An essential part of trust administration is filing annual trust or fiduciary income tax returns if required. A federal return is filed using Form 1041. Most states also have trust income tax returns, like Minnesota’s Form M2.
The federal Form 1041 requires the trustee to select the type of trust entity for which the trustee is filing the return. Two of the most common entities are the simple trust and the complex trust. Determining which entity is correct requires a careful reading of the trust agreement. Each entity has several advantages and disadvantages.
Determining the Appropriate Entity
The key factors in whether a trust is simple or complex is determining the trust’s beneficiaries and what can be distributed from the trust to those beneficiaries. A trust generally qualifies as a simple if it:
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- Requires all its income to be distributed currently;
- Does not provide for any amounts to be paid, permanently set aside, or used for charitable purposes; and
- Does not distribute any amounts from the trust’s principal.
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Complex trusts can be viewed as the default entity for when the trust is not eligible for simple trust status. Generally, a trust is complex if at least one of the following occurs:
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- There is no requirement to distribute all the trust income to the beneficiaries.
- The beneficiaries received principal distributions during the tax year.
- Distributions were made to charitable organizations.
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The Fluid Nature of Entity Selection
Whether a trust is simple or complex is not necessarily permanent. Based on the language in the trust agreement, the trust may be simple one year and complex the next. Therefore, the entity selection should be evaluated every time a trust income tax return is filed.
A common example of the fluid nature between simple and complex is a trust that both:
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- Requires all its income be distributed currently.
- Gives the trustee discretion to distribute the trust’s principal.
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Under these circumstances, the analysis of whether a trust is simple or complex hinges in part on whether the trustee actually distributed principal to the beneficiaries during the tax year. In a year in which no principal was distributed, the trust will likely qualify as a simple trust if the other criteria are met. However, for years in which principal is distributed, the trust is complex.
Another common example is a trust that terminated during the year. A trust is required to distribute its principal to terminate. Even if the trust was simple during all previous years, the requirement to distribute principle means it cannot meet the simple trust rules in its final year and must be complex for the final tax return.
Advantages and Disadvantages
There are many advantages and disadvantages to simple and complex trusts. Which trust works best will depend upon the grantor’s goals in creating the trust.
Exemption Amount
Similar to the standard deduction for personal income tax returns, a trust has an exemption that lowers taxable income on a trust income tax return. Simple trusts have a $300 exemption. Complex trusts generally have a $100 exemption.
Deductions
Both complex and simple trusts can deduct the trust income distributed to the trust’s beneficiaries, which lowers the trust’s taxable income. Simple trusts can usually maximize this deduction, as they are required to distribute all trust income whether or not the distribution in fact occurred. Complex trusts may not require the same distribution and therefore may be limited to the amount actually distributed, potentially lowering the deduction.
Distribution Requirements
While a simple trust requiring all income to be distributed may be beneficial to lowering a trust’s taxable income, it may not be the best result depending on the grantor’s goals and the beneficiaries’ needs. A requirement to distribute all income may frustrate the trust’s purpose if:
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- A beneficiary is receiving income-based assistance like Medicaid or Social Security Supplemental Income.
- A beneficiary has substance abuse, spendthrift, or creditor issues.
- A beneficiary is too young to manage the income received.
- The grantor’s goal is to preserve wealth within the trust.
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A complex trust usually allows greater control over distributions. The trust can potentially direct the trustee to:
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- Only make income distributions when certain criteria are met.
- Stop distributions when an event occurs. For example, a beneficiary having a creditor issue.
- Have complete discretion to make any distributions as the trustee sees fit.
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While the complex trust may not always maximize the income distribution deduction or have the larger exemption, the ability to control certain distributions may outweigh those benefits.
Getting Professional Help
Whether you are interested in creating a trust or need help with an existing trust, a professional’s guidance can help:
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- Design a trust that balances your goals.
- Determine the appropriate trust status.
- Make sure returns are properly filed.
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Boulay advisors can assist you and your family with these difficult tasks and find the best solutions for you. Learn more by contacting a Boulay advisor at 952-893-9320 or learnmore@boulaygroup.com and asking about our estate and trust services.
Legal services provided by Andrew Kremer Law.