Income vs Principal in Trust Administration California: Complete Allocation Guide

One of the most confusing aspects of trust administration is the distinction between "income" and "principal" (also called "corpus"). This distinction is critical because many trusts have different beneficiaries entitled to income versus principal, and California law provides specific rules for how receipts and expenses must be allocated.

Getting this wrong can lead to beneficiary disputes, trustee liability, and improper distributions. This guide explains everything trustees need to know about income versus principal accounting.

Why the Distinction Matters

Different Beneficiaries

Many trusts create separate interests:

Income Beneficiary: Person entitled to receive income during a specified period

Example: "My wife shall receive all income during her lifetime"

Remainder Beneficiary: Person entitled to principal when trust terminates

Example: "Upon my wife's death, distribute principal to my children"

These beneficiaries have conflicting interests:

• Income beneficiary wants high income (dividends, interest)
• Remainder beneficiary wants growth (capital appreciation)
• Trustee must balance both interests fairly

Legal Requirements

California Probate Code requires trustees to:

• Act impartially between income and remainder beneficiaries (§16003)
• Follow allocation rules under the Principal and Income Act (§16320-16375)
• Maintain accurate accounting showing income vs. principal

Breach of duty: Improperly favoring one beneficiary over another can result in surcharge and removal.

Basic Definitions

Principal (Corpus)

Principal includes:

• Original trust assets
• Property received from the settlor
• Proceeds from principal assets (sale of trust property)
• Capital gains
• Insurance proceeds on principal property
• Amounts added to principal by trust terms

Think of principal as: The trust "body" - the core assets

Income

Income includes:

• Interest on bonds, savings accounts, notes
• Dividends from stocks and funds
• Rental income from real estate
• Royalties from intellectual property or natural resources
• Business income from trust-operated business

Think of income as: What the trust assets "produce" or "earn"

California Principal and Income Act

Statutory Framework

California Probate Code §§16320-16375 adopted the Uniform Principal and Income Act (UPIA) with modifications.

Key principle: Allocations should be "fair and reasonable" to both income and remainder beneficiaries.

Trust document controls: Trust provisions override statutory defaults.

Trustee's Duty of Impartiality

Probate Code §16003:

"If a trust has two or more beneficiaries, the trustee shall act impartially in investing, managing, and distributing the trust property, giving due regard to the beneficiaries' respective interests."

What this means:

• Can't favor income beneficiary by choosing only high-dividend investments
• Can't favor remainder beneficiary by choosing only growth stocks
• Must maintain balanced, diversified portfolio
• Must allocate receipts and expenses correctly

Allocation of Receipts

Interest Income → Income

Always allocated to income:

• Savings account interest
• Bond interest (corporate, treasury, municipal)
• Promissory note interest
• CD interest
• Accrued interest

Example: Trust holds $100,000 corporate bonds earning 5% interest = $5,000/year income to income beneficiary

Dividends → Usually Income

Ordinary dividends: Cash dividends from stocks and mutual funds → Income

Stock dividends:

• Same class as original shares → Principal
• Different class → Income
• Trust document may provide otherwise

Stock splits: Additional shares of same class → Principal (not income)

Example:

• Trust owns 100 shares of XYZ Corp
• XYZ pays $2/share cash dividend = $200 income
• XYZ issues 2-for-1 stock split = Trust now has 200 shares (principal, no income)
• XYZ issues preferred stock dividend = Income

Capital Gains → Principal

General rule: Capital gains are principal, not income

Why this matters:

• Sale of stock for profit → Gain allocated to principal
• Remainder beneficiaries benefit, not income beneficiaries
• Exception: Trust document may allocate differently

Example:

• Trust bought stock for $10,000
• Trust sells stock for $50,000
• $40,000 gain → Principal
• Income beneficiary gets $0 from this transaction

Rental Income → Mixed

Rental receipts allocated:

Item	Income or Principal
Monthly rent	Income
Security deposits	Principal (held, not distributed)
Damage payments from tenant	Principal
Insurance proceeds (casualty)	Principal
Sale of rental property	Principal
Gain on sale	Principal

Expenses of rental property:

• Ordinary maintenance → Income
• Capital improvements → Principal
• Property taxes → Income (usually)
• Insurance → Income (usually)
• Mortgage principal → Principal
• Mortgage interest → Income

Example: Trust owns rental house:

• Collects $2,000/month rent = $24,000/year income
• Pays $500/month mortgage (principal + interest)
• Mortgage interest portion → Charge to income
• Mortgage principal portion → Charge to principal

Business Income → Income

If trust operates a business:

• Net business income → Income
• Business assets themselves → Principal
• Depreciation → Charge to principal (usually)

Natural Resources → Mixed

Oil, gas, minerals, timber:

Uniform Principal and Income Act approach:

• 90% of net receipts → Principal
• 10% of net receipts → Income

Or trust may provide:

• Cost depletion allocation
• 50/50 split
• Other arrangement

Why: Exhausting natural resource depletes principal, so most proceeds should rebuild principal.

Insurance Proceeds → Principal

Property insurance:

• Casualty loss reimbursement → Principal (replaces asset)
• Business interruption coverage → Income (replaces lost income)

Life insurance:

• Death benefit → Principal

Trust Asset Sales → Principal

When trust sells asset:

• Sale proceeds → Principal
• Gain or loss → Adjust principal
• Income beneficiary receives nothing from sale

Allocation of Expenses

Expenses Charged to Income

Typical income expenses:

Expense Type	Charged to Income
Interest on loans	Yes
Ordinary repairs & maintenance	Yes
Property taxes (recurring)	Yes
Insurance premiums (property)	Yes
HOA fees	Yes
Utilities	Yes
Property management fees	Yes
Trustee fees (portion)	Usually 50%
Investment advisory fees	Usually 50%
Tax return preparation	Usually 50%

Rationale: These are costs of producing income, so income beneficiary should bear them.

Expenses Charged to Principal

Typical principal expenses:

Expense Type	Charged to Principal
Capital improvements	Yes
Major repairs (structural)	Yes
Principal payments on loans	Yes
Costs of selling property	Yes
Estate and trust admin expenses	Usually Yes
Trustee fees (portion)	Usually 50%
Attorney fees (administration)	Usually Yes
Appraisal fees	Usually Yes
Extraordinary repairs	Yes

Rationale: These preserve or enhance principal value, so remainder beneficiary should bear them.

Mixed Expenses

Some expenses benefit both income and remainder beneficiaries:

Trustee compensation:

• Typically 50% charged to income, 50% to principal
• Or allocated based on time spent on income vs. principal matters
• Trust document may specify different allocation

Tax return preparation:

• Income tax return (Form 1041) preparation → Split 50/50
• Estate tax return (Form 706) → Principal only

Attorney fees:

• General administration → Principal
• Income tax advice → Income
• Defending beneficiary challenge → Both (proportionate)

Special Situations

Unitrust Conversion

Problem: Traditional income/principal distinction can create problems:

• Growth stocks produce little income (income beneficiary suffers)
• High-dividend stocks sacrifice growth (remainder beneficiary suffers)
• Trustee can't optimize portfolio

Solution: Unitrust

What it is:

• Trust pays income beneficiary fixed percentage of trust value each year (typically 3-5%)
• Calculated on fair market value (revalued annually)
• Eliminates need to distinguish income vs. principal
• Trustee can optimize total return

California law: Probate Code §16336.4 allows conversion to unitrust

Example:

• Trust worth $1,000,000
• Unitrust percentage: 4%
• Income beneficiary receives $40,000/year
• Regardless of whether trust earns interest, dividends, or capital gains

Benefits:

• Simplifies administration
• Allows total return investment strategy
• Provides predictable income
• Eliminates income/principal disputes

Power to Adjust

California Probate Code §16336.4 gives trustees power to adjust between income and principal if:

Requirements:

1. Trustee invests with total return strategy
2. Traditional income allocation would be unfair to beneficiaries
3. Adjustment is fair and reasonable
4. Trust doesn't prohibit adjustment

Example:

• Trust invests in growth stocks producing minimal dividends
• Income beneficiary would receive very little under traditional rules
• Trustee allocates some capital gains to income
• Creates fair result for both income and remainder beneficiaries

Limitations:

• Cannot use if trust qualifies for estate tax marital deduction
• Cannot use if trust qualifies for gift tax annual exclusion
• Must consider tax consequences
• Must act impartially

Tax Implications

Income Taxation

Who pays tax on trust income:

General rule: Trust pays tax unless income is distributed to beneficiaries

Distribution deduction:

• Trust deducts distributed income (Form 1041, Line 15)
• Beneficiaries report on their Form 1040 (via Schedule K-1)

Character of income:

• Interest remains interest
• Dividends remain dividends
• Capital gains remain capital gains (unless allocated to income by trust)

Distributable Net Income (DNI)

DNI determines:

• Maximum income distribution deduction for trust
• Amount and character of income to beneficiaries

Key rule: Capital gains usually NOT included in DNI

What this means:

• Capital gains typically taxed to trust, not beneficiaries
• Even if capital gains allocated to "income" under trust accounting
• Exception: Trust document specifically requires distribution of capital gains

Example:

• Trust has $20,000 dividends and interest
• Trust has $50,000 capital gain from stock sale
• DNI = $20,000 (gains excluded)
• If trust distributes $30,000 to income beneficiary:
  • Beneficiary reports only $20,000 income (limited by DNI)
  • Trust pays tax on $50,000 capital gain

Principal Distributions

Tax treatment:

• Distributions of principal NOT taxable to beneficiary
• Beneficiary receives principal tax-free
• Principal distributions don't generate distribution deduction

Why: Principal represents after-tax amounts (already taxed or received via step-up in basis)

Practical Examples

Example 1: Simple Trust

Facts:

• Trust requires all income distributed to Wife during her life
• Remainder to Children at Wife's death
• Trust owns:
  • $500,000 stocks (paying dividends)
  • $300,000 bonds (paying interest)
  • Rental house

Year 1 receipts:

• Dividends: $15,000
• Interest: $12,000
• Rent: $24,000
• Total: $51,000

Year 1 expenses:

• Trustee fee: $5,000
• Property taxes: $4,000
• Repairs/maintenance: $3,000
• Insurance: $2,000

Allocation:

Income side:

• Receipts: $51,000
• Expenses: $(14,000) [All charged to income]
• Net income to Wife: $37,000

Principal side:

• No change (stocks, bonds, house remain)

Example 2: Capital Gain

Continuing Example 1:

Year 2: Trust sells stocks for $600,000 (basis $500,000)

Allocation:

• Sale proceeds: $600,000 → Principal
• Capital gain: $100,000 → Principal
• Wife receives: $0 from this sale
• Children benefit (remainder increased by $100,000)

Tax treatment:

• Trust pays tax on $100,000 gain
• Wife doesn't report gain (wasn't distributed to income)

Example 3: Power to Adjust

Facts:

• Trust modernizes and invests in total return index funds
• Funds produce 2% dividends ($10,000) + 8% appreciation ($40,000)
• Income beneficiary entitled to "income"
• Under traditional rules, would receive only $10,000

Trustee uses power to adjust:

• Determines fair return is 4% of trust value ($20,000)
• Allocates $10,000 additional from principal to income
• Income beneficiary receives $20,000
• Fair to both income and remainder beneficiaries

Best Practices for Trustees

1. Review Trust Document First

Trust document controls:

• May define "income" differently than statute
• May require specific allocations
• May prohibit power to adjust

Don't assume statutory defaults apply - read the trust.

2. Maintain Separate Accounting

Keep clear records:

• Separate income account and principal account
• Or detailed ledger showing income vs. principal
• Document all receipts and how allocated
• Document all disbursements and how charged

3. Invest Impartially

Balanced portfolio:

• Some income-producing assets (bonds, dividend stocks)
• Some growth assets (growth stocks, real estate)
• Diversified across asset classes
• Consider total return approach

Avoid:

• All growth stocks (unfair to income beneficiary)
• All high-dividend stocks (unfair to remainder beneficiary)

4. Allocate Consistently

Pick allocation method and stick with it:

• If charging 50% of trustee fees to income, do so consistently
• Don't cherry-pick allocations year-to-year
• Document rationale for allocation decisions

5. Communicate with Beneficiaries

Explain allocations:

• Provide accountings showing income vs. principal
• Explain why certain receipts allocated to principal
• Discuss investment strategy and how it balances interests
• Get beneficiary input when appropriate

6. Consider Unitrust Conversion

If appropriate:

• Simplifies administration
• Eliminates allocation disputes
• Allows optimal investment strategy
• Requires court approval or beneficiary consent in California

7. Get Professional Help

Consult with:

• Trust attorney for complex allocation questions
• CPA for tax implications
• Financial advisor for investment strategy

Beneficiary Rights

If You're an Income Beneficiary

You're entitled to:

• All trust income (if trust requires distribution)
• Fair allocation of receipts to income
• Proper charging of expenses to income vs. principal
• Not bear expenses that benefit remainder beneficiaries

Red flags:

• Trust invests only in growth stocks (produces no income)
• Trustee charges capital improvements to income
• You receive nothing despite trust earning income

If You're a Remainder Beneficiary

You're entitled to:

• Preservation of principal
• Not have principal depleted for income beneficiary
• Fair investment strategy that includes growth
• Proper allocation of capital gains to principal

Red flags:

• Trust invests only in high-yield bonds (sacrifices growth)
• Principal depleted to make income distributions
• Capital gains improperly allocated to income

Challenging Trustee's Allocations

If allocations are improper:

1. Request accounting showing income vs. principal
2. Object to specific allocations in writing
3. Request correction
4. Petition court if trustee refuses
5. Seek surcharge for losses caused by improper allocation

Conclusion

The distinction between income and principal is fundamental to trust administration, especially when there are different beneficiaries entitled to each. Trustees must:

Remember:

• Allocate receipts correctly (interest/dividends vs. capital gains)
• Charge expenses appropriately (ordinary vs. capital)
• Act impartially between income and remainder beneficiaries
• Maintain clear, separate accounting
• Consider unitrust conversion if appropriate
• Seek professional guidance for complex situations

Proper income and principal accounting protects both the trustee from liability and ensures all beneficiaries receive their fair share.

Related Articles

Learn more about trust accounting and taxes:

• Form 1041 Trust Tax Return Guide - How income vs. principal allocation affects trust tax returns, DNI calculations, and Schedule K-1 preparation.

• Capital Gains Tax on Trust Property Sales - Whether capital gains are allocated to income or principal beneficiaries and tax implications for distributions.

• Trustee Compensation and Taxes - How trustee fees are allocated between income and principal, and impact on beneficiary distributions.

• Trust Administration IRS Audit - Common IRS audit issues with income vs. principal allocations and documentation requirements.

• Common Trust Administration Mistakes - Avoid improper income/principal allocations that lead to beneficiary disputes and trustee liability.

Need Help With Trust Accounting?

If you're dealing with income vs. principal allocation issues in California trust administration, our experienced attorneys can help ensure proper accounting and fair treatment of all beneficiaries.

Contact us for a consultation about your trust administration questions.

This article is for informational purposes only and does not constitute legal or tax advice. Trust accounting rules are complex and fact-specific. Consult with qualified legal and tax professionals about your specific situation.