When a settlor creates a trust, he or she may prescribe the trustee’s powers and performance. Generally, state law applies only to the extent that it does not conflict with the terms of the trust. When state law does apply, it is most likely to restrict the trustee’s investment of trust funds. Typically, state statutes restrict trustees to investments in conservative debt securities such as government, utility, and railroad bonds and first-mortgage loans on realty. It is common, however, for a settlor to grant a trustee discretionary investment power. In that circumstance, any statute may be considered only advisory, with the trustee’s decisions subject in most states to the prudent person rule.
A difficult question concerns the extent to which a trustee has the discretion to invade the principal and distribute it to an income beneficiary if the income is found to be insufficient to provide for the beneficiary in an appropriate manner. A similar question concerns the extent of a trustee’s discretion to retain trust income and add it to the principal, if the income is found to be more than sufficient to provide for the beneficiary in an appropriate manner. Generally, the income beneficiary should be provided with a somewhat predictable annual income, but with a view to preserving the principal. A trustee may therefore make individualized adjustments in annual distributions.
Allocating Expenses between Principal and Income
Frequently, a settlor will provide one beneficiary with a life estate and another beneficiary with the remainder interest in a trust. For example, a farmer may create a testamentary trust providing that the farm’s income be paid to his or her surviving spouse and that on the surviving spouse’s death, the farm be given to their children. Among the income and principal beneficiaries, questions may arise concerning the apportionment of receipts and expenses for the farm’s management, as well as the trust’s administration between income and principal. Even when income and principal beneficiaries are the same, these questions may occur. To the extent that a trust instrument does not provide instructions, a trustee must refer to applicable state law. The general rule is that ordinary receipts and expenses are chargeable to the income beneficiary, whereas extraordinary receipts and expenses are allocated to the principal beneficiaries. The receipt of rent from trust realty would be ordinary, as would the expense of paying the property’s taxes; but the cost of long-term improvements and proceeds from the property’s sale would be extraordinary.