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What's the Difference Between Income and Principal for a California Trust Beneficiary?

A Trust, to be validly created, must have assets. In other words, a Trust cannot exist, legally speaking, without some property being held by the Trustee. Trusts are not like corporations, they do not exist absent Trust property.

And all Trust property fits into one of two categories: principal or income. That’s the only two choices you have. It’s important under Trust law to pay attention to principal and income. It’s also important to know and identify what property is principal and what property is income. Why? There are several reasons. Let’s discuss a few.

Income Beneficiaries and Principal Beneficiaries

Many times, the people who will receive the income of the Trust are different from the people who will receive the principal of the Trust. For example, a Trust may require that all income be distributed to a surviving spouse, but none of the principal. Instead, the principal is held and accumulated for the children, to be paid after the surviving spouse dies.

This might be the case where the Trust has income-producing property, like an apartment building. All of the rents received from the apartment building is considered income and can be distributed to the surviving spouse during his or her lifetime. But the apartment building itself must remain in Trust and cannot be distributed to the surviving spouse.

If the Trustee does not differentiate between the income and the principal, then it would be impossible to know what the surviving spouse should receive during her lifetime, and what she should NOT receive.

The same could apply to a dividend paying stock. The shares of stock would be principal and could not be distributed to the surviving spouse. Any dividends received from the stock, however, would be income and could be distributed to the surviving spouse.

As you can see, income versus principal identification matters in Trust administration because it has a significant impact on deciding who gets what.

Income and Principal Distribution Standards

Further, there are times when a beneficiary can receive both income and principal, but the distribution standard is different. For example, a beneficiary may be entitled to receive all income from the Trust but can only receive principal if required for the beneficiary’s support, health, education, or maintenance. In other words, the Trust document may provide a liberal distribution standard for income, and a more restrictive distribution standard for principal.

This is often the case when a Trust is created for a surviving spouse. The spouse will be entitled to income, but principal distributions will be more tightly controlled. The same scenario applies to children’s Trusts, where a child can receive income, but has a limited right to receive principal.

The difference in distribution standards is meant to allow the income to continue for an extended period by retaining the principal property that generates the income. If the principal were distribution to a Trust beneficiary, then the Trust would not be able to generate income.

For example, in the case of a dividend paying stock, once the stock is given to a beneficiary, the Trust will no longer receive dividend income from the stock. The income stops. The only way to ensure regular income payments to the Trust (which are then used to distribute to beneficiaries) is to retain principal.

Of course, principal can still be distributed on a limited basis where the need arises, but the stated purposes for principal distribution must be met; such as distributions for healthcare or education.

If the Trustee did not keep track of the difference between income and principal of the Trust property, then there’d be no way of knowing what to distribute to the Trust beneficiaries.

How Do You Know the Difference?

The California Probate Code provides a set of rules for determining the difference between Trust principal and income. Specifically, Probate Code sections 16320 to 16375. Most of the time, the difference between principal and income is obvious. An apartment building is principal. The rents from the apartment building is income. A stock is principal, the dividends from the stock is income.

Sometimes, however, the difference is less clear. For example, if you sell a stock and receive a gain on the price of the stock, that gain amount is principal, not income. When in doubt the best course is to open the Probate Code and review the allocation rules. Most of the time, the Probate Code will provide the answer to determining what is income and what is principal.

That’s our basic overview of principal versus income for your Trust. You must ensure you know what your rights to distribution are as a beneficiary. You should know whether you are entitled to income versus principal. And what distribution standard applies to each.