Is this for real or a homework question, out of curiousity?
It sounds like the lawsuit is something outside of the trust administration duties of the trustee... The trustee could be personally liable in some cases, and the amounts taken by the trustee would be considered stolen in some cases, so it's hard to say from your question what is going on here. If the trustee did his/her job correctly and had to defend it in court against beneficiaries, then I would look to the specifics of the court case, but I would think a reimbursement of legal fees to the trustee would be nontaxable to the trustee, not deductible by the trust (should be paid by the beneficiaries personally, and not out of trust assets, noting the beneficiaries may take out the trust assets personally and then pay if allowed as a trust provision), and in addition to hourly service rates if the trustee is being paid for the service time on top of it all...
side note - The principle amount, with respect to assets in a trust is almost always different than the income one would claim from selling/distributing a trust's assets.
The trust will subtract administration costs in coming up with income to be distributed and left over principal. The beneficiaries would also pay the tax on income coming out of the trust, but if not distributed, the trust would have to pay the income tax, under most normal trust circumstances.
Here is the answer, as I'll make it simple again to end it:
To the extent the administrator is being paid for reasonable services to the trust, the amounts paid to the administrator are income to the administrator and a deduction for the trust. If the administrator was not entitled to the trust assets and took them, the beneficiaries could charge the administrator with theft.
Edited by BK-CPA on 5/3/2010 at 6:16 PM EST