The Default Rule and Its Exceptions
The baseline is straightforward. Money a trust receives from an entity goes to income. That means income beneficiaries benefit from ordinary distributions like dividends or partnership draws. But the statute carves out clear exceptions for receipts that represent a return of capital rather than ongoing earnings.
Except as otherwise provided in this section, a trustee shall allocate to income money received from an entity.
A.R.S. § 14-7410(A)Property other than money, proceeds from selling part or all of a trust's interest in an entity, liquidation distributions, and capital gain dividends from regulated investment companies or real estate investment trusts all go to principal. These exceptions protect the trust's capital base so it continues to produce income over time.
Understanding Partial Liquidation
One of the trickier areas involves partial liquidation. The statute provides two tests. First, if the entity itself labels a distribution as a partial liquidation, the trustee can rely on that. Second, if the total distribution exceeds twenty percent of the entity's gross assets based on recent financial statements, it qualifies as a partial liquidation by default.
Money is received in partial liquidation to the extent that the entity, at or near the time of a distribution, indicates that it is a distribution in partial liquidation.
A.R.S. § 14-7410(C)(1)Trustees can also rely on statements from an entity's board of directors or equivalent governing body about the source or character of a distribution. This practical safe harbor gives trustees a reasonable basis for classification without requiring independent investigation into the entity's finances. For trusts holding interests in closely held businesses or investment entities, getting this classification right is essential. An incorrect allocation can shift value between income beneficiaries and remainder beneficiaries in ways the trust creator never intended. Working with experienced estate planning counsel helps ensure these allocations are handled properly.
