SEG C.S.H.B. 2936 75(R)BILL ANALYSIS PENSIONS & INVESTMENTS C.S.H.B. 2936 By: Williams 4-18-97 Committee Report (Substituted) BACKGROUND The Internal Revenue Code (IRC) permits the creation of split-interest trusts called charitable remainder trusts (CRTs). Such trusts permit individuals to gift property into a trust, but retain the right to receive income generated from such property for their lifetimes. At the death of the beneficiaries of a trust, the corpus of the trust will pass to a qualifying charity with no federal estate tax assessed on the value of the corpus. The trustee must protect the interest of the charity which will ultimately receive the corpus, but can also administer the trust for the benefit of the income beneficiary provided such actions do not constitute self-dealing with the income beneficiary or in any way harm the remainder interest passing to charity. The IRC requires all "income" to be distributed out of the trust annually to the income beneficiary of the trust. However, the IRC permits these trusts to include make-up provisions in the event the income of the trust is insufficient to pay out the prescribed amount of income set forth in the trust language. For example, assume an individual gifted $1 million worth of appreciated stock to a charitable remainder trust. The trust states the trustee will pay the individual the lesser of the "net income" of the trust or 9% of the corpus of the trust. If the trust has no income, the amount not distributed in a current year can be "made-up" in future years. Let's assume the trustee determines the beneficiary of the charitable remainder trust does not need income currently, but wishes to create and manage a diversified portfolio of assets which will benefit both the ultimate beneficiary, the charity, and the current income beneficiary. The trustee determines that a deferred annuity, especially a variable annuity, is the ideal investment vehicle. The income beneficiary will receive income when the trustee determines it is most beneficial. If the beneficiaries die while there is make-up money in the trust, that amount all passes to the charity. Thus, the charity could receive an amount greater than the original gift to the CRT. The trustee reviews the Texas Principal and Income Act and is unclear whether the build-up in the annuity contract is principal or income since the Texas statute does not address the issue. The Principal and Income Act was enacted well before deferred annuities and zero coupon bonds became popular investment vehicles. Today trustees seek greater flexibility to manage assets for growth and income in accordance with a standard that is prudent and reasonable. Four other states (Maryland, South Dakota, Indiana, and Delaware) have addressed the issue, and codified the language that specifically states the inside build-up of an annuity is not "distributable income," and therefore the trustee is not required to pay out the annual earnings of the annuity. The annuity makes sense, but the IRC says income and principal is determined under state law. State law is not specific, and the trustee needs guidance. HB 2936 would give the trustee the guidance he or she needs. PURPOSE HB 2936 seeks to clarify the Texas Trust Code relating to charitable remainder trusts by specifying proceeds from obligations distributable as income and those determined to be principal, and when such proceeds are distributable. RULEMAKING AUTHORITY It is the committee's opinion that this bill does not expressly grant any additional rulemaking authority to a state officer, department, agency or institution. SECTION BY SECTION ANALYSIS SECTION 1. Amends Subchapter D, Chapter 113, Property Code by adding Section 113.1021 (a)-(c). Sec. 113.1021. ALLOCATION OF PRINCIPAL AND INCOME IN CERTAIN TRUSTS. (a) Defines an increase in the value over the original purchase value of a deferred annuity before annuitization and a life insurance contract before the insured's death as income. (b) Allows the value increase of an obligation to be available for distribution upon receipt of the cash on account by the trustee; clarifies that surrendered or partially liquidated obligations must attribute cash received to the increase first; defines whom shall receive the increase in the value of the obligation. (c) Provides for the application of Section 113.109. SECTION 2. (a) Effective date is September 1, 1997. (b) Clarifies that the change in law is only applicable to principal and income subject to allocation on or after September 1, 1997. Any principal and income allocated before September 1, 1997 is governed by law previously in effect before that date, continued for that purpose. SECTION 3. Emergency Clause. COMPARISON OF ORIGINAL TO SUBSTITUTE SECTION 1. The original bill amends Section 113.102. Texas Trust Code, (VTCS and Codes Annotated Property Code, Title 9), and the substitute bill amends Subchapter D, Chapter 113, Property Code by adding Section 113.1021 which provides for the allocation of principal and income in certain trusts as stipulated. SECTION 2 of the substitute provides conditions for the effective date.