If you are thinking of putting your assets into a trust, you probably wonder whether a simple or complex trust is right for you. Learn about the differences between each to make an educated decision.
Simple trusts are trusts that don't distribute to charity and don't distribute the principal. They must distribute any earned income from trust assets annually to their beneficiaries. Anything that isn't a simple trust is a complex trust. Simple trusts have larger tax exemptions.
Look at the differences between simple and complex trusts in more detail, as well as tips for deciding which type of trust to create.
Simple vs. Complex Trusts
Both simple and complex trusts are types of non-grantor trusts. This means that after the grantor creates the trust, they don't have rights to the trust nor any control over it. As a refresher, a trust is a legal entity commonly used to manage assets or as part of estate planning. The grantor creates the trust, putting assets in it. Then, a trustee (or more than one trustee) manages the trust. The trustee is responsible for distributing the assets of the trust.
There are various types of trusts, including:
- Asset protection
- Special needs
Whether a trust is simple or complex is crucial for tax status. Every trust will fit into one of these two categories. Read on to learn the differences.
Why Do People Create Trusts?
Before getting into the differences between simple and complex trusts, you may want a better idea of why people create trusts in the first place. Maybe you are still debating whether to create one or just want confirmation that you are making the right decision.
Trusts are most commonly used as part of estate planning. A trust can let you:
- Protect your assets from creditors
- Manage your estate tax and gift tax liabilities
- Receive your life insurance policy proceeds
- Keep certain assets out of the probate process (which is time-consuming and expensive)
- Give specific assets to the beneficiaries you choose
- Provide care for a special needs beneficiary
Keep in mind that some of these benefits only apply to non-grantor trusts, a distinction we'll cover in more detail later.
What Is a Simple Trust?
Because the difference between a simple and complex trust affects your taxes, the IRS defines what is considered a simple trust. There are three main criteria that a simple trust must meet:
- Not distribute any of the principal
- Distribute income earned on any of the trust assets annually
- Not distribute to charities
What Is a Complex Trust?
A complex trust must do one of the following three things:
- Distribute at least some (possibly all) of the principal assets to the beneficiaries
- Not distribute all the income to the beneficiaries annually
- Distribute to charities
You will notice that these directly contradict the three requirements for a simple trust. As such, meeting any of the requirements for a complex trust automatically disqualifies it from being a simple trust. The opposite is also true, and if something is a simple trust, it can't qualify as a complex trust.
Importantly, complex trusts have a few other roles in addition to these. Most importantly, the trustee can't distribute any of the principal unless they have already distributed all the trust's income for the year. Any distributions made must be equitable, with all beneficiaries receiving an equitable amount.
Additionally, ordinary income has to be distributed before dividends. And dividends must be distributed before capital gains. So, the order of distribution must be ordinary income, dividends, capital gains, and finally, the principal.
What Is the Tax Effect of Simple Trust vs. Complex Trust?
As mentioned, the most important difference between simple and complex trusts is how they affect your taxes.
Taxes for Simple Trusts
With a simple trust, the income from the trust is taxable for the beneficiaries, whether or not they withdraw income from it. Simple trusts have to report their income to the IRS. From there, the IRS can take deductions on any distributions to beneficiaries.
The trust also has to pay a capital gains tax on its earnings. There is a $300 exemption.
Taxes for Complex Trusts
As with simple trusts, complex trusts have to file tax returns. A complex trust can take advantage of deductions during its taxable income calculations. The deduction will be the same as the amount of income the trust had to distribute that year. Complex trusts have an exemption of $100.
Other Notes on Taxes for Trusts
No matter which of these two types of trusts you are the trustee, the trust needs to file an income tax. This will require filing for an EIN (employer identification number) and filing Form 1041. That is the U.S. Income Tax Return for Estates and Trusts. Trustees must file this form for the trust every year that the gross income or taxable income is at least $600.
If the trust makes any distributions during the tax year, the trustee also has to file a Schedule K-1. This lets the IRS confirm how much tax the beneficiaries owe on their distributions. Beneficiaries pay taxes on trust income that is distributed to them. By contrast, the trust pays taxes on trust income that stays in the trust.
Can a Trust Change From Simple to Complex?
Yes! If you start with a simple trust and realize a complex trust fits your needs better, you can make the change. You can also change a complex trust to a simple trust.
To change either, just adjust the distribution and other requirements. This will automatically make you change how the trust is considered on the taxes. This means that trusts commonly vary between simple and complex year-to-year.
Because a simple trust can become a complex one and vice versa, it is crucial to always work with a tax accountant familiar with trusts. They will be able to confirm what type of trust you have in that tax year and file the appropriate documents.
Trustees may also want to work with accountants throughout the year if they hope to file taxes as a simple trust or a complex trust. The accountant can help ensure that you meet the requirements of your preferred type of trust.
Which Is Better, a Simple or a Complex Trust?
There is no direct answer to which of these two types of trusts is better. The answer will depend entirely on your situation, including your financial goals. You will likely want to talk to an estate planner or similar financial professional to figure out which one makes more sense for you.
The biggest advantage of simple trusts is their simplicity. This applies to both distributions and taxes. The biggest advantage of a complex trust is its flexibility, especially if you have a lot of beneficiaries or a large estate.
Other Considerations When Setting Up a Trust
Now that we have covered the differences between a simple and complex trust, it's important to think about other considerations as you set up a trust. The following are some important decisions you will have to make.
Revocable vs. Irrevocable
Whether a trust is revocable or irrevocable refers to whether it can be changed. With a revocable trust, the grantor can change it while they are still alive. This lets them change the beneficiaries of the trust or add assets to it. By contrast, an irrevocable trust cannot be changed. Once the grantor chooses beneficiaries and adds assets to it, that is final. No more assets can be added, nor can beneficiaries be added or removed.
Grantor vs Non-grantor
Whether a trust is a grantor or a non-grantor depends on how much power the grantor has over it. Grantor trusts let the creator or grantor of the trust keep some powers. These include having rights to the income and assets of the trust. With a grantor trust, the assets of the trust might be part of the grantor's estate.
By contrast, non-grantor trusts do not let grantors have any control or interest in the trust. In most cases, a non-grantor trust will exclude the assets from the grantor's estate.
Simple and complex trusts are both types of non-grantor trusts. This is the reason both simple and complex trusts have to file income taxes. By contrast, grantor trusts don't typically have to file separate tax returns, as the income and assets are usually part of the grantor's tax return.
In addition to the tax differences, it is important to note that grantor trusts don't provide protection from creditors or avoid probate.
Simple and complex trusts are different types of non-grantor trusts, and they are incredibly common in estate planning. With a simple trust, the trust distributes all the income but none of the principal and doesn't distribute to any charities. Complex trusts do the opposite of at least one of these (not distributing all the income, distributing some of the principal, or distributing to charities). Each has its advantages, and the status of a trust can change from year-to-year.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.