What is a Complex Trust?

Estate, financial, and legacy planning can be extremely complex processes, but once they are complete they can bring unmatched peace of mind knowing you have established a financial game plan to take care of your heirs. 

Setting up a trust ensures the heirs of your choosing receive their designated assets unchallenged and according to your desires. Trusts can also be beneficial if you become incapacitated in the final stages of your life and can no longer make important financial decisions, and they also can help minimize the impact of state and federal taxes on large estates. 

There are many different kinds of trusts, such as living, revocable, irrevocable, and charitable, to name a few. Regardless of the type of trust, however, they fall under two umbrella entities: simple and complex. 

In this article we’ll take a look at complex trusts and discuss how they differ from simple trusts. 

What is a Simple Trust?  

The Internal Revenue Service defines simple trusts as entities that distribute all income earned during the year to the trust beneficiaries. Simple trusts cannot make distributions to charitable organizations, nor can they distribute any part of the trust’s principal. Since all income earned from the trust’s assets must be distributed, simple trusts don’t allow the trust’s wealth to grow over time. 

Simple trusts must report any earned income annually to the IRS, although any income distributed to trust beneficiaries is tax deductible and can be used to lower the taxable income of the trust. Although the trust must pay capital gains taxes on any earnings, simple trusts also qualify for a $300 annual tax exemption from the IRS. 

If any of these conditions are not met, the trust is not considered a simple trust in the eyes of the IRS. Instead, it is defined as a complex trust. 

What Is a Complex Trust? 

Complex trusts – which describes most trust entities – are pretty much the exact opposite of simple trusts. 

A complex trust must meet any one of the following three conditions in any given year: 

• Distribute principal to trust beneficiaries 

• Keep some or all of the income generated from trust assets 
• Make distributions to charitable organizations or causes 

Any trust that does one of these three things is considered a complex trust. 

Complex trusts are often the preferred trust entity for estate planning because they offer much more flexibility over the way trust distributions are handled. Since trust income doesn’t have to be 100-percent distributed each year, complex trusts can be used to accumulate wealth. Complex trusts also only qualify for a $100 tax exemption.  

Putting it all Together 

A trust is deemed complex or simple depending on how it’s structured, how assets under trust are distributed, and qualified tax exemptions. 

With a simple trust, distributions are made to beneficiaries, and the trustee files a Schedule K-1 to go with the trust’s annual Form 1041. Income tax on distributions is paid by the beneficiary. However, with a complex trust, income can be retained within the trust, and any income taxes due are paid by the trust itself. The distinction is important, since trust distributions are generally taxed at a higher rate than most individuals' tax rates. The 2023 federal tax rate for trust distributions exceeding $14,451 is $3,491, and 37 percent for any amount above that $14,451 threshold. 

A simple trust can become a complex trust within the same year, and vice-versa. It all depends on the way distributions are handled and if the trust distributes income to charitable organizations. Consult with a certified estate planner or legal professional to learn more about which type of trust entity best meets your financial and estate planning objectives.