Navigating Accounting Rules of New York’s Surrogate Courts

The Uniform Principal and Income Act (UPIA) was drafted in 1997 to provide trustees across the country with consistent standards for allocating trust funds. New York State (NYS), one of 39 states that adhere to the UPIA, adopted the standards in 2002. Nearly 20 years later, there is still confusion among CPAs and attorneys over these accounting rules and their role in the Surrogate Courts.

Purpose of Uniform Accounting Rules

The UPIA is unique to trust and estate accounting and was designed to ensure that the intention of the grantor or decedent is carried out, namely by governing the proper classification and distribution of assets. It applies to all trusts and estate proceedings in NYS, unless there are specific provisions in the trust document or last will and testament that state otherwise.

The need for these procedures stems from the conflict created by the two classes of beneficiaries: income beneficiary and residuary (principal) beneficiary. If a receipt is classified as income, the income beneficiaries will benefit, whereas if a receipt is allocated to principal, the residuary beneficiaries will benefit. Usually it is a straightforward application, but there are nuances that can lead to litigation.

Basics of UPIA

To understand these classifications, one must start with the definitions of income and principal under NYS’s Estates Powers and Trusts Law (EPTL):

  • Income is “money or property that a fiduciary receives as a current return from a principal asset.”
  • Principal includes initial funding of the trust; funds received from the sale, exchange, or liquidation of a principal asset; and anything that is not income.

This distinction is the answer to “who gets what” when trusts are distributed. It appears straightforward until one considers the different situations that occur throughout the life of the trust that could shift economic benefit from one category to the other. For example, not all moneys received from a rental property are income. A security deposit is initially added to principal until the time it is either returned to the tenant or added to income.

Knowing which disbursements can be made from which category is equally important to ensuring beneficiaries receive their fair share of assets.

Income disbursements include:

  • Expenses related to administration, management and preservation of trust property
  • Repairs
  • Income and real estate taxes
  • Insurance premiums made for asset preservation
  • 1/3 of investment fees
  • 1/3 of annual commissions

Principal disbursements include:

  • Debt payments
  • Expenses for accountings and judicial proceedings
  • Life insurance premiums
  • Estate, inheritance and other transfer taxes
  • 2/3 of investment fees
  • 2/3 of annual commissions
  • 1% principal commissions

The UPIA makes these parameters clear, but there is still room for ambiguity. For example, Bill’s last will and testament creates a trust that provides annual income for his wife Jane. At the end of the trust term, the principal goes to Bill’s children, John and Sue, in equal shares. The children challenge that major improvements made to a building held by the trust should have been allocated to income as “repairs” – to Jane’s detriment. Since there is little Surrogate Court case law on this matter, unless it is completely obvious (e.g. new addition to the home), this can be unclear and subjective.

Trustee Commissions

Trustees have a vested interest in accurate accounting, as it impacts their annual commissions. If commissions are not taken annually, and income is completely distributed to the beneficiary, there may not be sufficient income to cover onethird (1/3) of commissions, and the trustee would forfeit that portion.

Misunderstood Areas of the UPIA

UPIA accounting differs vastly from Generally Accepted Accounting Principles (GAAP) and other more commonly used accounting methods. Among the most frequently asked questions are:

When does a right to income begin and end?

With inter-vivos trusts (created during the lifetime of the grantor), the right begins on the date assets are transferred to the trust. For testamentary trusts, the right begins on the date of the estate holder’s death.

How are receipts from entities treated?

Distributions from corporations, partnerships, LLCs, regulated investment companies, real estate investment trusts or any other organization are generally allocated to income. One does not typically review an entity for components of income. The actual distributions received are considered income. This conflicts with tax law and is a very important distinction. For example, K-1s, which report income components into tax buckets, are irrelevant under UPIA.

The UPIA does provide special rules if the entity is being partially or totally liquidated, in which case distributions could be allocated to principal. Specifically, if the series of distributions is greater than twenty percent (20%) of the entity’s gross assets, the assumption is that those distributions are principal. If the distribution does not exceed the income tax obligation on the beneficiary’s taxable income, it could be considered income.

How are deferred compensation and annuities allocated?

Pension payments and IRA distributions, which are typically not classified as interest or dividends, should be allocated as follows:

  • If payment is required to be made (e.g. required minimum distribution (RMDs), 10% to income and ninety percent 90% to principal.
  • If payment is not required, the entire amount is principal.

What happens with assets that diminish in value?

For some assets, such as patents, copyrights and royalties, value diminishes over time, rendering receipts useless. The UPIA stipulates that distributions from these assets are allocated 10% to income and ninety percent 90% to principal.

How is depreciation handled?

Unlike GAAP, which defines depreciation as a reduction in value due to wear, tear or decay, depreciation under the UPIA must be an actual reduction in value, not a fixed amount. If a property held by a trust can be used by a beneficiary resident or is tangible personal property held and used by a beneficiary, depreciation cannot be taken.

How are income taxes allocated?

Income taxes are typically allocated to income, with the exception of tax on gains and tax on receipts from entities, which are principal.

Accounting Format

For trusts, principal and income are kept in separate buckets throughout the years and carried forward. The accountings also include details of new investments made in principal, a cash reconciliation and narratives of any pertinent facts from the trustee. On the other hand, estate accounting does not separate principal and income.

Exceptions to UPIA

UPIA is not applicable if the trust has elected, or the court has mandated, the application of Unitrust provisions, which provide a flat rate of 4% of the fair market value of all assets to be classified as income. This can be an election of the trust or can be part of the trust document. It can also be mandated by the court.

Prudent investor rules in Section 11-2.3 of the EPTL give trustees the “power to adjust” between principal and income to create fairness between beneficiaries. Just as it sounds, this is subjective, subject to interpretation, and of course can lead to litigation.

The Immeasurable Value of Annual Accountings

Given the many intricacies of the UPIA, trust accountings signed by the beneficiaries each year are crucial. Waiting to prepare accountings when the trust ends – usually years or decades after the transactions and allocations – is time-consuming, costly and inferior in accuracy to “real time” accountings. Annual accountings also give beneficiaries a shorter window to contest transactions under the statute of limitations, if proper legal procedures are followed.

Even the most well-intentioned trustee who does not follow UPIA to a tee can risk litigation when a beneficiary is looking for ways to discredit and call the validity of the trust into question. Proactive and accurate accounting is key to protecting the trustee and ensuring the grantor’s wishes are fulfilled.

This article was published with the Westchester County Bar Association’s July 2021 Issue

Lisa Rispoli Lisa Rispoli is the Partner-in-Charge of Trust & Estate Services at Grassi and leader of the firm’s Private Client Services group. She has over 30 years of experience in accounting, estate planning & valuation, as well as gift, estate and trust taxation. Lisa is adept at working with clients and their professional advisors to develop estate plans to transfer family, business and personal wealth... Read full bio