Individuals are often called on to serve as trustee for a family member or friend. This seems like it might be an easy job, but in reality it could be a huge liability if it is not done properly.
Typically assets are held in trust with income going to a current beneficiary(s) and the principal managed for a future beneficiary(s). The biggest mistake trustees make is when they account for principal and income. Not allocating principal and income properly can create a liability for the trustee from the beneficiary that was shorted. Nearly everything earned by the principal is trust income – dividends from stocks, interest from bonds, rent from real estate, or earnings from a closely held business. These all may seem obvious. What is not obvious is the distinction of capital gains and losses. A capital gain or loss is the difference between the cost to purchase an asset and the sales proceeds. The resulting gain or loss from the transaction is considered principal.
Other items that stay on the principal side are settlements from a judgment or lawsuit, return of capital, and special or extraordinary dividends. An extraordinary dividend is considered principal because in most situations the corporation has issued a large portion of corporate profits. The payment almost always causes the share price of the stock to drop by at least the amount of the dividend.
Trust documents usually include a provision that allows the trustee to make the final determination of what’s principal and income. This provision doesn’t give you a free pass to do whatever you like. A trustee has a fiduciary responsibility to act in the best interest of current beneficiaries as well as future ones. You may want to seek professional advice from an accountant or attorney who specializes in trusts to make sure your allocations are following the guidelines.