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101 Definitions

102 Fiduciary Duties: General Principles

103 Limitation on Fiduciary Liability

201 Introductory Provisions

202 Determination of Net Income

203 Distribution of Net Income

204 Partial Distributions

301 When Right to Income Begins

302 Apportionment of Receipts and Disbursements When Decedent Dies or Income Interest Begins

303 Apportionment of Receipts and Disbursements When Income Interest Ends

304 When Payments Are Due

402 Character of Distributions

403 Other Trusts and Estates

404 Business Conducted as a Proprietor

410 Principal Transactions

411 Rental Property

412 Obligations to Pay Money

413 Insurance Policies and Other Contracts

414 Options

421 Deferral Assets

422 Deferred Compensation

423 Liquidating Assets

424 Minerals, Water and Other Natural Resources

425 Timber

426 Receipts From Sale or Exchange of Unproductive Property

427 Derivative Financial Instruments, Arbitrage Activities and Similar Assets and Activities

501 Disbursements From Income

502 Disbursements From Principal

503 Transfer From Income to Principal for Depreciation

504 Income Taxes

505 Equitable Adjustments Between Principal and Income Because of Taxes

601 Trustee's Power to Reallocate

701 Uniformity of Interpretation

702 Short Title

703 Severability

704 Repeal

705 Effective Date

706 Application of [Act] to Existing Trusts and Estates

Several sections have been revised extensively:

Section 102 - Fiduciary Duties: General Principles

Section 424 - Minerals, Water and Other Natural Resources

Sections 101(a)(4) (which is new), 202(1), 501(a)(5), 502(a)(4), and 504(a)(5) (environmental expenses)

An alternate section 103 is included to serve as a basis for discussing whether to abandon the idea of a nonjudicial resolution of proposed actions by trustees, and there are numerous other changes throughout the draft. There are also bold face insertions of alternate language, which in most cases have been suggested by others, to which I would like to have the Committee's reactions.

I am still working on sections 426 (unproductive property) and 427 (derivatives, and perhaps moving to that section all of the provisions on options, as well as covering deep discount bonds and high yield bonds), and I may have additional draft material to give you at the meeting. Section 425 (timber) has only minor changes because I have not yet received all of the comments that I expect from people who have called me about that section.

I did not receive the reviewed draft from the Style Committee in time to incorporate their suggestions in this draft.

SECTION 101. DEFINITIONS.

(a) In this [Act]:

(1) "Accounting period" means a calendar year or the taxable year for which the fiduciary files a federal income tax return for the trust or estate or a 12-month period for which the fiduciary accounts to a court or beneficiary. The term includes a shorter portion of the accounting period that begins when the income interest begins or ends when the income interest ends.

(2) "Beneficiary" includes, in the case of a decedent's estate, an heir[, legatee,] or devisee and, in the case of a trust, an income beneficiary or a remainder beneficiary.

(3) "Deferral asset" means an asset received from a decedent or transferor that is:

(i) a contractual right to receive one or more future distributions from a pension plan, profit-sharing plan, individual retirement account, deferred compensation plan, annuity, or similar arrangement;

(ii) an asset that had not been used by the decedent or transferor or had not produced income during the three-year period before it became subject to the trust if the decedent or transferor had not attempted to make the asset income producing during that period; or

(iii) an asset designated as a deferral asset in the governing instrument.

(4) "Environmental remediation expense" means an expense

the fiduciary incurs because the trust or estate owns an asset that is subject to environmental requirements imposed by governmental authority. The term includes disbursements made or required to be made for investigations, studies, clean-up, penalties, and expenses incurred to recover of all or any portion of these disbursements from others. The term does not include expenses incurred because of the operation of a site, the contribution of waste to a site not owned by the trust or estate, or the transportation of waste to such a site.

(5) "Fiduciary" means a personal representative or a trustee.

(6) "Governing instrument" means a will, a trust instrument, an instrument exercising a power of appointment, any other instrument that provides for successive income and remainder beneficiaries, or a court order.

(7) "Income" means money or property a fiduciary receives during an accounting period as the current return from a principal asset to the extent the receipt became due or accrued during an accounting period in which a current income beneficiary possessed an income interest. The term includes a portion of the receipts from a complete or partial sale, exchange, or liquidation of a principal asset, to the extent provided in [article] 4.

(8) "Income beneficiary" means a person to whom a trust's net income is or may be payable.

(9) "Income interest" means an income beneficiary's right to receive all or part of the net income, either in the accounting period in which the trust receives it or in a later accounting period, whether the governing instrument requires it to be distributed or authorizes it to be distributed in the trustee's discretion. The term also includes the net income accumulated pursuant to a governing instrument if the instrument permits or requires the trustee to accumulate all or part of the net income.

(10) "Mandatory income interest" means an income beneficiary's right to receive net income that the governing instrument requires the fiduciary to distribute in the accounting period in which the trust receives it or in a later accounting period.

(11) "Net income" means the total receipts [properly?] allocated to income during an accounting period minus the disbursements and other items [properly?] charged to income during that period. [Bracketed language suggested by a Commissioner from the floor.]

(12) "Personal representative" includes an executor, administrator, successor personal representative, special administrator, and a person who performs substantially the same function under applicable law.

(13) "Principal" means property held in trust for distribution to a remainder beneficiary when the trust terminates, including undistributed income that is added to principal pursuant to the governing instrument or Section 303.

(14) "Remainder beneficiary" means a person, including another trust, who is entitled to receive principal when an income interest ends.

(15) "Trustee" includes an original, additional or successor trustee, whether or not appointed or confirmed by a court.

(b) Other definitions that apply to this [Act] and the sections in which they appear are:

"Carrying charge" Section 426(h)

"Computation period" Section 426(f)

"Controlled entity" Section 401(2)

"Deferred compensation" Section 422(a)

"Delayed income" Section 426(e)

"Due date" Section 304

"Entity" Section 401(1)

"Inventory value" Section 426(d)

"Liquidating Asset" Section 423(a)

"Net proceeds" Section 426(g)

"Partial liquidation" Section 402(c)

"Successive income interest" Section 201(a)

"Terminating trust" Section 201(b)

"Undistributed income" Section 303(b)

"Unproductive property" Section 426(a)

The purpose for classifying an asset as a deferral asset is to take these assets out of the liquidating asset and unproductive property categories and to deal with them in a separate section.

"Discretionary income beneficiary" and "Discretionary income interest" are not defined because those terms are not used in the Act, but the definitions of income beneficiary (section 101(a)(7)) and income interest (section 101(a)(8)) are broad enough to cover both mandatory and discretionary beneficiaries and interests.

SECTION 102. FIDUCIARY DUTIES: GENERAL PRINCIPLES.

(a) In allocating receipts and disbursements to or between principal and income, and in any other matter [for which a rule is provided by] [within the scope of?] this [Act], a fiduciary:

(1) must administer a trust or estate in accordance with the provisions of the governing instrument, notwithstanding a contrary provision of this [Act];

(2) may administer a trust or estate by the [good faith] [reasonable?] exercise of a discretionary power given the fiduciary by the governing instrument even if the fiduciary's exercise of that power results in a determination contrary to a provision of this [Act];

(3) in the absence of a contrary provision or a grant of discretion in the governing instrument, a fiduciary must administer a trust or estate in accordance with the provisions of this [Act]; and

(4) to the extent that paragraphs (1), (2) and (3) do not apply, a fiduciary must administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries and by considering the factors in section 601(b).

(b) If a fiduciary is in doubt about what is fair and reasonable in allocating receipts and disbursements to or between principal and income under the provisions of the governing instrument or Articles 1 through 5 of this [Act], the fiduciary shall resolve the doubt by adding the receipt or charging the disbursement to principal.

(c) If the governing instrument provides that this [Act] does not apply, but contains no provision about a matter for which there is a provision in this [Act] or gives the fiduciary discretion to decide the matter, the fiduciary must be fair and reasonable to all of the beneficiaries unless the governing instrument clearly manifests an intention that the fiduciary must or may favor one or more beneficiaries. A fiduciary who makes a determination in accordance with the provisions of this [Act] is presumed to be fair and reasonable to all of the beneficiaries.

Section 102(a)(2) incorporates the rule in 1962 Act 2(b) that a discretionary allocation by the trustee that is contrary to a rule in the Act should not give rise to an inference of imprudence or partiality by the trustee.

Fiduciary discretion. The general rule is that if a discretionary power is conferred upon a trustee, the exercise of that power is not subject to control by a court except to prevent an abuse of discretion. Restatement (Second) of Trusts 187. The situations in which a court will control the exercise of a trustee's discretion are discussed in the comments to 187. See also 233, Comment p.

Prudent man rule. This draft deletes the language at the end of 1962 Act section 2(a)(3) - "and in view of the manner in which men of ordinary prudence, discretion and judgment would act in the management of their affairs" - because persons of ordinary prudence, discretion and judgment, acting in the management of their own affairs don't normally think in terms of the interests of successive beneficiaries. If there is an analogy to an individual's decision-making process, it is probably the individual's decision to spend or to save, but this is not a useful guideline for trust administration. No case has been found in which a court has relied on the 1962 Act's "prudent man" rule.

Doubtful questions. The allocation of doubtful items to principal, as provided in subsection (b), will initially favor the income beneficiary if the doubtful item is a disbursement, but thereafter it will reduce the income produced by principal. If the doubtful item is a receipt, it will initially favor the remainder beneficiary, but thereafter will favor the income beneficiary by increasing the annual income.

The provision in section 102(c) is intended to establish as a matter of public policy that the rule of impartiality applies even if a governing instrument provides that the Act does not apply if it then fails to provide how a fiduciary should treat a particular receipt or disbursement and also fails to give the fiduciary discretion to decide the question.

SECTION 103. LIMITATION ON FIDUCIARY LIABILITY.

(a) A fiduciary acting in good faith is not liable to a beneficiary for an action taken or a decision made either to act or not to act regarding a matter that is governed by this Act if:

(1) the fiduciary notifies the beneficiary in writing of the proposed action or decision and the date on which it will be implemented, which must be no earlier than 60 days after giving notice;

(2) the notice states that it is pursuant to this section and contains sufficient information to inform the beneficiary of the factual and legal reasons for the action or decision, the facts upon which the fiduciary relies, and an explanation of how the beneficiary will be affected by the action or decision; and

(3) the fiduciary receives no written objection to the proposed action or decision from the beneficiary before the end of the 60-day period that begins when notice is given.

(b) If the fiduciary receives a written objection within the 60-day period, either the fiduciary or a beneficiary may petition the court having jurisdiction over the trust or estate to have the proposed action or decision implemented as proposed, implemented with modifications, or denied. In the proceeding, a beneficiary objecting to the proposed action or decision has the burden of proving that the fiduciary's proposed action or decision should not be implemented. A beneficiary who has not objected is not estopped from opposing the proposed action or decision in the proceeding. If the fiduciary decides not to implement the proposed action or decision, the fiduciary shall notify the beneficiaries of the decision not to implement it and the reasons for that decision. A beneficiary may petition the court to have the action or decision implemented, and has the burden of proving that it should be implemented.

(c) The fiduciary's expenses incurred in formulating the proposed action or decision and invoking the procedure provided for in this section must be allocated to principal and income pursuant to Sections 202, 501, and 502. The court shall determine whether a beneficiary's expenses are to be charged to the estate or trust and, if so, whether to principal or income.

(d) [Procedural provisions]

(i) Notice to whom. Virtual representation.

(ii) Time within which proceeding must be brought.

No fiduciary is required to proceed under this section, and it applies only if the fiduciary gives a notice stating that it is pursuant to this section. A beneficiary would have the same remedies that he now has if a fiduciary takes an action or makes a decision without using the procedure in this section and a beneficiary feels the fiduciary took the wrong action, made the wrong decision, or failed to act when the beneficiary believes an action or decision was required.

ALTERNATE SECTION 103 (For consideration by the Drafting Committee)

SECTION 103. PROCEEDINGS FOR INSTRUCTIONS.

(a) A fiduciary acting in good faith is not liable to a beneficiary for an action taken or a decision made either to act or not to act regarding a matter that is governed by this Act if the fiduciary petitions the court having jurisdiction over the trust or estate for instructions regarding the proposed action or decision, the petition states that it is pursuant to this section, and it contains sufficient information to inform the beneficiaries of the factual and legal reasons for the action or decision, the facts upon which the fiduciary relies, and an explanation of how the beneficiaries will be affected by the action or decision.

(b) A beneficiary who objects to the proposed action or decision has the burden of proving that it should not be implemented. The court may order that the proposed action or decision be implemented as proposed, implemented with modifications, or denied.

(c) The fiduciary's expenses incurred in formulating the proposed action or decision and in a proceeding under this section must be allocated to principal and income pursuant to Sections 202, 501, and 502. The court shall determine whether a beneficiary's expenses are to be charged to the estate or trust and, if so, whether to principal or income.

(d) This section does not apply to any matter contained in a petition for the approval of a fiduciary's account.

Perhaps the informal procedure contemplated by the original proposal can be achieved by encouraging fiduciaries to discuss the proposed action or decision informally with the beneficiaries in order to solve any objections they may have before a proceeding is initiated. The proceeding might then proceed by consent.

SECTION 201. INTRODUCTORY PROVISIONS.

(a) "Successive income interest" means an income interest in some or all of the principal assets that were subject to an income interest that has ended. It may follow an income interest in the same trust or it may be an income interest in another trust that receives some or all of the principal assets of a terminating trust.

(b) "Terminating trust" means a trust in which a partial or complete termination of an income interest occurs and assets subject to that interest are distributed free of trust or become subject to one or more successive income interests, or both.

(c) An income interest ends when an income beneficiary dies or another terminating event occurs. An income interest also ends when a trustee who is required or permitted by the governing instrument to accumulate part or all of the net income ceases to be required or permitted to accumulate any net income.

SECTION 202. DETERMINATION OF NET INCOME. After a decedent dies, in the case of an estate, or after an income interest ends, the following rules apply:

(1) A fiduciary of an estate or terminating trust shall determine the net income from property specifically given to a beneficiary under the rules in [Articles] 3 through 5 that apply to trustees, but the fiduciary may not subtract from the property's income a disbursement described in section 501 to the extent that the governing instrument or applicable law requires the fiduciary to make the disbursement from assets other than the property or its income, or to the extent that the fiduciary recovers or expects to recover the disbursement from a third party. The property's net income is determined by including receipts and disbursements accrued or due before, on, or after the date of the decedent's death or an income interest's terminating event, and disbursements that the fiduciary will be obligated to make after the property is distributed.

(2) The fiduciary shall determine the remaining net income of a decedent's estate or terminating trust under the rules in [Articles] 3 through 5 that apply to trustees and by:

(i) including in net income all income from property used to discharge liabilities;

(ii) excluding from net income all receipts from a sale or liquidation of assets and the collection of accounts receivable that are part of a business conducted by the decedent or the terminating trust; and

(iii) charging against principal all disbursements made or incurred in connection with the settlement of a decedent's estate or the winding up of a terminating trust, including debts, funeral expenses, family allowances, fees of attorneys, accountants and fiduciaries, court costs, and death taxes and related penalties that are apportioned to the estate or trust by the governing instrument or applicable law.

SECTION 203. DISTRIBUTION OF NET INCOME. A fiduciary shall distribute:

(1) to a beneficiary who is to receive specific property, outright or in trust, the net income from the property as determined under Section 202(1);

(2) to a beneficiary who is to receive a pecuniary amount outright, the amount, if any, provided by applicable law or the governing instrument, [or, if the pecuniary amount is required to be paid from a terminating trust and there is no applicable law or governing instrument provision, the amount, if any, to which the beneficiary would be entitled under applicable law if the pecuniary amount were required to be paid under a will]; and

(3) to all other beneficiaries, including a trust that receives a pecuniary amount, the balance of the net income. Each beneficiary shall receive a percentage of the net income equal to the beneficiary's percentage interest in the estate or trust after deducting gifts described in paragraphs (1) and (2), using values as of the distribution date. The beneficiaries to which this paragraph applies includes even though a beneficiary of the trust holds an unqualified power to withdraw assets from the trust or another form of presently exercisable general power of appointment over the trust.

Section 203(2) provides for the beneficiary of an outright pecuniary amount to receive the interest or other amount provided by applicable law, but it does not provide for the situation in which there is no applicable law or governing instrument provision, and in particular where there is a provision dealing with gifts in a will, but not gifts appearing in an inter vivos trust agreement. The consensus of the Drafting Committee at our last meeting was that, since many states now have applicable provisions, at least as to pecuniary bequests in wills, this question should be resolved on a state by state basis to avoid the possibility that a provision in this Act might overlap or be inconsistent with existing law. The bold face language is proposed for the purpose of reconsidering this question.

David English, Reporter for the Uniform Probate Code, has suggested that the provision for the payment of interest on outright pecuniary legacies should be in this Act rather than in the probate code. If we do this, the provision could cover pecuniary gifts under both wills and revocable living trust agreements. UPC section 3-904 now provides: "General pecuniary devises bear interest at the legal rate beginning one year after the first appointment of a personal representative until payment, unless a contrary intent is indicated by the will."

If there is no provision in this Act, the problem that should be addressed in each state is that applicable law for paying interest on pecuniary gifts may apply only to pecuniary bequests under wills and not to pecuniary gifts payable from inter vivos trusts, especially revocable living trusts used as will substitutes. The various state authorities that provide for the amount that a beneficiary of an outright pecuniary amount is entitled to receive are collected in Covey, Marital Deduction and Credit Shelter Dispositions and the Use of Formula Provisions, App. B (Supp. 1993).

SECTION 204. PARTIAL DISTRIBUTIONS.

(a) If a fiduciary makes more than one distribution of assets to beneficiaries who are to receive net income pursuant to Section 203(3), all of those beneficiaries, including those who do not receive part of the distribution, are entitled, as of each distribution date, to the net income the fiduciary has received, and the net gain [or loss?] realized, after the date of death or terminating event or earlier distribution date but has not distributed as of the current distribution date. In determining a beneficiary's share of net income:

(1) the beneficiary shall receive a percentage of the net income equal to the beneficiary's percentage interest in the undistributed principal assets immediately before the distribution date, including assets that later may be sold to meet principal obligations; and

(2) the beneficiary's interest in the undistributed principal assets shall be computed on the basis of the aggregate fair market value of those assets as of the distribution date without reducing the value by any principal obligation that has not been paid as of the distribution date. For the purpose of this section, the distribution date shall be the date as of which the fiduciary computes the fair market value of the assets, which may be a date reasonably near the date on which assets are actually distributed.

(b) If a fiduciary does not distribute all of the collected but undistributed net income to each person on a distribution date, the fiduciary shall maintain appropriate records showing the interest of each beneficiary in that net income.

If all of the assets are distributed at one time, after administration of the estate or terminating trust is complete, section 204 does not apply. Section 204 applies only if partial distributions are made before the final distribution. If no partial distributions are made, all of the income earned during administration will be distributed on the basis of the fractional interests in the property that exist when the final distribution is made. It also applies only to income and not to gains realized during the administration from the sale or other disposition of principal asset. Those gains (and losses) become part of the final residue to be distributed when administration is complete, based on the final fractional interests the beneficiaries have in the estate or terminating trust.

Impartiality does not require a fiduciary to make interim distributions to beneficiaries as administration progresses even though their interests in the income would be different if distributions were made from time to time; nor does it require a fiduciary to make book allocations of income as changes in beneficial interests occur because the fiduciary sells assets or pays debts, taxes and expenses. Any such requirement would make administration much more complex.

Section 204(a) is intended to include a distribution that a fiduciary makes to some but not all of the beneficiaries described in Section 203(3) as well as a non-pro rata distribution to all of the Section 203(3) beneficiaries.

The Act does not contemplate a need to change the proportions used in making a distribution of income even though values for the assets may be changed due to an IRS audit of an estate tax return.

The 1962 Act uses inventory value to determine beneficiaries' rights in the undistributed assets; subsection 204(a)(2) changes that to fair market value.

The provisions in section 204 are intended to make it clear that the "gross-net share" method (using the terminology Covey used in an article at 2 Real Prop., Prob. and Tr. L. J. 1, 8-9 (1967)) is to be used in determining the amount of income due to residuary beneficiaries and recipients of pecuniary gifts in trust; that no redeterminations are to be made of their respective shares in net income just because assets are sold and principal obligations are paid between the times when distributions are made to beneficiaries; and that no principal or income receipts or disbursements are to be accrued or anticipated in computing net income when a distribution is made. In other words, a strict cash receipts and disbursements method of accounting is to be applied.

SECTION 301. WHEN RIGHT TO INCOME BEGINS.

(a) An income beneficiary is entitled to net income from the date specified in the governing instrument or, if no date is specified, from the date an asset becomes subject to the trust or to a successive income interest.

(b) An asset becomes subject to a trust or a successive income interest:

(1) on the date it is transferred to the trust in the case of an asset that is transferred to a trust during the transferor's life;

(2) on the date of an individual's death in the case of an asset that is transferred to the fiduciary by a third party because of the individual's death;

(3) on the testator's date of death in the case of an asset that becomes subject to a trust by reason of a will, even if there is an intervening period of administration of the testator's estate; or

(4) on the date the preceding income interest ends in the case of an asset that becomes subject to a successive income interest, even if there is an intervening period for the winding up of the terminating trust.

SECTION 302. APPORTIONMENT OF RECEIPTS AND DISBURSEMENTS WHEN DECEDENT DIES OR INCOME INTEREST BEGINS.

(a) A receipt that would be income under [Article] 4 must be allocated to principal if it is due before a decedent dies or before the principal asset that produces the receipt becomes subject to a trust unless it is a receipt from property to which Section 202(1) applies.

(b) A disbursement must be charged to principal if it is made to pay an obligation that is due before a decedent dies or an asset becomes subject to a trust.

(c) Income or obligations that are not due when a decedent dies or an income interest begins must be treated as accruing from day to day. The portion of the income or obligation accruing before that date is principal and the balance is income.

Professor Bogert stated that "Section 4 of the [1962] Act makes a change with respect to the apportionment of the income of trust property not due until after the trust began but which accrued in part before the commencement of the trust. It treats such income as to be credited entirely to the income account in the case of a living trust, but to be apportioned between capital and income in the case of a testamentary trust. The [1931] Act apportions such income in the case of both types of trusts, except in the case of corporate dividends." Bogert, The Revised Uniform Principal and Income Act, 38 Notre Dame Law 50, 52 (1962). The 1962 Act accomplishes this by providing in Section 4(b) that the Act applies "in the administration of a decedent's estate or an asset becoming subject to a trust by reason of a will...," and in Section 4(c) that "[i]n all other cases, any receipt from an income-producing asset is income even though ... earned or accrued in whole or in part before the date when the asset became subject to the trust."

Having two different rules is confusing. In order to simplify administration, Section 302 applies the same rule to inter vivos trusts (revocable and irrevocable), testamentary trusts and assets that become subject to an inter vivos trust through a pour-over bequest in a will. There is no apparent policy reason for the 1962 Act distinction, and Professor Bogert does not explain why different rules should apply.

Under section 302, payments that are due but unpaid before a decedent dies or an asset becomes subject to a trust are principal, but the next payment is not apportioned and instead is allocated entirely to income. Thus, periodic rents, dividends, interest, annuities and similar payments are not apportioned. This is the original common law rule. Edwin A. Howes, Jr., The American Law Relating to Income and Principal 70 (1905). In trusts in which the income beneficiary is dependent upon the regular flow of cash from the decedent's securities portfolio, the surviving spouse for example, this rule insures a continuation of payments to the spouse at the same level of payments experienced prior to the settlor's death. Under the 1962 Act rule, the predeath portion of the dividend and interest payments first due after death would be apportioned to principal.

Interest accrued before a person dies or a trust begins on an obligation that does not provide a due date for the interest payment, such as interest on an income tax refund, would be apportioned to principal unless the obligation is specifically given to a devisee or remainder beneficiary, in which case subsection 202(1) would give the accrued income to the person who receives the obligation.

SECTION 303. APPORTIONMENT OF RECEIPTS AND DISBURSEMENTS WHEN INCOME INTEREST ENDS.

(a) When a mandatory income interest ends, a mandatory income beneficiary who survives that date or the estate of a deceased mandatory income beneficiary whose death causes the interest to end is entitled to the beneficiary's share of the undistributed income that is not disposed of by the governing instrument, but undistributed income from assets or the proceeds of assets that a mandatory income beneficiary transferred to the trust must be added to principal.

(b) "Undistributed income" means the net income that has been received before the month in which an income interest ends but has not been distributed to an income beneficiary or added to principal or is not required to be added to principal pursuant to the terms of the governing instrument. The term does not include net income from property to which Section 202(1) applies.

The definition of undistributed income in subsection (b) is different from the provision in Section 4(d) of the 1962 Act. Under Section 303(b), items that are due or that have accrued are excluded from the definition of undistributed income. The requirement that undistributed income include only net income received is also intended to exclude "accruals" of items such as the increment in value that may have occurred on zero coupon bonds.

Both the 1931 Act (Section 4) and the 1962 Act (Section 4(d)) provide that a deceased income beneficiary's estate is entitled to the undistributed income. The Drafting Committee concluded that this is probably not what most settlors would want, and that most settlors would probably favor the income beneficiary first, the remainder beneficiaries second, and the income beneficiary's heirs last, if at all. However, it decided not to eliminate this provision completely to avoid causing disputes about whether the trustee should have distributed collected cash before the income beneficiary died.

The provision at the end of subsection (a) applies to the undistributed income in a revocable living trust when the grantor who is also the income beneficiary dies.

SECTION 304. WHEN INCOME OR OBLIGATIONS ARE DUE. An item of income or an obligation is due on the date on which the payor is required to make a payment. If there is no stated payment date, there is no due date for the purposes of this [Act]. Corporate distributions to stockholders are deemed to be due on the date fixed by the corporation for determination of stockholders of record entitled to distribution or, if no date is fixed, on the declaration date for the corporate distribution.

SECTION 401. DEFINITIONS.

(1) "Entity" includes a corporation, partnership, limited liability company, regulated investment company, real estate investment trust, common trust fund, business that a trustee accounts for as an entity under Section 404, another estate or trust, and any other organization in which the trustee owns an equity interest. The term does not include a tenancy in common or an entity that acts as an agent or nominee for the trustee.

(2) "Controlled entity" means an entity in which a trustee owns an interest that enables the trustee to terminate the entity's existence or to withdraw the trust's pro rata share of the entity's assets.

The definition in paragraph (2) is not used in any substantive provision of this draft, but is included for the purpose of discussing whether the Act should have a look-through provision for the purpose of (for example) treating distributions from an entity that owns wasting assets as though the trustee directly owned those assets.

Section 402. CHARACTER OF DISTRIBUTIONS.

(a) Except as otherwise provided in subsection (b), all distributions from an entity are income, including a distribution chosen when the distributing entity gives the trustee an option to receive a distribution either in cash or in its own shares or other units of equity.

(b) Distributions from an entity that are principal include:

(1) a distribution of its own shares or other units of equity, securities or obligations, including a distribution in the form of a stock split or stock dividend or a comparable distribution from a noncorporate entity;

(2) a distribution of shares, other units of equity, securities or obligations of an entity other than the distributing entity;

(3) a distribution of rights to subscribe to shares, other units of equity, securities, or obligations of the distributing entity or another entity and the proceeds of those rights;

(4) a distribution from an entity that is a regulated investment company or a real estate investment trust if it is a capital gain dividend for federal income tax purposes whether in the form of cash or additional stock; and

(5) except to the extent that an entity indicates that some part of a distribution is a settlement of preferred or guaranteed amounts accrued since the trustee became an owner, a distribution that is pursuant to:

(i) a call of shares or other units of equity ownership;

(ii) a merger, consolidation, reorganization, or other plan by which assets of the entity are acquired by another entity; or

(iii) a total or partial liquidation of the entity.

(c) "Partial liquidation" means:

(1) a distribution that the entity, at or near the time of distribution, indicates is a distribution in partial liquidation;

(2) a distribution or series of related distributions by an entity in an amount greater than [20] percent of the entity's gross assets, as shown by the entity's annual financial statements for the year-end immediately preceding the initial distribution; or

(3) a distribution of assets, other than cash, pursuant to a court decree or final administrative order by a government agency ordering distribution of the particular assets.

(d) A distribution is not a partial liquidation to the extent it is made to provide cash to a beneficiary to pay an income tax obligation on the entity's undistributed taxable income, nor is it a partial liquidation solely because the entity has realized a gain from the sale of investment assets or of business assets not held for sale to customers in the normal course of its business.

(e) A trustee may rely upon a statement made by an entity about the source or character of a distribution if the statement is made at or near the time of distribution by the distributing entity's board of directors or other person or group of persons authorized to exercise powers of distribution comparable to those of a corporation's board of directors.

Under the Internal Revenue Code and the Income Tax Regulations, a "capital gain dividend" from a mutual fund or an REIT is the excess of the fund's net long-term capital gain over its net short term capital loss. As a result, a fund's capital gain dividend does not include any net short-term capital gain. Moreover, it is frequently difficult or impossible to obtain any information about the extent to which a fund has actually distributed any net short-term capital gain it may have realized. The Committee has continued the treatment of capital gain dividends as principal, but no inference should be drawn that distributions from other entities that have their origin in an entity-level transaction that results in long-term capital gain for income tax purposes is principal for the purposes of this Act. (See subsection (e)).

SECTION 403. OTHER TRUSTS AND ESTATES. Income includes income received from another trust in which the trust has an income interest because of a donative transfer, including income to which Section 203 applies. Principal includes a distribution from principal of another trust in which a trustee has a beneficial interest because of a donative transfer. If a trustee transfers principal assets to a trust that is an investment entity in exchange for a beneficial interest in that entity, or if a decedent or donor transfers a beneficial interest in such a trust to a trustee, Section 402 applies to distributions from that trust.

SECTION 404. ACTIVITIES CONDUCTED AS A PROPRIETOR.

(a) If a trustee uses part of the principal in the conduct of a business or other activity for which the trustee considers it necessary or desirable to account separately for its receipts, disbursements, accounts receivable, accounts payable, inventories, or invested capital, the trustee may account for those transactions as though the business or activity were an entity separate from but wholly owned by the trust.

(b) A trustee may determine the extent to which net cash receipts from the conduct of a business in an accounting period must be retained for working capital, the acquisition or replacement of fixed assets, and other reasonably foreseeable needs of the business. The trustee shall transfer the remaining net cash receipts to the trust's general income account.

(c) Net cash receipts from a sale of business assets not in the ordinary course of business must be transferred to trust principal to the extent the trustee determines they are no longer required in the conduct of the business.

(d) Activities for which the trustee may account pursuant to this section include farming operations, management of rental properties, extraction of natural resources, timber operations, and activities described in Section 427. The trustee may aggregate in one or more entities described in subsection (a) as many separate business activities as the trustee considers appropriate.

These provisions are intended to give more appropriate powers to a trustee who operates a business in proprietorship form. Section 404 would also permit (but not require) a trustee to account for rental properties and oil and gas properties as though they were held by a separate entity.

If a fiduciary liquidates a sole proprietorship during probate or during a trust's winding-up period, section 202(2)(ii) requires the proceeds to be added to principal.

SECTION 410. PRINCIPAL RECEIPTS. Principal includes:

(1) assets received from a transferor during the transferor's lifetime, a decedent's estate, a terminating trust, or a payor pursuant to a contract naming the trust or its trustee as beneficiary, to the extent those assets are not income under Section 202 or 403;

(2) cash or other property received from the sale, exchange, or liquidation of a principal asset, including profit realized in such a transaction, subject to the provisions in [Part] 3 of [Article] 4;

(3) proceeds of property taken by eminent domain, but if a separate award is made for the loss of income with respect to an accounting period during which a current income beneficiary had a mandatory income interest, that part of the separate award is income;

(4) money or property received that became due or accrued during an accounting period in which no current income beneficiary had an income interest; and

(5) other receipts as provided in [Part] 3 of [Article] 4.

SECTION 411. RENTAL PROPERTY. An amount received as rent of real or personal property, including an amount received for cancellation or renewal of a lease is income. An amount received as a refundable deposit, including a security deposit or a deposit that is to be applied as rent for future periods, must be added to principal and held subject to the terms of the lease, and is not available for distribution to a beneficiary until the trustee's contractual obligations have been satisfied with respect to that amount.

SECTION 412. OBLIGATIONS TO PAY MONEY.

(a) An amount received as interest on an obligation to pay money to the trustee, including an amount received as consideration for the privilege of prepaying principal, is income. An amount received from the sale, redemption, or other disposition of such an obligation is principal. Provision may not be made for amortization of premium or for accumulation of discount on an obligation that provides for payment of interest at least annually if the premium or discount occurs because of market changes in the obligation's price.

(b) If an obligation provides for payment at a future time of an amount greater than the price at which it was issued, the increment in value is determined and distributable as income in the following manner:

(1) The increment in value for each accounting period must be determined from a fixed schedule of appreciation if one is established for that obligation. If no fixed schedule is established, the increment must be the amount of original issue discount that the trustee is required to report for federal income tax purposes for that accounting period.

(2) A beneficiary who has a mandatory income interest during the accounting period when the increment accrues is entitled to receive an amount equal to the increment from the first principal cash available or, if none becomes available earlier, when the increment is realized by sale, redemption, or other disposition of the obligation, but:

(i) the trustee is not required to distribute any amount from principal if the trustee is in doubt about the obligor's ability to pay the obligation in full when due or if the market value of a readily marketable obligation is less than the price at which it was issued plus the accrued increments;

(ii) the right of an income beneficiary or that beneficiary's estate to receive the increment terminates when that beneficiary's mandatory income interest terminates; and

(iii) when an obligation's increment is realized, principal must be reimbursed from that increment for amounts distributed from principal pursuant to this paragraph because of that obligation before any part of the increment is added to income.

(c) If the amount distributed pursuant to subsection (b) (2) exceeds the increment, principal may not be reimbursed for that excess from any other source.

(d) This section does not apply to obligations to which Sections 421 through 423, 426 and 427 apply.

This section is intended to apply to bonds and to promissory notes that evidence an obligation to repay borrowed money or to pay the balance of an asset's purchase price. It is not intended to apply to money under a notional principal contract or any other derivative financial instrument to which Section 427 applies.

SECTION 413. INSURANCE POLICIES AND OTHER CONTRACTS.

(a) Insurance proceeds are principal if they are from a life insurance policy whose beneficiary is the trust or its trustee or a policy that insures the trust or its trustee against loss for the damage or destruction of, or loss of title to, a principal asset. Dividends received from an insurance policy are principal and the proceeds of any other contract in which the trust or its trustee is named as beneficiary are principal. This section does not apply to a contract to which Section 422 applies.

(b) Insurance proceeds are income if they are from a policy that insures the trustee against the loss of occupancy or other use by an income beneficiary, the loss of income, or, subject to Section 404, the loss of profits from a business.

SECTION 414. OPTIONS. If a trustee grants, acquires or exercises an option in circumstances to which Section 427 does not apply:

(1) An amount received from granting an option to buy property from a trustee, whether or not the trustee owns the property when the option is granted, must be held as part of the trust principal until the option expires or is exercised. The amount is income if the option is not exercised and is part of the sales proceeds if the option is exercised.

(2) A gain realized upon the exercise of an option granted as compensation or upon a later sale of the property acquired by the exercise of the option is principal.

(3) An amount disbursed to acquire an option to sell an asset owned by the trustee must be paid from principal, whether or not the option is exercised.

This section applies to occasional option transactions and not to options granted or acquired in connection with arbitrage or hedging activities or dealings in derivative financial instruments. It applies to an option to purchase real estate owned by the trustee in an isolated real estate transaction and to a put option purchased by a trustee to guard against a drop in value of a large block of marketable stock that must be liquidated to pay estate taxes. A continuing and regular practice of selling call options on securities owned by the trust is subject to Section 427.

This section does not apply to an agreement between owners of an entity who grant options to each other to buy or sell their interests in the entity if an owner dies, retires or wants to transfer part or all of his interest in the entity; nor would it apply to any other option if the consideration received or given for the option were not cash or property.

SECTION 420. INSUBSTANTIAL ALLOCATIONS NOT REQUIRED. If a trustee determines that an allocation required by Sections 421 through 427 is insubstantial, the trustee may make such an allocation but is not required to do so. If the trustee decides not to allocate a receipt between principal and income because it is insubstantial, the receipt must be added to principal. An allocation is presumed to be insubstantial if:

(1) the amount of the allocation would increase or decrease an accounting period's net income, as determined before any adjustment, by less than 10 percent; or

(2) the value of the asset producing the receipt for which the allocation would be made is less than 10 percent of the total trust asset value at the beginning of the accounting period.