I have had an interest in writing about issues
on the accounting for estates and trusts, especially the income/principal
distinction which is articulated in the Uniform Principal and
Income Act (UPIA) adopted by most states. After all, this income
versus principal distinction assists in answering the "who gets
what" question as to the economic benefits a trust or estate
will be providing its beneficiaries; something the beneficiaries
and their advisers should be keenly interested in.
A number of UPIA
topics, each worthy of an article, come to mind. The problem
is that any one aspect of UPIA will, by definition, have limited
utility. More importantly, the broader subject of how UPIA
works can only be touched upon in an article devoted to, for
instance, depreciation under UPIA. And more often than not
it is these underlying concepts that are the stumbling block
for practitioners struggling with a particular UPIA issue.
For this reason, this article is devoted to UPIA's concepts
and underlying principles.
In many states,
a revised version of UPIA (RUPIA 1997) has replaced the first
revision (RUPIA 1962) or the original 1931 law (UPIA 1931).
RUPIA 1997 maintained many of the basic rules and principles
of RUPIA 1962, though some significant changes were incorporated
in the newer uniform law. Understanding how these changes may
affect trust and estate client's situations will be valuable
to advisors. Accordingly, many of these significant changes
will be discussed. Further, some less universal changes included
in the new law will be examined in future articles focusing
on various aspects of UPIA.
What Is UPIA
It is sometimes
said that UPIA governs the accounting for trusts and estates.
This statement is overly broad and, as such, it can be misleading:
UPIA is for the most part confined to a particular aspect of
trust and estate accounting. That aspect is the determination
of what is income versus what is principal for
the receipts and disbursements of a trust or estate.
This income versus principal determination
flows from a distinctive characteristic of trusts and estates.
These entities have two classes of owners; those that have an
interest in the entity's income (income beneficiaries) and those
having an interest in the principal (principal beneficiaries).
Stated in accounting terminology, trusts and estates have two
different equity interests - income and principal. Accordingly,
the (UPIA) rules governing how a receipt or disbursement is
to be categorized (principal versus income) will determine which
equity interest holder is to receive the benefit of any receipt
or whose interest will be reduced by a disbursement. This naturally
creates a conflict: If a receipt is determined to be income,
the income beneficiary (a.k.a., equity interest holder)
will benefit to the detriment of the principal beneficiary,
and vice versa. Therefore, beneficiaries will likely be sensitive
to the fiduciary's determinations of income versus principal.
Before moving on, let us agree on some
terminology. There are three existing versions of the UPIA:
the original 1931 statute and its progeny, the 1962 revised
statute and the most recent 1997 revised act. Some states now
have the original 1931 law; others have either the 1962 or 1997
revision. There are characteristics all three have in common,
as well as differences. UPIA will be the acronym used to introduce
universal principles; used in those cases where all three laws
share traits in common. Correspondingly, UPIA 1931 will be
used to refer specifically to the original law, and RUPIA to
refer to both the 1962 and 1997 revised statutes. And, of course,
RUPIA 1962 or RUPIA 1997 is meant to refer to these individual
A Basic Example
Let us look at the financial information
of a trust, and by doing so, examine how UPIA's income/principal
classification rules affect the rights of beneficiaries. Specifically,
let us look at how these rules play an important role in answering
the "who gets what" question. Please refer to Illustration
In order to focus
the attention on the UPIA issues in this example, the presentation
has been streamlined. The relevant terms of the trust in this
example are as follows.
must be distributed annually to the trust's only income beneficiary,
- The principal
beneficiaries of the trust are John and Bill Smith (children
of Jane) who are to receive equal shares of principal following
Jane's death, and Jane, who is to receive five percent of
the trust principal annually.
1, notice that this charge and discharge statement presents
two reports - one on the principal (equity) account, the other
on the income (equity) account.
The report on principal
starts with the beginning of the year balance, and then reflects
additions and reductions occurring during the year to arrive
at the balance before distributions. These additions and reductions
reflect the same type of information one sees in the income
statement of a commercial enterprise, and that is exactly what
this is - the income statement of the trust's principal equity
account. The remaining information - the distributions from
principal and year-end balance in the principal account - complete
the report on the principal equity account.
The report on income
contains the same sorts of information and follows the same
format as the principal report of the charge discharge statement.
Put into perspective,
what is shown are two income statements: the principal-income
statement and income-income statement, one could say,
and the distributions from each account to arrive at the year-end
balance for these two equity accounts.
Overall, the illustration
shows how the income/principal determinations (in conjunction
with the distribution provisions of the trust agreement) affect
what each beneficiary is to receive. Such determinations are
governed by UPIA.
What is Principal
and What is Income?
UPIA 1931 as well
as RUPIA 1962 and RUPIA 1997 provide similar definitions of
principal and income. (However, beyond these basic definitions,
the specifics of these laws differ.) The most current laws
define principal as follows.
1962. Principal is the property which has been set aside
by the owner or the person legally empowered so that it is
held in trust eventually to be delivered to a remainderman
while the return or use of the principal is in the meantime
taken or received by or held for accumulation for an income
1997. "Principal" means property held in trust for distribution
to a remainder beneficiary when the trust terminates.
refer to the beginning amount of principal (when initially funding
a trust). These definitions relate to the accounting procedure
of the opening entry, which reflects the beginning principal
(equity), which is the offset to recording the trust's assets
(net of liabilities, if any) in the appropriate detail. This
beginning principal amount then changes by later activity, including:
- The resulting
gain or loss from the sale or other disposition of property.
due to liquidating distributions from corporations.
- For trusts,
a decrease for half of legal, accounting, and trustee fees
(the other half being an expense charged against the income
For estates, such fees are generally charged entirely against
principal under RUPIA 1962, and for RUPIA 1997 the executor
is given the discretion to charge these expenses against either
income or principal or allocating them in some fashion to
and decreases to principal are reflected in the accounting records
and attendant financial statements as items of income and expense,
and are shown in the income statement of the principal equity
account. (It may be helpful to view such a statement as a principal-income
statement and focus on the fact that the changes being reflected
will reduce or increase the principal account, finally resulting
in its year-end balance.)
In RUPIA 1962,
income is defined as "the return in money or property derived
from the use of principal, including return received as.[lists
various examples]." And RUPIA 1997 defines income as
"means money or property that a fiduciary receives as current
return from a principal asset." For both laws, some of the items
includible under this definition are:
(to the extent not included as principal, as liquidating dividends
- the net
income from rental of real estate or other property; and
- the other
half of legal, accounting, and trustee fees (see the laundry
list of principal items above).
It is helpful to
note that these definitions of income are a subset of the usual
concept of income from the accounting for commercial enterprises,
with the added wrinkle that at the end of an accounting period
the net result of such activity is closed to the equity account
income - as opposed to, for example, retained earnings
(for corporations) or capital (for partnerships). Further,
the other part of this subset (the usual income/expense items)
will be reflected in the principal account of a trust or estate.
To which account a particular item belongs - principal or income
- depends upon the rules laid out in UPIA.
Another part of
the conceptual framework is that a trust or estate will start
out with an amount for beginning principal (equity), which will
change over the accounting periods by additions (principal-income
and additional funding activity that may occur) and reductions
(principal-expenses and distributions of principal).
However, the income (equity) account starts with no beginning
balance at inception but will change over future accounting
periods by additions (income-income) and reductions (income-expenses
and distributions of income).
Other RUPIA Derived
For those familiar
with accounting principles and procedures for commercial enterprises,
the fact that trusts and estates have two income statements
and two equity accounts is a phenomenon that most will be able
to understand and put into practice. But there is more. Some
additional peculiarities (applicable to both RUPIA 1962 and
1997) are worth becoming familiar with early on; others will
be saved until later.
RUPIA has special
rules for depreciation expense. Depreciation is a reduction
of income and an increase to principal.
This rule may cause consternation for accountants: The accounting
entry for a commercial enterprise is to debit depreciation
expense and credit the balance sheet account, allowance
for depreciation. For a trust or estate, the debit entry
would be the same but the credit would be to the principal account,
thus increasing this equity account rather than an allowance
account in the balance sheet.
the amortization of bond premiums or discounts. Thus, reclassification is not made between
interest income and the carrying value of the bond in the balance
sheet as the bondholder receives payments. Due to this omission
of the usual amortization entries, the income account will be
slighted for a discount situation and the principal account
will benefit. The opposite will occur when bonds are acquired
at a premium.
Who Gets What?
The Instrument Rules
In a traditional
trust where the income beneficiary receives distributions of
the income at least annually and the principal beneficiary gets
the trust principal upon the death of the income beneficiary,
the UPIA rules regarding income/principal determine the benefits
to be shared between the beneficiaries. Likewise, with a traditional
will, UPIA governs what the income is and who gets it. However,
this all can change depending upon the written instrument (the
will or trust agreement). Such changes can occur for two reasons:
(1) the instrument can override the UPIA rules as to what is
indeed income or principal, and (2) the instrument may call
for a different arrangement regarding distributions besides
the traditional trust or will arrangements. Let us look at
how each of these can work to change things for the beneficiaries.
UPIA 1931 and continued in RUPIA, these laws provide that the
governing instrument's provisions will trump the UPIA rules
as to the determination of income and principal. Specifically,
in the process of determining if a certain receipt or disbursement
is to be classified as income or principal or allocated between
the two, UPIA provides the following ordering rules:
- Read the
written instrument to see if it provides an answer (which
is to be followed even if different from UPIA's guidance).
- If the
instrument provides no answer - follow the guidance of UPIA.
- Per RUPIA
1962, if neither the instrument nor RUPIA provides an answer,
then the item is to be classified based upon what is "reasonable
But RUPIA 1997 provides that such items will, by default,
be classified to principal.
A common mistake
is to make an income/principal determination based upon one's
recollection of UPIA or based upon some previous experience,
instead of reading the instrument to see what really
is the final word. So, for instance, if a trust agreement says
that receipts from an IRA or pension account are to be allocated
15 percent to income and 85 percent to principal, you do exactly
that, avoiding deciphering the generally more complicated UPIA
rules. In short, to the extent the written instrument provides
guidance on accounting for income and principal, this guidance
is treated by state law as the final authority.
Another word of
caution: read your state's version of UPIA. Uniform
laws are not guaranteed to be uniform; many states change them
to some extent. For instance, RUPIA 1962 requires that depreciation
be charged to income and added to principal (as explained above); however,
some states have taken a different approach on this. For example,
Florida's statute calls for the charging
of an allowance for depreciation only if the trust instrument
so instructs, whereas Washington
law leaves the depreciation decision to the trustee. There are many other examples of
states making changes to this uniform law - so reading the state's
law is the only way to discover what the applicable rules are.
If you have read the provisions of
the instrument addressing principal and income and you understand
state law, other issues still need to be addressed before you
will be able to competently answer the "who gets what" question.
These other issues are the distribution provisions of the instrument.
Not all trusts follow the traditional distribution model of
the income beneficiary receiving the income annually with the
remainderman receiving the principal at the end of the trust
term. The possibilities for such provisions are limited only
by the boundaries of imagination or for the less inspired, by
their forms book. To give some idea of how a departure from
the traditional distribution scheme can change things, two common
alternatives and how they would alter beneficiary rights and
be accounted for are offered for illustration.
trust gives the trustee the discretion to distribute all,
a portion, or none of the trust income, based upon the trustee's
judgment regarding the financial needs of the income beneficiary
(and the principal beneficiary receives his interest when
the trust terminates). Should the trustee (appropriately)
decide to distribute less than all the year's income, such
distribution would be shown in the charge and discharge statement,
leaving a balance in the income (equity) account at year end.
This result does, however, leave an unanswered question:
Does this year-end balance in the income account carry forward
to future years or should it instead be transferred to the
principal account? (RUPIA does not provide a certain answer
to this question.) One should peruse the instrument for guidance,
hoping it would provide that either: (1) the year-end balance
in the income account is to remain in this account and be
available for distribution to the income beneficiary in future
years (if need be), or (2) this income account balance instead
will be transferred to principal at year-end (and therefore
be unavailable to the income beneficiary in the future).
income beneficiary is given the option - on a year-to-year
basis, should he or she so elect - to receive a withdrawal
of principal equal to five percent of the trust principal
at the beginning of each year (the so-called five-and-five
power). This discretionary principal distribution is in addition
to the trust being required to distribute the income annually
to the same beneficiary. Such terms were incorporated
into the example shown in Illustration 1, and the corresponding
accounting presentation will be found there.
In summary, besides being familiar with your
state's version of UPIA, one needs to interpret the instrument
and understand the distribution scheme, before implementing
the income and principal determinations of an estate or trust.
For the Accountants
But in the end
it is the accountants who will be responsible for doing
the accounting for estates and trusts. For them, the following
references to resources along with some comments should provide
useful information. Also, since the revised versions of UPIA
(RUPIA 1962 and 1997) are the law in the majority of states,
the following discussion will deal exclusively with RUPIA.
addresses the notion of two equity accounts for estates and
trusts and explicitly contains the rules for determining how
receipts and disbursements will be classified, as between principal
and income. With some limited exceptions, RUPIA does not address
other accounting issues for estates and trusts. These "other"
issues include guidance on financial statement presentation
and direction on disclosure and measurement principles. We
need to look elsewhere to resolve these issues. Before moving
on to other sources, here are the few such issues for which
RUPIA does provide an answer.
Basis of Accounting:
Implicit in RUPIA is the cash basis of accounting. The discussion
throughout RUPIA refers to "receipts" and "expenditures" or
"disbursements", and those familiar with RUPIA interpret such
language as a directive to apply the cash basis of accounting.
from Standard GAAP: For a handful of specific situations,
RUPIA provides for an accounting treatment that departs from
standard generally accepted accounting principles (GAAP). Two
of these are discussed under the heading Other RUPIA Derived
Accounting Peculiarities and just need to be committed to
memory. The few others that apply will be discussed in future
Some states have
other laws that may address financial statement presentation
and other accounting principles issues for trusts and estates.
Check your state laws to see if this is so. (For instance,
Washington has a Trustees' Accounting Act.) And when presenting
a statement or other financial information to a court, it is
the court's format that must be complied with, regardless of
anyone else's notion of what is appropriate.
There are no Financial
Accounting Standards Board (FASB) Statements, Accounting Principles
Board (APB) Opinions or the like that deal with trust and estate
specific accounting principles. What exists is on the lowest
rung of the GAAP hierarchy. Within this category, the (rather limited) resources
are (1) the Fiduciary Accounting Principles and the Model Trustee's
Account as presented by the National Fiduciary Accounting Standards
Committee and (2) courses sponsored by the American Institute
of Certified Public Accountants (AICPA) on the subject of fiduciary
The National Fiduciary
Accounting Committee produced a document (finalized in 1984)
presenting what the Committee considered to be the basic objectives
and general standards of fiduciary accounting as well as two
sample financial statements - one for an estate the other for
a trust. The Committee included members from the American Bar
Association, the American Bankers Association, the American
College of Trust and Estate Counsel (attorneys), and other professional
and general standards portion of the Committee's report contain
a number of general statements not relevant to or amendments
of standard GAAP (e.g., "A fiduciary account[ing] shall contain
sufficient information to put the interested parties on notice
as to all significant transactions."). However, this portion of the Committee's
report does include some statements that are departures
from or embellishments to standard GAAP. These are:
- The financial
information presented should include both carrying values
(later defined similarly to the cost basis information as
would be presented for a commercial enterprise) and
current values (not later defined, per se, but based upon
the sample financial statements presented, presumed to be
the fair market value). In the financial presentations that
followed, this dual-valuation scheme was accommodated by a
two-columnar approach with the column headings of Fiduciary
Acquisition Value and Current Value.
and losses incurred during the accounting period shall be
shown separately in the same schedule." Accordingly, this rule requires
the gains and losses from the sale (or other disposition)
of assets to be shown in detail, as opposed to netting the
results of individual transactions.
sample financial statements illustrate some unusual presentation
standards. What follows are some of the more unique financial
statement presentation conventions reflected in the Committee's
sample financial statement for trusts (Model Trustee's Account).
income statements (that for principal and for income) reflect
the cumulative activity from inception to the current
trust's receipts and disbursements are shown in transaction
detail (date, vendor, and amount). Also, totals from the
date of the trust's inception to the current year are presented,
but yearly totals are not.
balance sheet information shows (in two separate columns)
both the current value as well as the fiduciary
acquisition value of the assets held.
are two balance sheets - one for principal (Principal Balance
on Hand) the other for income (Balance of Income on Hand).
This splitting of the assets into two balance sheets presents
some problems (both theoretical and practical): For instance,
if one were interested in the total cash available to the
trust, they would have to look at both statements and add
the reported cash in each to arrive at this basic information.
The result of these
conventions is a tedious, 14-page financial statement for a
relatively uncomplicated trust (comprised mostly of securities
and originally funded with assets of $158,000). To say a reader
would be buried in sometimes trivial detail and have
difficulty finding key information is a polite understatement.
(As will be discussed later, we have not incorporated these
conventions in our trust financial statements, with the exception
of item 3, above, if the trustee elects to show the current
value of trust property.)
An alternative to the above National
Fiduciary Accounting Committee's approach is provided by the
Charge and Discharge Statement (CDS) format, a
somewhat revised sample of which is included in Illustrations
1 and 2. This CDS statement is also generally presented and
discussed in courses on fiduciary accounting.
A detailed discussion
of the CDS format and how it varies from that of the National
Fiduciary Accounting Committee is beyond the scope of this article.
Nonetheless, reviewing Illustrations 1 and 2 will allow accountants
some insight into the presentation differences, as well as the
accounting procedure differences underlying the CDS approach.
The AICPA courses on fiduciary accounting
usually include a discussion of the accounting system that banks
and trust companies use for fiduciary accounting. This system
works reasonably well when a trust is invested in securities
(being able to record the gains/losses on sales of securities,
and interest and dividend income activity without difficulty)
but it has some shortcomings handling other financial activity.
Although these courses acknowledge that this system is not GAAP,
some of the deficiencies of this accounting system have found
their way into the accounting standards and procedures for both
the National Fiduciary Accounting Committee and CDS models.
Some of these deficiencies and the fixes we have devised to
correct them are:
assumed by a trust or estate upon funding (such as mortgages
on real estate) are omitted from the balance sheet. (Though some later acquired
liabilities, such as mortgages assumed as part of the purchase
of property, are included.) We do record the liabilities
assumed when a trust or estate is created. Hopefully, no
accountant really believes omitting liabilities from
the balance sheet improves the accounting for an estate or
trust - and accordingly will accept our recommendation on
- The cash
account(s) is bifurcated in the accounting records into two
accounts, cash - principal and cash - income.
(The net of the two amounts is the actual cash account balance.)
In the bank and trust company system, this provides a way
to keep track of the amount that should be distributed to
the income beneficiary at any point in time (as the net activity
results in a cash-income balance equal to the trust's
income less year-to-date distributions to the beneficiary).
This procedure, when coupled with the presentation of two
balance sheets, can result in such nonsense as an apparent
cash overdraft in the cash - principal account when
no overdraft in total cash exists. Contrary to the approach
taught in fiduciary accounting courses, we do not create these
two cash accounts but follow the usual standard of a single
account for any bank account. Further, we present only one
balance sheet, believing the reader will recognize that the
amount of each of the two equity accounts represents that
equity interest's claim on the assets. (This approach also
has the obvious benefit that all assets and liabilities will
be shown in total on one statement.) And to accommodate the
need to keep track of the income beneficiary's due at any
point in time (presuming a traditional trust where the income
beneficiary is to receive all income), we make the following
entries as illustrated in Chart 1.
to Income Beneficiary
record ytd net income distribution due
to Income Beneficiary
record ytd actual distributions
Accountants working in this area should
appreciate that this is a different environment than that for
commercial enterprises: In the commercial environment, GAAP
and auditing standards are designed around the public policy
issue of protecting investors, creditors and lenders. In the
trust and estate area, the beneficiaries are the people we need
to be concerned about. Considering this, our approach has been
to encourage the trustee to offer beneficiaries a choice as
to which financial statement format would be most useful and
meaningful to them. Most have chosen the CDS model, though
some have requested additional supplementary information to
suit their needs.
RUPIA 1997 -
How is it Different from the 1962 Law?
Things can change
a lot in 30 years. The financial market during the 1960's was
quite different from that of the 1990's. During the 1960's,
corporations typically paid out a significant part of their
earnings in dividends, interest rates were relatively stable,
and the stock market appreciated over time at a steady (though
not dramatic) rate. This financial environment promoted a basic
strategy for many trustees: A mix of stocks and bonds was chosen
to allow the income beneficiary his due while still allowing
the principal beneficiary growth opportunities over time. The
exact mix of stocks/bonds was debated, but the wisdom of such
a mix was not in doubt. During the 1990's all of this changed.
This change in
the financial markets gave rise to the changing of uniform laws
regarding a fiduciary's investment practices. These laws focused
upon a new performance standard based upon the measurement statistic
of total return - how the portfolio as a whole performed,
regardless of the source (e.g., dividends versus appreciation
in value). This new measurement criterion induced many to weight
a portfolio significantly with stocks, which might pay little
or no dividends (but tended to appreciate over time) and less
toward interest earning securities. Based upon the design of
RUPIA 1962 and its definition of income this portfolio mix left
income beneficiaries with much less.
RUPIA 1997 provides a unique response to
this dilemma by giving the trustee the power to adjust between
principal and income.
(Though the impetus for this law change was based on the notion
that a fiduciary would allocate from principal to income, the
language of this law would also allow a transfer in the opposite
direction.) This power is conditioned upon the trustee applying
it in a manner that is "fair and reasonable to all of the beneficiaries",
thus safeguarding all involved. Accordingly, a trustee will
be able to invest using optimal strategies for the trust as
a whole and still maintain a balance between the different interests
of the beneficiaries. However, this approach creates its own
dilemma: What is the "fair and reasonable" amount of income?
Those involved with estate and trust administration will have
to wait to see how the answer to this question plays out.
Other less dramatic
new rules were added to RUPIA 1997, most in response to issues
not contemplated in RUPIA 1962. In this category are rules
for the income/principal determinations of receipts from recently
developed financial instruments, including derivatives, various
types of options, and asset-backed securities. Also new are rules dealing with disbursements made
because of environmental laws.
Further, a number
of matters provided for in RUPIA 1962 have been changed or clarified
in RUPIA 1997. For instance, income from a partnership is based
on distributions from the partnership, as opposed to the trust-partner's
share of partnership income (the RUPIA 1962 rule). Another change is that charging
depreciation against income is no longer mandatory, but is left
to the discretion of the trustee. Similarly, the methodology for distinguishing
income from principal has changed for receipts from certain
kinds of property (e.g., IRA and pension accounts).