An ongoing trust funded with the assets of a deceased settlor benefits both current and remainder (future) beneficiaries, but at different times and in different ways. Such a trust restricts what the current (e.g., lifetime) beneficiary receives to ensure that some trust assets remain for the remainder beneficiaries. This is where the dual concepts of “income” and “principal” are relevant.
Consider a trust funded by the assets of a deceased spouse that gives the surviving spouse all the net income for her life and provides for use of the principal, if necessary and at the trustee’s discretion, for the surviving settlor’s, “Health , Education, Maintenance and Support” (aka, “HEMS”). At the surviving spouse’s death what remains goes to the deceased settlor’s own children. What does that mean and how is it administered?
First, it means that the trustee must categorize the trust’s receipts and expenses between the dual concepts of “income” and “principal” to know what the surviving spouse mandatorily receives as income. What is “income” and “principal” is established under the trust’s own terms (definitions) and, otherwise by the California’s statutory rules in the Uniform Principal and Income Act (UPIA) in Probate Code sections 16320 – 13375.
What receipts (additions to the trust) are income and principal vary by the type of asset from which a receipt is received by the trustee. For example, under the UPIA distributions from a retirement plan (e.g., an Individual Retirement Plan or a 401(k)) are allocated ten percent (10%) to income and ninety percent (90%) to principal. This treatment of retirement receipts is often a shock to someone who expected all of the retirement plan receipts to be income. Receipts of interest and dividends are allocated entirely to income. Receipts of capital gain (proceeds from the sale of appreciated assets) are generally allocated entirely to principal as the profit is an increase in asset value.
Again the foregoing UPIA statutory rules only apply to the extent that the trust itself is silent. The trust may have different rules which apply.
Moreover, the trustee must also allocate disbursements (expenses) between income and principal; first as provided under the terms of the trust and otherwise under UPIA. Allocation of disbursements vary by the type. For example, under UPIA trustee fees and other expenses of trust administration are allocated fifty percent to income and fifty percent to principal.
Naturally tension may develop between the current beneficiary and the remainder beneficiary over whether the trustee invests assets primarily to generate interest and dividends, which are income, or to grow in value, which is principal. Unless the trust gives the trustee discretion to favor one beneficiary over another, a trustee must administer a trust impartially. That means the trustee when investing assets and when allocating receipts and expenses between income and principal must follow the rules in the trust and the code.
Nonetheless, the UPIA allows the trustee, in certain limited situations, to make adjustments between principal and income if certain conditions are satisfied (section 16336 Probate Code).
Furthermore, a trustee may sometimes be able to eliminate the complexities and tensions associated with administering a “net income” trust by converting the trust to a much more manageable Unitrust. With a unitrust, the net income beneficiary receives a certain percentage of the trust’s average year end value as determined for the prior three (3) years. The unitrust distribution percentage is from 3 to 5 percent. A unitrust approach may be drafted into the settlor’s trust while the settlor is still alive as part of the estate planning, in which case the unitrust applies from the very start of administering the trust after the settlor’s death.
The foregoing is a brief discussion of the trust principal and income concepts. For legal guidance regarding beneficial rights and trustee duties consult a qualified attorney.
Dennis A. Fordham, attorney, is a State Bar-Certified Specialist in estate planning, probate and trust law. His office is at 870 S. Main St., Lakeport, Calif. He can be reached at Dennis@DennisFordhamLaw.com and 707-263-3235.
“Serving Lake and Mendocino Counties for nineteen years, the Law Office of Dennis Fordham focuses on legacy and estate planning, trust and probate administration, and special needs planning. We are here for you. 870 South Main Street Lakeport, California 95453-4801. Phone: 707-263-3235.”