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Technology—Probate Editor: Daniel B. Evans, P.O. Box 27370, Philadelphia, PA 19118, firstname.lastname@example.org.
Technology—Probate provides information on current technology and microcomputer software of interest in the probate and estate planning areas. The editors of Probate & Property welcome information and suggestions from readers.
Accounting for Income
One of the nice things about software is that it can prevent mistakes. By building rules of law into the software, the developers can ensure that those rules are followed whether or not the lawyer or paralegal using the software is aware of the rules. This is great when the rules are clear. But it’s not so great when the rules are not clear and the software is forcing lawyers to follow rules that the lawyers do not believe should apply.
Needless Double Entries
Several of the fiduciary accounting programs being marketed to law firms distinguish between “income assets” and “principal assets,” meaning that the programs require that the user set up separate accounts for “income cash” and “principal cash” and keep that cash (and the investments of that cash) separate at every step of the accounting process. The software simply will not let you deposit an income receipt to a “principal account,” and if you try to transfer cash or property from an “income account” to a “principal account,” the income balance on hand is reduced, which distorts the accounting and violates the principle that income and principal should be stated separately.
This requirement of tracing income and accounting for separate “income assets” can complicate the accounting process, can confuse beneficiaries receiving the account, is immaterial in most cases, and may not even be required by law.
Complicating the Accounting
In reality, income and principal are not kept separate, but are mixed together in bank accounts and other funds of the estate or trust. The software-imposed requirement of separate “income assets” can therefore double the number of asset accounts that need to be created. Every bank account, money market account, mutual fund, dividend reinvestment plan, or other asset that might accumulate or reinvest income must be entered twice, once as a principal asset and once as an income asset.
Treating each bank account as two separate accounts can also cause complications when trying to reconcile bank or brokerage statements because the transactions shown on the statements are divided between two separate accounts. The work-around in most software programs is to create a merged report that shows both income and principal transactions and try to reconcile them that way.
The fiction that there are two accounts can also force the accountant to make arbitrary adjustments in order to get the printed account to reflect reality. For example, suppose a mutual fund has been re-investing dividends, and the fiduciary then distributes cash equal to the dividends without actually selling any of the mutual fund shares. To get the account to reflect reality, the reinvested mutual fund shares that have been listed as “income assets” have to be “sold” to the principal account and the equivalent amount of cash has to be transferred from principal to income. It takes time to enter those additional transactions, and both of those transactions may show up in the printed account, increasing its length and complexity.
Misleading the Beneficiaries
There are several ways in which separating income assets from principal assets may be confusing or misleading to beneficiaries. It suggests to the beneficiaries that there are separate bank accounts for income and principal, which simply isn’t true. It might also lead income beneficiaries to believe that they are entitled to the particular assets that are listed under “income balance on hand,” which also isn’t true. And, if the accountant has been forced to “sell” income assets to the principal account in order to make various income distributions or disbursements work out correctly and those transactions show up in schedules to the accounting, the beneficiaries may be confused by reports of “sales” and “investments” that actually never happened.
The most annoying part about all these careful distinctions between “income assets” and “principal assets” is that they are irrelevant in most cases.
In most estates, the income is divided among the residuary beneficiaries in the same proportion as the principal, so the distinction between “principal assets” and “income assets” is immaterial.
In most trusts, the distinction is also irrelevant because income earned by income assets is still income. The income beneficiaries will be receiving the same income regardless of whether the income is earned by “income assets” or “principal assets.”
The only situation in which the creation of separate “income assets” would be material is if the income is invested for a significant period of time in an asset that produces capital gains or losses instead of interest, dividends, or other forms of ordinary income and the capital gains (or losses) from the reinvested income must be accounted for and distributed to the income beneficiaries in order to make the income beneficiaries whole. But how often is that material?
Take the example mentioned before of the reinvested mutual fund dividends. The ordinary income dividends are reinvested (which supposedly makes them “income assets”), and the trustee later distributes cash from another source equal to the dividends received. How material is the change in the value of the mutual fund shares during the days (or even weeks) from the date of the dividend to the date of the distribution?
To accountants, “income” is an accounting concept, not an asset. So, when you look at the balance sheet of a corporation or partnership, the assets of the entity are all listed as “assets” and the debts and equity interests of the entity are listed as “liabilities.” There is no particular asset identified as “paid-in capital” or “accumulated earnings” or “partner’s income account.” The income account of an estate or trust could be just a liability of the trust, measured by the sum of the income receipts and disbursements and with no link to any particular asset or assets.
A review of several of the standard references on fiduciaries (such as Bogert’s Trusts and Trustees and Scott on Trusts) failed to turn up any case law requiring that all income receipts be traced as “income assets” and accounted for separately from “principal assets.”
The original Uniform Principal and Income Act (1958) did not seem to allow for the concept of “income from income” or “gains from invested income,” defining “income” as “the return derived from principal.” The Revised Uniform Principal and Income Act (1962) similarly defines “income” as “the return in money or property derived from the use of principal,” including a number of specific examples not relevant here. Although the revised act says that the receipt of property can be income, nothing in the act says that gains or losses from that property are also income. Instead, the language of the act is consistent with the principle that income is an amount to be determined, and not a particular asset or group of assets.
The most recent Uniform Principal and Income Act (1997) includes a reference to “principal assets” (which would suggest that there are also “income assets”), but it also provides increased flexibility to the trustee in allocating receipts between income and principal, raising the question of whether a failure to identify assets as “income assets” would actually violate the Act if there are no significant accumulations of income.
In those cases in which the accountant believes that some gains or losses should be allocated to income and not principal, it should be possible to make that kind of adjustment without having to keep track of “income assets” separately from “principal assets.” For example, the program “Fiduciary Accounting for Trusts and Estates” (or “FATE”) from West Publishing does not require the user to separate income assets from principal assets, but allows the user to allocate gains (or losses) to income in those cases in which the accountant considers it to be necessary or appropriate.
The ultimate issue is not whether accounting for “income assets” is or is not required, but whether fiduciary accounting software should force lawyers to create duplicate accounts (and make compensating entries to work around the imaginary nature of those accounts) if the lawyer does not believe it is necessary to do so. It’s a question of who is in charge, the lawyer or the software, and whether the software will help the lawyer or hinder the lawyer. If a lawyer might reasonably decide that in at least some cases no distinction needs to be made between “income assets” and “principal assets,” then the accounting software should allow the lawyer to make that decision.