Year-End Trust Planning, Part 2

Hey friends, welcome back!

Today we’re talking about Fiduciary Accounting Income (FAI) in Part 2 of the series ‘Year-End Trust Planning’.?If you haven’t had a chance to read Part 1, check it out here!

Okay, so FAI (or TAI) - what is it and why do we care?

Maybe you’re saying “I took a bookkeeping class in college, this shouldn’t be an issue” or “How hard can it be - it’s just taxable Income, right?” ??

Friends, I’m sorry to be the one to tell you this but FAI is like individual accounting and business accounting all got together and were like “Hey, we should make something like non-profit accounting but waaaaayyyy different and variable from state to state.?Doesn’t that sound fun?”

Okay, so the things you need to know about FAI:

1)?????You need to know what the trust document says

The trust document might have opinions about how you calculate it. It might not. But you need to know what it says. And, good news, you spent the last week gathering up your trust documents!

2)?????If the trust document is silent, you need to know what the State where the trust is sited (which court would you go to in order to make changes) says about it.

You’ve read the trust law provisions in your state’s laws, right??You took it on vacation instead of that steamy airport romance novel?

Okay, well, let’s assume you haven’t.?If you haven’t already given up by now and asked an attorney or accountant that specializes in T&E (that’s trust and estates) for help, your state should have their laws on their website.

For Washington State, it’s here. For California it’s here.

3)?????You need to know what Principal and Income is. You’re like “I know what Principal and Income is!”?

Okay, but you know how sometimes words can have a lot of meanings??Like principal can be the head of a school? And income can mean any number of things - like taxable income, non-taxable income, cash, accrual, etc.?

So, we need to know what Principal and Income means for Trusts.

Principal - property held in trust to make money and for later distributions to either current or future beneficiaries.

The key here is that it’s held in the trust.?It’s also called ‘corpus’, you know, like a body.?It’s the meat of the trust.

Income - cash or other property received as a current return on Principal.

Wut? Okay, yeah, I kind of stole that definition from the RCW, so it sounds all legal-speak.?But you know how you have a bank account, and it earns interest??That’s your “current return” on your bank balance.?So, basically Income is the money that you receive from your assets earning money.

States Have an Opinion (About FAI)

Okay, ready for it to get weird? You’re saying “Wait, it’s not already weird??I clicked a link for a website with state laws - that’s weirder than my typical Wednesday afternoon!”?

I get it, I totally do! But our adventure has just started…

So, forget everything you’ve ever known about how Income works.?Just wipe it out of your brain. Blank slate and all…

At the state level, fiduciary accounting Income is concerned with making sure that the current beneficiaries and the remainder beneficiaries get a fair piece of the fiduciary pie. (Which is apple pie because that’s my favorite pie).?

Now, settlors/grantors/trustors (the folks putting together the trust) might have a different idea of “fair,” which is why you need to read the trust document first. But we’re going to talk about what happens if the trust document is silent, because, as you’ll know if you’re a parent, there’s a lot of variations on “fair”.

Some high level rules of what is considered “Principal” and what is considered “Income”:

Income

• Interest
• Dividends
• Rents
• Distributions from partnerships

??Principal

• Capital Gains
• Insurance proceeds

When I say “high-level”, I’m talking stratosphere.?Principal and Income allocations can go down a rabbit hole.?Consider, an IRA distribution to a trust.?Let’s ignore QTIP’d trusts and just talk about a regular IRA going to a regular ol’ trust.?The rules for Washington say that the trustee has to calculate the Income and Principal inside of the IRA (as if it’s also a trust) and then allocate the IRA distribution between Principal and Income based on that IRA-as-a-trust calculation.?And if you have a current Income beneficiary and the Income inside the IRA-as-a-trust exceeds the IRA distribution, the trustee has to transfer funds from Principal to make sure the current Income beneficiary receives all of the Income.

???I digress…?

State Laws Are Often Different (About FAI)

Okay, now here’s where things get extra-weird. What can be Income for one state can be Principal for another state. For example, in Washington, bond premium amortization is Income but in Georgia, its Principal. It’s important to understand the trust document and state laws to determine the allocation between the two.

There has been an ongoing effort to make uniform trust accounting laws. You can follow the history and see which states have enacted which laws here. The thing to know is that even if your state follows a particular flavor of Uniform Principal and Income Rules (for example, Washington changed to the Uniform Fiduciary Income and Principal Act (fondly called ‘Uhfippa’ among friends) on January 1, 2022. California is getting their own version of UFIPA), they might sneak in their own “tweaks”.?So, the term “Uniform” is more “Uniform-ish”.

FAI is Flexible (Ish)

Oh, now you’re saying “Wait, I can allocate between Income and Principal??Why did I bother learning this nonsense?”?

Well, maybe you can.?Maybe you can’t.?Maybe you should think twice about doing it.

Remember how we were talking about the uniform trust accounting laws??Well, some states have decided to stick to the old 1962 version, which does *not* grant the fiduciary the ability to willy-nilly allocate receipts between Income and Principal.?Remember, though, the trust document CAN give the trustee that permission.?(Once again, a good reason to speak with a qualified T&E attorney).

But, even if you can change the allocation between Principal and Income, should you??It’s a common suggestion for tax savings – “Just allocate the capital gains to income and distribute them to the current beneficiaries…”?Here’s the thing, if my Aunt Brunhilda tells me over a holiday dessert (like apple pie) that she distributed all $8 million of capital gains to herself to save on taxes and I’m the remainder beneficiary on that trust??Well, I’m going to feeeeeeel some feelings.?

Okay, so why do we care?

1)?????FAI determines how much Income goes out to your current beneficiaries.

So, let’s say that you have a trust that says “once Griselda reaches the age of 25 years old, all Current Income gets distributed to her” or some such.?

What’s your Current Income??Is it all of the cash money that’s come in and gone out of the bank account during the year??Is it your Taxable Income with some minor tweaks? Is it something that you’re just going to let the tax software calculation (this happens far more than it should… which is that it should never happen)

Knowing what our FAI is tells us who gets money now and who gets money later. And if those are two different people, they probably have strong opinions on the money now vs later discussion.?

2)?????FAI and DNI determines your distribution deduction

We’ll talk about DNI and distribution deductions another time, but let’s just say that it generally is a good thing.?Trusts are taxed at compressed tax rates (37% after $14,450!). Beneficiaries are often in lower tax brackets. Distribution deductions suck out that Income and gently waft it around the beneficiaries’ taxable Income.

Your distribution deduction is either going to be (grossly oversimplified):

• Distributions made
• DNI
• FAI

So, it’s worth your time to figure out what your FAI is. (Plus, if you’re a fiduciary, it’s kind of your job.)

3)?????You might need to tell someone about it

In Washington State, fiduciaries have a duty to provide their beneficiaries with an annual report showing receipts and disbursements from both Income and Principal. And the beneficiary can request an itemized statement of the assets owned by the trust.

Also, your tax professional should totally be asking you for it. If they haven’t asked you for the trust document and your FAI, how are they supposed to be reporting it on the trust’s tax return???(Beyond that, how are they even going to know what kind of entity that they’re dealing with?)

Who can Help with FAI?

So, if FAI is an important but often overlooked piece of Fiduciary Management and this post has convinced you that you never ever want to talk about FAI again, what do you do??There are professionals out there that can help.

• CPAs with trust and estate backgrounds (like me) – we can help even if you outsource the tax preparation elsewhere;
• Professional Fiduciaries – bringing in a professional fiduciary as a trustee or co-trustee can save you a ton of headaches, especially with more complicated trusts;
• Trust and Estate Attorneys – some T&E attorneys have an internal group that can help to calculate FAI.

I know I promised to talk about distributions in this article, but can we all agree that we are all FAI’d out and distributions can wait until next time? Just wait until you hear what happens when you distribute Aunt Margaret’s cherry 1965 Mustang to her ungrateful nephew, Herbert…

?? Hi, I'm Ashley. I could talk about death and taxes for days. Follow me for more content like this post. ??