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Trusts • Principal and Income Allocation
TRUSTS#047
Legal Definition
The entire cost of ordinary expenses (including interest, repairs, regularly recurring taxes, and insurance premiums) is allocated against the income interest. The entire cost of payments on the principal of a trust, debt, estate taxes, and disbursements on environmental matters is allocated against the principal interest. Half of each of the following are charged against both principal and income interests: the trustee's compensation; investment, advisory, or custodial fees; and expenses for accountings, judicial proceedings, and other expenses that affect both the income and remainder interests.
Plain English Explanation
Imagine you've got a piggy bank that earns money from the coins you put in it. This rule is kind of like deciding who pays for what when taking care of this piggy bank. Now, there are two types of expenses: those for keeping the piggy bank running smoothly (like regular check-ups, fixing small cracks, or paying for a spot on the shelf), and those for making big changes (like paying off a debt the piggy bank owes, or dealing with government taxes).
The first kind, the everyday maintenance expenses, come straight out of the piggy bank's own savings. The second type, the big-ticket items, come out of the money the piggy bank makes for you over time, the income. This makes sense because you don't want to dip into the savings for big expenses – it's better to use the money that the piggy bank is generating to pay for big expenses.
Now, there's a third category: the costs that are a bit of both, like paying the person who advises you on how to handle the piggy bank or the costs of sorting out legal matters. These costs are shared equally between the piggy bank's savings and the income it generates. It's like saying, "Both the savings and the earnings should chip in," because both benefit from these services. This rule helps make sure the piggy bank is taken care of fairly, without unfairly dipping too much into either the savings or the earnings.
The first kind, the everyday maintenance expenses, come straight out of the piggy bank's own savings. The second type, the big-ticket items, come out of the money the piggy bank makes for you over time, the income. This makes sense because you don't want to dip into the savings for big expenses – it's better to use the money that the piggy bank is generating to pay for big expenses.
Now, there's a third category: the costs that are a bit of both, like paying the person who advises you on how to handle the piggy bank or the costs of sorting out legal matters. These costs are shared equally between the piggy bank's savings and the income it generates. It's like saying, "Both the savings and the earnings should chip in," because both benefit from these services. This rule helps make sure the piggy bank is taken care of fairly, without unfairly dipping too much into either the savings or the earnings.
Hypothetical
Hypo 1: Bob is the trustee for a trust created by Sam's great aunt that provides income to Sam during his life, with the remainder going to charity after he dies. The trust assets need a new roof that costs $20,000. Result: As an ordinary maintenance expense for the residence held in trust, the full $20,000 cost is allocated against the trust principal. Sam does not have to pay anything.
Hypo 2: Bob is trustee of a trust funded with cash and real estate. The real estate contained lead paint requiring special disposal per environmental regulations at a cost of $50,000. Result: As a disbursement related to an environmental issue, the full $50,000 is allocated against the principal of the trust. Significant expenses like environmental cleanup are charged to the principal, as they are long-term obligations that affect the value of the trust property.
Hypo 3: Sam receives income from a trust managed by trustee Bob. Bob takes $5,000 as his annual trustee fee this year. Result: Half of Bob's trustee compensation is charged against the trust principal, and half against the trust income that Sam receives. So Sam's income is reduced by $2,500 this year.
Hypo 4: Bob and Sam are co-trustees for a trust established by their dead friend, Amy. They spend $10,000 on accountants and lawyers for a required periodic trust accounting. Result: As an expense related to trust accountings, half is charged to the trust principal and half to income. The trust principal and income each bear $5,000 of the cost.
Hypo 5: Bob owns a trust fund that generates rental income from properties. The trust needs to pay for roof repairs on one of the properties. Sam, the trustee, uses money from the principal to cover these repairs. Result: This was proper because roof repairs are considered an ordinary expense. Therefore, the cost is appropriately charged against the principal interest of the trust.
Hypo 2: Bob is trustee of a trust funded with cash and real estate. The real estate contained lead paint requiring special disposal per environmental regulations at a cost of $50,000. Result: As a disbursement related to an environmental issue, the full $50,000 is allocated against the principal of the trust. Significant expenses like environmental cleanup are charged to the principal, as they are long-term obligations that affect the value of the trust property.
Hypo 3: Sam receives income from a trust managed by trustee Bob. Bob takes $5,000 as his annual trustee fee this year. Result: Half of Bob's trustee compensation is charged against the trust principal, and half against the trust income that Sam receives. So Sam's income is reduced by $2,500 this year.
Hypo 4: Bob and Sam are co-trustees for a trust established by their dead friend, Amy. They spend $10,000 on accountants and lawyers for a required periodic trust accounting. Result: As an expense related to trust accountings, half is charged to the trust principal and half to income. The trust principal and income each bear $5,000 of the cost.
Hypo 5: Bob owns a trust fund that generates rental income from properties. The trust needs to pay for roof repairs on one of the properties. Sam, the trustee, uses money from the principal to cover these repairs. Result: This was proper because roof repairs are considered an ordinary expense. Therefore, the cost is appropriately charged against the principal interest of the trust.
