Income and Principal

The Basics

Assets are considered to be entirely principal when an estate or trust is first formed. Over time, market value changes and estate transactions (e.g., sales, capital gains distributions, debt payments) may increase or decrease that principal. Transactions may also introduce income to the estate, and may reduce that income by spending it on expenses or distributing it to heirs.

Note that from an income tax perspective, any income generated in a given year is taxed that year and then ignored in future years, but estate and trust accounting track that income forever until it is spent or distributed.

Tracking principal versus income can be more complex than it might seem, but don't worry – EstateExec will automatically handle this for you in most cases.

Tracking Changes Over Time

On the surface, it seems simple to track income and principal: you have a pool of principal that represents the assets at the start of everything, and a separate pool into which you can record deposits of income generated by those assets.

So far, so good. But what happens when you write a check for legal fees? Or pay taxes? Or deposit a capital gains distribution? What happens when you sell an asset and it has appreciated in value, maybe due to market conditions, or maybe because you spent money improving it?

A trust document (or even a will) may have special definitions or rules for determining what is considered income vs principal.

But if not, and covering any cases not explicitly handled by those documents, there are default accounting rules for almost any situation. While these rules can be complex, the following basics explain the core principles you normally need to know:

Distributions

Classification of distributions into income and principal depends on the nature of the distribution and the nature of the asset:

Handling Asset/Estate Differences

The notion of income and principal applies to transactions, assets, and the estate or trust overall. If you have consolidated everything into a single bank account, everything is easy and straighforward.

But if you have several assets, with varying mixes of income and principal, and then want to pay something out of a particular asset, it can be confusing if the transaction should be paid from income (for example), and while the estate overall contains enough income to fund the transaction, the asset from which you want to write the check does not.

How you should handle such a case depends on the circumstances. For example:

• If you are writing an income distribution check that is supposed to be funded by that particular asset, you might want to wait until the income actually becomes available, or potentially reduce the amount of the check.
• If there are no complications concerning prior claims on asset income or principal, and it's just a general administration expense, you might want to first transfer income from another asset so that you can properly fund the check. You don't necessarily need to move funds around in the real world – you can instead simply record an income transfer from an asset that has the needed income, and record a reverse transfer of principal.
• If it's just a temporary situation, you might want to just go ahead with the full allocation to income, recording a negative income balance for the given asset, with the understanding that this will need to be made whole at some point.

Ultimately, you will have to use your judgment to ensure that everything is handled appropriately, that neither income nor principal is inadvertantly transmuted into the other, and that estate and trust obligations are met in their priority order.

Priorities

If certain estate heirs or trust beneficiaries are entitled to receive only income, and others only principal, you will need to pay extra attention to the differentiation between income and principal.

For example, should you manage assets and invest to maximize short-term income or long-term capital appreciation? For many estates, this question is somewhat irrelevant, as the executor's job is to expeditiously settle the estate, and in the short term the priority is simply to avoid catastrophic loss while still maintaining reasonable returns.

If you are dealing with a more long-term situation, however, these tradeoffs can become important, and you usually need to ensure you are not maximizing one group's results over another's.

Complex Situations

Income and principal accounting can get rather convoluted in complex edge cases (e.g., accrued bond interest held less than a year, investment funds in which income versus principal return information is not available, depreciation and amortization, etc.). If you think your trust (or estate) needs to account for such things, you should seek the help of a qualified accountant.

Tax Implications

As mentioned above, income tax accounting focuses on net income generated in a given tax year, while estate and trust (e.g., fiduciary) accounting tracks income forever until it is spent or distributed.

There are other key differences. In particular, income tax accounting assumes any distributions in a given year come first from any available income, only dipping into principal after all income from that year has been exhausted (this is especially important for trusts, as the burden for paying taxes on that income shifts to anyone who receives a portion of that year's income). Consequently, a trust could report to heirs that it distributed a bequest of principal, while simultaneously reporting that from an income tax perspective, that distribution must be considered income.