenant uses for fuel, fences, and other similar purposes.

The life tenant may operate mines, wells, quarries, and so on, that have been opened and erated on the property

op-6 Losses due to casualty and theft of general trust assets.

7 Expenses of administration except those directly pertaining to the administration of income.

For example, legal expenses incurred in defending the trust estate are chargeable to pal; however, the expenses of litigation in an action to protest only the income are payableout of income

princi-8 Trustee’s commissions in respect to the receipts or disbursements out of principal

Commis-sions computed on income are ordinarily payable out of income

9 Brokerage fees and other expenses for changing investments should generally be chargeable

to principal, since they are a part of the cost of purchase or sale

41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 27

10 Income taxes on gains made from disposition of principal assets.

11 Carrying charges on unproductive real estate, unless the terms of the trust direct the trustee

to retain the property even though it is unproductive

12 Cost of improvements to property held as part of the principal.

(iii) Receipts of Income The following six receipts have been held to be income and to belong to

the life tenants or persons entitled to the income:

1 Interest, rent, and so on, accruing after the date of the beginning of the trust The proceeds of

a foreclosed mortgage may be apportionable between principal and income Interest includesthe increment in securities issued at a discount

2 Increase in value of investments made by the trustee from accumulated undistributed income.

3 Dividends (see discussion below).

4 Crops harvested during the trust.

5 Royalties or other income from operation of mines, quarries, or wells that were made

pro-ductive prior to the beginning of the trust, or were developed or leased in cooperating withthe remainderman

6 Net profit from the operation of a business.

(iv) Disbursements of or Charges to Income The following eight items have been held to be

chargeable against the income of the trust:

1 Interest payable, accruing during the life of the trust

2 Any expenses incurred in earning or collecting income, caring for trust property, or preserving

its value, and an appropriate share of administration fees and expenses

3 Income tax except those levied on gains from sale of principal assets

4 Premiums on trustee’s bond

5 Provision for amortization of wasting property, including leasehold interests, royalties, oil and

gas wells, machinery, and farm implements (see discussion of depreciation below)

6 Provision for amortization of improvements to trust property when such improvements will

not outlive the duration of the trust

7 Losses of property due to the negligence of the life tenant

8 Losses due to casualty and theft of income assets

(k) PRINCIPAL AND INCOME—SPECIAL PROBLEMS The distinction between principal and

income also involves a consideration of such problems as unproductive property, accruals, dends, bond premium and discount, and depreciation and depletion

divi-(i) Unproductive Property. When the trustee is required to sell unproductive property andthe sale is delayed, the net proceeds of the sale should be apportioned between principal andincome The net proceeds are allocated by determining the sum that, with interest thereon atthe current rate of return on trust investments, would equal the net proceeds, and the sum so de-termined is treated as principal and the balance as income (Restatement of Trusts 2d,

§ 241) Apportionment between principal and income is generally applicable to real estate, but

it has been applied in the case of personal property also It does not matter whether the erty is sold at a gain or a loss

prop-(ii) Accruals There are two dates at which the matter of accruals becomes significant The first is

the date at which the trust begins Income and expenses accrued at that date belong to the corpus ofthe estate The second date is the one when the life interest terminates Income and expenses accrued

at that date belong to the life tenant or his estate

Larsen and Mosich provide a summarization of the general rule of accrual as applied to certainitems, from which the following is taken:

1 Interest Interest accrued on receivables and investments at the date the trust is established is

considered part of the trust corpus Exceptions are interest on (a) savings accounts when the terest is paid only if the deposit remains until the end of the interest period, and (b) couponbonds when the payment is contingent upon the owner presenting the coupon, in which case thedate of receipt is controlling Similar rules apply to the accrual of interest expense

in-2 Rent The accrual of rent prior to the beginning of the trust is considered by many states as a

portion of a trust corpus Any rent accruing between the date of the establishment of the trustand the termination of the tenancy belongs to the income beneficiary Rent expense is handledsimilarly

3 Dividends Ordinary cash dividends are not divisible If the dividend is declared and the date of

record has passed before the trust is created, the dividend is a part of the corpus Otherwise it isconsidered income to the trust A stock dividend is treated in the same manner in manystates [For a discussion of special treatment of cash and stock dividends under the Massa-chusetts and Pennsylvania rules, see below.]

4 Property taxes Taxes which have been levied on trust property prior to the beginning of the trust

are charges against the principal Any taxes assessed on the basis of trust property held for thebenefit of the income beneficiary are chargeable against income Special assessments made duringthe administration of the trust are usually paid by the remainderman, although in some caseswhere the assessment is for improvements which benefit the life tenant, a part or all of the assess-ment may be charged against income When the assessment is paid from the corpus, interest onthe funds advance may be charged against income

5 Profits Income earned by a partnership or proprietorship does not accrue The income which is

earned prior to the creation of the trust is considered a part of the principal of the trust In manycases a partnership is dissolved upon the death of a partner, and there may be no income earnedafter the trust is established In the event that the business continues by specific direction of thegrantor or provision of the partnership agreement, any income earned after the trust is created isincome of the trust

6 Executory contracts Any profits earned on the completion of an executory contract by the

trustee is an addition to the principal of the trust

7 Livestock and crops Any livestock born during the tenancy under the trust is considered

in-come, except to the extent that the herd must be maintained as directed by the grantor, in whichcase the increase must be divided between principal and income in a manner which honors thisintention If the principal includes land, any crops harvested during this tenancy are consideredincome of the trust

8 Premium returns Any return of premium or dividend on insurance policies which was paid

prior to the creation of the trust is a part of the principal This is considered realization of assets

9 Royalties Royalties or other income from the operation of mines or other natural resource

de-posits which were made operative before the trust was created or which were developed in operation with the remainderman are income to the trust.9

co-(iii) Dividends The determination of whether a dividend is principal or income involves a

con-sideration of applicable state laws Ordinary cash dividends declared during the period of the trustbelong to the income beneficiary An ordinary stock dividend is usually regarded as income except instates that follow the Massachusetts rule This rule holds that all cash dividends are treated as incomeand that stock dividends are entirely principal

Some states follow the Pennsylvania rule, which holds that, in regard to extraordinary dends, it is not the form of the dividend but its source that determines whether and to what extent it

divi-41.3 TRUSTS AND TRUSTEES—LEGAL BACKGROUND 41 29

9E J Larsen and A N Mosich, Modern Advanced Accounting, 6th ed (Shephards McGraw-Hill, New York,

1994)

is income or principal Generally, under this rule extraordinary dividends are income if declared out

of earnings accruing to the corporation during the period of the trust, but they are principal if clared out of earnings accruing prior to the creation of the trust Thus, if such dividends cause thebook value of the corporation’s stock to be reduced below the book value that existed at the creation

de-of the trust, that portion de-of the dividend equivalent to the impairment de-of book value is principal andonly the remainder is income The present Pennsylvania law provides that stock dividends of 6% orless “shall be deemed income” unless the instrument provides to the contrary

Although there is still wide diversity among the courts and state statutes in the apportionment ofcorporate distributions, Scott points out that the recent trend has been in favor of the Massachusettsrule.10The Uniform Principal and Income Act (Uniform Laws Annotated, Vol 7B, § 5) follows theessence of the Massachusetts rule in treating cash and other property dividends as income and stockdividends as principal

(iv) Premium and Discount on Bonds The necessity of accumulating bond discount or

amor-tizing bond premium in order to determine the correct interest income still gives rise to a great deal

of confusion in trust and estate administration In general, it appears that most courts support theamortization of premium on bonds purchased by the trustee, but there has been little or no support ofthe accumulation of discount Any difference between the inventory value and the face value of thebonds taken over by the trustee is usually treated as an adjustment of principal

In the event of redemption before maturity, it has been held that the proper procedure is to tize the premium to the date of redemption; the unamortized balance is a loss borne by principal If abonus is received, it should be credited to principal

(v) Depreciation and Depletion In determining whether provision must be made for

deprecia-tion and depledeprecia-tion, it is essential to consider carefully the intendeprecia-tions and wishes of the trustor If thetrustor intended to give the full, undiminished income to the life tenant even though the principalwould thereby be partially or completely exhausted, no deduction from income for depletion or de-preciation is allowed If, however, there is an expressed or implied intention to preserve the principalintact, the trustee is required to withhold from income an amount sufficient to maintain the originalproperty of the trust

When the trustor’s intentions regarding the receipts from wasting property cannot be determinedfrom the trust instrument, then, according to Scott, the inference is that the trustor did not intend thatthe life beneficiary should receive the whole income at the expense of the principal.12Thus, when thetrustee holds wasting property, including royalties, patents, mines, timberlands, machinery, andequipment, he is under a duty to make a provision for amortization of such property The general rulehas been applied to new buildings erected and improvements made by the trustee; however, thecourts have generally held that buildings that were part of the trust estate at the beginning of the trustneed not be depreciated The courts have, in effect, refused to treat the buildings as wasting property.The trend appears to be in the direction of adopting principles of depreciation followed in account-ing practice For example, the position taken in Section13 of the Revised Uniform Principal and In-come Act is that, with respect to charges against income and principal, there shall be:

10Scott, The Law of Trusts.

11Id

12Id

a reasonable allowance for depreciation under generally accepted accounting principles, but no lowance shall be made for depreciation of that portion of any real property used by a beneficiary as aresidence or for depreciation of any property held by the trustee on the effective date of this Act forwhich the trustee is not then making an allowance for depreciation.

al-(l) TAX STATUS OF TRUST Unless the trust qualifies as an exempt organization (charitable,

ed-ucational, etc.), or unless the income of the trust is taxable to the grantor (revocable, or grantor tains substantial dominion and control), the income of the trust is subject to the federal income tax in

re-a mre-anner similre-ar to the cre-ase of re-an individure-al In generre-al, the trust is trere-ated re-as re-a conduit for tre-ax poses and is allowed a deduction for its income that is distributed or distributable currently to thebeneficiaries The trust may also be subject to state income taxes, personal property taxes, and so on

pur-A tax service should be consulted for the latest provisions and rulings as to deductions, credits, rates,and filing requirements

It is important to note that although trusts and estates are taxed similarly, there are two major ferences Trusts must be operated on a calendar year basis, whereas estates may operate on a fiscalyear, usually tied to the decedent’s date of death Secondly, trusts must pay estimated taxes in thesame fashion as individuals Estates, on the other hand, are exempt from this requirement, but onlyfor their first two tax years

dif-The impact of RRA ’93 (the Revenue Reconciliation Act of 1993) substantially compressed theincome tax rates applicable to trusts and estates Indexed from its original level effective for taxyears beginning in 1993, trusts reach the top 38.6% marginal bracket at $9,200 of taxable income in

2002 Compare this to married individuals filing jointly, for example, where the 38.6% top marginalbracket is not reached until taxable income exceeds $307,050 in 2002 That is quite a disparity.Trustees of existing trusts need to consider their responsibility to take this disparity into considera-tion when reviewing the mix of assets in the current trust portfolio and when exercising their discretion

to make discretionary distributions of income In certain cases, where older trusts were establishedwith a different rate structure in mind, and where state law permits, a trustee may want to considerbringing a court proceeding to reform the terms of the trust accordingly If the settlor is still alive, all

of the beneficiaries are adults, and trust is irrevocable, it may be possible under state law, as it is inNew York, to revoke the trust and create a new one if the gift tax cost is not excessive

(m) TERMINATION OF TRUST A trust may be terminated by the fulfillment of its purpose or by

the expiration of the period for which the trust was created A trust may also be terminated under apower reserved by the grantor or by the consent of all beneficiaries unless continuance of the trust isnecessary to carry out a material purpose for which it was created

When the trust is terminated, the trustee is discharged when he has transferred the property tothose entitled to it according to the terms of the trust instrument The trustee, to protect himself, maysecure a formal release of all claims from all who receive any of the property and are competent toconsent, may require a bond of indemnity from the beneficiaries, or may refuse to act without a de-cree of court

41.4 ACCOUNTING FOR TRUSTS

(a) GENERAL FEATURES Generally, accounting for a trust is the same as accounting for an

es-tate The emphasis for a trust, however, is that principal or corpus versus income should be properlydistinguished Two interests, that is, current or life versus future or remainder, usually serve differentparties One party may have a current or income interest whereas another party holds a future or re-mainder interest Therefore, allocation between principal and income is important See discussion atSection 41.3(j) for an update on these issues

(i) Accounting Period The accounting period for a trust depends somewhat on the nature of the

trust and the provisions of the trust instrument Reports may be required by the court or may be mitted to other interested parties at various intervals during the life of the trust

sub-41.4 ACCOUNTING FOR TRUSTS 41 31

(ii) Recording Principal and Income A careful distinction must be made between principal

(corpus) and income in recording the transactions The legal theory seems to be that the principal of

a trust is not a certain amount of monetary value but is a certain group of assets that must be capable

of isolation from the assets that compose the undistributed income Actual separation of cash and vestments is difficult because of such factors as accrued interest and amortization of bond premiumand discount Ordinarily it is sufficient to keep one account for cash and one for each type of invest-ment, and to indicate the claims of the principal and income in the total

in-Accounts should be kept with the beneficiaries to show the amounts due and paid to each.The trustee should keep records that will meet both the requirements of the income tax law andregulations and the law relating to principal and income There are apt to be conflicts at variouspoints in the determination of taxable income and of income belonging to the life tenant The onlysolution is to keep sufficiently detailed records so that all of the information is available for both pur-poses In some cases, it may be necessary to prepare reconciliation schedules in order to keep arecord of the differences between the income tax calculation of net income and the application oftrust accounting principles of accounting income

See discussion at Section 41.3(j) for an update on these issues

(iii) Accounting for Multiple Trusts Several trusts may be created by a single instrument, such

as trusts originating through the provisions of a will, and a single trustee may have to keep his counts so as to be able to prepare a report of the administration of the estate as a whole and also aseparate report of each trust

ac-(iv) Treatment of Liabilities In some cases, trust property will be encumbered with an unpaid

mortgage or other obligation of which the trustee must keep a record It is also possible that in dling the business of the trust some liabilities will be incurred These are usually current in character,and the entry made at the time of payment, charging the amount to an asset or expense account, isusually sufficient

han-(b) RECORD-KEEPING SYSTEM The bookkeeping system requirements for the trust, like those

for any other enterprise, vary with the complexity of the situation The trustee should keep a plete record of all transactions relating to the trust in order to protect himself, to make reports to thecourt, to prepare income tax returns, and to give the beneficiaries of the trust an adequate accounting

com-No special type of bookkeeping system is prescribed by law, but a complete record of all transactionsmust be kept in such a way that the reports required by the courts can be prepared All records should

be kept in permanent form and should be carefully preserved and filed for possible future reference

(i) Journals In a comparatively simple situation, one multicolumn journal may be satisfactory,

but in most cases a set of various journals should be kept

(ii) Principal and Income Accounts It is necessary to distinguish carefully between principal

and income in the administration of trusts The Trust Principal account and the Undistributed TrustIncome account record the net worth or capital of the trust It will usually be necessary to analyzethose accounts for income tax purposes, just as equity is analyzed in corporation accounts to obtainall of the information required for the income tax return There may be some conflicts between in-come as defined by the law relating to the administration of trusts and taxable income as defined bythe income tax law and regulations

(iii) Opening Books of Account If an inventory has been filed with the court, such as an

execu-tor’s or guardian’s inventory, the trustee must record the same values in his accounts If no such ventory was filed, the trustee should have one prepared that will serve as the basis of his propertyaccounting Whenever possible, the inventory should contain the same values as those required forincome tax purposes in determining the gain or loss from the sale of property In any case, a record

in-of such values must be available

(iv) Amortization of Bond Premium or Discount When bonds are taken over in the inventory

at more or less than their face value, the difference between the inventory value and the amount ceived at maturity is ordinarily treated as a loss or gain on realization; but when bonds are pur-chased at a premium or discount, the difference between the amount paid and the amount to bereceived at maturity should be treated as an adjustment of the interest earned and should be writtenoff during the remaining life of the bond If the amount is not large, the “straight-line” method may

re-be used, that is, the total premium or discount is divided by the numre-ber of remaining interest ments to obtain the amount to be written off at each interest date If the amount is large, amortiza-tion tables may be used in which the effective rate of interest is applied to the present value of thebond to obtain the income due to the life tenant

pay-(v) Depreciation Except for buildings forming part of the inventory at the date of origin of the

trust, or in trusts where contrary provisions were intended by the grantor, wasting assets, includingbuildings and equipment, should be preserved by reflecting depreciation as a charge to income, if al-lowed by the trust instrument or state law Many states have no provision for depreciation

If all of the trust income is distributed to beneficiaries without regard for depreciation, the entireperiodic deduction for depreciation is taken for income tax purposes by the beneficiaries, and thetrustee has no occasion to record depreciation in his records In all instances, the trustee should beguided by the provisions of the trust instrument or state law in his handling of depreciation

(vi) Payments of Expenses A distinction must be made between expenses chargeable to

princi-pal and income In the absence of direction in the instrument, the fiduciary should rely on state law

as to allocation of trust expenses Generally if an expense is recurring each year, it is usually charged

to income It could also be allocable one-half to principal and one-half to income If an expense is tributable to corpus, it should be charged to principal If the expense was to maintain and collect in-come, then it should be charged to income For example, capital gains are allocated to principal, andthe income tax paid by the trustee on capital gains should also be charged to principal; however,when a bank assesses an annual fee for a custody account, the custody fee could be charged to in-come or split 50/50 between income and principal

at-(c) TRUSTEE’S REPORTS Trustee’s reports vary in form and in frequency according to the

na-ture and provisions of the trust, and whether it is being administered under the jurisdiction of a court.Moreover, the form of the report varies among jurisdictions Before preparing the report, the ac-countant should ascertain from the court whether a particular form is required The valuations to beused must always be the same as those appearing on the inventory unless specific permission hasbeen granted to change them If assets have been written off as worthless, they must nevertheless ap-pear in the new inventory without value

If income and principal cash accounts have been properly maintained, the balance of the tributed income would be represented by an equal amount of cash in the bank If specific investmentshave been made with the intention that the funds used were still to be considered as undistributed in-come, the assets acquired should be shown as assets belonging to the trust income account.The reports consist primarily of an analysis of the principal and income accounts In addition, astatement showing the changes in the investments, an inventory of the property at the date of the re-port, and supporting schedules of various items will be required A reconciliation of cash receipts anddisbursements is also often prepared

undis-41.5 SOURCES AND SUGGESTED REFERENCES

Denhardt, J.G., Jr., and Denhardt, J.W., Complete Guide to Trust Accounting and Trust Income Taxation

Pren-tice-Hall, Englewood Cliffs, NJ, 1977

Denhardt, J.G., Jr., and Grider, John D., Complete Guide to Estate Accounting and Taxes, 4th ed Prentice-Hall,

Englewood Cliffs, NJ, 1988

41.5 SOURCES AND SUGGESTED REFERENCES 41 33

———, Complete Guide to Fiduciary Accounting Prentice-Hall, Englewood Cliffs, NJ, 1981.

Executors and Administrators, 31 Am Jur 2d (rev.), Lawyer’s Cooperative Publishing Rochester, NY, 1989, April

1995 Cum Suppl

Federal Taxes Weekly Alert, Effect of Death on an Individual’s Income Tax Attributes, November 16, 1995

Prac-tice Alert, Research Institute of America

Ferguson, M Carr, Freeland, James J., and Ascher, Mark L., Federal Income Taxation of Estates, Trusts and eficiaries, 2nd ed Little, Brown, Boston, 1993.

Ben-Gillett, Mark R., and Stafford, Joel D., “Steps to Prepare and File Estate Tax Returns Effectively,” Estate ning, May/June 1995 Warren Gorham & Lamont.

Plan-Harris, Ann C., “Proper Disposition if IRD Items Can Produce Tax Savings,” Estate Planning, September/

October 1994 Warren Gorham & Lamont

Harris, Homer I., Estates Practice Guide, 4th ed Lawyer’s Cooperative Publishing, Rochester, NY, 1984,

No-vember 1994 Suppl

Harrison, Louis S., “Coordinating Buy-Outs and Installment Payment of Estate Tax,” Estate Planning, May/June

1995 Warren Gorham & Lamont

Herr, Philip M., and Etkind, Steven M., “When and How an Interest in a Tax Shelter Should Be Disposed of

Be-fore Death,” Estate Planning, September/October 1990 Warren Gorham & Lamont.

Larsen, E J., and Mosich, A N., Modern Advanced Accounting, 6th ed Shephards McGraw-Hill, New York,

1994

Nossman, Walter L., Wyatt, Joseph L., Jr and McDaniel, James R., Trust Administration and Taxation, rev 2nd

ed Matthew Bender, New York, 1988, August 1995 Cum Suppl

Peschel, John L and Spurgeon, Edward D., Federal Taxation of Trusts, Grantors and Beneficiaries, 2nd ed

War-ren, Gorham & Lamont, New York, 1989, 1995 Cum Suppl

Restatement 3rd Trusts (Prudent Investor Rule) §§ 227-229 American Law Institute, 1990.

Restatement, Second, Trusts American Law Institute, 1959.

Sages, Ronald A., “The Prudent Investor Rule and the Duty Not to Delegate,” Trust & Estates, May 1995 Schlesinger, Sanford J., and Weingast, Fran Tolins, “Income Taxation of Estates and Trust: New Planning Ideas,” Estate Planning, May/June 1995 Warren Gorham & Lamont.

Scott, Austin Wakeman, The Law of Trusts, 4th ed Little, Brown, Boston, 1987, 1995 Suppl.

Share, Leslie A., “Domicile Is Key in Determining Transfer Tax of Non-Citizens,” Estate Planning, January/

February 1995 Warren Gorham & Lamont

Stephens, Richard B., Maxfield, Guy B., Lind, Stephen A., and Calfee, Dennis A., Federal Estate and Gift tion, 6th ed Warren, Gorham & Lamont, New York, 1991, 1995 Cum Suppl No 3.

Taxa-Stephenson, G T., and Wiggins, Norman, Estates and Trusts, 5th ed Appleton-Century-Crofts, New York, 1973 Tractenberg, Beth D., “Transferee Liability Can Reach Trustee as Well as a Beneficiary,” Estate Planning, Sep-

tember/October 1994 Warren Gorham & Lamont

Trusts & Estates Staff, “Uniform Laws Provide a Road Map for Estate Planners,” Trust & Estates, May 1994 Trusts, 76 Am Jur 2d (rev.) Lawyer’s Cooperative Publishing, Rochester, NY, 1992, April 1995 Cum Suppl Turner, George M., Trust Administration and Fiduciary Responsibility, Shephards McGraw-Hill, New York,

1994

Uniform Principal and Income Act American Laws Annotated, Vol 7.

Uniform Probate Code American Laws Annotated, Vol 8, 8A and 8B.

Waggoner, Lawrence W., “The Revised Uniform Probate Code,” Trust & Estates, May 1994.

CHAPTER 42

VALUATION OF

NONPUBLIC COMPANIES

Allyn A Joyce

Allyn A Joyce & Co., Inc.

Jacob P Roosma, CPA

Williamette Management Associates

(a) Definition of Nonpublic 2

(b) Purposes for Valuations 2

42.2 GENERAL PROCEDURE FOR

(a) Compile Background

Information about the Company 2

(b) Compile Financial Information

Regarding the Company 3

(c) Select Guideline Companies 3

(i) Compile Data on

(j) Employee Stock Ownership

42.1 DEFINITION OF VALUE

(a) DEFINITION OF NONPUBLIC A public company is one whose common stock has

wide-spread ownership and investment interest and such active trading that market quotations ordinarilyrepresent fair market value In contrast, the common stock of a nonpublic company generally hasconcentrated ownership and such few trades that the transactions do not provide reliable indications

of fair market value

(b) PURPOSES FOR VALUATIONS. The need for valuing the common stock of a nonpublic orclosely held company arises on many occasions Among the more important situations requiringthe valuation of nonpublic stock are filing estate and gift tax returns, transactions involving estateplanning, financial planning, employee stock ownership plan transactions and reports, grantingstock options, drawing stock purchase agreements, marital dissolutions, structuring recapitaliza-tions, sales, mergers, and divestitures, and litigation

(c) FAIR MARKET VALUE Briefly stated, fair market value is that value at which a willing buyer

and a willing seller, both well informed and neither under any compulsion to act, would arrive in anarm’s-length sale of the asset in question Such value is always determined as of a specific date and

is based on all pertinent facts and conditions that are known or reasonably might be anticipated onthat date The existence of a willing buyer and a willing seller is assumed in the very definition of fairmarket value

42.2 GENERAL PROCEDURE FOR VALUATION

(a) COMPILE BACKGROUND INFORMATION ABOUT THE COMPANY In valuing the

common stock of a nonpublic company, it is necessary to become as informed as the well-informedbuyer and seller assumed in the definition of value

The appraiser should review the history of the corporation, including date and state of tion, the products originally made, evolutionary developments to the present, and changes in controlover the years A list of stockholders, directors, and a listing of officers’ names, salaries, ages, and ex-perience should be obtained

incorpora-The appraiser must understand the nature of the company’s products and/or services, raw materialsused, and the methods of manufacture A facilities tour is helpful He should inquire as to how techno-logically advanced (or backward) the company is and review anticipated capital expenditures.Information on the size of the labor force, the existence of collective bargaining agreements, andbackground information on employee relations as well as the corporation’s strike experience should

be obtained The risk of customer loss during a strike must be evaluated

The analyst should carefully analyze the structure of the industry, including the identity ofexisting competitors, barriers to entry and exit, and the bargaining position of customers andsuppliers

Obtain information on the sales force, including its size, structure, methods of compensation,and radius of distribution Information on markets, including principal industries served and

42.6 SOURCES AND SUGGESTED

principal customers served, is also important Any material dependence on a single industry(25% or more of sales) or on a single customer (10% or more of sales) should be carefully re-viewed and the risk of a sudden loss evaluated The nature of the markets served (e.g., replace-ment versus original equipment market or job shop versus proprietary) should be examined Theeconomic forces that give rise to demand for the company’s products or services should be un-derstood Market share data, when available, can be helpful Price, quality, and service as com-petitive factors should be assessed The role of patents and proprietary or secret technology in thecompetitive structure of the industry should be examined, and if these are important, the possibleeffects of patent expirations should be reviewed Research and development projects under wayshould be reviewed with management.

Changes in the industry, particularly those of a technological or marketing nature, must be lyzed in terms of the company’s outlook The analyst should obtain a “feel” for the industry Back-ground information can usually be obtained from trade sources The analyst should understand thegrowth and cyclical characteristics of the industry He should review the performance of the com-pany relative to its industry, and he should understand the reasons for any pronounced differences intrends between the company and its industry

ana-(b) COMPILE FINANCIAL INFORMATION REGARDING THE COMPANY The appraiser

should obtain audit reports for the past five years Some situations may require a complete audit of thebooks or even the services of a forensic accountant The appraiser should disclose the source of the fi-nancial information upon which he has relied

The appraiser should review the historical income accounts, including such areas as officers’compensation, the company’s relationship with affiliated entities, and travel and entertainment

It is helpful to restate the income account in ratios, as this may disclose trends in cost-price tionships that should be discussed with management Margins by product lines should be reviewedfor a multiline company The appraiser should obtain the latest interim statement and interview man-agement with regard to the company’s outlook It is useful to get the interim statement for the sameperiod of the previous year

rela-It is helpful to review a five-year comparison of the balance sheets, to analyze changes that may

be occurring in financial position, and to evaluate its capacity to finance future growth The balancesheet may indicate the existence of nonoperating assets, which, if material, should be segregated andvalued separately The potential existence of hidden assets or hidden liabilities should be discussed

in interviews with management The capital structure must be carefully reviewed, as well as theterms of any stock purchase agreements or stock options

The appraiser should get sales, income, and dividend data to review both the growth and cyclicalcharacteristics of the company, as well as its long-term dividend policy It is important to review thelong-term outlook with management and to obtain financial projections if available

(c) SELECT GUIDELINE COMPANIES. Having reviewed the quantitative and qualitativefactors discussed above, the appraiser must translate this complex array of facts into value Thisrequires an analysis of the most relevant facts from the actual marketplace This is ordinarilydone through the selection and analysis of guideline companies that can be used to formulateobjective guidelines for the evaluation of the subject company Guideline companies are pub-licly held companies that come as close as possible to the investment characteristics of the com-pany being valued Ideally, they are in the same industry Frequently, however, there are nopublic companies in the same industry, so it is necessary to select companies with an underlyingsimilarity of investment characteristics based on markets, products, growth, cyclical variability,and other factors

Such companies were traditionally called “comparative companies,” a term that seems toconnote companies “just like” the company being valued It is seldom, if ever, possible to findpublicly held companies “just like” the company under consideration Appraisers have come togenerally use the term “guideline companies” as a more appropriate term than “comparativecompanies.”

42.2 GENERAL PROCEDURE FOR VALUATION 42 3

The importance of a thorough, objective selection of guideline companies cannot be mated The credibility of any valuation analysis is dependent on the demonstrated objectivity of theselection of guideline companies.

overesti-There are numerous sources for identifying public companies by industry In recent years,many appraisers have switched from printed sources of information on possible guideline com-panies to computerized databases It must be recognized that the breadth and depth of coverageand the accuracy of the information contained in such services will affect the results Althoughthey are far more efficient than the traditional printed sources, if such databases are not com-prehensive in the number of companies they cover or in the way they classify businesses, someactively traded companies that meet the criteria established for the selection of guideline com-panies may be missed

The appraiser must clearly state the criteria used in selecting guideline companies A description

of each guideline company finally selected should be part of the report

(i) Compile Data on Guideline Companies It is necessary to compile financial and operating

data on the guideline companies Annual reports should be obtained on the guideline companies, and10-K reports often are helpful As much information as possible must be gleaned from official re-ports, trade sources, prospectuses, and so on, regarding products, markets, and customer depen-dence, for each of the guideline companies Balance sheet and income account comparisons arerecommended Where possible, adjustments should be made to the income and balance sheets of theguideline companies and/or the subject company to minimize differences in accounting when suchdifferences are material

Generally, public companies compute depreciation on the straight-line basis for financial ing purposes If the company being valued uses accelerated depreciation, its income and net worthshould be adjusted to a straight-line basis when the difference is substantial (10% or more of averageincome over the past five years)

report-Adjustments should be considered when there is a difference in inventory accounting method tween the subject company and the guideline companies The most common difference is that most orall of the guideline companies are on last-in, first out (LIFO) and the subject company is on first-in,first-out (FIFO)

be-The income accounts of the subject company should be carefully reviewed and the managementinterviewed with regard to extraordinary factors affecting income, such as inventory write-downs,uninsured losses, plant moving expenses, or anything of a substantial and nonrecurring nature Ad-justments should be made to eliminate the effects of these extraordinary, nonrecurring items

(ii) Calculate Market Value Ratios. Next, the appraiser should calculate the market values

of the guideline companies by multiplying the number of shares outstanding by the price pershare on the valuation date If the company has preferred stock outstanding, include it in thiscomputation

It is necessary to compute the price-earnings ratio The period selected must be the one thatbest measures the earning power of the subject company relative to the earning power of theguideline group Generally, median ratios are used to avoid the distorting effect of extremes onthe arithmetic average

Compute the average cash flow (net income plus noncash charges) for each of the guideline panies using the same period Compute the median price-cash flow ratio of the guideline group.Compute the price-dividend ratio of each of the guideline companies Generally, the dividend ofthe latest year is suitable for this purpose However, if there has been an abrupt change in the divi-dend rate in a recent quarter, the new rate may be more indicative of dividend expectations Computethe median price-dividend ratio of the guideline group

com-Compute market-value-to-book-value ratios and the median of these ratios

(d) ESTIMATE DIVIDEND-PAYING CAPACITY. The use of the price-dividend ratio raisesthe question of the significance of the actual dividend payments of a nonpublic corporation In