Impartiality Between Income and Remainder Beneficiaries

A trust that pays income to one person for life and principal to another at death contains a conflict built into its structure. Every decision the trustee makes moves value between them. A portfolio tilted toward yield feeds the current beneficiary and erodes the remainder in real terms. A portfolio tilted toward appreciation preserves the remainder and starves the current beneficiary. The duty of impartiality does not resolve that conflict. It requires the trustee to occupy a defensible position between the two and to be able to say how the position was reached.

What the duty actually requires

The statutory formulation is short: if a trust has two or more beneficiaries, the trustee shall act impartially in investing, managing and distributing the trust property, giving due regard to the beneficiaries' respective interests. The phrase carrying the weight is due regard to respective interests. Impartiality does not mean equal treatment, and it does not mean the trustee ignores the differences between the interests. It means the trustee may not import a preference the settlor did not express.

Where the instrument states a priority, the trustee follows it. A direction to pay so much of the income as the trustee deems necessary for the comfortable support of a surviving spouse, with the remainder to children, has already ranked the interests. The duty of impartiality then operates within that ranking, constraining how discretion is exercised rather than overriding the settlor's choice. It is only in a silent instrument that the trustee is left to strike a balance without guidance.

How receipts and expenses are classified

The mechanics live in the state's principal and income act. Interest, dividends other than those in the nature of a capital distribution, and rents are ordinarily income. Proceeds of a sale, stock dividends, capital gain distributions, and receipts from the sale of a mineral interest are ordinarily principal. On the expense side, ordinary repairs, ordinary property taxes, insurance premiums covering current risk and part of the trustee's regular compensation are charged to income, while capital improvements, principal payments on debt, and costs of a proceeding concerning an interest in principal are charged to principal.

The classifications look mechanical and they are consequential. They decide who is paid. A trust holding a portfolio of low-yield equities generates almost no accounting income, so the current beneficiary receives almost nothing while the remainder appreciates. A trust holding high-coupon debt does the reverse. Under the older legal-list regime that mismatch was tolerable because the permitted investments produced income by construction. Under a total return standard it is not, and the statutes responded.

The power to adjust

Most states now permit a trustee who invests under the prudent investor rule to transfer amounts between principal and income when the trust describes the current beneficiary's entitlement in terms of income and the trustee cannot otherwise administer impartially. The adjustment is a bookkeeping transfer, not a distribution, and it can run in either direction. Exercising it toward income raises what the current beneficiary receives; exercising it toward principal reduces an unusually large income receipt that would otherwise deplete the remainder.

The power is discretionary, and a trustee is not obliged to exercise it. What a trustee is obliged to do is consider it, because a decision not to adjust is a decision that affects both beneficiaries and is reviewable on the same terms as any other. Several states supply a safe harbor allowing the trustee to treat a stated percentage of the fair market value as accounting income without justifying the figure, which converts a contested judgment into an administrable one.

The statutes list factors the trustee must weigh. They include the nature, purpose and expected duration of the trust, the settlor's intent, the identities and circumstances of the beneficiaries, the need for liquidity and for preservation of capital, the composition of the assets and how they were acquired, the effect of economic conditions, and the tax consequences. They also list circumstances in which the power may not be exercised at all, including where the adjustment would diminish an interest qualifying for a marital deduction, would change a fixed annuity amount, or would benefit the trustee directly.

Where the disputes actually arise

Three fact patterns account for most litigation. The first is a trustee who never exercises the adjustment power and never records considering it, leaving an income beneficiary with a token distribution from a large trust. Nonexercise is permitted, but unexamined nonexercise looks like inattention. The second is retention of a concentrated low-yield holding contributed by the settlor, which simultaneously raises a diversification question under the prudent investor standard and an impartiality question about who bears the cost of the concentration.

Discretionary distributions raise the same tension in a different form. A trustee holding a power to invade principal for the current beneficiary's health, education, maintenance and support is deciding, every time it is exercised, how much of the remainder to spend. Impartiality does not forbid the invasion, since the settlor authorized it, but it does require that the standard be applied as written rather than expanded because the current beneficiary is the one in the room.

The third is allocation of a large irregular receipt. Proceeds of litigation, a redemption of a closely held interest, or a distribution from an entity that is partly a return of capital can be characterized either way, and the characterization can be worth a substantial sum. The safest course is to state the reasoning in the annual accounting rather than to record a figure without explanation, because a disclosed allocation begins the limitation period described in approving an accounting or objecting to it.

Where the structural mismatch cannot be repaired by adjustment, the remaining options are structural. Beneficiaries may agree to a modification, or a court may act on changed circumstances, both of which are set out in decanting, consent and changed circumstances. A trustee who lets an untenable allocation continue for years, having neither adjusted nor sought relief, is the one most likely to be surcharged for the difference.