Massachusetts Supreme Judicial Court Upholds Trustee’s Adjustment from Principal to Income

Trustees have many duties, including the duty of loyalty, the duty to invest prudently, and the duty of impartiality to all beneficiaries. Trustees must also effectuate the wishes of the trust’s settlor. These duties often require the trustee to make discretionary decisions about how to invest and administer the trust. These decisions directly impact the beneficiaries. How can a trustee balance the interests of various beneficiaries while also faithfully discharging their responsibilities under the terms of the trust and governing law?

The Massachusetts Supreme Judicial Court recently offered guidance on a specific power granted to trustees: the power to reclassify trust assets between principal and income.  The SJC’s decision should give trustees comfort in their authority to make discretionary decisions, but it also articulates important considerations when doing so to ensure trustees remain and appear impartial.

BACKGROUND

What is the difference between principal and income of a trust, and why does it matter?

To use a simple analogy, a trust’s principal is a tree and the trust’s income is the fruit that grows on the tree.  Items of principal traditionally consist of investments like real estate, stocks, or private funds, while items of income traditionally consist of rent, dividends, and interest.  However, it is not always this straightforward. For example, classifying capital gains distributions as either principal or income can be complicated depending on the circumstances, and certain stock-dividends may be treated as principal or income depending on whether the dividend represents a distribution of existing shares or an issuance of new shares. 

Trusts often have different principal and income beneficiaries. For example, a trust might provide a surviving spouse with all the trust’s income for the remainder of his or her lifetime, and then call for a distribution of principal to children from a prior marriage upon the surviving spouse’s subsequent death.  As a result, whether an asset is allocated to principal or income can determine who ultimately benefits from that asset.

What are a trustee’s duties with respect to managing the principal and income of a trust?

A trustee, having a duty of impartiality to all beneficiaries, also has a duty to invest the trust’s assets prudently under the Prudent Investor Act. These duties can and often do conflict. For example, a prudent investment might generate more principal growth at the expense of immediate income, while another strategy might favor dividend returns over long-term principal growth. This conflict is particularly acute in the context of modern diversified portfolios that may not yield a steady income stream, such as a growth-oriented stock portfolio with minimal dividends. While such an investment strategy may be considered prudent, it may not be impartial, particularly when there are different income and principal beneficiaries.

The Massachusetts Principal and Income Act, M.G.L. c. 203D Sections 1-29 (MPIA), seeks to address this conflict. Section 4 of the MPIA permits a trustee to adjust trust assets as between principal and income, allowing the trustee to administer the trust impartially based on what is fair and reasonable to all of the beneficiaries, while also pursuing a prudent investment strategy.  Although the MPIA authorizes such an adjustment, it still must be done in accordance with the terms of the trust instrument.  Whether a trust instrument bars or permits such adjustments is a trust-specific question. 

THE SJC’S RECENT GUIDANCE ON TRUSTEE DUTIES IN MAKING MPIA ADJUSTMENTS

In a recent case of first impression, In the Matter of The Trusts Under the Will of Helyn W. Kline (Docket No. SJC-13579, November 5, 2024), the Massachusetts Supreme Judicial Court was asked to evaluate the boundaries of a trustee’s discretionary authority to adjust between a trust’s principal and income under the MPIA. 

The SJC ruled that the trustee (1) had authority to adjust between trusts’ principal and income under the MPIA, and (2) did not abuse his discretion when he transferred certain trust assets from principal to income. Although the mandatory-income beneficiary of the trusts at issue could only receive principal distributions for emergency situations, the Court held that the disinterested trustee did not make an impermissible principal distribution when he made an adjustment from principal to income, followed by an immediate distribution to the income beneficiary.  The Court reached this conclusion because, under the circumstances, the decision was made impartially, did not violate the terms of the trust and adhered to the terms of the MPIA.

The Facts

Under the will governing the testamentary trusts at issue, the trustees were required to make income distributions to a beneficiary (Levy), and were permitted to make principal distributions to Levy only in emergency situations, and only under the most extraordinary circumstances.  Levy served as a trustee with a non-beneficiary co-trustee, Kline.

In overseeing the trusts’ assets, Kline testified that he had pursued a “total growth” investment strategy for the trusts’ assets, which resulted in significant growth of the trusts’ principal, but trust income “had not kept pace.” Kline further explained that, had he modified the investment strategy by shifting investments for a higher rate of income, Levy, the income beneficiary, would have benefited to the detriment of the remainder beneficiaries, Levy’s children. To address the lopsided returns on investment, Kline exercised his power to adjust under the MPIA by moving certain items of principal to income, stating that he considered Levy’s cost of living, her other income sources, and the relevant factors set forth in the MPIA, including the intent of the testator. 

After making the adjustment, the trustees made an income distribution to Levy. Levy’s son, one of the remainder beneficiaries who stood to benefit from the principal of the trust, brought suit against the trustees, claiming an improper distribution of principal to Levy in excess of the trust’s net income. The Probate and Family Court granted the trustees’ motion for summary judgment on the basis that the MPIA authorized the adjustment, and Levy’s son appealed. The SJC transferred the case on its own motion.

The Decision

The SJC upheld the grant of summary judgment in favor of the trustees.  First, the SJC ruled that the terms of the trust instrument did not preclude Kline from adjusting between principal and income. Under the MPIA, a trustee may adjust between principal and income if the trustee considers it necessary and if three prerequisites are met: (1) the trustee must invest and manage trust assets as a prudent investor, (2) the terms of the trust must describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and (3) the trustee must determine that he or she cannot administer the trust impartially absent an adjustment between principal and income, and the trust does not contain a “different provision” barring the exercise of the power to adjust. Importantly, the Court held that the provision limiting principal distributions to Levy to extraordinary emergency situations was not a “different provision barring the power to adjust.” As a result, this provision did not preclude adjustments between principal and income, but only addressed distributions of principal, distinguishing MPIA adjustments as different from distributions of principal to a beneficiary. 

Second, having found that the trust instrument did not provide a clear prohibition of the MPIA’s power to adjust, the Court ruled that Kline, as the non-beneficiary trustee, did not abuse his discretion in exercising the power to adjust. The MPIA requires a trustee to consider all factors relevant to the trust and its beneficiaries, and enumerates nine nonexclusive factors (discussed further below) that may be relevant to a trustee’s determination to exercise the power to adjust. The court gives substantial deference to a trustee’s decision to adjust between income and principal, and only steps in if it finds that the trustee abused his or her discretion, which Levy’s son failed to sufficiently allege in this case. 

KEY TAKEAWAYS

The SJC’s decision highlights that a trustee’s discretion under the MPIA to adjust between principal and income is a tool that Massachusetts trustees may use to address the sometimes-inherent conflict between a trustee’s duty to invest prudently, on one hand, and a trustee’s duty of impartiality as between current beneficiaries and future remainder beneficiaries, on the other. In other words, MPIA adjustments allow trustees to comply with their duty of impartiality without compromising trust asset performance.

Before deciding to make an adjustment under the MPIA, a trustee should carefully consider all of the conditions outlined in Section 4 of the MPIA, including confirming that the governing trust instrument does not otherwise prohibit an adjustment between principal and income. The trustee must also consider whether the factors set forth in MPIA Section 4(b) weigh in favor of an adjustment. Those nonexclusive factors are:

1. The nature, purpose and expected duration of the trust; 
2. The settlor’s intent;
3. The beneficiaries’ identity and circumstances; 
4. The needs for liquidity, regularity of income and preservation and appreciation of capital; 
5. The nature and character of the assets held in the trust (including whether an asset is used by a beneficiary and whether the trustee purchased an asset or received it from the settlor); 
6. The net amount allocated to income under the MPIA and the increase or decrease in the value of the principal assets; 
7. Whether the terms of the trust expressly permit or prohibit the trustee from invading principal or accumulating income, and whether the trustee has previously exercised these powers; 
8. The actual and anticipated effect of economic conditions; and 
9. The anticipated tax consequences of an adjustment.

As seen in this case, the trustee must balance the needs of income beneficiaries and remainder beneficiaries without favoritism, or conflict could arise. Without justification, adjustments could be viewed as breaching the trustee’s duty of impartiality. Trustees should document the rationale behind any adjustment decisions, aligning them with the trust’s goals and the MPIA’s nonexclusive factors, so that any decision can withstand potential scrutiny down the line.  This need is especially acute for trusts that place specific limitations on the rights of income beneficiaries to receive principal distributions.

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