Things That May Surprise You About Florida’s Principal and Income Act and Related Accounting Law, Part II
Part one of this two-part article introduced the reader to the provisions of the Florida Uniform Principal and Income Act.1 In part two, the authors continue using examples to explore the more complex workings of the act and how those provisions allocate trust and estate receipts and disbursements between income and principal of an estate or trust. As in part one, 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 personal representative and/or trustee a discretionary power of administration.
Example One: Life Estate in Real Property
Decedent’s will devises a vacation condominium (subject to a mortgage) to Spouse for life with the remainder to Child. In the first year after death, the condominium has the following expenses: monthly mortgage payments of $1,000; quarterly (regular) condominium association maintenance assessments of $400; real property taxes of $2,500; and routine repairs of $2,000. Also, as a result of hurricane damage to the building, each unit is specially assessed $30,000 for repairs.
Section 738.801 provides that the provisions of §§738.701 through 738.705 shall govern the apportionment of expenses between tenants and remainder beneficiaries when no trust has been created. A tenant (i.e., the holder of the life estate) must pay the income charges and the remainder beneficiary pays the principal charges. In this example, no trust was created. Accordingly, as required by §738.701(3), Spouse pays the interest portion of the mortgage payments, the quarterly association maintenance assessments, the property taxes, and the routine repairs. Under §738.702(1)(c), Child pays the principal portion of mortgage payments. Assuming the hurricane damage repairs are reasonably expected to outlast Spouse’s actuarial life expectancy, the cost of the special assessment is allocated between Spouse and Child based on an actuarial formula set forth in §738.801(2). If the special assessment repairs are not reasonably expected to last beyond Spouse’s life expectancy, §738.801(2) charges this expense to Spouse.2 Significantly, under §738.701(4), homeowner’s and windstorm insurance premiums must be paid by the life tenant.
Example Two: Mutual Fund Capital Gain Distributions
A trustee purchases 20,000 units in QZ mutual fund for $200,000. Shortly after the purchase, QZ mutual fund makes a $1 per unit ($20,000) distribution to the trust, representing short-term and long-term capital gains realized within the mutual fund. Pursuant to §738.401(3)(d), the distribution constitutes principal.
Example Three: Bond Discounts and Premiums
Example 3a (bond discount): On January 1, 2007, a trustee purchases 100,000 units of Edsel Motor Co. (“junk”) bond for $76,000. Bond has a coupon rate of 7.45 percent, paid annually, with a maturity date in 30 years. Because the bond was purchased at a discount, it yields approximately 9.8 percent annually. Every year $7,450 of interest is received by the trust from Edsel Motor Co. and, as provided in §738.503(1), the interest constitutes trust income. Five years after the bond purchase, Edsel Motor Co. merged with another car manufacturer and, pursuant to the terms of the merger, the trust’s 100,000 units of the bond were redeemed for $90,000. A, the income beneficiary of the trust, complains to the trustee that he should have received annually $9,800 (an amount equal to the yield on the bond). A argues that, because he was short-changed by a total of $11,750, the trustee should pay him that amount from the redemption proceeds. The trustee correctly responds that Florida law does not specifically authorize the accretion of bond discounts and that the $90,000 redemption amount constitutes trust principal pursuant to §738.503(2) of which $14,000 represents capital gain to the trust.
Example 3b (bond premium): On January 1, 2007, a trustee purchases 100,000 units of DEF Corp. bond for $105,000. The bond has a coupon rate of seven percent paid annually and it matures in five years. Each year the trustee receives $7,000 of interest from DEF Corp. Section 738.503(1) allocates the interest received to income, which will be distributed to the income beneficiary (net of expenses properly charged to income). The remainder beneficiary of the trust asserts that the $5,000 bond premium (i.e., $105,000 purchase price less $100,000 face amount) should be amortized, resulting in $1,000 of each $7,000 annual bond payment being allocated to principal.3 The trustee properly cites §738.503(1) for the proposition that Florida law does not provide for the amortization of bond premiums, and that the entire $7,000 annual interest payment is income.
In light of Florida law prohibiting amortization of bond premiums and not specifically authorizing accretion of bond discounts, trustees may be reluctant to purchase a bond at either a discount or premium (even though trustees may consider such bonds to be excellent investment opportunities). In fact, Florida law in this area may be at odds with prudent investor rule obligations imposed on trustees,4 and the described lack of authority for bond discount accretion and prohibition on bond premium amortization should be considered by trustees in determining whether to utilize a power to adjust (§738.104) or possibly convert the trust to a unitrust (§738.1041). However, §738.103(1)(a) provides the drafting attorney a solution to this problem by providing that the terms of the governing instrument control the administration of the trust regardless of any conflicting provisions of the act. Thus, the drafting attorney can provide the trustee with the authority to accrete bond discounts and to amortize bond premiums. Most practitioners seem to be aware of these issues as evidenced by the fact that many governing instruments reviewed by the authors provide the trustee with this authority to accrete bond discounts and to amortize bond premiums.
Example Four: Determination of Net Income of an Estate in Marital Deduction Instances
Mom’s will makes an outright preresiduary gift to Son of an amount equal to her unused applicable credit amount under Internal Revenue Code §2010 (note this gift is not phrased with reference to “the maximum amount that can pass without causing estate tax in my estate” or the like) and the residue of her estate remains in trust for Husband as a “residuary trust.” The residuary trust qualifies for the estate tax marital deduction, pursuant to IRC §2056(b)(7). The personal representative (PR) desires to fully utilize the estate tax marital deduction, so that no estate tax will be due as a result of Mom’s death.
Are the PR commissions and attorneys’ fees paid by the estate allocated to income or principal? Section 738.201(2)(b) gives the PR the discretion to charge these fees to income or principal, provided that their charge to income does not cause the reduction or loss of the estate tax marital deduction. Does the allocation of these administration expenses to income cause the reduction or loss of the estate tax marital deduction? The Treasury Regulations characterize administration expenses as either “transmission expenses” or “management expenses.”5 The Treasury Regulations define the marital share eligible to receive the marital deduction to include the property for which the Code allows a marital deduction, as well as income produced by the property or interest in the property during the period of administration if the income is payable to the surviving spouse.6 In this example, the marital share consists of the residuary trust principal and the probate estate income (which, net of estate expenses charged to income, gets distributed to Husband under the terms of the residuary trust and under §§738.201(4) and 738.402). Generally, PR commissions and attorneys’ fees constitute transmission expenses, which are described in the Treasury Regulations as any expenses that “would not have been incurred but for the decedent’s death and the consequent necessity of collecting the decedent’s assets, paying the decedent’s debts and death taxes and distributing the decedent’s property to those who are entitled to receive it.”7 The amount of estate transmission expenses paid from the marital share reduces the marital deduction by that amount.8 Pursuant to §733.805(1)(b), transmission expenses are paid by the residuary devisee (in this case the residual trust), whether they are allocated to income or principal. The preresiduary gift to Son does not bear the impact of any portion of these expenses.
With this background, we return to the initial question: Would an allocation of these administration expenses (i.e., the PR commissions and attorneys’ fees) to income cause the reduction or loss of the estate tax marital deduction? In the light of the foregoing, the answer is “no” because the marital deduction is reduced by all transmission expenses paid from the “marital share,” which is defined as the residuary trust (principal) and the probate estate income. Regardless of whether they are paid from income or principal, transmission expenses always reduce the marital deduction, so the choice to pay them from income does “not cause the reduction or loss of the [marital] deduction” under §738.201(2)(b). In this example, because the preresiduary gift is a fixed amount not phrased as a formula to reduce estate taxes to zero, regardless of whether the administration expenses are charged to income or principal, the only way to eliminate the estate tax is to take these administration expenses as deductions on the estate tax return, as opposed to taking them on the estate’s income tax return.9 If the preresiduary gift were a “reduce estate taxes to zero” formula, the administrative expenses could have been taken on the estate’s 1041 without reducing the marital deduction.
The key point in this example is that the PR is provided broad latitude under §738.201(2)(b) in allocating administration expenses to principal or income and such discretion could dramatically impact the amount of income to be distributed to the surviving spouse. Section 738.201(2)(b) was drafted based on the state of the law prior to the promulgation of the described Treasury Regulations with the intention that administration expenses could be charged to income without having to reduce the estate tax marital deduction. In fact, §738.201(2)(b) is not limited to trusts eligible for the estate tax marital deduction. For instance, a child who is the income only beneficiary of a residuary trust could see diminished income if the PR elects to charge administration expenses to income under §738.201(2)(b). In light of the foregoing regulations, the authors suggest revising §738.201(2)(b) to provide that all administration expenses are charged to principal.
It is important to note that it is possible to identify, for example, a portion of a PR’s fee as a management fee. Treasury Regulations exclude from its definition of “transmission expenses” commissions or fees specifically related to investment, preservation, or maintenance of the assets.10 “Management expenses” are defined by the Treasury Regulations as those that are incurred in connection with the investment of estate assets or with their preservation or maintenance during a reasonable period of administration.11 A PR is obligated to invest and manage the estate’s assets in accordance with the prudent investor rule12 and, of course, the PR is obligated to possess and control the decedent’s property.13 Certainly a portion of a PR’s fee is attributable to these aspects of the administration and this portion could be identified as management expenses. Unlike transmission expenses, which reduce the marital deduction, management expenses can be taken on the estate’s income tax return without reducing the marital deduction.14 Similarly, the portion of the attorneys’ fee attributable to counseling the PR on the legal investment obligations under the prudent investor rule or with respect to maintaining and preserving the estate property could also be characterized as a management expense. Since management expenses deducted on the estate’s income tax return do not cause the loss of or reduction of the marital deduction, the PR may charge this portion to income, under §738.201(2)(b). If management expenses are taken as a deduction on the estate tax return, under §2056(b)(9), the marital deduction must be reduced by the amount of these management expenses.
Example 5: Establishing a Principal Reserve for Future Income Expenses
Trust owns rental real estate as its sole asset. The trust agreement provides for mandatory monthly distributions of income for life to beneficiary. The trust collects monthly rent of $20,000. The trustee anticipates receiving a property tax bill, payable in November, for approximately $60,000.
Section 738.701(3) charges the property tax bill to income. Section 738.704(1) authorizes the trustee to transfer amounts from income to principal to provide a reserve for the type of future principal disbursements described in §738.704. Section 738.704(2)(a) includes principal disbursements for an amount chargeable to income but paid from principal because the amount is unusually large. In applying the described provisions of §738.704, the trustee prospectively establishes a reserve by transferring $5,000 a month from income to principal for payment of the November tax bill.
Assume that a mortgage encumbers the rental real estate. The note, secured by the mortgage, requires monthly interest and principal payments. Trustee intends to sell the rental real estate, but waits for the local real estate market to improve. Section 738.702(1)(c) charges the principal portion of each mortgage payment to principal. Remember that the trust holds only the rental real estate and has no cash (other than the described property tax reserve). For these reasons, the trustee utilizes §738.704(4) and pays the entire mortgage payment from income. Section 738.704(4) requires eventual reimbursement to the income beneficiary for all of the payments made from income with respect to the principal portion of each mortgage payment upon the sale of the property. Interestingly, however, the statute does not address whether it is appropriate to charge interest on these advances. Note that a successive income interest cuts off the beneficiary’s right of recovery of the advances against principal if the beneficiary dies prior to the sale of the rental real estate. Specifically, §738.704(4) provides that the reimbursement right lapses when the income interest ends followed by a successive income interest. Further, §738.704(4) prevents these income advances from constituting a lien on the assets of the trust.
As described in example two in part one, as alternatives to §738.704(4), the trustee might consider utilizing the provisions of §738.403 or transferring the property to an LLC. These alternatives should allow the trustee to retain rent for its working capital needs (e.g., payment of real estate taxes, and both the income and principal portions of the mortgage payments). If either of these alternatives is implemented by the trustee, the authors do not believe that the income reimbursement provisions of §738.704(4) would apply. Section 738.704(4) should only apply if §738.403 is not utilized or the property is not contributed to an LLC. However, in all cases, the trustee cannot implement a particular approach if it would be in violation of the duty of impartiality imposed on trustees by §736.0803.
Conclusion
The above examples, as well as the examples in part one, highlight the importance of practitioners having a good working knowledge of the Florida Principal and Income Act. Although some of the results are intuitive, many are not. In order for the practitioner to properly balance the interests of the income and remainder beneficiaries of a trust or estate and to keep themselves from running afoul of these rules, he or she must be aware of the subtle nuances contained in the act.
1 H.B. No. 585, Laws 2002, c. 2002-42; Section 3 establishes an effective date of January 1, 2003. The Florida Uniform Principal and Income Act, found in Fla. Stat. Ch. 738, is a modified version of the Uniform Principal and Income Act (1997).
2 See Jeffrey A. Baskies, The New Homestead Trap: Surviving Spouses Are Trapped by Life Estates They No Longer Want or Can Afford, 81 Fla. B.J. 69, (June 2007) for a detailed discussion of the application of §738.801 to a homestead life estate. A homestead life estate is created under §732.401(1) when there is a surviving spouse if the homestead is not devised as permitted under Fla. Const. art. X, §4(c). In this instance §732.401(1) provides the surviving spouse with a life estate with a vested remainder in the testator’s lineal descendants per stirpes.
3 Straight-line amortization of $1,000 per year for each of five years prior to maturity. An alternative amortization method is known as the effective interest method, which is based on the effective interest rate for the bond. See Roger H. Edwards, Financial Accounting: A Business Perspective 588-589 (9th ed. Freeload Press 2005), for a detailed discussion of the effective interest method.
4 Fla. Stat. §§736.0901 and 518.11.
5 Treas. Reg. §20.2056(b)-4(d)(1)(i) and (ii).
6 Treas. Reg. §20.2056(b)-4(d)(1)(iii).
7 Treas. Reg. §20.2056(b)-4(d)(1)(ii).
8 Treas. Reg. §20.2056(b)-4(d)(2).
9 I.R.C. §2053(a)(2); see also I.R.C. §642(g), which serves to disallow the deduction of administration expenses on the estate’s income tax return if these expenses are deducted in computing the taxable estate for federal estate tax purposes.
10 Treas. Reg. §20.2056(b)-4(d)(1)(ii).
11 Treas. Reg. §20.2056(b)-4(d)(1)(i).
12 Fla. Stat. §§518.10 and 518.11.
13 Fla. Stat. §733.608(1).
14 Treas. Reg. §20.2056(b)-4(d)(3); I.R.C. §67(e) may result in a portion of these management expenses not being income tax deductible in that they may be subject to the two percent floor on miscellaneous itemized deductions. See proposed Treas. Reg. §1.67-4 and Knight v. Commissioner, 101 AFTR 2d 2008-544, 128 S. Ct. 782 (2008).
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.
