Difference between Income and Principal | Accounting

In many estates, the executor faces the problem of differentiating between income and princi­pal transactions. For example, a will might state “all income earned on my estate for five years after death is to go to my sister, with the estate then being conveyed to my children.”

The recip­ient of the income is known as an income beneficiary whereas the party who ultimately receives the principal (also known as the corpus) is called a remainder man. As the fiduciary for the estate, the executor must ensure that all parties are treated fairly. Thus, if amounts are distributed incorrectly, the court can hold the executor legally liable.

The definitional difference between principal and income appears to pose little problem. The estate principal encompasses all of the decedent’s assets at death; income is the earnings on these assets after death. However, many transactions are not easily categorized as either principal or income.

As examples, consider these:

i. Are funeral expenses charged to principal or income?

ii. Is the executor’s fee charged to principal or income?

iii. Are dividends that are declared before death but received after death viewed as principal or income?

iv. If stocks are sold for a gain, is this gain viewed as income or an increase in principal?

v. Are repairs to rental property considered a reduction of principal or of income?

Clearly, the distinction between principal and income is not always obvious. For this rea­son, in writing a will, an individual may choose to spell out the procedure by which principal and income are to be calculated. If defined in this manner, the executor merely has to follow these instructions.

In many cases, the decedent will have provided no guidance as to the method by which transactions are to be classified. The executor must apply state laws to determine these two figures. Many states have adopted the Revised Uniform Principal and Income Act as a stan­dard for this purpose.

However, some states have adopted modified versions of the Revised Uniform Principal and Income Act and still others have created their own distinct laws. Gen­erally accepted accounting principles are not applicable; the distinction between principal and income is defined solely by the decedent’s intentions or by state laws.

Although differences exist because of unique state laws or the provisions of a will, the following transactions are normally viewed as adjustments (either increases or decreases) to the principal of the estate:

i. Life insurance proceeds if the estate is named as the beneficiary.

ii. Dividends declared prior to death and any other income earned prior to death.

iii. Liquidating dividends even if declared after death.

iv. Debts incurred prior to death.

v. Gains and losses on the sale of corporate securities or rental property.

vi. Major repairs (improvements) to rental property.

vii. Investment commissions and other costs.

viii. Funeral expenses.

ix. Homestead and family allowances.

The income of the estate includes all revenues and expenses recognized after the date of death.

Within this calculation, the following items are included as reductions to income:

i. Recurring taxes such as real and personal property taxes.

ii. Ordinary repair expenses.

iii. Water and other utility expenses.

iv. Insurance expenses.

v. Other ordinary expenses necessary for the management and preservation of the estate.

Several costs such as the executor’s fee, court costs, and attorneys’ and accountants’ charges must be apportioned between principal and interest in some fair manner.