To understand a complex trust, one must first understand what a grantor trust and a simple trust are, both of which are defined under the Internal Revenue Code.
What is Considered a Complex Trust
A complex trust is mostly a creature of taxation. It is a trust that is not a grantor trust or a simple trust. These classifications of grantor trust and non-grantor trusts (simple trust and complex trust) are important because it generally determines who pays for the income arising from the trust. Who pays for the income tax is important because trusts have different tax brackets and pay higher taxes than individuals. For this reason, it is important to take into consideration the differences between simple trust and complex trust when distributing income in order to save on taxes.
What is a Grantor Trust
A grantor trust is a trust that retains any power listed in 26 U.S.C. § 673 to 677 (i.e., reversionary interests, power to control beneficial enjoyment, administrative powers, power to revoke, and income for the benefit of grantor). Any power or interest held by the grantor’s spouse is considered the power or interest of the grantor (26 U.S.C. § 672), and for this reason, the Spousal Lifetime Access Trusts (SLATs) are considered grantor trusts as well.
Grantor trusts do not need to file separate income tax returns, as opposed to simple or complex trusts. Because assets in the trust are still considered the grantor’s property, the grantor reports the income from the trust assets using his own social security number. For single individuals, the tax is 37% for taxable income of $523,601 or more, as opposed to a trust that has a tax rate of 37% for taxable income in excess of $13,050.
The main drawback of grantor trusts is that the assets in grantor trusts do not avoid probate nor do they enjoy creditor protection. However, an intentionally defective grantor trust, such as a SLAT, if crafted and written well, may enjoy creditor protection and allows the grantor to still pay for the income tax, enjoying the lower rate, and avoid probate at the same time.
Simple Trusts as opposed to Complex Trusts
Non-grantor trusts can be classified as simple trusts and complex trusts. A trust may be a simple trust for one year and a complex trust for another year. 26 CFR § 1.651(a)-1. In Form 1041, the trustee can check whether the trust is a simple or complex trust for that particular taxable year.
Simple and complex trusts require the trustee to apply for an employer identification number (EIN) in order to file Form 1041, the US Income Tax Return for Estates and Trusts. A trustee must file Form 1041 if the trust has any taxable income or gross income of $600 or more.
If a trustee makes distributions to the beneficiaries, the trustee must file Schedule K-1 together with Form 1041. Schedule K-1 is the IRS form that reflects the beneficiary’s share of the trust’s income, deductions, and credits. When distributions have been made to beneficiaries, the beneficiary pays for the income tax. When income is retained by the trust, the trust pays for the income tax. This is important because the beneficiary and trust have different tax brackets as mentioned above. The trust has a higher tax rate than an individual. Thus, the beneficiary will use Schedule K-1 to report his share of the trust income in the beneficiary’s Form 1040 (US Individual Income Tax Return) or 1040-SR (US Tax Return for Seniors).
Under 26 CFR § 1.651(a)-1, a simple trust must pass all three criteria in a taxable year in order to be considered as a simple trust: (a) it must distribute all income to the beneficiaries; (b) it cannot distribute principal; and (c) it cannot make distributions to charity. On the other hand, a complex trust is a trust that does any one of the above criteria in a taxable year: it accumulates income or it distributes principal or it makes charitable distributions.
In spite of the benefits one can get from a simple trust, such as the transfer of income tax to the beneficiaries, some prefer a complex trust due to its flexibility. It also depends on one’s purpose and motive in establishing a trust and whether such motive or purpose outweighs the benefits of income tax savings, such as asset and creditor protection or avoidance of probate.
Examples of complex trusts are the nonexempt charitable trust under 26 U.S.C. § 4947(a)(1), the split-interest trust under 26 U.S.C. § 4947(a)(2), and several categories of charitable remainder trusts under 26 U.S.C. § 664.
Estate Planning with Complex Trusts
When planning one’s estate, it’s important to consider first the purpose and motive in establishing a trust, whether it is to leave money for the beneficiary’s special needs, asset and creditor protection, avoidance of probate, or minimization of taxes. It’s also imperative to identify the types of properties involved and the income generated from the properties to determine the best type of trust for that particular property or properties.
You don’t have to limit yourself to one type of estate planning strategy. There could be several types of estate planning documents that can be used, depending on the property involved. These types of documents can range from trusts to tenancy by the entirety.
Should you need assistance in planning your estate, we, at the Law Offices of Albert Goodwin, are here for you. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.