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Jerry Reiss ASA**

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Craft and Rogers
Estate Liquidation

THE INCOME TRUST

 

            An income trust automatically pays income to current named beneficiaries on specific sums of money or share interests bequeathed to them.  The trustees have discretion to pay principal from those specific sums or share interest bequeathed to them and such payment is conditioned on specific need.  There are often successor beneficiaries who obtain the rights to automatic income and discretionary principal upon the death of the current beneficiary.   The current and successor beneficiaries may receive their interest individually or jointly with the right of survivorship.  Upon the deaths of all beneficiaries to each specific sum or share interest bequeathed the balance can sometimes go to named charities.  These are also among the most complicated trusts to terminate and should never be untaken without the assistance of an actuary.  Terminating these trusts can be done without costly litigation only with the consent of all current, successor and residual beneficiaries as well as the trustees.  

 

            Because consent of all interested parties is functionally required, a proposal setting forth methodology and assumptions should be performed before doing the major work.  This determines whether such consent can be obtained before the trustees commit to spending the bulk of the money.

 

            When there is a long history associated with the operation of this trust, it may be used to help establish assumptions, particularly with respect to the payment of discretionary principal.   But understanding the way all the pieces fit together is the key to developing a methodology and assumptions used.  This trust involves a specific amount of money.  It is not operating as an insurance company making a profit or engaged in risks.  Hence everything contemplated must tie back to the specific amount of each beneficiary’s interest or the resulting distributions will be unduly prejudicial to some of the beneficiaries.   It is the main reason why explicit assumptions as to a specified amount of earnings or principal dispersed is contraindicated.  (Explicit assumptions include specific percentage or dollar amount of prncipal paid, earnings as a fixed amount or percentage of principal and a rate of discount, all of which are little more than wild guesses.)

 

            No methodology should be arrived at before understanding the financial circumstances of the current beneficiaries.  This allows one to subgroup these individuals by their future needs for discretionary principal.  Financial needs are frequently associated with age.  The less affluent aged will have greater needs related to health issues particularly as they advance in age.  The probability of becoming frail increases with age and this increases the likelihood of requiring long-term nursing care or residing in an assisted living facility.  Middle class beneficiaries who did not purchase long term nursing care insurance, and very few did, will not be able to afford long-term medical care without Medicaid assistance and this will not be possible with their current beneficiary status in this income trust.  (This is because the 1986 Medicaid Act limits the amount of assets that the ill-spouse has to almost nothing and it also limits what the healthy spouse can have to a very modest amount.) The Society of Actuaries has a twenty-year study on nursing care facilities showing probabilities based on attained age, which can be of great assistance in establishing discretionary principal assumptions based on the likely future need for this care.

 

            The right to future income is better valued implicitly ("a backdoor approach").  This means that no one assumption need be realistic or justified.  Instead, the assumptions, as a whole, must be reasonable.  This avoids the need to justify assumptions on future income and it also avoids a host of other problems, including rewarding future risk that was never undertaken with a terminated trust.  Whatever the future income will be is uncertain.  But it doesn’t matter because it will be paid, and as the trust will be liquidated there will be no principal remaining.  Thus distributions can be determined without respect to what portion represents a right to lifetime of future income or discretionary future principal, simply by valuing the discretionary principal paid using zero percent interest.    Complications arise at the intermediate stages with successor beneficiaries who inherit a principal balance. That balance obviously was not used implicitly to recognize a lifetime right to future earning with the previous beneficiary.  This error of "the implicit methodogy approach" can be corrected by adjusting and increasing the payout to the prior beneficiary to implicitly recognize earnings on the leftover balance, and proceeding to the next level of beneficiary after making that adjustment.      

 

            For a comphrensive analysis, see Jerry Reiss, Terminating the income Trust:  A Suggested Approach, ABA Bankers Journal (Dec. 2010).