A trust has two components, the principal and the income. The principal is all the property that’s available to produce ordinary income like dividends, interest, or rents. As you make payments, some may come from principal and some from income, depending on what you, as trustee, decide. Others, such as beneficiary payments, come only from the income.
Being able to allocate money to either the income or principal sides of a trust is a key element in successful trust administration because the people who are entitled to receive income may not be the same people entitled to receive the principal when the trust terminates. One of your jobs as trustee is to make sure that you don’t favor the income interest over the principal interest, or vice versa.
Principal, sometimes referred to as the corpus or body, of the trust, is the property that the trust owns. Although trust principal starts with the assets that originally fund the trust, it may increase or decrease in many situations, including the following:
The sale of trust property creates capital gains or losses.
The grantor makes additional contributions to the trust.
The trust receives a settlement or judgment as a party in a lawsuit.
You transfer into principal any accumulated income that’s not required to go to an income beneficiary.
Principal in a trust can shape-shift without ceasing to be principal. A common misconception is that when you sell an asset, the cash proceeds that you receive become available to pay the income beneficiary. But in a trust, the cash received from the sale of any asset still remains a principal asset, albeit in a different form.
Almost everything earned by the principal of the trust is income. Stock dividends, interest earned on bank accounts or bonds, rents from real estate owned by the trust, and earnings received from a business the trust owns all constitute income of the trust.
Your success as a trustee lies mainly in your ability to determine what’s principal and what’s income. Your assignment of all receipts to either the income or principal side of the trust dictates how you calculate trust accounting income, an amount that determines how much money the income beneficiary is entitled to receive. By understanding the difference between the two sides of the trust and applying your knowledge, you can give the income beneficiary the amount he or she is due.
The largest exception to the income/principal distinction is how you classify capital gains and losses. Capital gains occur when you sell a piece of property for more than your acquisition cost. Capital losses, on the other hand, are what you get when you sell property for less than your acquisition cost. Whether the trust generates gains or losses, those gains and losses stay on the principal side of the trust.
You also need to be aware of two other tricky types of principal payments you may receive on account of trust assets. Those two types are the following:
Return of capital: When you receive a return of capital, the company that has issued this payment has essentially determined that some part of what you owned no longer exists, so they issue payments that reduce your acquisition cost. To the extent that you still have an acquisition amount for that piece of property, you reduce that amount by the return of capital, record any cash you receive on the principal side of the trust, and don’t recognize income of any sort.
Special or extraordinary dividends: With a special or extraordinary dividend, the corporation has issued a larger than ordinary slice of the corporate profits. These extraordinary dividends are typically allocated to the principal side of the trust, because their payment almost always causes the share price of the stock to drop by at least the amount of the dividend. Unlike the return of capital, an extraordinary dividend doesn’t reduce the trust’s acquisition cost.
If you understand the distinction between income and principal, you should have no difficulty in allocating payments correctly, such as returns of capital or extraordinary dividends. However, sometimes the company isn’t clear on how it should categorize these payments until after it has made them. If the correspondence you receive from the company is confusing, you may want to contact a tax professional who can help walk you through the correct application of the payment.
Most trust instruments include a provision that states that the final determination of what’s principal and what’s income rests with the trustee. Trust administration isn’t a precise practice, and the lines between principal and income sometimes blur. If you’re not sure what something is, you may want to seek professional advice from an accountant, enrolled agent, or attorney who specializes in trusts.
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Source:http://www.dummies.com/how-to/content/what-are-a-trusts-principal-and-income.html
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