Things That May Surprise You About Florida’s Principal and Income Act and Related Accounting Law, Part I
In 2002, the Florida Legislature adopted the Florida Uniform Principal and Income Act, effective on January 1, 2003 (the act).1 The act, which is found in F.S. Ch. 738, is a modified version of the Uniform Principal and Income Act (1997). The statutory sections of the act allocate trust and estate receipts and disbursements between income and principal. Additionally, the act contains provisions that allow a trustee to make adjustments between income and principal (§738.104) and to convert a trust to a unitrust (§738.1041). Sections 738.104 and 738.1041 are beyond the scope of this article.
It is significant to note that the statutory sections of the act are “default” sections, meaning that the provisions of Ch. 738 only apply if the terms of the trust or will do not contain a different provision or do not give the fiduciary a discretionary power of administration.2 It is critically important that attorneys practicing in the trusts and estates area have a working knowledge of the act. Through extensive examples, this two-part article will explore the inner workings of some of the more significant provisions of the act. These examples assume that the will or trust is silent as to allocating the receipt or disbursement at issue to either income or principal, and does not give the fiduciary a discretionary power of administration.
Part one will introduce some of the basic provision of the act. Part two will cover some of the more complex issues.
Example 1: Specifically Devised Real Estate
Mom’s will specifically devises rental real estate to Son. The residue of the estate passes to Daughter. The will is silent as to who receives and/or pays the rental real estate receipts and expenses. Mom died on December 31. One year after Mom’s death rental real estate gets distributed to Son. During the probate administration, the estate has the following receipts and disbursements.
• Rent received on rental real estate: $12,000 ($1,000 per month).
• Property taxes on rental real estate: $2,000.
• Estate administrative expenses: $200,000.
Section 738.201(1) provides that the net income and principal receipts on property specifically devised to a beneficiary shall be distributed to the beneficiary. Section 738.201(1) specifically refers to and incorporates the provisions of §738.301 through §738.706 in determining the net income and principal receipts. Pursuant to §738.502, the $12,000 of rent constitutes income and under §738.701(3), the $2,000 of property taxes is charged against income. Therefore, in addition to the distribution of the rental real estate, Son also receives $10,000 of net rental income (i.e., $12,000 of rent less $2,000 of property taxes).
Can the personal representative (PR) charge any portion of the $200,000 of estate administration expenses to the specifically devised rental real estate? Section 733.805(1)(d) provides that the PR may charge a portion of the estate administration expenses to the specifically devised rental real estate only in an abatement situation. Pursuant to §733.805(1)(b), Daughter, as the residuary beneficiary, would fully bear the payment of estate administrative expenses.
Alter the facts so that Mom died on January 3. The $2,000 property tax bill became a lien on the property on January 1 and January’s rent of $1,000 (due on January 1) was not paid until January 10. These changes do not affect the result; Son still receives $10,000 of net rental income. Pursuant to §738.201(5), the net income and principal receipts on property specifically devised are determined based on amounts received or disbursed by the PR with respect to the property whether those amounts accrued or became due before, on, or after the date of the decedent’s death.
Assume, instead, that the property devised to Son was a vacant lot and not income producing rental real estate, with Mom dying on January 3 and the $2,000 property tax bill becoming a lien on the property on January 1. There is, however, no rental income from the specifically devised property against which to charge property tax. Would Son or the estate (i.e., Daughter as the residuary beneficiary) be responsible for the property tax bill? Section §733.803 mandates that, absent a clear direction in the will to the contrary, a specific devise of encumbered property does not entitle the devisee to have the encumbrance paid at the expense of the residuary beneficiary. Thus, Son would be responsible for the tax bill. If Mom died on December 31 and the $2,000 property tax bill became a lien on the property on January 1, would Son or the estate be responsible for this property tax bill? Neither §733.803 nor §738.201(1) specifically addresses this scenario. However, in keeping with the underlying premise of §738.201(1) (i.e., that income and principal receipts on specifically devised property are first reduced by expenses on such property), the authors believe that the property tax bill should be Son’s responsibility and not the estate’s. Also, under §732.514, because Son is a vested devisee at Mom’s death, he should be responsible for this property tax bill.
To address the above issues (but only if it meets with the intent of the testator or testatrix), the will might include the following provision: “The expenses of administering my estate shall include all real property taxes and maintenance expenses that may accrue or be incurred prior to or during the administration of such property, including specifically devised property, pending distribution or the relinquishing of possession as a matter of law.”
The authors also recommend that when specifically devised property is encumbered by a mortgage (or other lien), that the will specifically state whether the encumbrance is to be paid off by the estate (i.e., by the residue). The authors recommend clearly stating the testator’s intent rather than relying on the provisions of §733.803.
Example 2: Rental Real Estate
Example 2a : Trust owns rental real estate and provides for the mandatory payment of net income to the beneficiary. Pursuant to §738.403(1), the trustee may elect to maintain accounting records for this rental activity separate from the trust’s accounting records. In such a case, the trustee has the flexibility to retain a portion of the rental receipts for the rental real estate’s working capital needs, to make renovations to the property, and to pay the principal portion of any monthly mortgage payment. Without §738.403, all rent receipts, except for those used to pay expenses chargeable to income, need to be distributed to the beneficiary under the terms of the trust. For instance, principal payments on a mortgage secured by the rental real estate and capital improvement expenses for the real estate are principal charges;3 thus, the income beneficiary would receive the rental income without reductions for these expenses. The trustee, in maintaining a separate set of books under §738.403, can pay these expenses out of rental receipts, thereby decreasing income but maintaining principal (real estate) and its mortgage obligations.
Example 2b : Assume the facts in Example 2a, but with the further assumption that the trustee contributes rental real estate to a Florida limited liability company (LLC) naming the trustee as manager of the LLC. With this Example 2b, §738.401 would apply, and not §738.403. As manager of the LLC, pursuant to §§608.422(3) and 608.426, the trustee has the power to retain receipts for the LLC’s working capital and other needs. As manager of the LLC, the trustee also has the authority to determine the timing of distributions from the LLC to the trust. Section 738.401 determines the character of the receipts from the LLC to trust, as either principal or income.
Example 3: Distributions Received by a Private Trustee from Investment Entity and a Targeted Entity
Section 738.501(2), generally, provides that capital gains are allocated to principal. However, §738.401(2) may change that result and allocate capital gain cash receipts from an entity, such as an LLC, to income.
Example 3a: Mom, prior to her death, was the sole member of LLC. At Mom’s death, LLC was used to fund a testamentary trust. Mom’s second husband (Stepdad) is lifetime income beneficiary of the trust and Son is the remainder beneficiary. The trustee is Trust Company. Trust Company, as manager of LLC, sells five percent of LLC’s assets, realizing a $100,000 capital gain, and the $100,000 is distributed from LLC to the trust. Under §738.401(2), the LLC distribution to the trust constitutes income to be distributed to Stepdad, net of trust expenses allocable to income. Under §738.501(2), if there were no LLC and the $100,000 gain were incurred directly by the trust, it would constitute principal (and would not be distributed to Stepdad).
Example 3b: Assume Mom’s will creates a trust naming Stepdad as trustee and lifetime income beneficiary and Son as the sole remainder beneficiary. In 2007, Stepdad, as trustee, contributes 100 percent of the trust’s marketable securities portfolio to a newly established LLC. The trust is the sole member of the LLC and the marketable securities are its only assets. During 2007, LLC received $50,000 of dividends and $40,000 of interest. Also during 2007, LLC sold securities and realized $100,000 of capital gains. In 2007, $250,000 of cash is distributed from the LLC to the trust. Does this $250,000 cash receipt constitute trust income provided in §738.401(2), to be distributed to Stepdad as the income beneficiary?
Section 738.401(7)(c)(4) provides that Stepdad is a “private trustee” (because a trustee who is also beneficiary does not have the power to adjust under §738.104(3)(f)). If the LLC normally derives 50 percent or more of its annual cumulative net income from interest, dividends, annuities, royalties, rental activity, or other passive investments, including income from the sale or exchange of such passive investments, then §§738.401(7)(c)(3) and (5) define the LLC as an “investment entity.” The LLC in this example is an investment entity, because its only assets are marketable securities. Under §738.401(7)(c)(2)(a), the “designated amount” of money received from the LLC is $190,000, which is its 2007 income for federal income tax purposes. Applying §738.401(7)(b), the $190,000 is comprised of $50,000 of dividends and $40,000 of interest, both of which are allocated to trust income, and $100,000 of capital gains, which is allocated to trust principal.4 Also, under §738.401(7)(b), the remaining $60,000 portion of the LLC distribution is treated as trust principal. The described provisions of §738.401(7) were designed to prevent a “private trustee” like Stepdad, from converting capital gains (normally allocated to trust principal) to income by establishing an LLC to hold the trust’s securities. Section 738.401(7)(c)(2), in determining the “designated amount,” provides that such amount is to include the federal taxable income for the current and two prior years less any distributions from the entity (e.g., LLC) to the trust during the two prior years. This two-year income look back feature is designed to prevent manipulation by a private trustee (i.e., an attempt to convert amounts which would normally be treated as principal to income) which, but for §738.401(7)(c)(2), could have occurred by delaying distributions from the entity.
Example 3c: Mom owns all the shares in S Corp, a subchapter S corporation, of which she acts as president and sole director. In 2005 and 2006, S Corp retained $2,000,000 of earnings with the expectation of entering into a new line of business. Mom died on January 1, 2007. S Corp’s December 31, 2006, financial statements reflect $20,000,000 of gross assets. Subsequent to Mom’s death, S Corp has been operating on a break-even basis. All of the shares of the S Corp passed through Mom’s estate into a trust; Stepdad is the trustee and the lifetime income beneficiary and Son is the remainder beneficiary. Stepdad, as sole director and president of S Corp, abandoned the plan to enter into a new line of business and caused a $2,000,000 cash distribution to be made from S Corp to trust. Does Ch. 738 require distribution of the $2,000,000 to Stepdad as income or is it added to trust principal?
At first blush, §738.401(2), read in conjunction with §738.401(5)(b), appears to require distribution to Stepdad as income because the total amount of the distribution was less than 20 percent of S Corp’s gross assets. However, §738.401(7)(c)(5) treats S Corp as a “targeted entity” and §738.401(7)(c)(4) characterizes Stepdad as a “private trustee.” As a result, under §738.401(7)(a), the distribution constitutes trust principal. This is because §738.401(7)(a) allocates to income only “undistributed cumulative net income” during the time the S Corp shares were held by the trust. The $2,000,000 is attributable to S Corp earnings which occurred prior to the trust being funded with the S Corp shares and, therefore, under §738.401(7)(a), this distribution is allocated to principal.
Example 4: Allocation of Receipts at Decedent’s Death
Example 4a: Wife dies on May 31, 2007, owning $200,000,000 of bonds in XYZ Corporation. The bonds have a six percent coupon, payable semi-annually on June 1 and December 1. A residuary trust is the sole beneficiary under Mom’s will. The trust provides for quarterly distributions of net income to Husband for life, with the remainder to Son from Mom’s prior marriage. The PR receives the $6,000,000 semi-annual interest payment on June 1, 2007. Is this interest characterized as income and ultimately payable to Husband (net of trust expenses allocable to income); or is the interest added to estate/trust principal, ultimately benefitting Son, as the remainder beneficiary?
Section 738.302 apportions receipts and disbursements received or made around the time a testator dies to either income or principal. In applying §738.302, the first step is to look to the other provisions of Ch. 738 to determine whether the receipt or disbursement would normally be allocated for a trust to principal or income. If the other provisions of Ch. 738 characterize the receipt or disbursement as income, then the second step is applying the provisions of §738.302 to the receipt or disbursement received on or around the date of testator’s death. Section 738.302 may have the effect of allocating to principal what is otherwise characterized as income by another provision of Ch. 738. Section 738.302 does not apply to principal receipts or disbursements received or made on or around the date of testator’s death. These principal receipts/disbursements retain their principal character. Section 738.302 can, however, operate to allocate to principal what would otherwise be income under normally recognized fiduciary accounting concepts.
In this example, §738.503(1) allocates bond interest to income. Section 738.302(2) provides that an income receipt shall be allocated to income if the due date occurs on or after testator’s death and is periodic. Thus, because the bond interest payment is periodic (i.e., due semi-annually) and the due date occurs after Wife’s death, the receipt is allocated to income. Importantly, in administering a probate estate, §738.201(2) requires a PR to apply the described provisions of §738.302 to estate receipts and disbursements. Further, §738.402 directs the trustee of the trust established under the will in this example to allocate estate income distributions to trust income and estate principal distributions to trust principal. The prior version of the Florida Principal and Income Act added the portion accruing prior to Wife’s death (i.e., $5,970,000 of the $6,000,000 interest payment) to principal and allocated to income only the portion accruing after Wife’s death.5 Thus, under new law, the surviving spouse receives the benefit of an additional $5,970,000, net of expenses allocable to income.6
Assume instead Wife dies on June 2, 2007, one day after receipt of the semi-annual interest payment. Again, §738.503(1) serves to allocate bond interest to income. However, §738.302(1) recharacterizes this $6,000,000 interest income receipt as a principal receipt because its due date (June 1) occurs before date of Wife’s death (June 2). Prior law produced the same result.7
Example 4b: Wife dies on May 31, 2007, owning 10,000,000 shares of stock in ABC Corporation. Wife’s will creates a trust providing for mandatory quarterly income distribution to Stepdad for life with Son as the sole remainder beneficiary. ABC Corporation declared its most recent semi-annual cash dividend of $.50 per share to shareholders of record on June 1, 2007 (record date), payable June 15, 2007. Does the $5,000,000 in dividends constitute income or principal?
Section 738.401(2) allocates this dividend to income.8 Section 738.302(3) deems distributions to shareholders as due on the date fixed by the entity for determining the party entitled to receive the distribution. Because ABC Corp. uses the record date to determine who receives the distribution, June 1, 2007, marks the due date for the distribution. Section 738.302(2) applies to this receipt because the dividends due date occurs after Wife dies and is periodic (i.e., due semi-annual) and, thus, this receipt is properly allocated to income. Prior law produced the same result and allocated the dividends to income.9 If, however, Wife died on June 2, §738.302(1) recharacterizes this $5,000,000 interest income receipt to principal because its due date (June 1) occurs before Wife’s date of death (June 2). Prior law produced the same result and allocated the dividend to principal.10
It is important to note that the provisions of §738.201(2)(b) give the PR the discretion to charge estate administration expenses to income. Thus, a trustee of a testamentary trust might find that a receipt characterized as income by §738.302(2), and other estate income receipts, have been used for payment of §738.201(2)(b) estate administration expenses.
Example 5: Death of an Income Beneficiary
Husband’s trust is funded solely with rental real estate. Tenant pays monthly rent of $100,000 on the first of each month. The income beneficiary of the trust is Surviving Spouse, and Husband’s Son from a prior marriage is the remainder beneficiary. Surviving Spouse dies on June 2, 2007, and her will provides that her entire estate passes to Daughter. Tenant falls behind in rental payments but pays the $100,000 February rent on June 1, 2007, and the March through June rent ($400,000) on June 5, 2007.
Under §738.301(4) the income interest of Surviving Spouse ends the day before she dies (June 1). Section 738.303(1) provides that net income received on or before the date on which the interest ends is “undistributed income,” and as such does not include income that is due or accrued. Section 738.303(2) mandates that the undistributed income is to be paid to the estate of the deceased income beneficiary. Thus, net of trust expenses, Surviving Spouse’s estate receives the $100,000 of February rent, but the $400,000 of March through June rent gets distributed to Son. Specifically, under §§738.303(1) and (2), the income received prior to the date the income interest ends will be distributed to the deceased income beneficiary’s estate. It should be noted that oftentimes the governing instrument will direct that at the death of the income beneficiary, any undistributed income is to be added to trust principal. If a governing instrument so provides, §738.303(2) defers to its terms and the undistributed income will not be distributed to the deceased income beneficiary’s estate. Instead, it will be added to trust principal.
Example 6: Pecuniary Amounts
Mom has two children, Daughter and Son. Daughter is financially responsible and Son is a spendthrift. Mom’s will gives $2,000,000 outright to Daughter and puts $2,000,000 into a trust which provides Son with income for life. Mom’s will leaves the residue to charity. Distributions to Daughter and Son’s trust occurred six months after Mom’s death. Prior to these distributions, the estate received $1,000,000 of income, net of expenses properly charged against income.
Sections 738.201(4) and 738.202, read together, require that the testamentary trust established for Son and charity will share the $1,000,000 of net estate income. The statute does not allocate any portion of this net income to Daughter, who received the $2,000,000 outright pecuniary bequest.
Part one of this article has introduced the reader to some of the principles of the act and its application in real life situations. Part two will continue with this effort, but will address some of the more complex provisions of the act.
1 H.B. 585, Laws 2002, c. 2002-42; Section 3 establishes an effective date of January 1, 2003.
2 Fla. Stat. §738.103(1)(a) and (c).
3 Fla. Stat. §738.702(1)(c), payments on the principal of a trust debt are charged to principal; Fla. Stat. §738.201(1)(h), capital improvement disbursements are principal charges.
4 Under Fla. Stat. §738.503(1), $40,000 of interest is income; $100,000 of capital gains is principal, under Fla. Stat. §738.501(2); and $50,000 of dividends is income, under Fla. Stat. §738.401(2), assuming none of the dividends are redemption or liquidating dividends.
5 Fla. Stat. §738.04(2)(b) (repealed effective Dec. 31, 2002). A different result would have occurred under prior law if the bonds were titled prior to death in a settlor’s revocable trust. In this case all of the $6 million bond interest payment would have been allocated to income. Fla. Stat. §738.04(2)(b), repealed effective Dec. 31, 2002, only applied to estates or to an “asset becoming subject to a trust by reason of a will.”Instead, §738.03(1)(b), repealed effective Dec. 31, 2002, would have applied and allocated the $6 million of interest to income.
6 The $5,970,000 of interest accruing before death constitutes income in respect of a decedent (IRD) under I.R.C. §691(a) and it will be included in gross income of Husband (along with the portion accruing after death), net of trust expenses allocable to income, as it is distributed to him as the income beneficiary. Under I.R.C. §691(c), Husband may also be eligible to take an itemized deduction on his federal income tax return equal to the amount of estate tax attributable to this interest IRD. Under I.R.C. §67(b)(7), a §691(c) deduction is a miscellaneous itemized deduction.
7 Fla. Stat. §738.04(2)(a) (repealed effective Dec. 31, 2002).
8 Assumes that the dividends in Example 4b are not redemption or liquidating dividends. See Fla. Stat. §§738.401(3)(b) and (c).
9 Fla. Stat. §738.04(3) (repealed effective Dec. 31, 2002).
10 Fla. Stat. §738.04(2)(a) (repealed effective Dec. 31, 2002).
William C. Carroll is a partner with the law firm of Mettler Shelton Randolph Carroll & Sterlacci, P.A., in Palm Beach. His practice focuses exclusively in the areas of estate planning and estate and trust administration. Mr. Carroll received his J.D. and LL.M. in taxation from the University of Denver College of Law. He is board certified in both wills, trusts, and estates law and tax law.
John W. Randolph, Jr., is a shareholder in Pressly & Pressly, P.A., in West Palm Beach, where he devotes his practice exclusively to trust and estate matters. He is a board certified wills, trusts, and estates lawyer as well as a board certified tax attorney. Mr. Randolph is a graduate of the University of Florida College of Law, with honors, and received his LL.M. from the University of Miami in estate planning.
The authors thank F. Gordon Spoor, CPA, and Tereina R. Stidd for their assistance with this article.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, Sandra F. Diamond, chair, and William P. Sklar and Richard R. Gans, editors.