Articles Posted in Principal and Income Accounting

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In Program Manager Technical Advice 2011-013, the IRS determined that a tax return that was altered by a CPA without the taxpayer’s knowledge was a “nullity” because the amount of the claimed chartible deduction was unknown and unverified by the taxpayer. In the stated facts, a CPA provided his client a copy of his return which was signed by the taxpayer. However, subsequent to the client signing the return, the CPA changed the return by increasing the amount of charitable contributions.


The general test for establishing a valid return was outlined in Beard v. Com., 58 AFTR 2d 86-5290 , where the Sixth Circuit, affirming the Tax Court, held that for a document to constitute a valid return, it must:

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Let’s say Chris dies on January 5, 2011. He has an estate plan with a typical Bypass/QTIP trust arrangement for his second wife, Suzy, remainder to his children from his first wife, along with a pour-over will. The children get the principal of the Bypass and QTIP when Suzy dies. Needless to say Chris’ children and Suzy despise one another. Suzy also dies in 2011, and under her estate plan all her property goes to her children from a prior marriage.

Chris is owed unpaid periodic rent of $100,000 due on January 1, 2011. The $100,000 of rent is paid on January 10, 2011, five days after Chris died. Predictably, litigation ensues. Chris’s children claim the $100,000 should be allocated to “principal,” which means it goes to them as remaindermen. Suzy’s children claim the receipt was “income” due to Suzy, which goes to them under her estate plan. Who wins (assuming both sides have competent lawyers familiar with the P&I statute)?

The answer is found in Probate Code §16346(a). Suzy’s income interest began on Chris’s date of death. Accordingly the rental income, because it accrued before her income interest began, is allocated to principal. Chris’s children, not Suzy’s children, get the cash.

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This is the last thing any attorney who represents executors, trustees and conservators wants to hear. And yet after more than a quarter century of experience scrutinizing fiduciary accounts, our firm has concluded that virtually every high-net-worth fiduciary account filed with the court has fundamental flaws. This has resulted from the complex rules of California’s Principal and Income Act, and in particular the rules for allocating assets and expenses among subtrusts.

Here’s why.

Attorneys and CPAs Speak Different Languages. Even accounts prepared by qualified CPAs familiar with fiduciary tax issues almost never meet the standards of the Principal and Income Act. CPAs know how to apply accounting concepts, not legal rules; attorneys are trained in legal rules, not accounting concepts. So, like two people who speak different languages, the attorneys and CPAs involved in preparing fiduciary accounts predictably misunderstand each other.