Simple trust vs. complex trust

Simple and complex trusts differ in how their assets are distributed. Simple trusts are more restrictive about what can and can't be distributed whereas complex trusts are more flexible.

Understanding trusts

A trust is a legal entity created under state law for the management and distribution of assets to beneficiaries. The trust grantor creates the trust and places assets into it.

A trustee, chosen by the grantor, is responsible for managing the trust and eventually distributing its assets to the beneficiaries chosen by the grantor when the trust is set up.

A beneficiary can be anyone the grantor chooses, but is often an heir, family member, or charity.

Trusts can be used to minimize taxes, simplify or eliminate the probate process, and protect assets.

There are lots of different types of trusts (revocable, irrevocable, testamentary, asset protection, charitable, special needs, spendthrift, and so on), but when it comes to tax status, a trust is either a simple trust or a complex trust.

Definition of a simple trust

There are three basic characteristics that define a simple trust:

• The trust must annually distribute to the beneficiaries any income it earns on trust assets.
• The trust cannot distribute the principal of the trust.
• The trust cannot make distributions to charitable organizations.

When this type of trust is used, the trust income is taxable income for the beneficiaries, even if they don't withdraw the income from the trust. Capital gains taxes are applied to the trust itself.

Definition of a complex trust

A complex trust is essentially the opposite of a simple trust. To be classified as a complex trust, it must do at least one of three activities within the year:

• The trust must retain some of its income and not distribute all of it to beneficiaries.
• The trust must distribute some or all of the principal to the beneficiaries.
• The trust must distribute some funds to charitable organizations.

Taxation of trusts

Trusts are treated as separate taxable entities, so they must file tax returns and pay income tax on their income. Trusts can deduct their expenses and are permitted a small tax exemption:

• A simple trust can take a $300 exemption.
• A complex trust can take a $100 exemption.

Choosing a trust taxation type

When setting up your trust, don't automatically assume you want a simple trust because it sounds easier. A complex trust actually gives you more flexibility and may be a better option, depending on your goals. It's also possible to convert a simple trust to a complex trust and vice versa, if you find your needs change.