Take-Away: Fiduciary accountings are different from tax or financial statement accountings, the big difference being that fiduciary accountings must allocate between principal and income.

Background: Professional fiduciaries are fully aware of their responsibilities to account to beneficiaries and courts following the Uniform Fiduciary Principal and Income Act, which has been adopted in Michigan. That is often not the case when an individual is named as fiduciary. That Uniform Act provides rules that determine who is entitled to property, income and principal in a trust or an estate, and how receipts and disbursements should be allocated between principal and income. In short, the preparation of a fiduciary accounting is neither for the novice, nor for the faint-of-heart.

Governing Instrument: These special accounting rules are normally followed unless the governing instrument (Will or Trust) expressly authorizes that the fiduciary not follow the Act. Accordingly, it is imperative to check the governing instrument and state law when an accounting is required to determine if the Act’s rules must be followed when preparing an accounting. This becomes even more important if the situs of a trust is moved to a different jurisdiction with different state laws that address a fiduciary’s accounting responsibilities.

Fiduciary Accounting Rules: A fiduciary accounting differs from a traditional financial statement. Financial statements do not allocate between principal and income. Nor do financial statements contain detailed descriptions of financial transactions required to be included in a fiduciary’s accounting.

Fiduciary Accounting Income: The proper allocation of receipts and disbursements between principal and income is necessary to accurately calculate fiduciary accounting income. This information must be sufficient to put interested parties on notice as to all significant transactions that affect the Estate or Trust during an accounting period, and it is also necessary to start a statute of limitations running to bar future claims against the fiduciary.

Why Fiduciary Accounting Income: Fiduciary accounting income is important because: (i) it is needed for the fiduciary to know how much income exists to be distributed to an income beneficiary; (ii) the tax preparer needs to know the amount of fiduciary accounting income to be disclosed for complex trusts on the Trust’s Form 1041 income tax return; and (iii) it is necessary to determine distributable net income (DNI)for income tax planning for the Trust’s beneficiaries who receive distributions from the Trust.

Fiduciary Income vs. Taxable Income: Fiduciary accounting income is different from taxable income, as has been covered in previous missives. Many of the rules used to determine income for income tax purposes do not apply to the calculation of fiduciary accounting income, which frequently causes confusion and leads to mistakes. Some of the differences between the two are: (i) fiduciary accountings are prepared on a cash basis, so that a Trust or an Estate only has a receipt or disbursement when an item is actually received and paid; (ii) when allocating inventory on the sale of securities, a fiduciary’s accounting uses the weighted-average method, while tax reporting uses a ‘first-in, first-out’ average basis or a specific identification; (iii) activities within flow-through entities, e.g. LLCs, S corporation, and partnerships, are ignored for fiduciary accounting income purposes, i.e. a receipt only occurs when a distribution is received, but until the entity makes a distribution to the Trust, the Trust does not have any fiduciary accounting income; and (iv) there are complex rules with regard to whether distribution received from an IRA, annuity or deferred compensation arrangement to an Estate or Trust is either treated as either income or principal.

Tips for Reviewing a Fiduciary’s Account: Since the rules with regard to preparing a fiduciary’s account are different, as is the concept of fiduciary accounting income, consider the following:

  1. Review the governing instrument to determine if special instructions apply, or if the instrument relieves the fiduciary from having to follow the Uniform Fiduciary Principal and Income Act. For example, some Trusts direct that capital gains be treated as income, not principal.
  2. Understand the distribution requirements under the governing instrument and how they interact with the determination of ‘income.’
  3. Understand the purpose of the accounting. Is it to be prepared because of a beneficiary’s death, the death or resignation of the fiduciary, or is it a required periodic filing with the probate court? If the accounting is prepared due to the death of an income beneficiary or the termination of an income interest, special rules will apply and the fiduciary may have more discretion in allocating certain expenses.
  4. Even if the accounting does not need to be filed with the probate court, it is best to consistently use an acceptable format, particularly if the accounting needs to be filed with the probate court at a later date. There is even a National Standard Format for fiduciary accountings that is often used or followed.
  5. The accounting needs to reflect all the information contained in the source data, such as checking, savings, brokerage, and trust account statements and often a Form 706.
  6. Each transaction must be documented on the appropriate schedule and should be itemized with detailed descriptions for each item. Dividends and interest should be described by source and date. Each disbursement should be listed separately by date and payee, and not grouped together in a broadly defined category.
  7. Each schedule needs to be reviewed to confirm that entries are correctly categorized as either principal or income.
  8. Capital changes need to be confirmed. Stock dividends, ‘spin-offs,’ and asset exchanges should be reviewed to document that the inventory values are correctly applied, along with details of the assets that were ‘spun-off’ or exchanged.
  9. Finally, and most obviously, there is the need to confirm that the accounting actually balances. Total charges must equal total credits, and all must be reconciled properly. ‘Getting by’ or being ‘close enough’ is totally inconsistent with a fiduciary’s account.

Conclusion: In my prior life as a practicing attorney, I frequently saw individual fiduciaries completely ignore their duty to account, or those who actually did prepare an accounting, blissfully ignore the requirements of the Uniform Principal and Income Act. If the governing instrument requires that the fiduciary follow the Uniform Act (which is the default rule in Michigan) then it must be followed. Individual fiduciaries do not get a ‘pass’ for being oblivious to that responsibility, which many seem to be believe is the case.